A lack of common regulation for risk retention groups could put insureds at risk, warn Sonja Bensen and Lawrence Cluff

In 1981, in response to recurring shortages of commercial liability insurance, the US Congress passed what is now known as the Liability Risk Retention Act (LRRA). This act authorised the creation of risk retention groups (RRGs) to increase the availability and affordability of commercial liability insurance. An RRG is a group of similar businesses with similar risk exposures, such as educational institutions, which create their own insurance company to self-insure their risks on a group basis.

To ease the creation of RRGs, LRRA partially preempts state insurance laws by allowing an RRG to be regulated primarily by the state in which it is chartered - its domiciliary state - even when the RRG sells insurance in other states. In having only one regulator, RRGs differ from "traditional" insurance companies, which are subject to the regulation of each state in which they operate. Additionally, Congress prohibited RRGs from participating in state guaranty funds, believing that this restriction would provide RRG members a strong incentive to establish adequate premiums and reserves. States have established guaranty funds, funded by traditional insurance companies, to pay the claims of policyholders in the event that an insurance company fails.

RRGs are not the only mechanism by which businesses may establish self-insurance coverage. States also charter captive insurance companies, which are established by single companies or groups of companies to self-insure their risks. However, unlike RRGs, captives do not benefit from the partial preemption. Both RRGs and captives generally employ management companies to administer their operations.

The RRG impact

RRGs have had a small but important effect in increasing the availability and affordability of commercial liability insurance for certain groups with limited access to insurance. In 2003, according to estimates by the National Association of Insurance Commissioners (NAIC), RRGs provided about $1.8bn or 1.17% of all commercial liability insurance. While their overall market impact has been small, most state regulators responding to a Government Accountability Office (GAO) survey indicated that RRGs have benefited groups that have had difficulties obtaining affordable coverage, such as healthcare providers.

According to RRG regulators and the industry, members have benefited from coverage targeted at their risks and risk-reduction programmes. Industry representatives noted that RRGs benefit from prices that remain stable over time. In recent years, a shortage of affordable liability insurance prompted the creation of many new RRGs, particularly for the healthcare industry. From 2002 through 2004, 117 RRGs were formed, more than the total formed over the previous 15 years. Consequently, more than half of all currently operating RRGs insure healthcare-related areas, which studies have characterised as volatile.

LRRA's partial preemption of state insurance laws has resulted in a regulatory environment characterised by widely varying state standards and limited regulator confidence in the system. In part, state requirements differ because some states charter RRGs as captive insurers, which operate under less restrictive regulation than traditional insurers. For example, unlike traditional insurers, captives are permitted to start their operations with less capital and use letters of credit to meet capitalisation requirements. Accordingly, the majority of RRGs have domiciled in six states, including the District of Columbia, South Carolina, and Vermont because these allow them to be chartered as captives, rather than in states where they conduct most of their business.

In addition, regulatory requirements for captive RRGs differ among states. For example, five of the six leading domiciliary states allow RRGs to use a modified version of generally accepted accounting principles, rather than statutory accounting principles, when filing financial statements. In part, this variation is possible because regulation of RRGs and captives is not subject to uniform, baseline standards, such as those set forth in NAIC's accreditation standards for a state's regulation of traditional companies. Often because of their concerns about a lack of uniform standards and their perceived need for additional regulatory authority, only eight regulators of 42 responding to a particular GAO survey question considered that LRRA's provisions adequately protect RRG insureds. Finally, some evidence exists to support regulator assertions that some states may be creating lenient regulatory environments to encourage RRGs to domicile in their state. For example, states have allowed RRGs to relocate their charters, even though the RRGs were subject to unresolved regulatory actions in their original state of domicile.

Inadequate safeguards

Because LRRA does not specify minimum characteristics of ownership and control for RRGs (other than requiring that owners must also be insureds) or establish minimum governance requirements, RRGs can be operated in ways that do not consistently protect the best interests of their insureds. While RRGs were authorised for the purpose of providing self-insurance, LRRA does not explicitly require that all of the insureds contribute toward the capitalisation of the RRG or have the ability to exert control of their RRG. As a result, some states do not expect, or expect consistently, that RRG insureds contribute anything beyond their insurance premiums or have the ability to elect their governing body (such as a board of directors).

However, other regulators are concerned that members without "skin in the game" will have minimal interest in insuring the success of their RRG. Likewise, LRRA does not include governance protections to counteract potential conflicts of interest between service providers, such as management companies, and insureds. However, the circumstances surrounding more than half of past RRG failures examined suggest that management companies or managers have promoted their own interests at the expense of the insureds, by promoting self-serving transactions unfavourable to the RRG for example. In contrast, Congress previously addressed a similar situation within the mutual fund industry by passing legislation, including the Investment Act of 1940, intended to minimise potential conflicts of interest between mutual fund shareholders and management companies. Finally, LRRA does not require an RRG to disclose to its insureds that they would not benefit from guaranty fund protection should the RRG fail. The recent failure of three RRGs suggests that even when a disclosure permitted by Congress is used, insureds may not fully understand the consequences of failure.

Know the risks

In establishing RRGs, Congress intended to alleviate a shortage of affordable commercial liability insurance. While RRGs as an industry, according to most state insurance regulators, have fulfilled this vision, RRG members and their claimants could benefit from a more consistent regulatory environment. The wide variety of regulatory practices among states, the increase in the number of new states chartering RRGs, and the growing number of RRGs chartered to offer medical malpractice insurance, have increased the potential for future solvency risks.

Historically, US insurance regulators have recognised the value of having a consistent set of regulatory laws, practices, and expertise through the successful implementation of NAIC's accreditation programme for state regulators of traditional multi-state insurers. Regulators working through NAIC could develop a set of parallel standards for RRGs. While RRG standards need not be identical to those for traditional insurers, uniform standards for RRGs could create a more transparent and protective regulatory environment. In addition, while acknowledging that LRRA has worked well to promote the formation of RRGs, its lack of governance standards has left some RRGs vulnerable to abuse. Principles drawn from legislation such as the Investment Company Act of 1940 would strongly suggest, for example, that an RRG's board of directors could have a substantial number of directors to control policy decisions who are unaffiliated with service providers. However, we do not believe that RRGs should be afforded the protection of guaranty funds because such coverage could further reduce incentives insureds might have to participate in the governance of their RRG. On the other hand, RRG insureds have a right to be adequately informed about the risks they could incur before they purchase an insurance policy.

- Sonja Bensen is a senior analyst and Lawrence Cluff is an assistant director at the US Government Accountability Office.




NRRA chairman comments on the GAO study

Steve Crim, chairman of the National Risk Retention Association, said following the GAO study, "We are pleased that the GAO has acknowledged the important positive effect that RRGs have had on the availability and affordability of commercial liability insurance. This was clearly Congress' intent when it passed the Liability Risk Retention Act in 1986."

Crim added, "NRRA wholeheartedly supports good state regulation, but is concerned about some of the recommendations in the GAO report for changes in regulatory standards and enforcement. Good regulation for RRGs is not the same as good regulation for traditional insurers."