Risk retention groups: Pros and cons
Despite regulatory inequities, RRGs bring cost-effective risk financing to many buyers
By Michael J. Moody, MBA, ARM
Much of the innovation that is associated with the insurance industry has been a direct result of major disturbances within the commercial market's pricing cycles. A good example of this innovation is risk retention groups (RRGs). The original concept was one that grew out of desperation on the part of Congress, after they received continued expressions of concern from their constituents. During the mid '70s, many commercial insurance carriers had abandoned product liability lines of coverage. This resulted in a number of manufacturers being unable to obtain reasonably priced product liability coverage and caused some business owners to worry about their very survival as a going concern.
After much discussion, Congress began to consider crafting a federal mechanism that would assist manufacturers nationwide in resolving this issue. The fact that was this would result in a major change in the insurance market was a concern for some lawmakers. The federal government was now getting into an area that heretofore had been pretty much the exclusive domain of state insurance regulators. However, because of the enormity of the issue, it took quite a bit of time to complete. But ultimately, it was passed into law on September 25, 1981, when President Ronald Reagan signed H.R. 2120, or, as it has become known as, the Product Liability Risk Retention Act, into law.
The signing of the Act, however, came a little late to assist the average commercial insurance buyer, since the insurance market had already moved to the soft pricing portion of the market cycle. As a result, over the next five years, only one RRG had been formed. But, thanks in large part to the insurance industry's lack of ability to properly price its product, by the mid-'80s, commercial insurance buyers of liability coverage were once again at the mercy of the pricing cycle. Again, Congress began hearing from voters that conditions were desperate; this time, however, Congress acted swiftly by expanding the definition of liability under the existing Act to include any liability, except workers compensation. This time, the revised Act, the Liability Risk Retention Act of 1986, turned out to be a godsend for those buyers that were struggling, trying to obtain liability coverage. By comparison, within the first year following the passage of the '86 Act, 38 RRGs had been formed.
Filling a void
Subsequent to the passage of the 1986 Act, RRGs have become a viable risk finance method that has assisted numerous commercial insurance buyers in obtaining competitively priced liability coverage. Today, there are an estimated 250 RRGs licensed in various domiciles in the United States, and they currently account for about 3% of the overall liability market. While the total number of RRGs or the volume of coverage written has not been great, they have filled a critical need for their owners. Since the Act stipulates that the RRG is required to be licensed in only a single, domiciliary state to be able to provide coverage nationwide, the need and cost of a fronting carrier are eliminated, thereby proving initial cost savings.
As prescribed by the federal Act, the owners/insureds must be a homogeneous group with similar exposures. This major concept that is at the core of the RRG has become one of its major strengths. By creating a liability insurance company in this manner, over the long run, they can develop sophisticated risk management and loss control programs that have been specifically tailored to the group. Additionally, claims management procedures can be established that are also customized to the exposure. Informed underwriting decisions that are based on industry-specific data is also viewed as a long-term advantage. As a result, since most RRGs are established at a time when the commercial insurance market has withdrawn or greatly restricted its writing of these exposures, frequently the RRG is able to fill a critical role.
While the fundamental role of the RRG has remained the same since the beginning—providing a cost-effective approach for liability insurance buyers—a number of issues still remain. Congress's intent with the passage of the Act was to provide legislation that preempted state insurance laws. Unfortunately, a number of state insurance regulators have taken umbrage with this approach. Their positions have been allowed to remain, primarily because the Act is a federal statute which is not overseen or regulated by any federal agency. As a result, some state insurance departments have usurped certain aspects of the federal Act.
What it comes down to is that "RRGs have a right without a remedy," notes Jon Harkavy, executive vice president and general counsel of captive manager Risk Services. From the start, he points out, "there has been over reaching by some state insurance departments."
Over reaching by the individual states has taken a number of forms, including registration requirements and fees, financial responsibility requirements, premium taxes, definition of liability, etc. Since there is a lack of federal oversight, it falls on organizations like the National Risk Retention Association (NRRA) to become an advocate for the RRG segment. Over the last few years, the incidences of this over reaching have become so frequent that the NRRA and other captive industry organizations have been requesting that the GAO review the actions of the states to determine if they are detrimental to RRGs.
The GAO report, which came out earlier this year, was, according to most captive observers, a little disappointing, at best. While the primary purpose of the GAO report was to clarify certain provisions of the Act such as registration requirements, fees, and coverage, it failed for the most part. Harkavy points out that the GAO says that change is needed to resolve the ambiguities in the law. But he says, "There are no ambiguities."
The real issue, according to Harkavy and numerous other risk transfer specialists, is that the federal Act is adequate; however, there is no federal agency to oversee its compliance. A perfect example of this lack of oversight is, he notes, is Louisiana, where 16 years ago, the state was charging RRGs a fee to operate within the state. This issue was litigated and, "the courts said you cannot have a fee." But he points out, "Today, Louisiana has a fee."
That is the real disappointment from the recent GAO study, says Harkavy. "Preemption then becomes a right without a remedy." One possible solution that he suggests would be to use the power of NAIC accreditation as a means of controlling this situation. To date, however, he says the NAIC has pretty much used its authority to restrict RRGs' powers, rather than as an enforcement mechanism for the federal law.
Despite the shortcomings of the recent GAO study, RRGs have been used to resolve a number of critical liability crisis areas. With about 250 RRGs currently in use, accounting for more than $2.5 billion in premium volume, their participation is not in doubt. From the start, RRGs offered their owner/insureds a number of distinctive advantages that have stood the test of time. Key among these advantages is the issue of preemption. This has eliminated the need and cost of obtaining a fronting carrier, thus reducing the initial cost. Additionally, the Act requires that similar types of risks must be included in the RRG, thus affording the RRG the ability to develop industry-specific loss mitigation and claims management strategies that traditional multi-line carriers cannot do. This then is the real long-term value of the RRG—allowing their owners to control their own destiny.
Several attempts have been made to expand the scope of RRG coverage in the past. One of the most noted efforts involves expanding into the property insurance market but, to date, this has not materialized. A major reason for not moving into this area is that it would require a revision of the existing law, since it is not a "liability" coverage. However, many experts believe that should the property market contract in a meaningful way, this may again be addressed.
Another major coverage area that has been receiving a lot of attention is employee health coverage, since it does not require any specific changes or revision to the existing law. With the continued increases in employee health costs, corporations are searching for new, viable ways to reduce their overall costs. Several RRGs have begun to offer their owners excess stop loss coverage, considered by many to be a type of liability coverage. This appears to offer a viable approach to lowering overall employee health cost and, as a result, should provide significant benefit to RRG owners and may increase ownership in RRGs as well.
The traditional insurance market has a long history of rating surprises that, for the most part, are not appreciated by insurance buyers. For many larger buyers, a movement to a captive insurance company has become commonplace; however, smaller buyers, for the most part, had been excluded from this transition until the passage of the RRG legislation. RRGs have provided smaller buyers a path to a more cost-effective risk-financing approach. As the GAO pointed out in a previous study, "RRGs have a small but important effect" on providing affordable liability coverage.
As the industry looks at a potential hardening of the commercial insurance market, further growth of RRGs is sure to continue. Agents and brokers must become aware of this eventuality and make strategic decisions to assist their better clients to find ways to take advantage of this continuing trend. Partnering with experienced, independent service providers such as Risk Services can help an agency successfully move into the alternative risk transfer market.
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