Captive Consulting - Health Care

Alternative Risk
Transfer Solutions
Rising medical malpractice costs are inflicting real pain on
patients, doctors, hospitals, nursing homes, and insurers.
Insurers are paying out significantly more in claims than they
collect in premiums, and many have scaled back their
exposure to the medical malpractice market and, in some
cases, exited the market completely. Insurers that remain have
imposed significant rate increases in order to cover their costs.
According to the American Medical Association (AMA), the medical liability
situation has reached a crisis point in at least 20 states and is looming in many
others. Trauma Centers and specialist practices, such as obstetrics and gynecology,
are increasingly under threat. Also under pressure are the nation’s hospitals, nursing
homes, and other health care facilities. These facilities are being forced to close or
to reduce the range of services they can offer to the communities they serve.
Medical Malpractice
Insurance Crisis
JOHN J. O’BRIEN, JD, CLU, CPCU
Vice President and Director, Client Services
Wilmington Trust SP Services (South Carolina), Inc.
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Medical Malpractice Insurance Crisis
Medical malpractice insurance coverage problems
are regional or state specific, so the severity of the
situation differs from state to state. Various state
legislative attempts at malpractice reform have been
implemented, including peer review, state
catastrophic funds, caps on damages (particularly
non-economic damage caps), prohibitions on venue
shopping, mandatory arbitration, and outright
insurance premium rate control (i.e., California’s
Proposition 103).
While these attempts have experienced some
success, the medical malpractice crisis continues to
grow. Accordingly, the medical community can
continue to wait for further state and federal
legislative mandates, or this community can seek a
proactive approach to dealing with this problem—
the alternative risk transfer solution.
The Alternative Solution
Today’s medical malpractice insurance market is a
mix of traditional insurers, provider-owned groups
(physicians and hospitals), and alternative risk
transfer entities. The primary alternative market
structures available to health care providers are risk
retention groups, captive insurance companies,
reciprocals, and purchasing groups. The majority of
medical malpractice alternative vehicles are formed
as risk retention groups or captives. While captives
and risk retention groups are formed for the same
purpose, there are important distinctions and
benefits associated with each of these vehicles.
Control is the primary reason for implementing an
alternative risk transfer (ART) solution: control over
underwriting guidelines and procedures, control of
rates, control of coverage, and control of claims.
Certain physicians may find that coverage is not
available in the commercial market because of the
nature of their practice, claims history, or gaps in
their coverage. ART solutions are better positioned
and provide the flexibility needed to administer such
individual differences. In addition, seekers of an
alternative solution may be motivated to find a risk
transfer vehicle that will not lump their exposure
with poor underwriting risks. Statistics support the
theory that a few physicians are responsible for a
majority of the medical malpractice claims.
Accordingly, ART options, including the formation
of onshore/offshore captives and risk retention
groups, are becoming increasingly popular in the
health care community.
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The charts below indicate that health care captives will grow significantly in
coming years. Of the 12 new Risk retention Groups (RRGs) added to the Risk
Retention Reporter in the first quarter of 2006, ten are in health care.
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RRGs are primarily used by small to medium size
hospitals or medical centers, small to medium size
assisted living or nursing home organizations, as well
as physicians’ groups.
RRGs have a distinct advantage over all other
available alternative risk financing vehicles. They are
the only entities authorized to actively market and
sell insurance in all 50 states without being subject to
the extremely cumbersome and costly state-by-state
regulatory environment imposed on all other forms
of insurance carriers, provided they have properly
registered in the states where they operate, they are
in good standing in their state of domicile, and they
abide by the owner/insured requirements under the
LRRA. In most cases the only other means by which
groups of individuals and small organizations could
operate a multi-state alternative risk program would
be to partner with a fronting carrier. A front is a
multi-state admitted commercial carrier that allows
other entities to utilize its paper, and sometimes
underwriting and claims services, for a fee.
Unfortunately, the recent hard market and medical
malpractice crises have resulted in many fronting
carriers discontinuing their operations, and the ones
that have remained have increased their fees and
collateral requirements significantly. Without the
ability to utilize the RRG structure, most groups of
individuals and small organizations that have
gathered to form alternative risk financing vehicles
in recent years would not have been able to afford
to do so.
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Medical Malpractice Insurance Crisis
Types of Alternative
Risk Transfer Vehicles
Risk Retention Groups (RRGs)
Federal law actually created the concept of Risk
Retention Groups. The initial purpose of these
groups was to mitigate the impacts of a different
crisis - the availability of product liability insurance.
The original federal act was known as the Product
Liability Risk Retention Act of 1981 (PLRRA).
Subsequently in 1986, the Liability Risk Retention
Act (LRRA) was adopted to allow risk retention
groups and purchasing groups for all types of liability
insurance, including medical malpractice.
Risk retention groups do not have to be licensed in
every state like a traditional insurance company. A
risk retention group is licensed and created under
state law but, pursuant to federal law, is authorized to
sell insurance in all states.
The members of the risk retention group own the
insurance company and are insured by the insurance
company. Owners must be insureds and insureds
must be owners. This form of ownership is required
by law, and it enables members to have control over
rates, coverage, loss control, defense costs, risk
management, and underwriting. Furthermore, the
group has control over the selection of managers,
auditors, actuaries, attorneys, and other service
providers necessary in operating the RRG.
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Captive Insurance Companies (Captives)
A captive insurance company is an insurance
company that insures the risks of its owners and is
licensed in a domicile that permits licensing of
such groups. This includes onshore domiciles like
Nevada, Vermont, South Carolina, and Delaware, as
well as offshore domiciles like the Caymans and
Bermuda. Unlike risk retention groups, a captive is
only authorized to write insurance in the domicile
where it is licensed and, as such, is subject to
regulation in each jurisdiction where it conducts
business.
Traditionally, offshore domiciles have been selected
by medical malpractice groups because of lower
minimum capitalization requirements and less
conservative premium-to-surplus ratio require-
ments. The Cayman Islands, in particular, have
gained a reputation for understanding the health
care profession’s insurance needs and providing a
high level of expertise in the regulation of medical
malpractice captives. Because of this receptivity
towards medical malpractice captives, the Caymans
seem to be the location of choice for those seeking
to establish an offshore facility.
More recently, captive formation in onshore
locations has gained significant momentum. This is
in part due to the increase in the number of U.S.
domiciles allowing the formation of captives, an
improvement in the captive laws and regulations in
U.S. domiciles, the renewed tax haven perception of
offshore domiciles due to the recent Enron debacle,
With these vehicles,
medical professionals
have direct involvement in
risk and loss control and
do not have to subsidize
the overhead and profits
of a commercial carrier of
malpractice insurance.
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and changes to tax laws that have eliminated many
of the tax benefits of offshore jurisdictions. Vermont
has become the onshore health care leader and the
number one worldwide domicile in terms of
premium size for health care, with in excess of 85
captive programs and $1.2 billion in health care
premiums.
Another distinct advantage to a captive, particularly
for larger health care facilities, such as urban hospitals
with a wide variety of risks, is that the captive can
provide all lines of coverage, including commercial
auto, worker’s compensation, and employer’s liability.
These types of coverage are not available under risk
retention or purchasing group programs.
The forms and types of captive structures available
continue to evolve every year. However, most
captives can be categorized under three main
groupings: Single parent or pure captives; group
captives; or rent-a-captives.
Single Parent
Single parent or pure captives represent the majority
of active captives. They are typically stock
corporations owned 100% by their insured parent. An
example of a single parent captive would be a large
hospital that insures its malpractice risk, including
the liability of all staff physicians and all staff.
The hospital, through its own captive, now has the
advantage of being able to offer customized coverage
and level premiums without severe fluctuations. In
addition, the hospital will not have to worry about
lack of insurance availability from year-to-year
within its primary layer. The hospital will have
control over investment return, control over the
underwriting proposal, and increased control over
staff through risk management programs.
Single parent or pure captives are primarily used by
medium or large hospitals, or medical centers, as well
as medium or large assisted living or nursing home
organizations.
Group Captives
Group Captives provide insurance to groups that
share similar risks. Many group captives operate
much in the same manner as single parent captives
except, as the name implies, they are owned by and
insure a group of entities or individuals. This captive
form is typically chosen because the participants are
not large enough to form their own single parent
captive. While most single parent captives may
require minimum capital ranging from $120,000 to
$250,000, group captives may require up to $1.0
million in capital.
Associations may form a group captive that is owned
by the association members or by the association
itself. In addition, non-profit associations can
sponsor or own captives, e.g., Medical Associations.
The non-profit association captive is typically set up
as an exempt organization and must only cover
controlled affiliates. Distributions to members are
generally prohibited.
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Medical Malpractice Insurance Crisis
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Group Captives are primarily used by small and
medium size hospitals or medical centers, small to
medium assisted living or nursing home
organizations, as well as physician’s groups. Physician
captives would often need a minimum of 60 to 100
physicians to be viable depending on the type of
practice/specialty.
Rent-a-Captives
In certain respects, rent-a-captives are a relatively
new type of captive and have grown significantly in
popularity in recent years. This structure is designed
for those insureds who want to take small steps in
entering the alternative market or who cannot afford
to fund the capital and operating cost requirements
for a free-standing captive. Rent-a-captives combine
characteristics of single parent and group captives.
As the name implies, rent-a-captives allow third
parties to insure their own risk in the captive for a
fee. The rent-a-captive owner fronts the capital and
surplus required for the underwriting of risk and also
typically provides many of the services required for
the administration of the program. Therefore, rent-
a-captive users relinquish a large part of the
management control of their program to the rent-a-
captive owner.
The biggest advantages of rent-a-captives are ease of
access, as they are typically turn-key operations;
lower start-up costs as no capital infusion is required;
and possible lower ongoing costs of operation from
pooling of services.
It is important to note, however, that while no start-
up capital is required, the rent-a-captive owner may
require significant levels of collateral or guarantees to
protect the owner from insurance losses that may be
greater than expected. Because the rental facility is
typically a non-admitted carrier, a fronting company
usually issues the paper and reinsures into the captive
cell under a reinsurance agreement securitized by a
letter of credit or other security.
In the late 1990s, a new form of rent-a-captive was
introduced, known as the protected cell, the
segregated cell, or the sponsored captive. These
captives operate virtually the same way as pure rent-
a-captives except that the risk of the participants or
users is kept separate from each other. In other
words, the assets of one participant cannot be used to
pay the losses of another participant in the event of
adverse results. However, it is important to note that,
while most captive experts feel confident about its
contractual validity, the segregated cell legislation has
never been tested in the Courts.
Risk Purchasing Groups (RPGs)
Risk Purchasing Groups came into existence as a
result of the federal Risk Retention Act of 1986.
Unlike a risk retention group an RPG is not an
insurance company, but an association of insurance
buyers with a common identity (e.g., a medical
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Medical Malpractice Insurance Crisis
A reciprocal may have an advantage over a risk
retention group because in certain states it qualifies
as an insurance company and may contribute to the
state insurance guarantee fund. Therefore, in the
event of insolvency, claimants can make a claim
against the insurance guarantee fund. A reciprocal
may insure any subscriber, whether related to the
organization or not. Accounting is done through the
subscriber’s accounts and income is allocated
annually to members.
Hybrid structures
It should also be noted that in some circumstances,
or to achieve specific goals, there might be benefits
in combining some of the above structures. For
example, some tax exempt organizations involved in
the health care industry have formed reciprocal risk
retention groups. This structure has the benefit of
providing both the ability of writing insurance in
all 50 states (RRGs) and accessibility to some tax
advantages offered by the reciprocal structure to tax
exempt organizations. Detailed tax implications of
hybrids is beyond the scope of this paper.
specialty society) who form an organization to
purchase liability insurance on a group basis. Since
an RPG purchases coverage from an insurance
carrier, no capital contributions are required in order
to join. The company from which the RPG
purchases insurance need not be licensed in every
state. The purchasing group’s insurer must indicate
how much premium was generated by the
purchasing group in each state on its National
Association of Insurance Commissioners’ annual
statement. Physicians considering purchasing
insurance through an RPG should inquire about the
strength of the insurance company that provides
coverage to the purchasing group.
Reciprocal Insurance Companies
A reciprocal insurance company is an
unincorporated association in which the insureds
have subscriber accounts and there is joint and
several liability among subscribers. Basically, a
reciprocal insurance company is a group of
individuals or entities that exchange promises – each
subscriber agrees to pay its pro rata share of certain
risks of the other participants.
Reciprocal arrangements are not corporate entities,
but less formal arrangements overseen by a common
attorney-in-fact appointed by the subscribers. The
reciprocal form (also known as an “inter-insurance
exchange”) has been around for over 100 years.
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Decision-Making Process—
Should we use an Alternative
Risk Transfer Vehicle?
As discussed previously, the use of alternative risk
transfer vehicles as a means of addressing the
national epidemic of skyrocketing medical mal-
practice insurance costs has grown considerably.
With these vehicles, medical professionals have
direct involvement in risk and loss control and do
not have to subsidize the overhead and profits of a
commercial carrier of malpractice insurance.
Alternative vehicles afford the physician the
opportunity to take control of his or her response to
situations where malpractice has occurred or has
been alleged. Through trial and error, many well-run
alternative vehicles have learned to place strong
emphasis on early recognition, and even give
acknowledgement to the patient when a medical
error takes place. In fact, this is the method of
operation for several successful physician-owned
captives. This is sometimes a very difficult step for a
physician to initially take, and it may not be the
procedure historically taken. Physicians are
concerned that actions taken post error will be subject
to examination in subsequent court proceedings.
Regardless of their philosophy of handling claims,
since alternative risk transfer vehicles do require a
commitment of time and resources, they may not be
the best solutions for all medical malpractice
insurance needs. Accordingly, there are a few key
variables that should be analyzed when evaluating
the feasibility of such a vehicle.
—Premium Size. To overcome the start-up costs
and ongoing operating expenses, ART programs will
often require annual premiums of $1 million or more
to have long-term viability.
—Good historical loss experience. An insured with a
good historical loss record that is experiencing
premium increases resulting from the commercial
insurance market cycles is an ideal candidate for a
captive program.
—Commercial market availability. As previously
discussed, medical malpractice insurance costs are
skyrocketing and the availability of commercial
insurance for this market is declining. ART vehicles
provide more control over insurance rates and ensure
that insurance will be available at levels necessary to
cover malpractice exposure.
—Risk retention appetite. While they are real insur-
ance companies, captives (especially single parent) are
really a formalized form of self insurance. An adverse
result at the captive level will negatively impact the
results of its parent(s) through financial consolidation
or via premium increases. If your organization is risk
adverse, a captive may not be right for you.
—Dedicated project leader. An ART is a complex
entity subject to accounting, tax, and regulatory
guidelines that may be unfamiliar to the organiza-
tion(s) or individuals considering this form of insur-
ance. The presence of a dedicated project leader, with
senior management credibility or credibility with
peers, in the case of physician group captive programs,
will greatly enhance the successfulness of forming
and operating the alternative risk transfer vehicle.
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Medical Malpractice Insurance Crisis
Should I form a Captive or
a Risk Retention Group?
Both captives and risk retention groups are viable
ART vehicles for dealing with today’s medical
malpractice insurance problems. However, as
evidenced by the table on page 11, each has specific
characteristics that must be considered when making
an informed decision.
It should be noted that with any well run medical
malpractice alternative vehicle, whether it is a captive
or a risk retention group, the insured or insureds
should be involved as much as possible in all major
decisions impacting the operation of the entity,
as well as all issues surrounding the ART’s
ongoing operation.
Of course, prior to implementing any ART, a
feasibility study must be completed, which will
include an actuarial study, as well as a financial and
operations evaluation of the insurance situation. In
addition, a feasibility study should, if it reaches the
conclusion that an alternative risk transfer vehicle is
the best solution, provide for consideration of one or
a few proposed structures, including a comparison of
domiciles and available ownership considerations.
Tax Treatment of
Alternative Vehicles
A very important issue facing the designers of an
alternative structure for both taxable and tax-exempt
health care organizations and practitioners is the
deductibility of premiums paid to the ART program
and the tax treatment of the captive or risk
retention group itself. This topic is well beyond
the scope of this paper, but should be addressed
with professionals prior to setting up any type of
ART vehicle.
Captives and Wealth
Protection and Wealth
Preservation for Physicians
Many physicians are also very interested in the
possible employment of captive vehicles for wealth
protection and wealth preservation strategies. These
considerations should be discussed with the
physician’s advisors. Captives can be used in the
areas of insured-owned life insurance, annuities, and
disability policies, as well as employee benefits.
Conclusion
In conclusion, ART vehicles, when structured and
run properly, can effectively manage risk and
control insurance costs. In addition, ARTs bring
the advantage of direct involvement in risk and
loss control, along with the potential for reduced
premiums for health care practitioners. ARTs can
provide a viable alternative to waiting out the
medical malpractice storm.
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John J. O’Brien, JD, CLU, CPCU
wilmingtontrust.com
Delaware (Corporate Headquarters)
Wilmington
302.636.6766
New York
New York City
212.751.9500
Nevada
Las Vegas
702.866.2200
South Carolina
Charleston
843.723.0418
Vermont
Burlington
802.865.4331
Cayman Islands
Grand Cayman
345.946.4091
Channel Islands
Jersey
4415.3449.5555
UK
London
4420.7614.1111
Ireland
Dublin
+353 (0)1.612.5555
Germany
Frankfurt
+4969.2992.5385
John is responsible for overseeing the design, implementation, formation,
and ongoing management services required by captive insurance company
clients. His duties also include liaising with regulatory authorities.
Prior to joining Wilmington Trust SP Services (South Carolina), Inc. in
2005, John was the CEO of Charleston Captive Management Company.
Generally acknowledged as one of the earliest proponents of the captive
industry in South Carolina, John founded the first captive insurance
management company in the state and helped form the South Carolina
Captive Insurance Association, serving as president and as a member of
the board of directors.
John has over three decades of experience as an attorney in private
practice and in the insurance industry. He holds a JD from the University
of Tennessee and earned his bachelor’s degree from LaSalle College. He
has taught and written extensively on insurance matters and addressed
insurance conferences in many locations. He has also testified as an
insurance expert in state and federal courts.