ENTERPRISE RISK MANAGEMENT

GROUP SOLUTIONS--PART II

Growth of new options allows more small firms
to access the alternative market

By Michael J. Moody, MBA, ARM

As favorable as federal RRG legislation has been, RRGs represent only half of the available solutions under the federal statutes.

Last month we looked at one of the most viable group risk financing approaches for dealing with the current hard market--the risk retention group (RRG). While the original federal legislation authorizing the use of RRGs was enacted in 1981 and amended in 1986, the current hard market is ideally suited to further RRG formations. The current lack of fronting carriers should serve to greatly increase the attractiveness of the RRG option, since RRGs do not need fronting carriers. It is generally believed that interest in RRGs will be greatly increased should Congress expand their scope to include property exposures.

Risk purchasing groups

As favorable as the federal RRG legislation has been, RRGs represent only half of the available solutions under the federal statutes. The same federal law that allows risk retention groups also allows for the formation of risk purchasing groups (RPGs). And as successful as RRGs have been, implementation of RPGs would have to be considered wildly successful. The January 2002 Monthly Update from the Risk Retention Reporter notes that there are currently 758 RPGs.

Differences between the risk retention groups and risk purchasing groups are significant. However, some of the underlying concepts are the same. Exposures for either group are limited to public liability, and either group alternative must be comprised of businesses with similar insurable risks (i.e., homogeneous risks). However, while the RRG requires the formation of a licensed insurance company including capitalization and regulatory approval, the RPG does not require similar commitments.

Any homogeneous group or association that wants to purchase its liability coverage on a group basis can form an RPG. Once the group has been formed, it contacts a traditional insurance company and agrees to have the insurer offer coverage to the members. Additionally, the RPG notifies each state's regulatory authority of its intention to purchase liability insurance as a group; however, there is no regulator approval to be obtained.

Since the RPGs were included in the federal RRG legislation, insurance companies are free to offer groups pricing advantages that are available only via group purchasing power. Additionally, carriers are able to bypass many state rate and form requirements, as well as other intrusive state regulations. At the end of the day, by banding together via an RPG, businesses with similar liability exposures can obtain pricing concessions that are typically reserved for only the largest accounts. This formula has proven successful over the past 15 years; and, given the ease of entry and lack of capital commitment required, one would expect RPGs to continue to flourish in the upcoming months and years.

Rent-a-captive

As smaller firms began to consider group captives, it soon became obvious that some of these companies would not be in a position to make the commitment needed to be a member of a group captive concept. While a few of these companies liked many of the aspects of the captive concept, they did not have the ability to make the financial commitment, or be involved in the active management, etc. While this would normally preclude them from the captive option, they found they had other options to consider such as the "rent-a-captive" alternative. Several enterprising organizations were able to see interest in the captive concept, as well as the inability by some companies to move to captives, and decided to capitalize on it. Accordingly, they formed their own captives and "rented out" their capacity to interested third parties. Interest in this "rent rather than buy" concept ran high when it was originally introduced. While the general liability and property insurance markets have managed to sustain soft pricing over the past 15 years, the workers compensation market experienced market hardening several times through that 15-year period. And during that time, rent-a-captives (RAC) gained a number of insureds.

The RAC concept is quite simple. An unrelated, third party forms a captive insurance company with the expressed purpose of "renting" its capacity to outside risks. For the insureds that participate in the RAC, the decision becomes a classic "rent vs. buy" financial equation. While RACs were formed by a number of different organizations, most were formed by brokers, insurance companies, financial services providers, and other insurance-related, third-party vendors. While several of the early RACs came to the attention of the market, one group obtained the lion's share of the new business. The group, Mutual Risk (MRM), and its sister company, Legion Insurance Company, developed an approach that required them to work through independent agents. Their proposals and presentations were well documented and delivered and were typically well received. However, the prolonged soft market required Mutual Risk to provide competitively priced premiums, and recently they have encountered serious problems with their reinsurance recoverables. As a result, both Legion and MRM are inactive in this arena at the current time.

One would expect to see an increasing amount of business going to existing RACs as well as a number of new start-up RACs to assist small to mid-sized companies weather the hardening insurance market. While the RAC concept can provide a viable approach to risk financing, there are generally two major shortcomings to the concept. The first major issue is that the expense factors are typically high, with many being in the 40% to 50% range. With the short-range prospects for limited numbers of fronting carriers and reinsurers, the ability to reduce the overall costs appears to have little chance of improving. Accordingly, expense factors will likely remain high.

Protected cell captive

The other major drawback to the RAC concept is the joint and several liability that is typically a part of the pooling aspect of the program. In order to counter this shortcoming, some organizers have begun a new variation of the RAC that allows the participants to retain their own cell, which will be allocated to the risks of their own company. While this has helped participants overcome concerns regarding the joint and several aspects of the RAC, it has also called into question the deductibility of premiums paid to the RAC.

This concept was first begun in several offshore domiciles such as Guernsey. However, it has quickly spread to a number of other offshore domiciles, as well as several domestic domiciles. Today, many of the popular domiciles do allow some form of protected cell captives. While the confinement to a single cell has generally been viewed as a positive, since pooling of risks may be absent in the transaction, care must be taken if a participant wants to maintain premium deductibility.

Agency captive

Today, many agents and brokers are looking for ways to provide value-added services to their customers. Some of these agents are considering the establishment of an agency captive. In essence, an agency captive is really nothing more than a rent-a-captive that is owned by the agency. Ownership of the captive can be structured so that it rests with a single agency or it can be owned by several agencies, in order to maintain sufficient premium volume. An agent can have a variety of reasons for considering the establishment of an agency captive. Concern about the continuing relationship with key insurers will be one of the primary reasons. Some of these concerns would include abandonment of a line(s) of coverage, forcing stricter underwriting guidelines, increasing minimum premium volumes, or reducing commissions paid.

By forming their own agency captive, many agents believe that they can better control their business, as well as offer a competitive advantage for their owners. Agency captives can also provide a mechanism that allows agents to share the profit of good business, as well as assist their customers in controlling their insurance expenditures. While finding support for a start-up agency captive can be difficult, agents who have good relationships with their lead underwriters may be able to look to their carriers for support. Several insurers are working with their elite agents to establish agency captives.

Any agent who has a sizable book of business, particularly in a niche market that is served by a limited number of carriers, should consider the formation of an agency captive. Many experts think that the majority of growth in rent-a-captive business will occur via the agency captive route. The ability to showcase an agency captive to new or prospective clients is one clear way to differentiate your firm from your competition.

Group pooling

Group pooling is yet another joint risk funding option. It is used most often in conjunction with self-insuring workers compensation exposures. Some states do allow companies to band together for the purpose of pooling their workers compensation risks. However, as with an individual self-insurance workers compensation option, the state insurance department must grant the group the privilege to self-insure its coverage. And in today's difficult insurance market, there are several major impediments to formation.

One of the concerns that the state insurance department will voice is the financial stability of the group. The state will conduct a specific financial analysis of all of the group's members prior to granting the right to self-insure. The insurance department will want to ascertain the financial health of each of the potential members. An additional problem for self-insured accounts these days is securing the necessary surety bond. Most states have minimum requirements that must be met by all self-insureds, but with the lack of bonding companies this is getting to be a significant problem. As appealing and cost-effective as self-insuring may be, it is extremely difficult to actually obtain the privilege from the state and even more difficult to find the bonds needed to begin operations. Use of existing pools may be a better option than trying to start a new one from scratch.

Another group that has made extensive use of pooling is public entities. Many public entity pools were started in the hard market of the mid-1980s. This was a time when many insurance companies dropped coverage for a wide variety of public exposures (e.g., jails, playgrounds, swimming pools, etc.). Governmental entities found that they have several advantages over other business organizations that may attempt to establish a pool. First and foremost, while the statutes that govern the formation of such risk financing alternatives vary state by state, in general, most states have minimal or non-existent laws that control public pools. As a result, there is significant ease of entry for public entities with very little government oversight.

Many different kinds of public entities have developed pools. Among the more popular ones are:

* Municipalities such as cities, towns and counties

* Special divisions such as fire districts, park districts and housing authorities

* School districts

Other positive forces that favor establishing pools for governmental entities is that they rarely are in competition with each other, which is a major stumbling block for some RRGs. Additionally, public entities can benefit from sovereign immunity statutes and tort liability caps that can greatly limit potential losses. All in all, one would expect that pooling of public entity exposures would continue during this hard market. Agents who are involved in this niche should consider the feasibility of group pooling before their competition does.

Conclusion

As we have noted over the past two months, the current hard insurance market will present numerous growth opportunities for agents and third-party vendors. If you are an agent who has developed a niche market, it may be time to actively consider group risk financing alternatives for your insureds. If you don't have an established niche, this is a good time to approach a prospect niche and propose determining the viability of a group option for these insureds. You must realize, however, that most of these options take considerable time to form and be in a position to offer appropriate coverage.

Now is the time to develop strategies that will get you and your clients through the hard market. Being involved with a group risk financing solution is one of the best ways to develop a competitive advantage for you and your agency. *

The author

Michael J. Moody, ARM, is managing director of Strategic Risk Financing, Inc. (SuRF). SuRF is an independent consulting firm that has been established to advance the practice of enterprise risk management. The primary goal of SuRF is to actively promote the concept of enterprise risk management by providing current, objective information about the concept, the structures being used, and the players involved.