3 Lessons from the Spirit Commercial Auto RRG Failure

On February 27, 2019, the Eighth Judicial District Court of Nevada issued an order appointing the Nevada insurance commissioner as the permanent receiver for Spirit Commercial Auto Risk Retention Group (Spirit). The risk retention group (RRG) was placed into permanent receivership because the court found it was insolvent, in hazardous financial condition, and unable to pay all its insurance policy claims. Spirit is not the first RRG to be placed into receivership nor is it likely to be the last. And, while it's too early to know the exact cause or causes that led to its failure, Spirit does provide an opportunity to look at lessons that can be learned from its failure.

(Editor's note: For additional details on the matter, see the Risk Retention Reporter's February 2019 issue, which contains an investigative report on Spirit, including reporting on an auditor's letter alleging material misstatements, the restatement of the company's 2017 annual filing, and a loss portfolio transfer deal in excess of $100 million.)

Formation and Growth

While the formation of new RRGs will not come to a halt, the failure of Spirit will impede the formation of new RRGs and the growth prospects for existing RRGs. Any time a failure like this occurs, it gives the traditional markets new ammunition in their quest to turn both agents and policyholders away from RRGs.

A quick Internet search turns up a number of articles and commentary about RRG insolvencies that highlight the risks in using these alternative market solutions.

The following is from a November 16, 2017, post titled "Recent Insolvencies Speak to the Risks of Insuring with an RRG" on a blog published by a Berkshire Hathaway-owned insurer.

We have written before about the risks of insuring with risk retention groups (RRGs). Among the risks is a lack of insolvency protection for policyholders. Since RRGs not licensed in NYS are not eligible for protection by the NYS Property/Casualty Insurance Security Fund, policyholders are not protected by the state's guaranty fund when such an RRG becomes insolvent....

The effect of liquidation on a policyholder creates a series of problems, distractions and disruptions. Foremost is that existing insurance coverage will, at worst, cease to exist before the policy expiration date or, at best, provide far less financial protection than originally agreed to and purchased. Policyholders will be faced with immediately procuring replacement coverage and the accompanying business disruption. For those policyholders actively engaged in malpractice litigation there will be even more financial uncertainty because they will now be responsible to pay some or all of their defense costs and indemnity payments. Beyond these increased financial obligations, the litigation process will be stayed for an extended period of time, meaning that the lawsuit will remain open for an extended period of time.

Educated Board Members and Independent Directors

The Spirit failure was a prominent topic for discussion during the Captive Insurance Companies Association 2019 International Conference March 10–12.

A.M. BestTV devoted a video segment to the issue as part of its reporting from the CICA conference. However, another A.M. BestTV video report from the conference also deserves attention. In it, A.M. Best interviewed Mike Meehan from Milliman about why captive board members need a crash course in risk.

Mr. Meehan made the point that most captive board members come from a different line of business than insurance, and therefore insurance is not their area of expertise. This is certainly true for RRGs and group captives, where the board is typically comprised of policyholders in the line of business the RRG or captive insurer was formed to protect. In the case of Spirit, the board members probably were owners of trucking companies. So, their vernacular is based on the business in which they operate. Therefore, insurance terminology and how to interpret risk are not specialties they acquired naturally and would have required some education. Unfortunately, probably for myriad reasons, this education did not occur.

For the industry, this should serve as a wake-up call. We need to ensure that board members become knowledgeable about insurance and how to read and interpret the data that is being provided to them. Good governance is the basis for this requirement. A board cannot make informed decisions about something that they lack the knowledge to understand. Nor can they raise pertinent questions with accountants, actuaries, and brokers regarding the company they represent.

It calls into further question whether captives and RRGs should have one true independent director on their boards. Our definition of independence is probably different from the definition currently accepted by most captive managers, attorneys, and regulators. For us, a true independent director has no relationship whatsoever with the entity on whose board he or she serves. Therefore, an independent director is not staff from the captive manager, the legal counsel to the RRG, or the broker or agent. An independent director would serve as an early warning system to both the policyholders and the regulators when problems begin to surface.

Regulation

Invariably, failures like this one will invite additional regulation.

During the regulatory hot topics panel discussion at the conference, Vermont's top captive regulator, David Provost, said, "Every RRG insolvency is another black eye on the industry, according to the traditional regulators. So, we really try to work with companies to identify these issues early on and fix them if we can. If we can't, as regulators our job is to pull the plug at some point. From the times I've had to pull the plug, it's almost always worse than [originally] thought."

On the same panel, District of Columbia captive regulator, Dana Sheppard, said, "We have to work together to keep an eye on some of these bad actors. While the NAIC [National Association of Insurance Commissioners] has been pretty quiet lately, this is the kind of thing (certainly in a big case that affects many states) that opens the door for the NAIC to revise the working group or go to the task force, and before you know it they are looking at changing the way RRGs operate. Anything is fair game for the NAIC if we don't do a good job of policing our folks—it's important."

The problem for the industry is to make sure the result is likely to be at least somewhat beneficial and not a knee-jerk reaction to the problem. For that to occur, the industry needs to perform a postmortem of what went wrong with Spirit and coalesce around some sound ideas about how to prevent this from happening again in the future. A proactive approach with an outreach to both legislators and regulators is a better path forward than waiting to see what happens. But this will require some sort of champion to undertake this initiative. Who will step up?