A higher standard

Drafters of tougher uniform financial and corporate governance standards for U.S. risk retention groups are debating a controversial issue concerning the capital requirements of reinsurers.

At issue is whether to require a reinsurer to have at least $20 million in capital or in trust before an RRG would be allowed to take credit for the reinsurance it cedes.

Pro-regulation supporters say the National Assn. of Insurance Commissioners' traditional standard for reinsurers is appropriate to ensure financial solvency of such groups, which consist of similar businesses with similar risk exposures that create their own insurer to self-insure on a group basis.

Pro-RRG supporters disagree, and say that a $20 million requirement is excessive for such groups.

While those discussions continue, regulators with domestic RRG industries, and those without such industries, joined with industry representatives in crafting tighter financial and corporate governance standards for RRGs. After nearly 18 months of work, the NAIC will consider formally adopting some governance recommendations at its March 10-13 meeting in New York.

Thus far, the proposed financial standards allow use of Generally Accepted Accounting Principles rather than mandating use of Statutory Accounting Principles. Even so, GAAP numbers would have to be converted to SAP in the footnotes of each RRG's annual statement.

It's "an important step forward" because the new financial standards are expected to become accreditation requirements, which would require states to use them. The standards would create "a more level playing field" among states concerned with RRG regulation and among RRGs themselves, said Tim Wagner, the Nebraska insurance director and chair of the NAIC's Property/Casualty Insurance Committee subgroup that is drafting the corporate governance requirements.

In addition, a wide range of proposed RRG corporate governance rules would increase disclosure requirements about the lack of guaranty fund coverage. They also would require that an RRG board have a majority of independent directors, review service provider contracts at least every five years and follow ethical guidelines.

The governance package "raises the bar for everyone," Mr. Wagner said. It will mean a change in "quite a few" RRGs because "it puts members in the driver's seat."

RRGs began operating in 1981 when Congress authorized their creation in response to recurring shortages of product liability insurance.

Following amendments in 1986, the Liability Risk Retention Act permits RRGs to offer all types of liability insurance nationwide by becoming licensed in one state. The law also pre-empts nearly all insurance laws of other states where an RRG operates, regardless of where members are located. Determining pre-emption boundaries has been a source of many disputes among RRGs and regulators.

In addition, the act bars RRGs from participating in state guaranty funds.

Almost two decades later, a 2005 congressional inquiry asked the U.S. Government Accountability Office to study RRGs after "recent failures of several large RRGs...raised questions about the adequacy of RRG regulation," in ownership, control and governance, according to the GAO report. From 1990 to 2003, 21 RRGs failed, including the Cayman Islands-based National Warranty Insurance RRG, which reported $74 million in losses in 2003. RRGs no longer can be established outside the United States.

Currently, U.S. RRGs are domiciled in 21 states and the District of Columbia, according to the Pasadena, Calif.-based Risk Retention Reporter.

The six largest domiciles by number of groups are, in order: Vermont, South Carolina, D.C., Nevada, Arizona and Hawaii.

STATE REGULATIONS VARY

The current act's broad regulatory pre-emption, however, "has resulted in widely varying requirements among states and limited confidence in RRG regulation," the GAO report said. "Many of the differences arise because some states allow RRGs to be chartered as captive insurance companies, which typically operate under a set of less restrictive rules than traditional insurers."

In addition, "some evidence exists to support regulator assertions that some domiciliary states may be creating lenient regulatory environments to encourage RRGs to domicile in their state," GAO researchers found.

Captive domiciles "all are interested in getting business," said Robert H. Myers Jr., managing partner of the Washington office of Morris, Manning & Martin L.L.P. in Atlanta. He also is Washington counsel to the Minneapolis-based National Risk Retention Assn.

Many states' economic development officials would like to follow Vermont's lead.

Since 1981, when Vermont began its captive program, the industry has paid the state $228 million in premium taxes and $12 million in license and examiners fees, said Len Crouse, deputy commissioner of captive insurance in the Vermont Department of Banking, Insurance Securities and Health Care Administration. The industry also has spurred development of more than 1,400 full- and part-time jobs and brought more than $1 billion in assets into Vermont financial institutions.

While Vermont's promoters emphasize regulators' accessibility and reputation for quality oversight, newer state domiciles tout their lower tax rates and streamlined regulation as advantages, said Thomas Hampton, commissioner for the District of Columbia's Department of Insurance, Securities and Banking.

For example, Arizona charges no premium taxes. However, most U.S. captive domiciles charge premium taxes, although the rates vary from state to state.

Most RRGs want regulators to be fair, firm and efficient, but they would also like "a little leeway," Mr. Hampton said. Regulators in each domicile must ensure the financial viability of the RRGs, "so they can't get too flexible," he said.

"It's a fine line between economic development and effective regulation," Mr. Hampton said. Without uniform standards, states seeking to grow as an RRG domicile might be tempted to engage in "a race to the bottom" in relaxing regulatory requirements, he said. Also, problems could muddy the reputation of an RRG as an alternative market option.

The District of Columbia department began licensing captives about four years ago and has 70 licensed entities, which are either captives or RRGs.

Messrs. Wagner, Hampton and Myers are among those who participated in the two NAIC subgroups' regulatory review during the past year. "It has been a mutually beneficial educational enterprise" for regulators in domiciliary and nondomiciliary states and the industry, Mr. Myers said.

Thus far, the financial condition subgroup "has done everything by consensus," said Betty Patterson, senior associate commissioner-financial division for the Texas Insurance Department, who chaired the subgroup representing Commissioner Mike Geeslin. Specifically, the group has developed accreditation standards that states would be required to apply to RRGs incorporated as captive insurance companies.

FINANCIAL CONDITION ISSUES

One key issue has been the lack of uniformity in the accounting system RRGs use to report financial information. It occurs because many domiciles allow RRGs to use GAAP, which typically allows using letters of credit, discounting loss reserves and amortizing acquisition costs. Meanwhile, regulators require that traditional insurers use the more conservative SAP accounting method that does not permit such accounting practices.

"The main argument we get from noncaptive jurisdictions is: We can't compare financial standards and information to other licensed companies," Mr. Hampton said.

The subgroup's proposed recommendation is that an RRG's financial statements may be prepared in conformity to GAAP, or some other modification of SAP, however, "a reconciliation back to SAP would be required in the footnotes," according to a summary that is yet to be approved.

In addition, the most controversial outstanding issue before that subgroup is setting the minimum capitalization requirement for reinsurers--if RRGs want to be able to take credit for the reinsurance.

Derick White, Vermont's director of captive insurance, said in an e-mail that "most of the other states are saying they follow the traditional guidelines," which require that an admitted reinsurer have at least $20 million of capital or a fully funded trust fund in place.

"I find that hard to believe," he said. "We worked it out with the NAIC back in the 1990s--when Vermont was being accredited--that our approved reinsurers would have at least $10 million in capital and surplus and that is what we are pushing," Mr. White said.

Requiring $20 million in reinsurer capitalization is "inappropriate for the marketplace," Mr. Myers said. "It is not necessary for the risk."

The subgroup expects to resolve that issue in the near future and then will review other accreditation policies and practices. It hopes to complete its work by June and make final recommendations to its parent committee, Ms. Patterson said.

DISCLOSURE and GOVERNANCE

Mr. Wagner's property/casualty subgroup first worked on improving transparency for insurance buyers by requiring RRGs to expand their disclosure notification and make clear that state insurance insolvency guaranty funds are not available for the RRG. While such disclosure notification has been required on all RRG policies, it was not present on the certificates that some RRGs gave buyers in lieu of a copy of the policy, Mr. Wagner said.

Now, the subgroup is proposing that disclosure must be made in prominent, boldface type on every application form, every certificate, and on the front and declarations pages of every policy.

The subgroup also tackled several corporate governance issues aimed primarily at so-called "entrepreneurial RRGS," which are typically capitalized and organized by an individual or small group of managers and service providers seeking both fees for services rendered and profits.

"The circumstances surrounding more than half of past RRG failures we examined suggest that management companies or managers have promoted their own interests at the expense of the insureds--for example, by charging excessive management fees or promoting transactions unfavorable to the RRG," the GAO report said.

"Because (other than requiring that owners must also be insureds) LRRA does not imposed minimum characteristics of ownership and control for RRGs or establish minimum governance requirements, RRGs can be operated in ways that do not consistently protect the best interest of the insureds," according to the GAO report.

In hard market conditions, however, there was a need for entrepreneurial RRGs, especially to meet the needs of physicians and hospitals seeking medical malpractice coverage, Mr. Hampton said. "A lot of policyholders did not know they had an ownership interest...and a lot of these boards had no independent directors," he said.

"The GAO expressed concern--which regulators shared--that control of the RRG should rest with the members...and not be subservient to the interests of the service providers," Mr. Wagner said.

Adoption of the proposed corporate governance guidelines "would be significant change," especially for newer state domiciles such as Delaware, Montana and Utah, because many do not have such corporate governance standards, Mr. Hampton said. The District of Columbia department would have to adopt measures to ensure boards have some independent directors as well as periodic approval of service provider contracts, he said.

The subgroup expects to adopt the disclosure and governance proposed standards before the NAIC's meeting in March. It then plans to refer them to the Financial Condition Committee for inclusion in the examiner's handbook, the adoption of which is an accreditation requirement, Mr. Wagner said.

Reaction to the work of the NAIC subgroups has been generally positive.

Overall, both NAIC subgroups "have been working hard and have made some progress, but they still have a ways to go," said Larry Cluff, assistant director--financial markets and community investment unit for the GAO. He oversaw research and writing of the GAO's report and has monitored the subgroups' progress.

"I'm not sure anyone is completely satisfied, but in a compromise situation, that's really the best you can hope for," Mr. Cluff said.

For both NAIC subgroups, "the process was well-done and, therefore, the results we've seen are good results and palatable," said Molly Lambert, president of the Burlington, Vt.-based Vermont Captive Insurance Assn.

Regulators from captive domiciles "have been wonderful educators and a moderating influence" on regulators who were less familiar with captives, said Jon Harkavy, executive vp with Risk Services L.L.C. in Arlington, Va.

"The result has been reasonably good for everyone," Morris Manning's Mr. Myers said, although he, like other industry representatives, says the result is "not perfect and we don't agree on everything."