Effective Strategies for Forming and Managing Risk Retention Groups

Once the decision to form a captive insurance company is made, the next important decision is choosing the appropriate type of captive. For those focused on liability risk, particularly within industry affinity groups or associations, risk retention groups (RRGs) can offer a suitable option. RRGs are often easier to establish and align closely with the goals of their members.

The Liability Risk Retention Act (LRRA) of 1986 is a federal law that authorized the formation of RRGs and Risk Purchasing Groups (RPGs) to provide insurance for certain types of liability exposures. The act aims to increase the availability and affordability of liability insurance by enabling businesses with similar risk profiles to pool their resources and form their own insurance companies. The LRRA allows these groups to be licensed in one state but operate in multiple states, preempting conflicting state insurance regulations. This has helped many businesses and associations manage their liability risks more effectively.

The LRRA enables RRGs to function as captive insurance companies overseen by federal regulation and licensed within a favorable state jurisdiction. A valuable feature of the LRRA allows RRGs to sell insurance in any state. However, while the LRRA facilitates policy issuance across all states, regulatory compliance remains essential. Compliance filings and statutory financial statements must be submitted to each state with persistent ongoing challenges among captive managers, RRG owners, and state regulators regarding approval to write policies in each state.

During the hard insurance market of the 1980s, which began in 1983 and lasted through the late 1980s, liability capacity nearly disappeared, prompting the creation of innovative group captive insurance solutions. For instance, Ace Ltd was formed in 1985 primarily to provide first-layer excess liability insurance, while XL Ltd was established in 1986 to cover second and upper-layer excess liability insurance. Both Ace and XL were creations of Marsh & McLennan. Ace eventually became a public company and purchased Chubb in 2016, changing their corporate parent's name to the more widely known brand, Chubb. XL also became public and was purchased by Catlin Group and then by the French global giant, AXA Insurance Group.

As capacity began to return in the late 1980s, RRGs and single-parent and group captives introduced new liability capacity, helping the market for general liability, product liability, and excess liability recover. RRGs also became a strategic tool for the healthcare industry.

The LRRA specifies that RRGs and RPGs may only insure third-party liability risks and cannot cover property. Unlike RRGs, RPGs do not retain any risk; instead, they are fully insured through guaranteed cost master policies that cover risks within a similar industry.

Forming an RRG is relatively straightforward, particularly in states favorable to hosting them. An RRG can be established with $500,000 in initial capital and surplus. There is also significant flexibility in the liability insurance policies that can be created, allowing for customized policy forms. RRG-tailored policies can reinstate important coverages that have been restricted by the commercial insurance market. When properly structured, reinsurers will generally accept the manuscripted policy wording.

Reinsurance partners are crucial for protecting the balance sheet of a newly formed RRG. For instance, it is possible to limit risk by retaining the first $150,000 or $250,000 of each occurrence, with reinsurers covering the difference between the RRG retention and policy limits. Following the 70 percent/30 percent rule, a new RRG can transfer excess losses beyond its retention to a reinsurer for about 30 percent of the premium or less. As the RRG matures, the reinsurance cost as a percentage of premiums will decrease. In this arrangement, the RRG retains 70 percent of the premium to fund its retained limit, known as the loss fund.

Owning an RRG allows for maximizing expense control, policy wording, and claim resolution. Key considerations when starting an RRG include maximizing the loss fund and minimizing expenses. Aim for expenses to be between 35 percent and 40 percent of the premium while setting aside 65 percent for the loss fund to cover retained losses. RRGs have a significant advantage in expense control. Once an RRG is licensed and properly established, it can write insurance in nearly every state within 60 days of receiving a certificate of authority. This eliminates the need to purchase a fronting policy from a commercial insurer, potentially saving 5 percent to 8 percent of the premium and expanding the loss fund. However, the RRG may need to be rated to gain acceptance from stakeholders. A crucial principle for maintaining rates and premiums and protecting the loss fund is to never charge a premium below the current insurance market rates. Adhering to this rule safeguards the loss fund and the RRG itself. Successful RRGs can return underwriting profits to their shareholder insureds.

Another opportunity for expense control is effective claims management. Partnering with a strong third-party administrator (TPA) can help manage claim costs more efficiently. TPAs typically charge a fee per claim rather than a percentage of the claim amount, as many insurers do. It is important for the RRG to build legal defense panels that understand its clients' businesses and work to resolve claims quickly. Skilled defense counsel, familiar with the RRG's policyholders and industry, can effectively work to absolve the RRG's insureds from liability, providing significant benefits. The goal is for the plaintiff's counsel to recognize that the RRG presents a strong defense and is not an "easy mark."

Defense expenses are a significant allocated loss expense. By negotiating legal fees with panel counsel, the RRG and TPA can better control these costs. Unlike conventional insurance, where settlement authority rests with the insurance company, an RRG retains this authority as a licensed insurer, allowing for more effective management of final claim decisions.

To be insured in an RRG, an individual must be an RRG owner. Different classes of stock are created, with controlling ownership holding Class A stock and RRG insureds purchasing Class B stock. Through ownership, insureds are entitled to a share of underwriting profits as declared by the board of directors. This ownership and potential to share in underwriting profits incentivize RRG insureds to manage risk, follow best practices, and control claim activity. Underwriting profits can be returned as taxable dividends or renewal premium credits, reflecting the insured's share of the profits.

Where should an RRG be domiciled? Several captive-friendly states actively seek RRGs for their domicile. An RRG-friendly regulator is the best business partner, and total transparency with the captive regulator is essential. When changes in policy wording, rate adjustments, or other key management and administrative issues arise, direct access and quick response from the regulator are critical to the RRG's mission. Some of the friendly domiciles include Vermont, Montana, South Carolina, Tennessee, and North Carolina.

The startup and ongoing service team for an RRG, essential to its operations, includes actuaries, lawyers, TPAs, and captive managers. Beyond interviewing the regulator, it is important to ensure that the RRG's actuaries, lawyers, and captive managers are recognized by the captive division at the state's Department of Insurance.

Successful RRGs should adhere to their business plans, which are required along with an actuarial study during the application process. Regulators monitor RRGs to ensure compliance with these plans. As an RRG grows and seeks to expand its coverage, updated business plans should be filed. Regular communication and in-person meetings with regulators can provide valuable insights into RRG operations. It helps to keep an open line of communication with the regulator and meet in person to grant insight into RRG operations. RRGs that consistently follow their business plans are typically successful.