RRGs: The Last Best Hope For State Regs?

Risk retention groups have been one of the most interesting experiments in insurance regulation in the past half-century. Designed to permit commercial and nonprofit entities to self-insure when capacity in the conventional market is limited, RRGs have recently flourished during the hard market of the past few years.

Yet how ironic it is that the National Association Insurance Commissioners has chosen this time to undertake yet another attack against this unique form of alternative risk transfer.

Ironic because the NAIC is vigorously seeking to defend state regulation from federal intrusion. RRGs are exclusively regulated by the states, even though the legislation which created the RRG regulatory system is federal. RRGs offer the most efficient and benign form of federal regulation.

In other words, if the states want to retain their authority over the business of insurance, they should perhaps look to the regulation of RRGs as a model. Their failure to do so may reflect more on their unwillingness to depend upon the day-to-day regulation of their sister states than on the validity of the model.

RRGs can provide capacity in hard markets for a number of reasons. First, the capitalization required of an RRG by its state of domicile is consistent with that of other forms of captivesit is not burdensome. An RRG is, after all, one form of captive–an association captive.

Second, an RRG, once it is licensed in the state of domicile, can do business in another state after it has made a “notice” filing with that state. It does not need to go through the time consuming process of becoming fully licensed in each state in which it does business.

Congress very clearly articulated in the legislative history of the Liability Risk Retention Act that the design of RRGs was to cut through the web of overlapping and sometimes conflicting state regulation for the purpose of enabling multistate programs. While a number of states still impose additional requirements on RRGs, Congress' design was to require an RRG only to file its plan of operation and feasibility study with a nondomiciliary state and then to be able to do business in that state without further regulatory approval.

Congress' intention was to provide flexibility or liquidity in the rigidity imposed by a hard market and, to a substantial extent, RRGs have been able to do so. In fact, nothing will cause an underwriter to reexamine pricing like the threat of losing market share to an upstart RRG.

The proof of this thesis is occurrences during the recent hard market. Over the past five years, RRG premium has approximately doubled, and the number of RRGs has grown from 70 in 2000 to about 147 today. Almost 40 percent of those RRGs have been in the health care sector. With the unavailability of medical professional liability insurance, RRGs have rushed in to fill the void.

State regulators dislike federal preemption because, of course, it creates a limitation on their authority. While Congress could have designated a federal agency to regulate RRGs, such as the Department of Commerce, it elected not to do so. This leaves the states with a different, but ultimately effective, regulatory structure.

Nonetheless, two myths continue: that RRGs are more likely to become insolvent than conventionally licensed insurers and that states are hamstrung in their ability to regulate RRG market conduct. Neither are true.

RRGs have performed comparably to licensed commercial insurers for solvency purposes over the last 20 years. A study of the property-casualty industry by AM Best for the period of 1981-2001 showed that approximately 1 percent of the 3,000 property-casualty carriers tracked by AM Best became insolvent annually. RRGs failed at a similar annual rate of about 1.1 percent per year.

It is important to understand that the state of the RRG's domicile is not limited in any way by federal law in its ability to regulate its domiciliary RRGs–preemption of state law only relates to the nondomiciliary states. This largely imitates the way licensed property-casualty carriers are regulated, although nondomiciliary states tend to defer to the domicile rather than being required to do so by federal law.

There is also no evidence that the regulatory structure for market conduct of RRGs is inadequate. In addition to the fact that the domiciliary state has unfettered legal authority, the nondomiciliary states have authority over the key ingredients of market conduct regulation such as taxation, claims settlement and unfair trade practices authority.

Without question, there have been examples of RRGs with market conduct or other regulatory infractions. RRGs are no more pure in heart and soul than other property-casualty insurers. Nonetheless, those infractions cannot be blamed upon an inadequate federally imposed regulatory structure.

More importantly, the means to address these problems lies within the existing capabilities of the states. A good example is recent concern about the issuance of automobile warranties by third-party contractors backed by insurance issued by RRGs.

Much regulatory angst has been expressed over the fact that RRGs have been involved in this business, even though many conventionally licensed carriers are involved, as well. An initial foray was made by state regulators to attack RRGs on the grounds that the liability exposure of the warranty obligors was not tort-based liability, but rather based on the contractual liability.

The problem with this approach is that there is absolutely no foundation for this conclusion in the LRRA or its legislative history. To the contrary, there is more than adequate support for the conclusion that contractual liability is permissibly offered by RRGs.

Upon reflection, however, two states have taken a more proactive approach to get at the root of the problem, which is not at the RRG level but at the warranty obligor level. The problem lies with lax and sometimes non-existent regulation of the warranty obligors, which generally are supposed to hold adequate reserves to pay warranty obligations. These obligations are, in turn, backed by a stop-loss or reimbursement coverage by either an RRG or a conventionally licensed p-c insurer.

Both Nebraska and Hawaii have issued bulletins that impose reporting and reserving requirements on these obligors so that funds are available to pay claims–a commendable approach because it targets the problem and then takes appropriate action to resolve it.

Nonetheless, it is also an example of a greater regulatory problem, which is that insurance regulators generally only have jurisdiction over insurance–not affiliated products.

In many states, a third-party warranty is not considered “insurance” and is subject to the oversight and regulation of the department of commerce or the attorney general of that state. This sort of regulatory structure produces any number of opportunities for commercial activities to slip under regulatory radar.

So though the regulatory structure for solvency and market conduct regulation of RRGs is adequate, good regulation takes time and attention and multistate coordination. In this respect, of course, RRG regulation does not differ from that of conventional insurers.

Insurance is the only portion of the financial services industry that is regulated primarily at the state level. This unique (and some would say antiquated) regulatory regime is subject to Congressional oversight on a continuing basis, but is only periodically subjected to a more vigorous challenge.

The last episode was during the early 1990s when the House Energy and Commerce Committee under then-Chairman John Dingell focused the attention of the industry and the media on some of the failings of state regulation.

Since the Dingell hearings, Congress has passed two statutes which have substantially encroached upon the exclusive authority of the states to regulate insurance–the Gramm-Leach-Bliley Act and the Terrorism Risk Insurance Act.

Perhaps more importantly, the insurance industry is beginning to warm to the prospect of federal regulation. Several large insurance trade associations support alternative federal chartering for insurance companies, and others appear to be open to the concept of federal minimum standards, which would be imposed on the states by Congress.

Congress has taken the necessary steps to prepare. The Congressional Research Service recently published a well-balanced evaluation of RRG regulation, and the General Accounting Office issued a study that was critical of many aspects of state regulation. GAO is now in the process of preparing an examination of the state regulation of risk retention and purchasing groups.

The House Financial Services Committee has announced it will hold at least two hearings this year even though the legislative calendar is already packed. The first, which may be as early as the end of March, will specifically deal with various state regulatory problems and will provide suggestions for congressionally imposed regulatory fixes. The introduction of legislation is likely to follow. The second, on the Terrorism Risk Insurance Act, will lay the groundwork for congressional deliberations about whether TRIA should be reauthorized.

How are the states positioning themselves to resist the assault on the citadel of state regulation? NAIC President Ernst Csiszar has been quoted recently saying that states should realize that federal encroachment on state authority is inevitable and they should become involved in the legislative process to ameliorate the results.

While the states are seeking a legal structure to preserve their regulatory authority, they are overlooking–and distancing themselves from–a model which clearly works: the “lead state” model employed in the LRRA. The only federal involvement in this model is the enactment of the legal structure in a law passed by Congress. There is no federal regulatory involvement other than oversight, which Congress already has.

More importantly, this model could readily be used for those issues which states currently find so difficult to deal with, such as agent licensing and insurer licensing. In a manner similar to the LRRA, Congress could enact a statute that would place primary regulatory authority on the state of domicile and require nondomiciliary states to accept that authority and to exercise limited ancillary authority in those areas that are of particular interest to the citizens of that nondomiciliary state.

Ironically, it is the NAIC itself which has touted “lead state” regulation. In its “A Reinforced Commitment: Insurance Regulatory Modernization Action Plan” dated Sept. 14, 2003, the NAIC mentions the “lead state” concept as essential to both solvency regulation and regulation for change of insurance company control. In regard to “speed-to-market” and producer licensing, the NAIC overlooks “lead state” regulation but relies on “uniformity” and “interstate collaboration.”

The NAIC should embrace this model, which has not only been proven with regard to RRG regulation, but also has been adopted by other countries. Insurance regulation in the European Union is structured on this basis.

An insurer chartered in France, for example, is licensed to do business in Greece, and the Greek authorities only have minimum ancillary regulatory authority. This model, however, is based on two important criteria: a minimum level of consistent regulatory standards and enforcement and trust among the participating countries that regulations will be applied consistently and fairly.

Why can't this system work in the United States? After all, if Italy can depend upon Germany, why can't Indiana depend upon Georgia?

Robert H. “Skip” Myers Jr. is general counsel for the National Risk Retention Association and a partner with Morris, Manning & Martin, LLP in Washington, D.C.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, March 12, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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RRGs: The Last Best Hope For State Regs?

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