GAO Recommends Common Regulatory Standards For Risk Retention Groups

The United States Government Accountability Office ("GAO") recently completed a study regarding regulation of risk retention groups ("RRGs"), insurers authorized to write insurance on a national basis pursuant to the federal Liability Risk Retention Act of 1986 ("LRRA").¹ The GAO has released the findings of its study in a report recommending more consistent regulation of RRGs (the "Report").² In preparing the Report, the GAO obtained general information from the National Association of Insurance Commissioners ("NAIC"), surveyed insurance regulators in all fifty states and the District of Columbia ("DC"), and interviewed representatives from individual RRGs. The Report focused on regulation by the six leading RRG domiciles: Arizona, DC, Hawaii, Nevada, South Carolina, and Vermont, as well as current RRG failures, in determining the scope and effect of current regulation. The GAO concluded that common regulatory standards, including minimum corporate governance standards, are necessary to strengthen overall regulation of RRGs. The Report recommends both Congressional amendment of the LRRA and state action to accomplish this objective. It is currently unclear which, if any, of these recommendations will be implemented by either Congress or the states acting in concert with the NAIC.

With respect to the market effect of RRGs, the GAO determined that "RRGs have had a small but important effect in increasing the availability and affordability of commercial liability insurance for certain groups." ³ Although RRGs accounted for only about 1.17 percent of all commercial liability insurance in 2003, the GAO report acknowledges the importance of RRGs in providing targeted coverage at consistent prices, particularly for types of insurance that are underserved by traditional insurers.⁴ The Report indicates that RRG formation increased dramatically in 2002 to 2004, and that approximately three quarters of new RRGs provide medical malpractice coverage.

Despite the acknowledged utility of RRGs within the commercial liability market, the Report focuses on what it deems "a regulatory environment characterized by widely varying state standards."⁵ The Report indicates that the lack of detail within the LRRA with respect to ownership, control and corporate governance standards allows RRGs to operate in a manner that fails to consistently protect member interests. Among the factors contributing to a lack of confidence in RRG regulation, the Report discusses the following:

Variations in RRG reporting requirements among states impede uniform financial condition assessments.⁶ The LRRA requires only that RRGs provide financial information to each state in which they operate, and such information is not prepared under consistent accounting and reporting rules. States vary in requiring use of GAAP, statutory accounting principles ("SAP") or allowing use of either GAAP or SAP. Further, states may allow modification of accounting principles through use of irrevocable letters of credit ("LOCs") to meet minimum capitalization requirements. Inconsistent use of accounting principles may impede the ability of state regulators, who are generally most familiar with SAP, to accurately determine the financial condition of RRGs.

Most RRGs take advantage of flexible captive laws in their domiciliary states but write a majority of their business outside of these states.⁷ The Report discusses the less restrictive captive laws of several states which make these states favorable domiciles for a variety of financial reasons, including lower capital and surplus requirements and more flexible standards for meeting these requirements, such as use of LOCs, rather than cash. RRGs formed as captives may take advantage of less stringent financial reporting requirements and avoid compliance issues relating to state insurance holding company system laws which are applicable to traditional insurers.

The Report suggests there is evidence that some states may set low captive regulatory standards to attract RRGs for economic development, creating a "regulatory race to the bottom." ⁸ The following areas of regulation are cited as examples: statutory minimum capitalization, permissible corporate forms, and willingness to domicile vehicle service contract providers or "entrepreneurial RRGs." ⁹ Entrepreneurial RRGs are described as RRGs formed by a few members, commonly including a service provider such as a management company, with future success contingent on recruiting additional members as insureds. Some regulators have indicated that entrepreneurial RRGs are often created for the primary purpose of turning a profit, rather than providing insurance.¹⁰ The LRRA does not require RRG members to make capital contributions above the premium amount or to maintain control over boards of directors or other governing bodies, which ambiguities the Report indicates may allow RRGs to operate in a manner that fails to protect insureds. The Report examines several RRG failures in which it indicates that management companies or other service providers maintained control of the RRG operation and made decisions based upon maximization of profits rather than in the best interest of insureds.

The Report also discusses the lack of guaranty fund protection and the fact that RRG members may not be aware of this lack of protection. Although the LRRA grants nondomiciliary state regulators the authority to mandate the inclusion of a policy disclosure regarding guaranty fund coverage, it does not provide authority to require the notice on policy applications or marketing materials.¹¹ Further, consumers may be directly affected by the lack of guaranty fund protection to service contract providers that form RRGs to insure their liability for claims on extended service contracts.¹²

In the absence of federal regulation, the GAO report suggests that the states, through the NAIC, develop regulatory standards for RRGs including but not limited to:¹³

• filing financial reports on a regular basis using a uniform accounting method.

• meeting NAIC’s risk-based capital standards.

• complying with the Model Insurance Holding Company Regulatory Act as adopted by the domiciliary state.

The Report also suggests that states consider standards similar to the accreditation standards for traditional insurers relating to laws, regulatory processes and procedures, and personnel.

In addition to the recommendations for state action outlined above, the GAO report offers a number of actions for Congressional consideration relating to the LRRA, including:¹⁴

• Setting a date by which NAIC and the state insurance commissioners must develop an initial set of uniform, baseline standards for the regulation of RRGs.

• After that date, making LRRA.s regulatory preemption applicable only to those RRGs domiciled in states that have adopted NAIC’s baseline standards for the regulation of RRGs.

• Requiring that insureds of the RRG qualify as owners of the RRG by making a financial contribution to the capital and surplus of the RRG, above and beyond their premium.

• Requiring that all of the insureds, and only the insureds, have the right to nominate and elect members of the RRG’s governing body.

• Establishing minimum governance requirements to better secure the operation of RRGs for the benefit of their insureds and safeguard assets for the ultimate purpose of paying claims. These requirements should be similar in objective to those provided by the Investment Company Act of 1940, as implemented by SEC; that is, to manage conflicts of interest that are likely to arise when RRGs are managed by or obtain services from a management company, or its affiliates, to protect the interests of the insureds. Amendments to LRRA could:

• Require that a majority of an RRG’s board of directors consist of "independent" directors (that is, not be associated with the management company or its affiliates) and require that certain decisions presenting the most serious potential conflicts, such as approving the management contract, be approved by a majority of the independent directors;
• Provide safeguards for negotiating the terms of the management contract.for example, by requiring periodic renewal of management contracts by a majority of the RRG’s independent directors, or a majority of the RRG’s insureds, and guaranteeing the right of a majority of the independent directors or a majority of the insureds to unilaterally terminate management contracts upon reasonable notice; and
• Impose a fiduciary duty upon the management company to act in the best interests of the insureds, especially with respect to compensation for its services.

• Expand the wording of the current disclosure to more explicitly describe the consequences of not having state guaranty fund protection should an RRG fail, and requiring that RRGs print the disclosure prominently on policy applications, the policy itself, and marketing materials, including those posted on the Internet. These requirements also would apply to insureds who obtain their insurance through organizations that may own an RRG; and

• Develop a modified version of the disclosure for consumers who purchase extended service contracts from providers that form RRGs to insure their ability to meet these contractual obligations. The disclosure would be printed prominently on the extended service contract application, as well as on the contract itself.

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