A risk retention group is defined in the risk retention act as any corporation or other limited liability association taxable as a corporation, or as an insurance company, formed under the laws of any state, Bermuda, or the Cayman Islands with the following characteristics:

1.     primary activity consists of assuming and spreading all, or any portion, of the product liability or completed operations liability risk exposure of its group members;

2.     entity is organized for the primary purpose of conducting the activity described under subparagraph (1);

3.     entity is chartered or licensed as an insurance company and authorized to engage in the business of insurance under the laws of any state, or which is so chartered or licensed and authorized before January 1, 1985, under the laws of Bermuda or the Cayman Islands, except that any group so chartered or licensed and authorized under the laws of Bermuda or the Cayman Islands shall be considered to be a risk retention group only after it has certified to the insurance commissioner of at least one state that it satisfies the capitalization requirements of such state;

4.     entity does not exclude any person from membership in the group solely to provide for members of such a group a competitive advantage over such a person; and

5.     entity is composed of members each of whose principal activity consists of the manufacture, design, importation, distribution, packaging, labeling, lease, or sale of a product or products.

Completed operations liability, as found in the 1981 Product Liability Risk Retention Act, is defined as those liabilities arising from the installation, maintenance or repair of any product on a site not owned or controlled by l) a person performing the work or 2) any person who hires an outside or independent contractor to perform that work. Completed operations liability coverage also includes liability for activities completed or abandoned prior to the date of the occurrence that brings about an exposure to liability.

Products liability, as found in the 1981 Product Liability Risk Retention Act, generally is defined as a liability for damages resulting from a personal injury, death, emotional harm, economic or property damages engendered by the loss of use of a property which arises from the manufacture, design, importation, distribution, packaging or labeling of a product leased or sold. It does not include the liability of any person for damages if the product was in the possession of that person when the occurrence causing the claim took place.

Ownership of an RRG is restricted. An RRG can be owned only by the members who are provided coverage. An ownership interest in an RRG is exempt from the registration requirements of the federal securities laws and is exempt from state “Blue Sky” laws. This does not mean that those forming an RRG do not have to fully and truthfully disclose the nature of the undertaking. Owners of an RRG are subject to those securities laws dealing with attempts to defraud the public.

The 1986 Risk Retention Act states that an RRG can be a corporation or other limited liability association. Examples of other limited liability associations include reciprocals and mutual companies. Thus far, most RRGs have been stock corporations.

The law allows risk retention groups to write liability insurance for all or any portion of the exposures of group members. Both liability and insurance are defined terms.

The term “insurance” includes primary insurance, excess insurance, reinsurance, and surplus lines insurance. Other risk-sharing arrangements that qualify as insurance under a state or federal law are also included in the definition.

“Liability” means legal liability for damages (including costs of defense, legal costs and fees and other claims expenses) because of injuries to other persons, damage to their property, or other damage or loss to such other persons. The liability must arise out of business (whether profit or non-profit), trade, product, services (including professional services), premises or operations. Alternatively, the liability must arise out of the activities of the operation of state or local governments, or their agencies or subdivisions. First party coverages (e.g., property coverage, workers compensation and personal lines) cannot be written by a risk retention group.

Risk retention groups are subject to regulation by insurance departments in the state in which they are chartered. This state regulation normally focuses on the licensing and the operations of the RRG. An RRG may be licensed as a standard domestic insurer. However, many states have passed enabling legislation permitting an RRG to be licensed as a captive or other special insurer under an RRG statute. Requirements for licensing are often less stringent under a captive or RRG law. (For example, the investment guidelines may not be as strict. Many of these laws permit the use of letters of credit to satisfy the capital and surplus requirements in lieu of cash or securities.) In addition, the capital and surplus requirements usually are not as high as those required of domestic insurers.

An RRG must file a plan of operation or a feasibility study with the state in which it is chartered before it can sell insurance in any state. The plan must include an actuarial analysis. The plan also must be filed in any state where the RRG plans to operate. Revisions of the plan also must be filed in the state where the RRG is chartered and in any states where the RRG plans to operate.

An RRG must file a financial statement certified by an independent public accountant with its domiciliary state and in each state where the RRG is doing or wishes to do business. The financial statement must include an opinion on the reliability of its loss and loss adjustment expense reserves.

State or federal courts can enjoin an RRG from selling insurance to an organization not eligible for membership in the group. State or federal courts also can enjoin an RRG from selling insurance or from operating if the RRG is in a hazardous financial condition or is financially impaired.

Risk retention groups are not exempt from meeting the coverage requirements of any state motor vehicle financial responsibility law or no-fault law. Therefore, RRGs must use the policy forms required by any state in which they operate.

In the states where an RRG is not chartered, the regulatory authority of the insurance commissioner over a risk retention group is restricted. While the primary responsibility for regulating an RRG lies with the state in which it is chartered, any state in which the RRG operates may conduct limited regulation of it. The regulation must be conducted so that it does not discriminate against the RRG. Any state can require an RRG to:

1.     comply with its unfair claim settlement practices law;

2.     pay the same taxes levied on admitted insurers and surplus lines insurers (This includes a premium tax.);

3.     participate in liability pools (Examples are joint underwriting associations, assigned risk plans, and reinsurance mechanisms.);

4.     register with the insurance commissioner and designate the insurance commissioner as its agent for service of process or service of legal documents;

5.     submit to an examination (Examinations are normally conducted by the state in which an RRG is chartered. However, another state can conduct an examination if the commissioner in the chartering state has not initiated or refuses to initiate an examination. The law stipulates that examinations should be coordinated to avoid unjustified duplication and unjustified repetition. But, the law does not define how the coordination process should function.);

6.     comply with a lawful order issued in a voluntary dissolution proceeding or in a delinquency proceeding following an examination that has revealed that the RRG is financially impaired;

7.     comply with laws governing deceptive, false, or fraudulent acts or practices;

8.     comply with an injunction issued at the request of the insurance commissioner (The injunction must be issued by a court of competent jurisdiction and must be based on the allegation that the RRG is in hazardous financial condition or is financially impaired.); and

9.     include a notice on all policies that the policies are issued by an RRG, that the RRG may not be subject to the insurance laws of the state, and that the state guaranty fund does not guarantee the policies issued by any RRG.

No state can require—or for that matter, even allow—a risk retention group to be part of a guaranty fund developed for domestic insurance companies. No state can require a policy to be countersigned by a licensed resident insurance agent or broker. This does not mean, however, that a countersignature by a nonresident licensed agent or broker cannot be required.

The rules cited above apply not only to RRGs but also to organizations providing services to RRGs. Thus, organizations providing insurance-related management, operation, claims, and investment services enjoy the same exemptions afforded RRGs.

States may regulate or prohibit ownership of an RRG by an insurance company. This would not apply if the RRG were comprised of and owned by insurance companies whose risks are covered by an RRG.

RRGs offer several advantages to organizations wanting to self-insure as well as to those organizations already self-insuring. The advantages include:

1.     risk management expertise;

2.     reinsurance coverage;

3.     a spread of risk;

4.     expertise in specialty area of the members;

5.     handling of regulatory requirements;

6.     a stable market for coverage and rates;

7.     legal, accounting, actuarial, and investment expertise;

8.     financial reports; and

9.     a network of coverage for worldwide exposures.

These advantages are similar to the advantages offered by group workers compensation self-insurers to their members.

While RRGs can be an excellent self-insurance tool, they are not without potential problems. The RRG process must be viewed as a long-term operation. Organizations that become involved with an RRG should realize that it is often more difficult to extricate themselves from the RRG than it was to form it.

An improperly managed RRG could become, in the long run, more expensive than buying insurance. Claims handling and underwriting can cause the most problems. Claims must be pursued vigorously. Underwriting guidelines must be followed regardless of the political pressure some owners might exert to write uninsurable coverage or to write coverage at inadequate rates.

It is possible to lose control of an RRG to a small group of owners. If the ownership of the RRG is evenly distributed among a large group of policyholders, this problem can be avoided.

Another problem area is reinsurance. If the reinsurance market is unwilling (for any number of reasons) to write the coverage the RRG needs, it will have difficulty meeting the insurance needs of its members.

An RRG may not provide the coverage that all its owners need. Some organizations may require specialized coverages that must be placed with insurers. Ordinarily, this should not create a problem.

Finally, the RRG option can result in rate stability, but not necessarily the lowest rates. Organizations may find that at some point during an underwriting cycle they can purchase coverage from an insurer less expensively than they can purchase coverage from their RRG.

There are five areas that should be examined when deciding whether to form an RRG. These areas are:

1.     leadership;

2.     funding;

3.     expertise;

4.     insurance markets; and

5.     nature of risks.

The first area that must be evaluated is leadership. An organization should never form an RRG unless there is strong leadership. The leadership can be provided by an individual or a group. Leadership does not mean an individual who likes the idea of starting an RRG. Leadership means someone who is committed to the concept of an RRG, who believes it will work for his or her organization or group of organizations, and most importantly, who wants to work to make an RRG a reality.

Funding is always a crucial issue. There are usually two stages involved in the funding process. The first stage involves funds to evaluate the RRG option and to determine if the concept is feasible. The second stage of the process involves capital for the formation and operation of the RRG.

Occasionally, the two stages are funded simultaneously. Funds are initially collected and used to evaluate the RRG option. If a decision is made to form an RRG, the balance of the funds is used to form and capitalize the RRG; if the decision is not to go forward, the funds are returned.

There are several methods of raising the funds necessary to meet these two stages, but two approaches are commonly utilized. Under the first approach, the funds for the initial stage are donated by those interested in the concept. (Contributions by organizations need not be in the form of money. An executive's time—which has a value—can be contributed. Often this person is the driving force behind the decision to examine the possibility of forming an RRG.) If the decision is made to form an RRG, additional funds can be obtained from other organizations that want to be part of the RRG.

The second approach involves advance deposits. Potential RRG insureds are frequently asked to contribute a percentage of the premium they are currently paying for the insurance coverage that will be offered by the RRG. For example, an organization now paying $100,000 for products liability coverage would be asked to deposit 5 percent of its current premium. Under this approach, if the RRG is formed, the deposit serves as the organization's contribution. (Under some plans, an organization may have the right to a refund should it decide not to join the RRG.)

If no funds are available, formation of an RRG is still not impossible—although the probability is fairly low. For example, some consulting firms assist in raising funds for an RRG.

With reference to expertise, the formation of an RRG may depend on whether the sponsoring organization has existing staff or is willing to hire staff with expertise in insurance. The more expertise the sponsoring organization has, the greater the chance the RRG will succeed once it is formed. Having expert staff is also important because most sponsoring organizations require a service company to assist in operating their RRG. The service company selection process can be less difficult when the sponsoring organization staff is familiar with the services required by their RRG. A knowledgeable staff also makes the proper evaluation of the service company more certain.

As for insurance markets, it is ironic that an organization must evaluate these markets to determine if it can form an RRG. However, if reinsurance is not available or is priced too high, the coverage that can be offered by the RRG will be severely limited (unless a substantial equity base can be developed).

Even if reinsurance is generally available, there is still no guarantee that a new RRG will be able to obtain the reinsurance coverage it requires. Many reinsurers are reluctant to offer coverage to a new RRG whose members do not yet have a track record. This fact should be considered when evaluating whether reinsurance is available. Reinsurers often require safety programs and other loss reduction and loss prevention programs. A new RRG should be prepared to pay for these programs and supply a prospective reinsurer with plans for them.

Finally, the federal RRG act permits RRGs to write coverage only for businesses with similar exposures, similar business natures. Therefore, a crucial consideration when evaluating the risks to be covered by an RRG is whether the risks are similar. If they are not, the RRG cannot insure them.

However, even if this criterion is met, there are still other factors to consider when examining the nature of the risks to be covered. For an RRG (or any other insurance entity) to function successfully, it is important to have a spread of risks—not one that is subject to adverse selection. Also, the risks should not be subject to a single catastrophic loss. Problems in these areas can be partially handled by reinsurance; for example, excess reinsurance coverage can be purchased to protect against catastrophic losses. However, reinsurance is not always available; or, if it is available, the reinsurer may not want to help an RRG out of the hole it dug for itself through improper underwriting.

Methods other than reinsurance exist for handling adverse selection and spread-of-risk problems. For example, adverse selection can be avoided with strict underwriting standards used in conjunction with a retrospective rating plan. Alternatively, a better spread-of-risk can be realized by bringing more organizations into the RRG.

This section examines factors that must be considered once the decision to form an RRG has been made. Some of these items overlap with the items just discussed. The factors include:

1.     Who should control the RRG?

2.     Where should the RRG be formed?

3.     How much equity is needed?

4.     How will operations be handled?

5.     What will be the underwriting guidelines?

6.     Can directors and officers liability coverage be purchased?

7.     Is the underwriting cycle producing a soft market?

8.     What organizational structure should be selected?

The decision to form an RRG does not mark the end of the questions that must be answered. Control of the RRG must be decided. Normally, control of an RRG hinges on which of two forms of sponsorship the RRG takes. First, the RRG can be sponsored by an association or secondly, it can be sponsored by individual firms that have a close, but informal, affinity. Both of these forms require 100 percent participation of the firms making up the sponsoring entity.

If a national association forms the RRG, it can encounter two problems. The first problem is political. Although associations are often controlled by a few active members, all the members of the association are required to participate in the RRG. (Under the 1986 Risk Retention Act, if an association sponsors an RRG, the members of the association must join the RRG and the owners of the association must comprise the membership of the RRG and be insured by the RRG.)

The second problem to be avoided is discrimination. The sponsoring organization must avoid discrimination against non-members. The federal statute forbids the formation of an RRG for the purpose of providing a competitive advantage to any member of an organization. (The problem of discrimination resulting in a competitive advantage for RRG members arises even when no association sponsor is involved. However, if a national association sponsors the RRG, it is particularly visible and subject to criticism.)

Many states have RRG statutes or include RRGs under their captive statutes. The state where the RRG is domiciled—or chartered—is the state whose insurance department regulates it. Consequently, the chartering state's insurance and captive laws—in comparison to other states—are important. Other factors to consider when deciding where to form an RRG include taxes, requirements for in-state directors, restrictions on home office location, expertise of regulatory personnel, capital and surplus requirements, initial filing requirements, investment restrictions, reinsurance requirements, time required for application approval, and coverage requirements.

A rule of thumb frequently used when establishing the capital requirements of an RRG is that equity should be ten times the retention per exposure. For example, if an RRG plans to offer liability coverage of $100,000, its equity should be at least $1 million. While this is a useful rule of thumb, the equity that is actually needed should be determined by an actuary. Regardless of how the RRG determines its capitalization, each jurisdiction allowing formation of RRGs prescribes a minimum equity requirement.

Another major question to answer as an RRG is being formed is who will be responsible for operating the RRG program. Most new RRGs are run by professional service companies.  Most major brokerage firms have subsidiaries that provide RRG management services. In addition, there are a substantial number of independent firms that manage RRGs.

Selection of a service company to run an RRG is often difficult. Three factors are important when evaluating a service company. First is the experience of the servicing firm. Running an RRG is a difficult task where experience counts. Finding and selecting an experienced service company is a task that requires patience. Candidates should be scrutinized closely.

The second important factor is personalities. Many organizations experience internal political problems while forming an RRG. Not all service companies are sensitive to the internal struggles of the sponsoring organization. Make these problems known to the candidates and look at how they deal with them in their proposals.

The cost of the services is important. Some service companies do not charge large fees to form an RRG but, instead, try to lock themselves into the management process. They break even on the initial stages of the process expecting to make it profitable over the long run. There is nothing wrong with such an approach. However, the service company should not be allowed to become so entrenched that it will be difficult to replace.

Underwriting guidelines must be established early in the RRG formation process and the fact that these guidelines exist for the benefit of the RRG must be made known to members. Often it is difficult for the organization sponsoring an RRG to realize that it must underwrite coverage. An RRG cannot accept every risk that is offered or its underwriting results will deteriorate. Some of the risks accepted will have to pay higher premiums, accept restricted coverage, or agree to be placed on an experience or a retrospective rating plan. This can create political problems—particularly if the RRG is sponsored by an association. Therefore, underwriting standards should be established quickly to avoid misunderstandings. This will mitigate friction when special considerations such as a deviation from underwriting standards are requested. Members must understand that the RRG is a long-run solution that demands adherence to strict underwriting and acceptance standards.

To find and retain good personnel, an RRG must obtain liability coverage for its directors and officers as soon as possible. When negotiating with the service company, procurement of Directors' and Officers' (D&O) coverage should be stipulated as one of its duties.

There is usually a direct correlation between the strength of a firm's desire to establish an RRG and the hardness of the insurance market. When insurers are raising premiums, organizations' interest in alternative risk financing increases. When premiums decline, interest in such alternatives also decline.

The result is that companies rush to form RRGs at the wrong time. This approach is unwise for at least two reasons. First, for an RRG to succeed, it is necessary to take the time to properly plan and organize it. Second, because of the nature of insurance cycles, a rush to form an RRG when rates are increasing can cause it to become operational just as rates begin to decline. Such rushing leaves the organizers with an improperly formed and badly-timed RRG. The best time to organize an RRG is when rates are still low, but there is talk about their increasing. It is important to understand, though, that the RRG will not always offer the lowest rates, particularly during a soft market.

As for the organizational structure, as noted previously, RRGs can be organized as corporations or other limited liability associations.