Risk Retention Groups: Common Regulatory Standards and Greater Member Protections Are Needed
Published: 2005-08-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Congress authorized the creation of risk retention groups (RRG) to increase the availability and affordability of commercial liability insurance. An RRG is a group of similar businesses that creates its own insurance company to self-insure its risks. Through the Liability Risk Retention Act (LRRA), Congress partly preempted state insurance law to create a single-state regulatory framework for RRGs, although RRGs are multistate insurers. Recent shortages of affordable liability insurance have increased RRG formations, but recent failures of several large RRGs also raised questions about the adequacy of RRG regulation. This report (1) examines the effect of RRGs on insurance availability and affordability; (2) assesses whether LRRA's preemption has resulted in significant regulatory problems; and (3) evaluates the sufficiency of LRRA's ownership, control, and governance provisions in protecting the best interests of the RRG insureds.
section_title: What GAO Found
paragraphs: RRGs have had a small but important effect in increasing the availability and affordability of commercial liability insurance for certain groups. While RRGs have accounted for about $1.8 billion or about 1.17 percent of all commercial liability insurance in 2003, members have benefited from consistent prices, targeted coverage, and programs designed to reduce risk. A recent shortage of affordable liability insurance prompted the creation of many new RRGs. More RRGs formed in 2002-2004 than in the previous 15 years--and about three-quarters of the new RRGs offered medical malpractice coverage. LRRA's partial preemption of state insurance laws has resulted in a regulatory environment characterized by widely varying state standards. In part, state requirements differ because some states charter RRGs as "captive" insurance companies, which operate under fewer restrictions than traditional insurers. As a result, most RRGs have domiciled in six states that offer captive charters (including some states that have limited experience in regulating RRGs) rather than in the states where they conduct most of their business. Additionally, because most RRGs (as captives) are not subject to the same uniform, baseline standards for solvency regulation as traditional insurers, state requirements in important areas such as financial reporting also vary. For example, some regulators may have difficulty assessing the financial condition of RRGs operating in their state because not all RRGs use the same accounting principles. Further, some evidence exists to support regulator assertions that domiciliary states may be relaxing chartering or other requirements to attract RRGs. Because LRRA does not specify characteristics of ownership and control, or establish governance safeguards, RRGs can be operated in ways that do not consistently protect the best interests of their insureds. For example, LRRA does not explicitly require that the insureds contribute capital to the RRG or recognize that outside firms typically manage RRGs. Thus, some regulators believe that members without "skin in the game" will have less interest in the success and operation of their RRG and that RRGs would be chartered for purposes other than self-insurance, such as making profits for entrepreneurs who form and finance an RRG. LRRA also provides no governance protections to counteract potential conflicts of interest between insureds and management companies. In fact, factors contributing to many RRG failures suggest that sometimes management companies have promoted their own interests at the expense of the insureds. The combination of single-state regulation, growth in new domiciles, and wide variance in regulatory practices has increased the potential that RRGs would face greater solvency risks. As a result, GAO believes RRGs would benefit from uniform, baseline regulatory standards. Also, because many RRGs are run by management companies, they could benefit from corporate governance standards that would establish the insureds' authority over management.

section_title: Letter
paragraphs: In 1981, in response to recurring shortages of liability insurance, Congress  passed the Product Risk Retention Liability Act, now known as the Liability  Risk Retention Act (LRRA), which authorized the creation of risk retention  groups (RRG) to increase the availability and affordability of commercial  liability insurance. An RRG is a group of similar businesses with similar  risk exposures, such as educational institutions or building contractors,  which create their own insurance company to self-insure their risks on a  group basis.  Through LRRA, Congress first established a flexible  framework that allowed states to develop their own standards for the  formation and operation of RRGs.  In light of the recent unavailability of  affordable liability insurance, especially for medical malpractice coverage,  interest in forming RRGs has greatly increased. In addition, some industry  advocates now propose that RRGs be permitted to offer property coverage  as well. However, the recent and notable failures of several large RRGs  have raised questions about the adequacy of the RRG regulatory  environment and whether existing safeguards, such as the requirement that  each RRG provide copies of operational plans and annual financial  statements to each state in which it operates, are sufficient to ensure that  RRGs are operated and governed adequately to protect their insureds.
LRRA, expanded in 1986, facilitates the creation and operation of RRGs in  several ways. Most notably, LRRA partially preempts state insurance laws  by allowing an RRG’s formation and operations to be regulated primarily by  the state in which it is chartered, its domiciliary state, even when it sells  insurance in other states. LRRA largely limits the oversight role of  insurance regulators from nondomiciliary states (all states other than the  chartering state) to the right to receive copies of an RRG’s operational  plans and annual financial statements. In having only one regulator, RRGs  differ from “traditional” insurance companies, which are subject to  licensing and oversight by regulators in each state in which they operate.  Additionally, LRRA prohibits RRGs from participating in state guaranty  funds, which are available to settle the claims of insureds of a traditional  insurance company should that company fail.
LRRA’s legislative history indicates a view that single-state regulation  would provide adequate supervision of RRGs, largely because RRGs would  be providing insurance coverage only to their own members, and not the  public at large. While preemption is central to LRRA’s objective of  facilitating the formation and efficient interstate operation of RRGs,  Congress also expressed a view that LRRA’s prohibition on participating in  guaranty funds would provide a strong incentive for RRGs to set adequate  premiums and establish adequate reserves, as each RRG member would  know that there would be no other source of funds (other than the RRG’s  own assets) from which to pay claims.
RRGs are not the only mechanism by which businesses may establish self- insurance coverage. States also charter and regulate captive insurance  companies, which are established by single companies or groups of  companies to self-insure their own risks. Traditional insurance companies  sell insurance to the general public and are licensed in all states in which  they do business. In contrast, captive insurance companies largely insure  only their owners, who have the ability to manage and retain their own risk.   Thus, the degree of regulatory oversight required for captives is different  than that which is required for commercial insurers. States chartering  captives offer some regulatory relief to these companies, based on the  presumption that the owners of captive companies have sophisticated  knowledge about managing their own risks and are motivated to protect  their own interests. The captive is licensed in only one state and operates  under the captive insurance law of that domicile. However, should the  captive choose to conduct business outside its state of domicile, it would  be subject to the licensing and oversight of each state because captives that  are not also RRGs do not benefit from the partial preemption. Many states  have recognized RRGs as a form of captive and charter them under their  captive regulations.
In light of proposals to expand LRRA, and recent shortages of affordable  liability insurance, you requested that we assess how well RRGs have  achieved LRRA’s legislative goals of making commercial liability insurance  available and affordable. This report (1) examines the effect RRGs have  had on the availability and affordability of commercial liability insurance;  (2) assesses whether LRRA’s partial preemption of state insurance laws has  resulted in any significant regulatory problems; and (3) evaluates the  sufficiency of LRRA’s ownership, control, and governance provisions for  protecting the best interests of the insureds.
To ascertain the effect of RRGs on the availability and affordability of  commercial liability insurance, we surveyed regulators in all 50 states and  the District of Columbia and interviewed representatives from eight RRGs  serving different markets. In addition, we obtained information from the  National Association of Insurance Commissioners (NAIC) that estimated  the share of the commercial liability insurance market that RRGs held in  2003. To determine if LRRA’s partial preemption of state insurance laws  has resulted in significant regulatory problems, we surveyed all state  insurance departments to obtain information on their regulatory  experiences and obtained more specific information from regulators in 14  states, including some that do not domicile RRGs. To understand the  regulatory framework, especially the capitalization and financial reporting  standards under which most RRGs are regulated, we compared the  regulatory standards of the six states (Arizona, the District of Columbia,  Hawaii, Nevada, South Carolina, and Vermont) that had chartered the most  RRGs as of June 30, 2004. To assess the sufficiency of LRRA’s ownership,  control, and governance provisions in protecting the best interests of the  insureds, we identified provisions in LRRA that relate to these issues and  reviewed LRRA’s legislative history to ascertain Congress’ concerns about  these issues. Since LRRA largely delegates the regulation of the formation  and operation of RRGs to the domiciliary states, we reviewed the statutory  provisions of the six leading domiciliary states to determine whether they  addressed ownership, control, and governance, and interviewed their  regulators to identify insurance departmental policies. To understand how  the regulators implemented these statutes and policies, we reviewed the  chartering documents of the three RRGs most recently domiciled by each  of the leading domiciliary states. Finally, we identified whether factors  related to the ownership, control, or governance of RRGs contributed or, in  some cases, were alleged to have contributed to RRG failures. We  conducted our review from November 2003 through July 2005 in  accordance with generally accepted government auditing standards.   Appendix I contains a more detailed description of our objectives, scope,  and methodology.
subsections: section_title: Background
paragraphs: In the legislative history, RRGs were described as essentially insurance  “cooperatives,” whose members pool funds to spread and assume all or a  portion of their own commercial liability risk exposure—and who are  engaged in businesses and activities with similar or related risks.   Specifically, RRGs may be owned only by individuals or businesses that are  insured by the RRG or by an organization that is owned solely by insureds  of the RRG. In the legislative history, Congress expressed the view that  RRGs had the potential to increase the availability of commercial liability  insurance for businesses and reduce liability premiums, at least when  insurance is difficult to obtain (during hard markets) because members  would set rates more closely tied to their own claims experience. In  addition, LRRA was intended to provide businesses, especially small ones,  an opportunity to reduce insurance costs and promote greater competition  among insurers when they set insurance rates. Because RRGs are owned  by insureds that may have business assets at risk should the RRG be unable  to pay claims, they would have greater incentives to practice effective risk  management both in their own businesses and the RRG. The elimination of  duplicative and sometimes contradictory regulation by multiple states was  designed to facilitate the formation and interstate operation of RRGs.  “The (regulatory) framework established by LRRA attempts to strike a  balance between the RRGs’ need to be free of unjustified requirements and the public’s need for protection from  insolvencies.”
RRGs are not the only form of self-insurance companies; “captive  insurance companies” (captives) also self-insure the risks of their owners.  States can charter RRGs under regulations intended for traditional insurers  or for captive insurers. Non-RRG captives largely exist solely to cover the  risks of their parent, which can be one large company (pure captive) or a  group of companies (group captives). Group captives share certain  similarities with RRGs because they also are composed of several  companies, but group captives, unlike RRGs, do not have to insure similar  risks. Further, captives may provide property coverage, which RRGs may  not. Regulatory requirements for captives generally are less restrictive than  those for traditional insurance companies because, for example, many pure  captives are wholly owned insurance subsidiaries of a single business or  organization. If a pure captive failed, only the assets of the parent would be  at risk. Finally, unlike captive RRGs, other captive insurers generally  cannot conduct insurance transactions in any state except their domiciliary  state, unless they become licensed in that other state (just as a traditional  company would) and subject to that state’s regulatory oversight.
In contrast to the single-state regulation that LRRA provides for RRGs,  traditional insurers, as well as other non-RRG captive insurers, are subject  to the licensing requirements and oversight of each nondomiciliary state in  which they operate. The licensing process allows states to determine if an  insurer domiciled in another state meets the nondomiciliary state’s  regulatory requirements before granting the insurer permission to operate  in its state. According to NAIC’s uniform application process, which has  been adopted by all states, an insurance company must show that it meets  the nondomiciliary state’s minimum statutory capital and surplus  requirements, identify whether it is affiliated with other companies (that is,  part of a holding company system), and submit biographical affidavits for  all its officers, directors, and key managerial personnel. After licensing an  insurer, regulators in nondomiciliary states can conduct financial  examinations, issue an administrative cease and desist order to stop an  insurance company from operating in their state, and withdraw the  company’s license to sell insurance in the state. However, most state  regulators will not even license an insurance company domiciled in another  state to operate in their state unless the company has been in operation for  several years. As reflected in each state’s “seasoning requirements,” an  insurance company must have successfully operated in its state of domicile  for anywhere from 1 to 5 years before qualifying to receive a license from  another state. RRGs, in contrast, are required only to register with the  regulator of the state in which they intend to sell insurance and provide  copies of certain documents originally provided to domiciliary regulators.
Although RRGs receive regulatory relief under LRRA, they still are  expected to comply with certain other laws administered by the states in  which they operate, but are not chartered (nondomiciliary states), and are  required to pay applicable premium and other taxes imposed by  nondomiciliary states. In addition to registering with other states, LRRA  also imposes other requirements that offer protections or safeguards to  RRG members:  LRRA requires each RRG to (1) provide a plan of operation  to the insurance commissioner of each state in which it plans to do  business prior to offering insurance in that state, (2) provide a copy of the  group’s annual financial statement to the insurance commissioner of each  state in which it is doing business, and (3) submit to an examination by a  nondomiciliary state regulator to determine the RRG’s financial condition,  if the domiciliary state regulator has not begun or refuses to begin an  examination. Nondomiciliary, as well as domiciliary states, also may seek  an injunction in a “court of competent jurisdiction” against RRGs that they  believe are in hazardous financial condition.
In conjunction with the regulatory relief Congress granted to RRGs, it  prohibited RRGs from participating in state guaranty funds, believing that  this restriction would provide RRG members a strong incentive to establish  adequate premiums and reserves. All states have established guaranty  funds, funded by insurance companies, to pay the claims of policyholders  in the event that an insurance company fails. Without guaranty fund  protection, in the event an RRG becomes insolvent, RRG insureds and their  claimants could be exposed to all losses resulting from claims that exceed  the ability of the RRG to pay.
Finally, in terms of structure, RRG and captive insurance companies bear a  certain resemblance to mutual fund companies. For example, RRGs,  captive insurance companies, and mutual fund companies employ the  services of a management company to administer their operations. RRGs  and captive insurers generally hire “captive management” companies to  administer company operations, such as day-to-day operational decisions,  financial reporting, liaison with state insurance departments, or locating  sources of reinsurance. Similarly, a typical mutual fund has no employees  but is created and operated by another party, the adviser, which contracts  with the fund, for a fee, to administer operations. For example, the adviser  would be responsible for selecting and managing the mutual fund’s  portfolio. However, Congress recognized that the external management of  mutual funds by investment advisers creates an inherent conflict between  the adviser’s duties to the fund shareholders and the adviser’s interests in  maximizing its own profits, a situation that could adversely affect fund  shareholders. One way in which Congress addressed this conflict is the  regulatory scheme established by the Investment Company Act of 1940,  which includes certain safeguards to protect the interests of fund  shareholders. For example, a fund’s board of directors must contain a  certain percentage of independent directors—directors without any  significant relationship to the advisers.
section_title: RRGs Have Had a Small but Important Effect on Increasing the Availability and Affordability of Commercial Liability Insurance
paragraphs: RRGs have had a small but important effect on increasing the availability  and affordability of commercial liability insurance, specifically for groups  that have had limited access to liability insurance. According to NAIC  estimates, in 2003 RRGs sold just over 1 percent of all commercial liability  insurance in the United States. However, many state regulators, even those  who had reservations about the regulatory oversight of RRGs, believe  RRGs have filled a void in the market. Regulators from the six leading  domiciliary states also observed that RRGs were important to certain  groups that could not find affordable coverage from a traditional insurance  company and offered RRG insureds other benefits such as tailored  coverage. Furthermore, RRGs, while tending to be relatively small in size  compared with traditional insurers, serve a wide variety of organizations  and businesses, although the majority served the healthcare industry.  Difficulties in finding affordable commercial liability insurance prompted  the creation of more RRGs from 2002 through 2004 than in the previous 15  years. Three-quarters of the RRGs formed in this period responded to a  recent shortage of, and high prices for, medical malpractice insurance.  However, studies have characterized the medical malpractice industry as  volatile because of the risks associated with providing this line of  insurance.
subsections: section_title: RRGs Have Represented a Small but Increasing Part of the Commercial Liability Insurance Market
paragraphs: RRGs have constituted a very small part of the commercial liability market.  According to NAIC estimates, in 2003 a total of 115 RRGs sold 1.17 percent  of all commercial liability insurance in the United States. This accounted  for about $1.8 billion of a total of $150 billion in gross premiums for all  commercial liability lines of insurance. We are focusing on 2003 market  share to match the time frame of our other financial analyses of gross  premiums.
While RRGs’ share of the commercial liability market was quite small,  market share and the overall amount of business RRGs wrote increased  since 2002.  For example, RRG market share increased from 0.89 percent in  2002 to 1.46 percent in 2004. However, in terms of commercial liability  gross premiums, the increase in the amount of business written by RRGs is  more noticeable. The amount of business that RRGs collectively wrote  about doubled, from $1.2 billion in 2002 to $2.3 billion in 2004. During this  same period, the amount of commercial liability written by traditional  insurers increased by about 21 percent, from $129 billion to $156 billion. In  addition, RRGs increased their presence in the market for medical  malpractice insurance. From 2002 through 2004, the amount of medical  malpractice written by RRGs increased from $497 million to $1.1 billion,  which increased their share of the medical malpractice market from 4.04  percent to 7.27 percent.
section_title: According to State Regulators, RRGs Have Filled Voids in Markets, Allowing Numerous Groups to Obtain Benefits of Coverage
paragraphs: Despite the relatively small share of the market that RRGs hold, most state  regulators we surveyed who had an opinion—33 of 36—indicated that  RRGs have expanded the availability and affordability of commercial  liability insurance for groups that otherwise would have had difficulty in  obtaining coverage. This consistency of opinion is notable because 18 of  those 33 regulators made this assertion even though they later expressed  reservations about the adequacy of LRRA’s regulatory safeguards. About  one-third of the 33 regulators also made more specific comments about the  contributions of RRGs. Of these, five regulators reported that RRGs had  expanded the availability of medical malpractice insurance for nursing  homes, adult foster care homes, hospitals, and physicians. One regulator  also reported that RRGs had assisted commercial truckers in meeting their  insurance needs.
Regulators from states that had domiciled the most RRGs as of the end of  2004—Arizona, the District of Columbia, Hawaii, Nevada, South Carolina,  and Vermont—provided additional insights. Regulators from most of  these states recognized that the overall impact of RRGs in expanding the  availability of insurance was quite small. However, they said that the  coverage RRGs provided was important because certain groups could not  find affordable insurance from a traditional insurance company. All of  these regulators cited medical malpractice insurance as an area where  RRGs increased the affordability and availability of insurance but they also  identified other areas. For example, regulators from Hawaii and Nevada  reported that RRGs have been important in addressing a shortage of  insurance for construction contractors. The six regulators all indicated (to  some extent) that by forming their own insurance companies, RRG  members also could control costs by designing insurance coverage  targeted to their specific needs and develop programs to reduce specific  risks. In contrast, as noted by the Arizona regulator, traditional insurers  were likely to take a short-term view of the market, underpricing their  coverage when they had competition and later overpricing their coverage  to recoup losses. He also noted insurers might exit a market altogether if  they perceived the business to be unprofitable, as exemplified in the  medical malpractice market. Regulators from Vermont and Hawaii, states  that have the most experience in chartering RRGs, added that successful  RRGs have members that are interested in staying in business for the “long  haul” and are actively involved in running their RRGs.  RRG representatives  added that RRG members, at any given time, might not necessarily benefit  from the cheapest insurance prices but could benefit from prices that were  stable over time. Additionally, as indicated by trade group representatives,  including the National Risk Retention Association, RRGs have proved  especially advantageous for small and midsized businesses.
In order to obtain more specific information about how RRGs have  benefited their membership, we interviewed representatives of and  reviewed documents supplied by six RRGs that have been in business for  more than 5 years, as well as two more recently established RRGs. Overall,  these eight RRGs had anywhere from 2 to more than 14,500 members.    They provided coverage to a variety of insureds, including educational  institutions, hospitals, attorneys, and building contractors.  The following  three examples illustrate some of the services and activities RRGs provide  or undertake.
An RRG that insures about 1,100 schools, universities, and related  organizations throughout the United States offers options tailored to its  members, such as educators’ legal liability coverage and coverage for  students enrolled in courses offering off-campus internships. According  to an RRG representative, the RRG maintains a claims database to help  it accurately and competitively price its policies. Members also benefit  from risk-management services, such as training and courses on sexual  harassment and tenure litigation, and work with specialists to develop  loss-control programs.
An RRG that reported that it insures 730 of the nation’s approximately  3,000 public housing authorities provides coverage for risks such as  pesticide exposure, law enforcement liability, and lead-based paint  liability. The RRG indicated that while premium rates have fluctuated,  they are similar to prices from about 15 years ago. The RRG also offers  risk-management programs, such as those for reducing fires, and also  reported that as a result of conducting member inspections it recently  compiled more than 2,000 recommendations on how to reduce covered  risks.
An RRG that primarily provides insurance to about 45 hospitals in  California and Nevada offers general and professional coverage such as  personal and bodily injury and employee benefit liability. The RRG also  offers a variety of risk-management services specifically aimed at  reducing losses and controlling risks in hospitals. According to an RRG  official, adequately managing risk within the RRG has allowed for more  accurate pricing of the liability coverage available to members.
section_title: RRGs Have Remained Relatively Small in Size Compared with Traditional Insurers but Serve a Wide Variety of Markets
paragraphs: Generally, RRGs have remained relatively small compared with traditional  insurers. Based on our analysis of 2003 financial data submitted to NAIC, 47  of the 79 RRGs (almost 60 percent) that had been in business at least 1 year,  wrote less than $10 million in gross premiums, whereas only 644 of 2,392  traditional insurers (27 percent) wrote less than $10 million. In contrast,  1,118 traditional insurers (almost 47 percent) wrote more than $50 million  in gross premiums for 2003 compared with six RRGs (8 percent).  Further,  these six RRGs (all of which had been in business for at least 1 year)  accounted for 52 percent of all gross premiums that RRGs wrote in 2003.  This information suggests that just a few RRGs account for a  disproportionate amount of the RRG market.
Additionally, RRGs that wrote the most business tended to have been in  business the longest. For example, as measured by gross premiums  written, of the 16 RRGs that sold more than $25 million annually, 14 had  been in business 5 years or more (see fig. 1). Yet, the length of time an RRG  has been in operation is not always the best predictor of an RRG’s size. For  example, of the 51 RRGs that had been in business for 5 or more years, 27  still wrote $10 million or less in gross premiums.
According to the Risk Retention Reporter (RRR), a trade journal that has  covered RRGs since 1986, RRGs insure a wide variety of organizations and  businesses. According to estimates published in RRR, in 2004 105 RRGs  (more than half of the 182 in operation at that time) served the healthcare  sector (for example, hospitals, nursing homes, and doctors). In 1991, RRGs  serving physicians and hospitals accounted for about 90 percent of  healthcare RRGs. However, by 2004, largely because of a recent increase in  nursing homes forming RRGs, this percentage decreased to about 74  percent. In addition, in 2004, 21 RRGs served the property development  area (for example, contractors and homebuilders), and 20 served the  manufacturing and commerce area (for example, manufacturers and  distributors). Other leading business areas that RRGs served include  professional services (for example, attorneys and architects), and  government and institutions (for example, educational and religious  institutions). Figure 2 shows how the distribution of RRGs by business area  has changed since 1991.
Additionally, according to RRR’s estimates, almost half of all RRG  premiums collected in 2004 were in the healthcare area (see fig. 3). The  professional services and government and institutions business areas  accounted for the second and third largest percentage of estimated gross  premiums collected, respectively.
In looking at other characteristics of RRGs, according to an NAIC analysis,  the average annual failure rate for RRGs was somewhat higher than the  average annual failure rate for all other property and casualty insurers.  Between 1987 and 2003, the average annual failure rate for RRGs was 1.83  percent compared with the 0.78 percent failure rate for property and  casualty insurers. Over this period, NAIC determined that a total of 22  RRGs failed, with between no and five RRGs failing each year. In  comparison, NAIC determined that a total of 385 traditional insurers failed,  with between 5 and 57 insurance companies failing each year. Although the  difference in failure rates was statistically significant, it should be noted  that the comparison may not be entirely parallel. NAIC compared RRGs  that can sell only commercial liability insurance to businesses with insurers  that can sell all lines of property and casualty (liability) for commercial and  personal purposes. Moreover, because NAIC included all property- casualty insurers, no analysis was done to adjust for size and longevity.
section_title: Recent Market Conditions Have Prompted the Creation of Many RRGs, Especially to Provide Medical Malpractice Insurance
paragraphs: In creating RRGs, companies and organizations are generally responding to  market conditions. As the availability and affordability of insurance  decreased (creating a “hard” market), some insurance buyers sought  alternatives to traditional insurance and turned to RRGs. In response,  more RRGs formed from 2002 through 2004 than in the previous 15 years  (1986–2001). This increase is somewhat similar in magnitude to an increase  that occurred in 1986–1989 in response to an earlier hard market for  insurance (see fig. 4). The 117 RRGs formed from January 1, 2002, through  December 31, 2004, represent more than half of all RRGs in operation as of  December 31, 2004.
More specifically, RRGs established to provide medical malpractice  insurance accounted for most of the increase in RRG numbers in 2002– 2004. Healthcare providers sought insurance after some of the largest  medical malpractice insurance providers exited the market because of  declining profits, partly caused by market instability and high and  unpredictable losses—factors that have contributed to the high risks of  providing medical malpractice insurance. From 2002 through 2004,  healthcare RRGs accounted for nearly three-fourths of all RRG formations.  Further, 105 RRGs were insuring healthcare providers as of the end of 2004,  compared with 23 in previous years (see again fig. 2). These RRGs serve a  variety of healthcare providers. For example, during 2003, 23 RRGs formed  to insure hospitals and their affiliates, 13 formed to insure physician  groups, and 11 formed to insure long-term care facilities, including nursing  homes and assisted living facilities.  However, the dramatic increase in the  overall number of RRGs providing medical malpractice insurance may  precipitate an increase in the number of RRGs vulnerable to failure. Studies  have characterized the medical malpractice insurance industry as volatile  because the risks of providing medical malpractice insurance are high.
Finally, many of the recently formed healthcare-related RRGs are selling  insurance in states where medical malpractice insurance rates for  physicians have increased the most. For example, since April 30, 2002, the  Pennsylvania Insurance Department has registered 32 RRGs to write  medical malpractice products. In addition, since the beginning of 2003, the  Texas Department of Insurance has registered 15 RRGs to write medical  malpractice insurance, more than the state had registered in the previous  16 years. Other states where recently formed RRGs were insuring doctors  include Illinois and Florida, states that have also experienced large  increases in medical malpractice insurance premium rates.
section_title: LRRA’s Regulatory Preemption Has Resulted in Widely Varying Requirements among States and Limited Confidence in RRG Regulation
paragraphs: LRRA’s regulatory preemption has allowed states to set regulatory  requirements that differ significantly from those of traditional insurers, and  from each other, producing limited confidence among regulators in the  regulation of RRGs. 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. As a result, RRGs generally domicile in those states that permit  their formation as captive insurance companies, rather than in the states in  which they conduct most of their business. For example, RRGs domiciled  as captive insurers usually can start their operations with smaller amounts  of capital and surplus than traditional insurance companies, use letters of  credit to meet minimum capitalization requirements, or meet fewer  reporting requirements. Regulatory requirements for captive RRGs vary  among states as well, in part because regulation of RRGs and captives are  not subject to uniform, baseline standards, such as the NAIC accreditation  standards that define a state’s regulatory structure for traditional  companies. As one notable example, states do not require RRGs to follow  the same accounting principles when preparing their financial reports,  making it difficult for some nondomiciliary state regulators, as well as  NAIC analysts, to reliably assess the financial condition of RRGs.  Regulators responding to our survey also expressed concern about the lack  of uniform, baseline standards. Few (eight) indicated that they believed  LRRA’s regulatory safeguards and protections, such as the right to file a suit  against an RRG in court, were adequate. Further, some regulators  suggested that some domiciliary states were modifying their regulatory  requirements and practices to make it easier for RRGs to domicile in their  state. We found some evidence to support these concerns based on  differences among states in minimum capitalization requirements,  willingness to charter RRGs to insure parties that sell extended service  contracts to consumers, or willingness to charter RRGs primarily started  by service providers, such as management companies, rather than  insureds.
subsections: section_title: Most RRGs Have Domiciled in States That Charter Them as Captives but Have Conducted Most of Their Business in Other States
paragraphs: Regulatory requirements for captive insurers are generally less restrictive  than those for traditional insurers and offer RRGs several financial  advantages. For example, captive laws generally permit RRGs to form with  smaller amounts of required capitalization (capital and surplus), the  minimum amount of initial funds an insurer legally must have to be  chartered. While regulators reported that their states generally require  traditional insurance companies to have several millions of dollars in  capital and surplus, they often reported that RRGs chartered as captives  require no more than $500,000. In addition, unlike requirements for  traditional insurance companies, the captive laws of the six leading  domiciliary states permit RRGs to meet and maintain their minimum  capital and surplus requirements in the form of an irrevocable letter of  credit (LOC) rather than cash. According to several regulators that  charter RRGs as captives, LOCs may provide greater protection to the  insureds than cash when only the insurance commissioner can access  these funds. The insurance commissioner, who would be identified as the  beneficiary of the LOC, could present the LOC to the bank and immediately  access the cash, but a representative of the RRG could not. However, other  state regulators questioned the value of LOCs because they believed cash  would be more secure if an RRG were to experience major financial  difficulties. One regulator noted that it becomes the regulator’s  responsibility, on a regular basis, to determine if the RRG is complying with  the terms of the LOC. In addition, in response to our survey, most  regulators from states that would charter RRGs as captives reported that  RRGs would not be required to comply with NAIC’s risk-based capital  (RBC) requirements. NAIC applies RBC standards to measure the  adequacy of an insurer’s capital relative to their risks. Further, RRGs  chartered as captives may not be required to comply with the same NAIC  financial reporting requirements, such as filing quarterly and annual  reports with NAIC, that regulators expect traditional insurance companies  to meet. For example, while the statutes of all the leading domiciliary  states require RRGs chartered as captives to file financial reports annually  with their insurance departments, as of July 2004, when we conducted our  survey, the statutes of only half the leading domiciliary states—Hawaii, South Carolina, and Vermont—explicitly require that these reports also be  provided to NAIC on an annual basis.
In addition, when RRGs are chartered as captive insurance companies they  may not have to comply with the chartering state’s statutes regulating  insurance holding company systems. All 50 states and the District of  Columbia substantially have adopted such statutes, based on NAIC’s Model  Insurance Holding Company System Regulatory Act.
As in the model act, a state’s insurance holding company statute generally  requires insurance companies that are part of holding company systems  and doing business in the state to register with the state and annually  disclose to the state insurance regulator all the members of that system.  Additionally, the act requires that transactions among members of a  holding company system be on fair and reasonable terms, and that  insurance commissioners be notified of and given the opportunity to  review certain proposed transactions, including reinsurance agreements,  management agreements, and service contracts. For 2004, NAIC reviewed  RRG annual reports and identified 19 RRGs that reported themselves as  being affiliated with other companies (for example, their management and  reinsurance companies). However, since only two of the six leading  domiciliary states, Hawaii, and to some extent South Carolina, actually  require RRGs to comply with this act, we do not know whether more RRGs could be affiliated with other companies. The Hawaii regulator said that  RRGs should abide by the act’s disclosure requirements so that regulators  can identify potential conflicts of interests with service providers, such as  managers or insurance brokers. Unless an RRG is required to make these  disclosures, the regulator would have the added burden of identifying and  evaluating the nature of an RRG’s affiliations. He added that such  disclosures are important because the individual insureds of an RRG, in  contrast to the single owner of a pure captive, may not have the ability to  control potential conflicts of interest between the insurer and its affiliates.   (See the next section of this report for examples of how affiliates of an  RRG can have conflicts of interest with the RRG.)
Because of these regulatory advantages, RRGs are more likely to domicile  in states that will charter them as captives than in the states where they sell  insurance. Figure 5 shows that 18 states could charter RRGs as captives.  The figure also shows that most RRGs have chosen to domicile in six  states—Arizona, the District of Columbia, Hawaii, Nevada, South Carolina,  and Vermont—all of which charter RRGs as captives and market  themselves as captive domiciles. Of these states, Vermont and Hawaii  have been chartering RRG as captives for many years, but Arizona, the  District of Columbia, Nevada, South Carolina, and five additional states  have adopted their captive laws since 1999. In contrast to an RRG  chartered as a captive, a true captive insurer generally does not directly  conduct insurance transactions outside of its domiciliary state.
However, states of domicile are rarely the states in which RRGs sell much,  or any, insurance. According to NAIC, 73 of the 115 RRGs active in 2003 did  not write any business in their state of domicile, and only 10 wrote more  than 30 percent of their business in their state of domicile. The states in  which RRGs wrote most of their business in 2003—Pennsylvania ($238  million), New York ($206 million), California ($156 million), Massachusetts  ($98 million)—did not charter any RRGs. Texas, which chartered only one  RRG, had $87 million in direct written premiums written by RRGs. For  more information on the number of RRGs chartered by state and the  amount of direct premiums written by RRGs, see figure 6.
section_title: Inconsistent Regulation of RRGs Resembles Earlier Regulation of Traditional Insurers, Which Suffered from Lack of Uniform, Baseline Standards
paragraphs: The current regulatory environment for RRGs, characterized by the lack of  uniform, baseline standards, offers parallels to the earlier solvency  regulation of multistate traditional insurers. Uniformity in solvency  regulation for multistate insurers is important, provided the regulation  embodies best practices and procedures, because it strengthens the  regulatory system across all states and builds trust among regulators. After  many insurance companies became insolvent during the 1980s, NAIC and  the states recognized the need for uniform, baseline standards, particularly  for multistate insurers. To alleviate this situation, NAIC developed its  Financial Regulation Standards and Accreditation Program (accreditation  standards) in 1989 and began the voluntary accreditation of most state  regulators in the 1990s. Prior to accreditation, states did not uniformly  regulate the financial solvency of traditional insurers, and many states  lacked confidence in the regulatory standards of other states. By becoming  accredited, state regulators demonstrated that they were willing to abide  by a common set of solvency standards and practices for the oversight of  the multistate insurers chartered by their state. As a result, states currently  generally defer to an insurance company’s domiciliary state regulator, even  though each state retains the authority, through its licensing process, to  regulate all traditional insurance companies selling in the state.
NAIC’s accreditation standards define baseline requirements that states  must meet for the regulation of traditional companies in three major areas:  First, they include minimum standards for the set of laws and regulations  necessary for effective solvency regulation. Second, they set minimum  standards for practices and procedures, such as examinations and financial  analysis, which regulators routinely should do. Third, they establish  expectations for resource levels and personnel practices, including the  amount of education and experience required of professional staff, within  an insurance department. However, NAIC does not have a similar set of  regulatory standards for regulation of RRGs, which also are multistate  insurers.
According to NAIC officials, when the accreditation standards originally  were developed, relatively few states were domiciling RRGs as captive  insurers, and the question of standards for the regulation of captives and  RRGs did not materialize until NAIC began its accreditation review of  Vermont in 1993. NAIC completely exempted the regulation of captive  insurers from the review process but included RRGs because, unlike pure  captives, RRGs have many policyholders and write business in multiple  states. NAIC’s accreditation review of Vermont lasted about 2 years and  NAIC and Vermont negotiated an agreement that only part of the  accreditation standards applied to RRGs. As a result of the review, NAIC  determined that RRGs were sufficiently different from traditional insurers  so that the regulatory standards defining the laws and regulations necessary for effective solvency regulation should not apply to RRGs.  However, NAIC and Vermont did not develop substitute standards to  replace those they deemed inappropriate. Subsequently, other states  domiciling RRGs as captives also have been exempt from enforcing the  uniform set of laws and regulations deemed necessary for effective  solvency regulation under NAIC’s accreditation standards. As a result,  some states chartering RRGs as captives do not obligate them, for example,  to adopt a common set of financial reporting procedures and practices,  abide by NAIC’s requirements for risk-based capital, or comply with  requirements outlined in that state’s version of NAIC’s Model Insurance  Holding Company System Regulatory Act.
In contrast, while NAIC’s standards for the qualifications of an insurance  department’s personnel apply to RRGs, they do not distinguish between the  expertise needed to oversee RRGs and traditional insurance companies.  Because half of the 18 states that are willing to charter RRGs as captives  have adopted captive laws since 1999, few domiciliary state insurance  departments have much experience regulating RRGs as captive insurance  companies. Further, in response to our 2004 survey, only three states new  to chartering captives—Arizona, the District of Columbia, and South  Carolina—reported that they have dedicated certain staff to the oversight  of captives. However, the State of Nevada later reported to us that it  dedicated staff to the oversight of captives as of June 2005.
The importance of standards that address regulator education and  experience can be illustrated by decisions made by state insurance  departments or staff relatively new to chartering RRGs. In 1988, Vermont  chartered Beverage Retailers Insurance Co. Risk Retention Group  (BRICO). Launched and capitalized by an outside entity, BRICO did not  have a sufficient number of members as evidenced by the need for an  outside entity to provide the capital. It failed in 1995 in large part because it  wrote far less business than originally projected and suffered from poor  underwriting. Further, according to regulators, BRICO began to write  business just as the market for its product softened, and traditional  licensed insurers began to compete for the business. As a result, the  Vermont regulators said that Vermont would not charter RRGs unless they  had a sufficient number of insureds at start-up to capitalize the RRG and  make its future operations sustainable. More recently, in 2000, shortly after  it adopted its captive statutes, South Carolina chartered Commercial  Truckers Risk Retention Group Captive Insurance Company. This RRG,  which also largely lacked members at inception, failed within a year  because it had an inexperienced management team, poor underwriting, and  difficulties with its reinsurance company. The regulators later classified  their experience with chartering this RRG, particularly the fact that the  RRG lacked a management company, as “lessons learned” for their  department.  Finally, as reported in 2004, the Arizona insurance department  inadvertently chartered an RRG that permitted only the brokerage firm that  formed and financed the RRG to have any ability to control the RRG  through voting rights. The Arizona insurance department explained that  they approved the RRG’s charter when the insurance department was  operating under an acting administrator and that the department would  make every effort to prevent similar mistakes.
According to NAIC officials, RRGs writing insurance in multiple states, like  traditional insurers, would benefit from the adoption of uniform, baseline  standards for state regulation, and they plan gradually to develop them.  NAIC representatives noted that questions about the application of  accreditation standards related to RRGs undoubtedly would be raised  again because several states new to domiciling RRGs will be subject to  accreditation reviews in the next few years. However, the representatives  also noted, that because the NAIC accreditation team can review the  oversight of only a few of the many insurance companies chartered by a  state, the team might not select an RRG.
section_title: Variations in RRG Reporting Requirements Have Impeded Assessments of Their Financial Condition
paragraphs: As discussed previously, states domiciling RRGs as captives are not  obligated to require that RRGs meet a common set of financial reporting  procedures and practices. Moreover, even among states that charter RRGs  as captives, the financial reporting requirements for RRGs vary. Yet, the  only requirement under LRRA for the provision of financial information to  nondomiciliary regulators is that RRGs provide annual financial statements  to each state in which they operate. Further, since most RRGs sell the  majority of their insurance outside their state of domicile, insurance  commissioners from nondomiciliary states may have only an RRG’s  financial reports to determine if an examination may be necessary. As we  have reported in the past, to be of use to regulators, financial reports  should be prepared under consistent accounting and reporting rules and  provided in a timely manner that results in a fair presentation of the  insurer’s true financial condition.
One important variation in reporting requirements is the use by RRGs of  accounting principles that differ from those used by traditional insurance  companies. The statutes of the District of Columbia, Nevada, South  Carolina, and Vermont require their RRGs to use GAAP; Hawaii requires  RRGs to use statutory accounting principles (SAP); and Arizona permits  RRGs to use either. The differences in the two sets of accounting  principles reflect the different purposes for which each was developed and  each produces a different—and not necessarily comparable—financial  picture of a business. In general, SAP is designed to meet the needs of  insurance regulators, the primary users of insurance financial statements,  and stresses the measurement of an insurer’s ability to pay claims (remain  solvent) in order to protect insureds. In contrast, GAAP provides guidance  that businesses follow in preparing their general purpose financial  statements, which provide users such as investors and creditors with  useful information that allows them to assess a business’ ongoing financial  performance. However, inconsistent use of accounting methodologies by  RRGs could affect the ability of nondomiciliary regulators to determine the  financial condition of RRGs, especially since regulators are used to  assessing traditional insurers that must file reports using SAP.
In addition, the statutes of each of the six domiciliary states allow RRGs,  like other captive insurers, to modify whichever accounting principles they  use by permitting the use of letters of credit (LOC) to meet statutory  minimum capitalization requirements.  Strictly speaking, neither GAAP nor  SAP would permit a company to count an undrawn LOC as an asset  because it is only a promise of future payment—the money is neither  readily available to meet policyholder obligations nor is it directly in the  possession of the company. In addition to allowing LOCs, according to a  review of financial statements by NAIC, the leading domiciliary states that  require RRGs to file financial statements using GAAP also allow RRGs to  modify GAAP by permitting them to recognize surplus notes under capital  and surplus. This practice is not ordinarily permitted by GAAP. A company  filing under GAAP would recognize a corresponding liability for the surplus  note and would not simply add it to the company’s capital and surplus.  See appendix III for more specific information on the differences between  SAP and GAAP, including permitted modifications, and how these  differences could affect assessments of a company’s actual or risk-based  capital.
Variations in the use of accounting methods have consequences for  nondomiciliary regulators who analyze financial reports submitted by  RRGs and illustrate some of the regulatory challenges created by the  absence of uniform standards. Most nondomiciliary states responding to  our survey of all state regulators indicated that they performed only a  limited review of RRG financial statements. To obtain more specific  information about the impact of these differences, we contacted the six  states—Pennsylvania, California, New York, Massachusetts, Texas, and  Illinois—where RRGs collectively wrote almost half of their business in  2003 (see fig. 6). Regulators in Massachusetts and Pennsylvania reported  that they did not analyze the financial reports and thus had no opinion  about the impact of the accounting differences, but three of the other four  states indicated that the differences resulted in additional work. Regulators  from California and Texas told us that the use of GAAP, especially when  modified, caused difficulties because insurance regulators were more  familiar with SAP, which they also believed better addressed solvency  concerns than GAAP. The regulator from Illinois noted that RRG annual  statements were not marked as being filed based on GAAP and, when staff  conducted their financial analyses, they took the time to disregard assets  that would not qualify as such under SAP. The Texas regulator reported  that, while concerned about the impact of the differences, his department  did not have the staffing capability to convert the numbers for each RRG to  SAP and, as a result, had to prioritize their efforts.
Further, NAIC staff reported that the use by RRGs of a modified version of  GAAP or SAP distorted the analyses they provided to state regulators. One  of NAIC’s roles is to help states identify potentially troubled insurers  operating in their state by analyzing insurer financial reports with  computerized tools to identify statistical outliers or other unusual data. In  the past, we have noted that NAIC’s solvency analysis is an important  supplement to the overall solvency monitoring performed by states and can  help states focus their examination resources on potentially troubled  companies. NAIC uses Financial Analysis Solvency Tools (FAST), such as  the ratios produced by the Insurance Regulatory Information System (IRIS)  and the Insurer Profile Reports, to achieve these objectives and makes the  results available to all regulators through a central database. However,  NAIC analysts reported that differing accounting formats undermined the  relative usefulness of these tools because the tools were only designed to  analyze data extracted from financial reports based on SAP. Similarly, when  we attempted to analyze some aspects of the financial condition of RRGs to  compare them with traditional companies, we found that information  produced under differing accounting principles diminished the usefulness  of the comparison (see app. III).
section_title: Lack of Uniform, Baseline Regulatory Standards Has Concerned Many Regulators
paragraphs: The lack of uniform, baseline regulatory standards for the oversight of  RRGs contributed to the concerns of many state regulators, who did not  believe the regulatory safeguards and protections built into LRRA (such as  requiring RRGs to file annual financial statements with regulators and  allowing regulators to file suit if they believe the RRG is financially  unsound) were adequate. Only 8 of 42 regulators who responded to our  survey question about LRRA’s regulatory protections indicated that they  thought the protections were adequate (see fig. 7). Eleven of the 28  regulators who believed that the protections were inadequate or very  inadequate focused on the lack of uniform, regulatory standards or the  need for RRGs to meet certain minimum standards—particularly for  minimum capital and surplus levels. In addition, 9 of the 28 regulators,  especially those from California and New York, commented that they  believed state regulators needed additional regulatory authority to  supervise the RRGs in their states. While RRGs, like traditional insurers,  can sell in any or all states, only the domiciliary regulator has any  significant regulatory oversight.
In addition, the regulators from the six leading domiciliary states—Arizona,  the District of Columbia, Hawaii, Nevada, South Carolina, and Vermont— did not agree on the adequacy of LRRA safeguards. For example, while the  regulators from the District of Columbia, Hawaii, Nevada, and Vermont  thought the protections adequate, the regulator from South Carolina  reported that LRRA’s safeguards were “neither adequate nor inadequate”  because LRRA delegates the responsibility of establishing safeguards to  domiciliary states, which can be either stringent or flexible in establishing  safeguards. The other leading domiciliary state—Arizona—had not yet  formed an opinion on the adequacy of LRRA’s provisions. The regulator  from Hawaii also noted that the effectiveness of the LRRA provisions was  dependent upon the expertise and resources of the RRG’s domiciliary  regulator.
While many regulators did not believe LRRA’s safeguards were adequate,  few indicated that they had availed themselves of the tools LRRA does  provide nondomiciliary state regulators. These tools include the ability to  request that a domiciliary state undertake a financial examination and the  right to petition a court of “competent jurisdiction” for an injunction  against an RRG believed to be in a hazardous financial condition. Recent  cases involving state regulation of RRGs typically have centered on  challenges to nondomiciliary state statutes that affect operations of the  RRGs, rather than actions by nondomiciliary states challenging the  financial condition of RRGs selling insurance in their states. Finally, in  response to another survey question, nearly half of the regulators said they  had concerns that led them to contact domiciliary state regulators during  the 24 months preceding our survey, but only five nondomiciliary states  indicated that they had ever asked domiciliary states to conduct a financial  examination.
However, according to the survey, many state regulators availed  themselves of the other regulatory safeguards that LRRA provides—that  RRGs submit to nondomiciliary states feasibility or operational plans  before they begin operations in those states and thereafter a copy of the  same annual financial statements that the RRG submits to its domiciliary  state. Almost all the state regulators indicated that they reviewed these  documents to some extent, although almost half of the state regulators  indicated that they provided these reports less review than those submitted by other nonadmitted insurers. In addition, nine states indicated that  RRGs began to conduct business in their states before supplying them with  copies of their plans of operations or feasibility studies, but most indicated  that these occurrences were occasional.  Similarly, 15 states identified  RRGs that failed to provide required financial statements for review, but  most of these regulators indicated that the failure to file was an infrequent  occurrence.
section_title: Some Evidence Suggests That States Have Set Their Captive Regulatory Standards to Attract RRGs to Domicile in Their States
paragraphs: Some regulators, including those from New York, California, and Texas— states where RRGs collectively wrote about 26 percent of all their business  but did not domicile—expressed concerns that domiciliary states were  lowering their regulatory standards to attract RRGs to domicile in their  states for economic development purposes. They sometimes referred to  these practices as the “regulatory race to the bottom.” RRGs, like other  captives, can generate revenue for a domiciliary state’s economy when the  state taxes RRG insurance premiums or the RRG industry generates jobs in  the local economy. The question of whether domiciliary states were  competing with one another essentially was moot until about 1999, when  more states began adopting captive laws. Until then, Vermont and Hawaii  were two of only a few states that were actively chartering RRGs and  through 1998 had chartered about 55 percent of all RRGs. However, between the beginning of 1999 and the end of 2004, they had chartered only  36 percent of all newly chartered RRGs.
The six leading domiciliary states actively market their competitive  advantages on Web sites, at trade conferences, and through relationships  established with trade groups. They advertise the advantages of their new  or revised captive laws and most describe the laws as “favorable”; for  example, by allowing captives to use letters of credit to meet their  minimum capitalization requirements. Most of these states also describe  their corporate premium tax structure as competitive and may describe  their staff as experienced with or committed to captive regulation. Vermont  emphasizes that it is the third-largest captive insurance domicile in the  world and the number one in the United States, with an insurance  department that has more than 20 years of experience in regulating RRGs.  South Carolina, which passed its captive legislation in 2000, emphasizes a  favorable premium tax structure and the support of its governor and  director of insurance for its establishment as a domicile for captives.  Arizona describes its state as “business friendly,” highlighting the lack of  premium taxes on captive insurers and the “unsurpassed” natural beauty of  the state.
However, in addition to general marketing, some evidence exists to support  the concern that the leading domiciliary states are modifying policies and  procedures to attract RRGs. We identified the following notable differences  among the states, some of which reflect the regulatory practices and  approaches of each state and others, statute:   Willingness to domicile vehicle service contract (VSC) providers:   Several states, including California, New York, and Washington,  questioned whether RRGs consisting of VSC providers should even  qualify as RRGs and are concerned about states that allow these  providers to form RRGs. VSC providers issue extended service contracts  for the costs of future repairs to consumers (that is, the general public)  who purchase automobiles. Until 2001, almost all of these RRGs were  domiciled in Hawaii but after that date, all the new RRGs formed by VSC  providers have domiciled in the District of Columbia and South  Carolina. The Hawaii regulator said that the tougher regulations it  imposed in 2001 (requiring that RRGs insuring VSC providers annually  provide acceptable proof that they were financially capable of meeting  VSC claims filed by consumers) dissuaded these providers from  domiciling any longer in Hawaii. In addition, one of the leading  domiciliary states, Vermont, refuses to domicile any of these RRGs  because of the potential risk to consumers. Consumers who purchase  these contracts, not just the RRG insureds, can be left without coverage  if the RRG insuring the VSC provider’s ability to cover VSC claims fails.  (We discuss RRGs insuring service contract providers and  consequences to insureds and consumers more fully later in this report.)
Statutory minimum capitalization requirements:  Differences in the  minimum amount of capital and surplus (capitalization) each insurer  must have before starting operations make it easier for smaller RRGs to  domicile in certain states and reflect a state’s attitude towards attracting  RRGs. For example, in 2003, Vermont increased its minimum  capitalization amount from $500,000 to $1 million—according to  regulators, to ensure that only RRGs that are serious prospects, with  sufficient capital, apply to be chartered in the state. On the other hand,  effective in 2005, the District of Columbia lowered its minimum  capitalization amount for a RRG incorporated as a stock insurer (that is,  owned by shareholders who hold its capital stock) from $500,000 to  $400,000 to make it easier for RRGs to charter there.
Corporate forms:  In 2005, one of the six leading domiciliary states—the  District of Columbia—enacted legislation that permits RRGs to form  “segregated accounts.”  The other leading domiciliary states permit the  formation of segregated accounts or “protected cells” for other types of  captives but not for their RRGs. According to the District’s statute, a  captive insurer, including an RRG, may fund separate accounts for  individual RRG members or groups of members with common risks,  allowing members to segregate a portion of their risks from the risks of  other members of the RRG. According to the District regulator, RRG  members also would be required to contribute capital to a common  account that could be used to cover a portion of each member’s risk.   The District regulator also noted that the segregated cell concept has  never been tested in insolvency; as a result, courts have not yet  addressed the concept that the cells are legally separate.
Willingness to charter entrepreneurial RRGs:  RRGs may be formed  with only a few members, with the driving force behind the formation  being, for example, a service provider, such as the RRG’s management  company or a few members.  These RRGs are referred to as  “entrepreneurial” RRGs because their future success is often contingent  on recruiting additional members as insureds. In 2004, South Carolina  regulators reported they frequently chartered entrepreneurial RRGs to  offset what they described as the “chicken and egg” problem—their  belief that it can be difficult for RRGs to recruit new members without  having the RRG already in place. Regulators in several other leading  domiciliary states have reported they would be willing to charter such  RRGs if their operational plans appeared to be sound but few reported  having done so. However, regulators in Vermont said that they would  not charter entrepreneurial RRGs because they often were created to  make a profit for the “entrepreneur,” rather than helping members  obtain affordable insurance. (We discuss entrepreneurial RRGs later in  the report.)
Finally, the redomiciling of three RRGs to two of the leading domiciliary  states, while subject to unresolved regulatory actions in their original state  of domicile, also provides some credibility to the regulators’ assertions of  “regulatory arbitrage.” In 2004, two RRGs redomiciled to new states while  subject to regulatory actions in their original states of domicile. One RRG,  which had been operating for several years, redomiciled to a new state  before satisfying the terms of a consent order issued by its original  domiciliary state and without notifying its original state of domicile.   Although the RRG satisfied the terms of the consent order about 3 months  after it redomiciled, the regulator in the original domiciliary state reported  that, as provided by LRRA, once redomiciled, the RRG had no obligation to  do so. The second RRG, one that had been recently formed, was issued a  cease and desist order by its domiciliary state because the regulators had  questions about who actually owned and controlled the RRG. As in the first  case, the original domiciliary state regulator told us that this RRG did not  advise them that it was going to redomicile and, once redomiciled, was  under no legal obligation to satisfy the terms of the cease and desist order.   The redomiciling, or rather liquidation, of the third RRG is more difficult to  characterize because its original state of domicile (Hawaii) allowed it to  transfer some of its assets to a new state of domicile (South Carolina) after  issuing a cease and desist order to stop it from selling unauthorized  insurance products directly to the general public, thereby violating the  provisions of LRRA. More specifically, Hawaii allowed the RRG to  transfer its losses and related assets for its “authorized” lines of insurance  to South Carolina and required the Hawaiian company to maintain a  $1 million irrevocable LOC issued in favor of the insurance commissioner  until such time as the “unauthorized” insurance matter was properly  resolved. South Carolina permitted the owners of these assets to form a  new RRG offering a similar line of coverage and use a name virtually  identical to its predecessor in Hawaii. Had these RRGs been chartered as  traditional insurance companies, they would not have had the ability to  continue operating in their original state of domicile after redomiciling in  another state without the original state’s express consent. Because  traditional companies must be licensed in each state in which they operate,  the original state of domicile would have retained its authority to enforce  regulatory actions.
section_title: RRG Failures Have Raised Questions about the Sufficiency of LRRA Provisions for RRG Ownership, Control, and Governance
paragraphs: Because LRRA does not comprehensively address how RRGs may be  owned, controlled, or governed, RRGs may be operated in ways that do not  consistently protect the best interests of their insureds. For example, while  self-insurance is generally understood as risking one’s own money to cover  losses, LRRA does not specify that RRG members, as owners, make capital  contributions beyond their premiums or maintain any degree of control  over their governing bodies (such as boards of directors). As a result, in the  absence of specific federal requirements and using the latitude LRRA  grants them, some leading domiciliary regulators have not required all RRG  insureds to make at least some capital contribution or exercise any control  over the RRG. Additionally, some states have allowed management  companies or a few individuals to form what are called “entrepreneurial”  RRGs. Consequently, some regulators were concerned that RRGs were  being chartered primarily for purposes other than self-insurance, such as  making a profit for someone other than the collective insureds. Further,  LRRA does not recognize that separate companies typically manage RRGs.  Yet, past RRG failures suggest that sometimes management companies  have promoted their own interests at the expense of the insureds. Although  LRRA does not address governance issues such as conflicts of interest  between management companies and insureds, Congress previously has  enacted safeguards to address similar issues in the mutual fund industry.  Finally, some of these RRG failures have resulted in thousands of insureds  and their claimants losing coverage, some of whom may not have been fully  aware that their RRG lacked state insurance insolvency guaranty fund  coverage or the consequences of lacking such coverage.
subsections: section_title: While RRGs Are a Form of Self-Insurance, Not All RRG Insureds Are Equity Owners or Have the Ability to Exercise Control
paragraphs: While RRGs are a form of self-insurance on a group basis, LRRA does not  require that RRG insureds make a capital investment in their RRG and  provides each state considerable authority to establish its own rules on  how RRGs will be chartered and regulated. Most of the regulators from the  leading domiciliary states reported that they require RRGs to be organized  so that all insureds make some form of capital contribution but other  regulators do not, or make exceptions to their general approach.    Regulators from Vermont and Nevada emphasized that it was important for  each member to have “skin in the game,” based on the assumption that  members who make a contribution to the RRG’s capital and surplus would  have a greater interest in the success of the RRG. The regulator from  Nevada added that if regulators permitted members to participate without  making a capital contribution, they were defeating the spirit of LRRA.  However, another of the leading domiciliary states, the District of  Columbia, does not require insureds to make capital contributions as a  condition of charter approval and has permitted several RRGs to be formed  accordingly. The District regulator commented that LRRA does not require  such a contribution and that some prospective RRG members may not have  the financial ability to make a capital contribution. Further, despite  Vermont’s position that RRG members should make a capital contribution,  the Vermont regulators said they occasionally waive this requirement under  special circumstances; for example, if the RRG was already established and  did not need any additional capital. In addition, several of the leading  domiciliary states, including Arizona, the District of Columbia, and Nevada,  would consider allowing a nonmember to provide an LOC to fund the  capitalization of the RRG.
However, as described by several regulators, including those in Hawaii and  South Carolina, even when members do contribute capital to the RRG, the  amount contributed can vary and be quite small. For instance, an investor  with a greater amount of capital, such as a hospital, could initially  capitalize an RRG, and expect smaller contributions from members (for  example, doctors) with less capital. Or, in an RRG largely owned by one  member, additional members might be required only to make a token  investment, for example, $100 or less. As a result, an investment that small  would be unlikely to motivate members to feel like or behave as “owners”  who were “self-insuring” their risks.
LRRA also does not have a requirement that RRG insureds retain control  over the management and operation of their RRG. However, as discussed  previously, the legislative history indicates that some of the act’s single- state regulatory framework and other key provisions were premised not  only on ownership of an RRG being closely tied to the interests of the  insureds, but also that the insureds would be highly motivated to ensure  proper management of the RRG. Yet, in order to make or direct key  decisions about a company’s operations, the insureds would have to be  able to influence or participate in the company’s governing body (for  example, a board of directors). A board of directors is the focal point of  an insurer’s corporate governance framework and ultimately should be  responsible for the performance and conduct of the insurer. Governance  is the manner in which the boards of directors and senior management  oversee a company, including how they are held accountable for their  actions.
Most leading state regulators said they expect members of RRGs to exert  some control over the RRG by having the ability to vote for directors, even  though these rights sometimes vary in proportion to the size of a member’s  investment in the RRG or by share class. Most of the leading state  regulators generally define “control” to be the power to direct the  management and policies of an RRG as exercised by an RRG’s governing  body, such as its board of directors. However, regulators from the District  of Columbia asserted that they permit RRGs to issue nonvoting shares to  their insureds because some members are capable of making a greater  financial contribution than others and, in exchange for their investment,  will seek greater control over the RRG. The regulators noted that allowing  such arrangements increases the availability of insurance and has no  adverse effect on the financial solvency of the RRG. Further, the District of  Columbia permits nonmembers (that is, noninsureds) to appoint or vote for  directors. In addition, we found that even regulators who expect all RRG  members to have voting rights (that is, at a minimum a vote for directors)  sometimes make exceptions. For example, an RRG domiciled in Vermont  was permitted to issue shares that did not allow insureds to vote for  members of the RRG’s governing body.  The Vermont regulators reported  that the attorney forming the RRG believed issuing the shares was  consistent with the department’s position that RRG members should have  “voting rights” because under Vermont law all shareholders are guaranteed  other minimal voting rights.
While most regulators affirmed that they expect RRG members to own and  control their RRGs, how these expectations are fulfilled is less clear when  an organization, such as an association, owns an RRG. Four states— Arizona, District of Columbia, South Carolina, and Vermont—reported that  they have chartered RRGs that are owned by a single or multiple  organizations, rather than individual persons or businesses. One of these  states—the District of Columbia—permits noninsureds to own the  organizations that formed the RRG. However, the District regulator said  that while the noninsureds may own the voting or preferred stock of the  association, they do not necessarily have an interest in controlling the  affairs of the RRG. In addition, Arizona has permitted three risk purchasing  groups (RPGs) to own one RRG. While the three RPGs, organized as  domestic corporations in another state, collectively have almost 8,000  policyholders, four individuals, all of whom are reported to be RRG  insureds by the Arizona regulator, are the sole owners of all three RPGs.
section_title: Regulators Expressed Concerns That Some RRGs Might Be Operated to Make Money for an Entrepreneur, Rather Than to Provide Self- Insurance
paragraphs: The chartering of an “entrepreneurial” RRG—which regulators generally  define as formed by an individual member or a service provider, such as a  management company, for the primary purpose of making profits for  themselves—has been controversial. According to several regulators,   entrepreneurial RRGs are started with a few members and need additional  members to remain viable. The leading domiciliary regulators have taken  very different positions on entrepreneurial RRGs, based on whether they  thought the advantages entrepreneurs could offer (obtaining funding and  members) outweighed the potential adverse influence the entrepreneur  could have on the RRG. We interviewed regulators from the six leading  domiciliary states to obtain their views on entrepreneurial RRGs. In 2004,  South Carolina regulators reported they firmly endorsed chartering  entrepreneurial RRGs because they believed that already chartered RRGs  stand a better chance of attracting members than those in the planning  stages. They cited cases of entrepreneurial RRGs they believe have met  the insurance needs of nursing homes and taxicab drivers. However,  regulators from Vermont and Hawaii had strong reservations about this  practice because they believe the goal of entrepreneurs is to make money  for themselves—and that the pursuit of this goal could undermine the  financial integrity of the RRG because of the adverse incentives that it  creates. Vermont will not charter entrepreneurial RRGs and has  discouraged them from obtaining a charter in Vermont by requiring RRGs  (before obtaining their charter) to have a critical mass of members capable  of financing their own RRG. In addition, the Vermont regulators said they  would not permit an entrepreneur, if just a single owner, to form an RRG as  a means of using LRRA’s regulatory preemption to bypass the licensing  requirements of the other states in which it planned to operate. Two of the  other leading domiciliary states—Arizona and Nevada—were willing to  charter entrepreneurial RRGs, providing they believed that the business  plans of the RRGs were sound.
Finally, some of the leading state regulators that have experience with  chartering entrepreneurial RRGs told us that they recognized that the  interests of the RRG insureds have to be protected and that they took  measures to do so. For example, the regulators from South Carolina said  that even if one member largely formed and financed an RRG, they would  try to ensure that the member would not dominate the operations.  However, they admitted that the member could do so because of his or her  significant investment in the RRG. Alternatively, the regulator from Hawaii  reported that the state’s insurance division, while reluctant to charter  entrepreneurial RRGs, would do so if the RRG agreed to submit to the  division’s oversight conditions. For example, to make sure service  providers are not misdirecting money, the division requires entrepreneurial  RRGs to submit copies of all vendor contracts. The Hawaii regulator also  told us that the insurance division requires all captives to obtain the  insurance commissioner’s approval prior to making any distributions of  principal or interest to holders of surplus notes. However, he concluded  that successful oversight ultimately depended on the vigilance of the  regulator and the willingness of the RRG to share documentation and  submit to close supervision.
section_title: LRRA Lacks Governance Standards to Protect RRG Insureds from Management Companies with Potential Conflicts of Interest
paragraphs: LRRA imposes no governance requirements that could help mitigate the  risk to RRG insureds from potential abuses by other interests, such as their  management companies, should they choose to maximize their profits at  the expense of the best interests of the RRG insureds. Governance rules  enhance the independence and effectiveness of governing bodies, such as  boards of directors, and improve their ability to protect the interests of the  company and insureds they serve. Unlike a typical company where the  firm’s employees operate and manage the firm, an RRG usually is operated  by a management company and may have no employees of its own.  However, while management companies and other service providers  generally provide valuable services to RRGs, the potential for abuse arises  if the interests of a management company are not aligned with the interests  of the RRG insureds to consistently obtain self-insurance at the most  affordable price consistent with long-term solvency.
These inherent conflicts of interest are exemplified in the circumstances  surrounding 10 of 16 RRG failures that we examined. For example,  members of the companies that provided management services to Charter  Risk Retention Group Insurance Company (Charter) and Professional  Mutual Insurance Company Risk Retention Group (PMIC) also served as  officers of the RRGs’ boards of directors, which enabled them to make  decisions that did not promote the welfare of the RRG insureds. In other  instances, such as the failure of Nonprofits Mutual Risk Retention Group,  Inc. (Nonprofits), the management company negotiated terms that made it  difficult for the RRG to terminate its management contract and place its  business elsewhere. Regulators knowledgeable about these and other  failures commented that the members, while presumably self-insuring their  risks, were probably more interested in satisfying their need for insurance  than actually running their own insurance company.
The 2003 failure of three RRGs domiciled in Tennessee—American  National Lawyers Insurance Reciprocal Risk Retention Group (ANLIR),  Doctors Insurance Reciprocal Risk Retention Group (DIR), and The  Reciprocal Alliance Risk Retention Group (TRA)—further illustrates the  potential risks and conflicts of interest associated with a management  company operating an RRG. In pending litigation, the State of Tennessee’s  Commissioner of Commerce and Insurance, as receiver for the RRGs, has  alleged that the three RRGs had common characteristics, such as (1) being  formed by Reciprocal of America (ROA), a Virginia reciprocal insurer,  which also served as the RRGs’ reinsurance company;  (2) having a  management company, The Reciprocal Group (TRG), which also served as  the management company and attorney-in-fact for ROA;  (3) receiving loans  from ROA, TRG, and their affiliates; and (4) having officers and directors in  common with ROA and TRG. The receiver has alleged that through the  terms of RRGs’ governing instruments, such as its bylaws, management  agreements with TRG (which prohibited the RRGs from replacing TRG as  their exclusive management company for as long as the loans were  outstanding), and the common network of interlocking directors among  the companies, TRG effectively controlled the boards of directors of the  RRGs in a manner inconsistent with the best interests of the RRGs and  their insureds. As alleged in the complaint filed by the Tennessee  regulator, one such decision involved a reinsurance agreement, in which  the RRGs ceded 90-100 percent of their risk to ROA with a commensurate  amount of premiums—conditions that according to the regulator  effectively prevented the RRGs from ever operating independently or  retaining sufficient revenue to pay off their loans with ROA and TRG and  thus remove TRG as their management company. Within days after the  Commonwealth of Virginia appointed a receiver for the rehabilitation or  liquidation of ROA and TRG, the State of Tennessee took similar actions for  the three RRGs domiciled in Tennessee.
The following failures of other RRGs also illustrate behavior suggesting  that management companies and affiliated service providers have  promoted their own interests at the expense of the RRG insureds:  According to the Nebraska regulators, Charter failed in 1992 because its  managers, driven to achieve goals to maximize their profits,  undercharged on insurance rates in an effort to sell more policies. One  board officer and a company manager also held controlling interests in  third-party service providers, including the one that determined if claims  should be paid. Further, the board officer and a company manager, as  well as the RRG, held controlling interests in the RRG’s reinsurance  company. A Nebraska regulator noted that when a reinsurance company  is affiliated with the insurer it is reinsuring: (1) the reinsurer’s incentive  to encourage the insurer to adequately reserve and underwrite is  reduced and (2) the insurer also will be adversely affected by any  unprofitable risk it passes to the reinsurer.
PMIC, which was domiciled in Missouri and formed to provide medical  malpractice insurance coverage for its member physicians, was  declared insolvent in 1994. The RRG’s relationship with the companies  that provided its management services undermined the RRG in several  ways. The president of PMIC was also the sole owner of Corporate  Insurance Consultants (CIC), a company with which PMIC had a  marketing service and agency agreement.  As described in the RRG’s  examination reports, the RRG paid CIC exorbitant commissions for  services that CIC failed to provide, but allowed CIC to finance collateral  loans made by the reinsurance company to CIC. In turn, CIC had a  significant ownership stake in the RRG’s reinsurance company, which  also provided PMIC with all of its personnel. The reinsurer’s own  hazardous financial condition resulted in the failure of PMIC.
In the case of Nonprofits, Vermont regulators indicated that essentially  the excessive costs of its outsourced management company and  outsourced underwriting and claims operations essentially contributed  to its 2000 failure. The regulators said that the management company  was in a position to exert undue influence over the RRG’s operations  because the principals of the management company loaned the RRG its  start-up capital in the form of irrevocable LOCs. In addition to charging  excessive fees, the management company also locked the RRG into a  management contract that only allowed the RRG to cancel the contract  1 year before its expiration. If the RRG did not, the contract would  automatically renew for another 5 years, a requirement of which the  RRG insureds said they were unaware.
Although LRRA has no provisions that address governance controls,  Congress has acted to provide such controls in similar circumstances in  another industry. In response to conditions in the mutual fund industry,  Congress passed the Investment Company Act of 1940 (1940 Act). The 1940  Act, as implemented by the Securities and Exchange Commission (SEC),  establishes a system of checks and balances that includes participation of  independent directors on mutual fund boards, which oversee transactions  between the mutual fund and its investment adviser.  A mutual fund’s  structure and operation, like that of an RRG, differs from that of a  traditional corporation. In a typical corporation, the firm’s employees  operate and manage the firm; the corporation’s board of directors, elected  by the corporation’s stockholders, oversees its operation. Unlike a typical  corporation, but similar to many RRGs, a typical mutual fund has no  employees and contracts with another party, the investment adviser, to  administer the mutual fund’s operations.
Recognizing that the “external management” of most mutual funds presents  inherent conflicts between the interests of the fund shareholders and those  of the fund’s investment adviser, as well as potential for abuses of fund  shareholders, Congress included several safeguards in the 1940 Act. For  example, with some exceptions, the act requires that at least 40 percent of  the board of directors of a mutual fund be disinterested (that is, that  directors be independent of the fund’s investment adviser as well as certain  other persons having significant or professional relationships with the  fund) to help ensure that the fund is managed in the best interest of its  shareholders. The 1940 Act also regulates the terms of contracts with  investment advisers by imposing a maximum contract term and by  guaranteeing the board’s and the shareholders’ ability to terminate an  investment adviser contract. The act also requires that the terms of any  contract with the investment adviser and the renewal of such contract be  approved by a majority of directors who are not parties to the contract or  otherwise interested persons of the investment adviser. Further, the 1940  Act imposes a fiduciary duty upon the adviser in relation to its level of  compensation and provides the fund and its shareholders with the right to  sue the adviser should the fees be excessive. The management controls  imposed on mutual fund boards do not supplant state law on duties of “care  and loyalty” that oblige directors to act in the best interests of the mutual  fund, but enhance a board’s ability to perform its responsibilities consistent  with the protection of investors and the purposes of the 1940 Act.
section_title: RRG Members May Not Realize They Lack Guaranty Fund Protection
paragraphs: In addition to lacking comprehensive provisions for ownership, control,  and governance of RRGs, LRRA does not mandate that RRGs disclose to  their insureds that they lack state insurance insolvency guaranty fund  protection. LRRA’s legislative history indicates that the prohibition on  RRGs participating in state guaranty funds (operated to protect insureds  when traditional insurers fail) stemmed, in part, from a belief that the lack  of protection would help motivate RRG members to manage the RRG  prudently. LRRA does provide nondomiciliary state regulators the authority  to mandate the inclusion of a specific disclosure, which informs RRG  insureds that they lack guaranty fund coverage, on insurance policies  issued to residents of their state (see fig. 8). However, LRRA does not  provide nondomiciliary states with the authority to require the inclusion of  this disclaimer in policy applications or marketing materials. For example,  of 40 RRGs whose Web sites we were able to identify, only 11 disclosed in  their marketing material that RRGs lack guaranty fund protection. In addition, 11 of the RRGs omitted the words “Risk Retention Group” from  their names.
All of the six leading domiciliary states have adopted varying statutory  requirements that RRGs domiciled in their states include the disclosure in  their policies, regardless of where they operate. The statutes of Hawaii,  South Carolina, and the District of Columbia require that the disclosure be  printed on applications for insurance, as well as on the front and  declaration page of each policy. By requiring that the disclosure be printed  on insurance applications, prospective RRG insureds have a better chance  of understanding that they lack guaranty fund protection. Regulators in  South Carolina, based on their experience with the failure of Commercial  Truckers RRG in 2001, also reported that they require insureds, such as  those of transportation and trucking RRGs, to place their signature beneath  the disclosure. The regulators imposed this additional requirement because  they did not believe that some insureds would be as likely to understand  the implications of not having guaranty fund coverage as well as other  insureds (for example, hospital conglomerates). In contrast, the statutes of  Arizona and Vermont require only that the disclosure be printed on the  insurance policies. The six leading domiciliary state regulators had mixed  views on whether the contents of the disclosure should be enhanced, but  none recommended that LRRA be changed to permit RRGs to have  guaranty fund protection.
It is unclear whether RRG insureds who obtain insurance through  organizations that own RRGs understand that they will not have guaranty  fund coverage. Four states—Arizona, the District of Columbia, South  Carolina, and Vermont—indicated that they have chartered RRGs owned  by single organizations. When an organization is the insured of the RRG,  the organization receives the insurance policy with the disclosure about  lack of guaranty fund protection. Whether the organization’s members, who  are insured by the RRG, understand that they lack guaranty fund coverage  is less clear.  The Vermont regulators indicated that members typically are  not advised that they lack guaranty fund coverage before they receive the  policy. Thus, the regulators recommended that applications for insurance  should contain the disclosure as well. The Arizona regulator reported that  the insurance applications signed by the insureds of the Arizona-domiciled  RRG owned by three RPGs did not contain a disclosure on the lack of  guaranty fund coverage, although the policy certificates did. Further, he  reported that the practices of RPGs were beyond his department’s  jurisdiction and that he does not review them.
Not understanding that RRG insureds are not protected by guaranty funds  has serious implications for RRG members and their claimants, who have  lost coverage as a result of RRG failures. For example, of the 21 RRGs that  have been placed involuntarily in liquidation, 14 either have or had  policyholders whose claims remain or are likely to remain partially unpaid  (see app. IV). Member reaction to the failure of the three RRGs domiciled  in Tennessee further illustrates that the wording and the placement of the  disclosure may be inadequate. In 2003, an insurance regulator from  Virginia, a state where many of the RRG insureds resided, reported that he  received about 150–200 telephone calls from the insureds of these RRGs  and the insureds did not realize they lacked “guaranty fund” coverage,  asking instead why they didn’t have “back-up” insurance when their  insurance company failed. He explained that the insureds were “shocked”  to discover they were members of an RRG, rather than a traditional  insurance company and that they had no guaranty fund coverage.
According to the regulator, they commented, “Who reads their insurance  policies?”  Regulators in Tennessee also noted that insureds of the RRGs,  including attorneys, hospitals, and physicians did not appear to understand  the implications of self-insuring their risks and the lack of guaranty fund  coverage. In 2004, the State of Tennessee estimated that the potential  financial losses from these failures to the 50,000 or so hospitals, doctors,  and attorneys that were members of the Tennessee RRGs could exceed  $200 million, once the amount of unpaid claims were fully known.
Other regulators, including those in Missouri, in response to our survey,  and New York, in an interview, also expressed concern that some RRG  members might not fully understand the implications of a lack of guaranty  fund protection and were not the “sophisticated” consumers that they  believe may have been presumed by LRRA. In addition, in response to our  survey, regulators from other states including New Mexico and Florida  expressed specific concerns about third-party claimants whose claims  could go unpaid when an RRG failed and the insured refused or was unable  to pay claims. The Florida regulator noted that the promoters of the RRG  could accentuate the “cost savings” aspect of the RRG at the expense of  explaining the insured’s potential future liability in the form of unpaid  claims due to the absence of guaranty funds should the RRG fail. In  addition, regulators who thought that protections in LRRA were  inadequate, such as those in Wyoming, Virginia, and Wisconsin, tended to  view lack of guaranty fund protection as a primary reason for developing  and implementing more uniform regulatory standards or providing  nondomiciliary states greater regulatory authority over RRGs.
section_title: Lack of Guaranty Fund Protection Also Has Consequences for Consumers Who Purchase Extended Service Contracts
paragraphs: Lack of guaranty fund protection also can have unique consequences for  consumers who purchase extended service contracts from service contract  providers. Service contract providers form RRGs to insure their ability to  pay claims on extended service contracts—a form of insurance also known  as contractual liability insurance—and sell these contracts to consumers.   In exchange for the payment (sometimes substantial) made by the  consumer, the service contract provider commits to performing services— for example, paying for repairs to an automobile. Service contract  providers may be required to set aside some portion of the money paid by  consumers in a funded “reserve account” to pay resulting claims and may  have to buy insurance (for example, from the RRG they have joined) to  guarantee their ability to pay claims. However, potential problems result  from the perception of consumers that what they have purchased is  insurance, since the service contract provider pays for repairs or other  service, when in fact it is not. Only the service contract provider  purchases insurance, the consumer signs a contract for services.
The failure of several RRGs, including HOW Insurance Company RRG  (HOW) in 1994 and National Warranty RRG in 2003, underscores the  consequences that failures of RRGs that insure service contract providers  can have on consumers:  In 1994, the Commonwealth of Virginia liquidated HOW and placed its  assets in receivership. This RRG insured the ability of home builders to  fulfill contractual obligations incurred by selling extended service  contracts to home buyers. While settled out of court, the  Commonwealth of Virginia asserted that the homeowners who  purchased the contracts against defects in their homes had been misled  into believing that they were entitled to first-party insurance benefits— that is, payment of claims. A Virginia regulator said that while his  department received few calls from the actual insureds (that is, the  home builders) at the time of failure, they received many calls from  home owners who had obtained extended service contracts when they  purchased their home and thought they were insured directly by the  RRG.
In 2003, National Warranty Insurance RRG failed, leaving behind  thousands of customers with largely worthless vehicle service contracts  (VSCs). This RRG, domiciled in the Cayman Islands, insured the ability  of service contract providers to honor contractual liabilities for  automobile repairs. Before its failure, National Warranty insured at least  600,000 VSCs worth tens of millions of dollars. In 2003, the liquidators of  National Warranty estimated that losses could range from $58 to $74  million. National Warranty’s failure also raised the question of  whether RRGs were insuring consumers directly, which LRRA  prohibits—for example, because the laws of many states, including  Texas, require that the insurance company become directly responsible  for unpaid claims in the event a service contract provider failed to honor  its contract.
The failure of National Warranty also raised the question of whether RRGs  should insure service contract providers at all because of the potential  direct damage to consumers. Several regulators, including those in  California, Wisconsin, and Washington, went even further. In response to  our survey, they opined that LRRA should be amended to preclude RRGs  from offering “contractual liability” insurance because such policies cover  a vehicle service contract provider’s financial obligations to consumers.  At a minimum, regulators from New York and California, in separate  interviews, recommended that consumers who purchase extended service  contracts insured by RRGs at least be notified in writing that the contracts  they purchase were not insurance and would not qualify for state guaranty  fund coverage.
section_title: Conclusions
paragraphs: In establishing RRGs, Congress intended to alleviate a shortage of  affordable commercial liability insurance by enabling commercial entities  to create their own insurance companies to self-insure their risks on a  group basis. RRGs, as an industry, according to most state insurance  regulators, have fulfilled this vision—and the intent of LRRA—by  increasing the availability and affordability of insurance for members that  experienced difficulty in obtaining coverage. While constituting only a  small portion of the total liability insurance market, RRGs have had a  consistent presence in this market over the years. However, the number of  RRGs has increased dramatically in recent years in response to recent  shortages of liability insurance. While we were unable to evaluate the  merits of individual RRGs, both state regulators and advocates of the RRG  industry provided specific examples of how they believe RRGs have  addressed shortages of insurance in the marketplace. This ability is best  illustrated by the high number of RRGs chartered over the past 3 years to  provide medical malpractice insurance, a product which for traditional  insurers historically has been subject to high or unpredictable losses with  resulting failures.
However, the regulation of RRGs by a single state, in combination with the  recent increase in the number of states new to domiciling RRGs, the  increase in the number of RRGs offering medical malpractice insurance,  and a wide variance in regulatory practices, has increased the potential for  future solvency risks. As a result, RRG members and their claimants could  benefit from greater regulatory consistency. Insurance regulators have  recognized the value of having a consistent set of regulatory laws,  regulations, practices, and expertise through the successful  implementation of NAIC’s accreditation program for state regulators of  multistate insurance companies. Vermont and NAIC negotiated the  relaxation of significant parts of the accreditation standards for RRGs  because it was unclear how the standards, designed for traditional  companies, applied to RRGs. However, this agreement allowed states  chartering RRGs as captives considerable latitude in their regulatory  practices, even though most RRGs were multistate insurers, raising the  concerns of nondomiciliary states. With more RRGs than ever before and  with a larger number of states competing to charter them, regulators,  working through NAIC, could develop a set of comprehensive, uniform,  baseline standards for RRGs that would provide a level of consistency that  would strengthen RRGs and their ability to meet the intent of LRRA. While  the regulatory structure applicable to RRGs need not be identical to that  used for traditional insurance companies, uniform, baseline regulatory  standards could create a more transparent and protective regulatory  environment, enhancing the financial strength of RRGs and increasing the  trust and confidence of nondomiciliary state regulators. These standards  could include such elements as the use of a consistent accounting method,  disclosing relationships with affiliated businesses as specified by NAIC’s  Model Insurance Holding Company System Regulatory Act, and the  qualifications and number of staff that insurance departments must have  available to charter RRGs. These standards could reflect the regulatory  best practices of the more experienced RRG regulators and address the  concerns of the states where RRGs conduct the majority of their business.  Further, such standards could reduce the likelihood that RRGs would  practice regulatory arbitrage, seeking departments with the most relaxed  standards. While it may not be essential for RRGs to follow all the same  rules that traditional insurers follow, it is difficult to understand why all  RRGs and their regulators, irrespective of where they are domiciled, should  not conform to a core set of regulatory requirements. Developing and  implementing such standards would strengthen the foundation of LRRA’s  flexible framework for the formation of RRGs.
LRRA’s provisions for the ownership, control, and governance of RRGs may  not be sufficient to protect the best interests of the insureds. While  acknowledging that LRRA has worked well to promote the formation of  RRGs in the absence of uniform, baseline standards, this same flexibility  has left some RRG insureds vulnerable to misgovernance. In particular,  how RRGs are capitalized is central to concerns of experienced regulators  about the chartering of entrepreneurial RRGs because a few insureds or  service providers, such as management companies, that provide the initial  capital also may retain control over the RRG to benefit their personal  interests. Further, RRGs, like mutual fund companies, depend on  management companies to manage their affairs, but RRGs lack the federal  protections Congress and SEC have afforded mutual fund companies. As  evidenced by the circumstances surrounding many RRG failures, the  interests of management companies inherently may conflict with the  fundamental interests of RRGs—that is, obtaining stable and affordable  insurance. Moreover, these management companies may have the means to  promote their own interests if they exercise effective control over an RRG’s  board of directors. While RRGs may need to hire a management company  to handle their day-to-day operations, principles drawn from legislation  such as the Investment Company Act of 1940 would strongly suggest that  an RRG’s board of directors would have a substantial number of  independent directors to control policy decisions. In addition, these  standards would strongly suggest that RRGs retain certain rights when  negotiating the terms of a management contract. Yet, LRRA has no  provisions that establish the insureds’ authority over management. Without  these protections, RRG insureds and their third-party claimants are  uniquely vulnerable to abuse because they are not afforded the oversight of  a multistate regulatory environment or the benefits of guaranty fund  coverage. Nevertheless, we do not believe that RRGs should be afforded  the protection of guaranty funds. Providing such coverage could further  reduce any incentives insureds might have to participate in the governance  of their RRG and at the same time allow them access to funds supplied by  insurance companies that do not benefit from the regulatory preemption.  On the other hand, RRG insureds have a right to be adequately informed  about the risks they could incur before they purchase an insurance policy.  Further, consumers who purchase extended service contracts (which take  on the appearance of insurance) from RRG insureds likewise have a right  to be informed about these risks. The numerous comments that regulators  received from consumers affected by RRG failures illustrate how  profoundly uninformed the consumers were.
Finally, while opportunities exist to enhance the safeguards in LRRA, we  note again the affirmation provided by most regulators responding to our  survey—that RRGs have increased the availability and affordability of  insurance. That these assertions often came from regulators who also had  concerns about the adequacy of LRRA’s regulatory safeguards underscores  the successful track record of RRGs as a self-insurance mechanism for  niche groups. However, as the RRG industry has matured, and recently  expanded, so have questions from regulators about the ability of RRGs to  safely insure the risks of their members. These questions emerge,  especially in light of recent failures, because RRGs can have thousands of  members and operations in multiple states. Thus, in some cases, RRGs can  take on the appearance of a traditional insurance company—however,  without the back-up oversight provided traditional insurers by other state  regulators or the protection of guaranty funds. This is especially  problematic because RRGs chartered under captive regulations differ from  other captives—RRGs benefit from the regulatory preemption that allows  multistate operation with single-state regulation. Further, we find it  difficult to believe that members of RRGs with thousands of members view  themselves as “owners” prepared to undertake the due diligence presumed  by Congress when establishing RRGs as a self-insurance mechanism.  Because there is no federal regulator for this federally created entity, all  regulators, in both domiciliary and nondomiciliary states, must look to  whatever language LRRA provides when seeking additional guidance on  protecting the residents of their state. Thus, the mandated development  and implementation of uniform, baseline standards for the regulation of  RRGs, and the establishment of governance protections, could make the  success of RRGs more likely.
section_title: Recommendations for Executive Action
paragraphs: In the absence of a federal regulator to ensure that members of RRGs,  which are federally established but state-regulated insurance companies,  and their claimants are afforded the benefits of a more consistent  regulatory environment, we recommend that the states, acting through  NAIC, develop and implement broad-based, uniform, baseline standards for  the regulation of RRGs. These standards should include, but not be limited  to, filing financial reports on a regular basis using a uniform accounting  method, meeting NAIC’s risk-based capital standards, and complying with  the Model Insurance Holding Company System Regulatory Act as adopted  by the domiciliary state. The states should also consider standards for laws,  regulatory processes and procedures, and personnel that are similar in  scope to the accreditation standards for traditional insurers.
section_title: Matters for Congressional Consideration
paragraphs: To assist NAIC and the states in developing and implementing uniform,  baseline standards for the regulation of RRGs, Congress may wish to  consider the following two actions:  Setting a date by which NAIC and the state insurance commissioners  must develop an initial set of uniform, baseline standards for the  regulation of RRGs.
After that date, making LRRA’s regulatory preemption applicable only to  those RRGs domiciled in states that have adopted NAIC’s baseline  standards for the regulation of RRGs.
To strengthen the single-state regulatory framework for RRGs and better  protect RRG members and their claimants, while at the same time  continuing to facilitate the formation and efficient operation of RRGs,  Congress also may wish to consider strengthening LRRA in the following  three ways:   Requiring that insureds of the RRG qualify as owners of the RRG by  making a financial contribution to the capital and surplus of the RRG,  above and beyond their premium.
Requiring that all of the insureds, and only the insureds, have the right to  nominate and elect members of the RRG’s governing body.
Establishing minimum governance requirements to better secure the  operation of RRGs for the benefit of their insureds and safeguard assets  for the ultimate purpose of paying claims. These requirements should be  similar in objective to those provided by the Investment Company Act of  1940, as implemented by SEC; that is, to manage conflicts of interest  that are likely to arise when RRGs are managed by or obtain services  from a management company, or its affiliates, to protect the interests of  the insureds. Amendments to LRRA could   require that a majority of an RRG’s board of directors consist of   “independent” directors (that is, not be associated with the  management company or its affiliates) and require that certain  decisions presenting the most serious potential conflicts, such as  approving the management contract, be approved by a majority of  the independent directors;    provide safeguards for negotiating the terms of the management  contract— for example, by requiring periodic renewal of  management contracts by a majority of the RRG’s independent  directors, or a majority of the RRG’s insureds, and guaranteeing the  right of a majority of the independent directors or a majority of the  insureds to unilaterally terminate management contracts upon  reasonable notice; and  impose a fiduciary duty upon the management company to act in the  best interests of the insureds, especially with respect to  compensation for its services.
To better educate RRG members, including the insureds of organizations  that are sole owners of an RRG, about the potential consequences of self- insuring their risks, and to extend the benefits of this information to  consumers who purchase extended service contracts from RRG members,  Congress may wish to consider the following two actions:   Expand the wording of the current disclosure to more explicitly  describe the consequences of not having state guaranty fund protection  should an RRG fail, and requiring that RRGs print the disclosure  prominently on policy applications, the policy itself, and marketing  materials, including those posted on the Internet. These requirements  also would apply to insureds who obtain their insurance through  organizations that may own an RRG; and   Develop a modified version of the disclosure for consumers who  purchase extended service contracts from providers that form RRGs to  insure their ability to meet these contractual obligations. The disclosure  would be printed prominently on the extended service contract  application, as well as on the contract itself.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from the President of the  National Association of Insurance Commissioners or her designee. The  Executive Vice President and CEO of NAIC said that the report was “…well  thought out and well documented,” and provided “…a clear picture of how  states are undertaking their responsibilities with regard to regulation of  risk retention groups.” She further stated that our report “…explored the  issues that are pertinent to the protection of risk retention group members  and the third-party claimants that are affected by the coverage provided by  the risk retention groups.” NAIC expressed agreement with our  conclusions and recommendations. NAIC also provided technical  comments on the report that were incorporated as appropriate.
As agreed with your office, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to other interested Members  of Congress, congressional committees, and the Executive Vice President  of NAIC and the 56 state and other governmental entities that are members  of NAIC. We also will make copies available to others upon request. In  addition, this report will be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions on this report, please contact me at  (202) 512-8678 or hillmanr@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made major contributions to this report are  listed in appendix VI.
section_title: Objectives, Scope, and Methodology
paragraphs: Our objectives were to (1) examine the effect risk retention groups (RRG)  have had on the availability and affordability of commercial liability  insurance; (2) assess whether any significant regulatory problems have  resulted from the Liability Risk Retention Act’s (LRRA) partial preemption  of state insurance laws; and (3) evaluate the sufficiency of LRRA’s  ownership, control, and governance provisions in protecting the interests  of RRG insureds. We conducted our review from November 2003 through  July 2005 in accordance with generally accepted government auditing  standards.
subsections: section_title: Effects on Availability and Affordability of Commercial Liability Insurance
paragraphs: Overall, we used surveys, interviews, and other methods to determine if  RRGs have increased the availability and affordability of commercial  liability insurance. First, we surveyed regulators in all 50 states and the  District of Columbia. The survey asked regulators to respond to questions  about regulatory requirements for RRGs domiciled in their state, their  experiences with RRGs operating in their state, and their opinions about  the impact of LRRA. We pretested this survey with five state regulators,  made minor modifications, and conducted data collection during July 2004.  We e-mailed the survey as a Microsoft Word attachment and received  completed surveys from the District of Columbia and all the states except  Maryland. Then, to obtain more specific information about how regulators  viewed the usefulness of RRGs, we interviewed insurance regulators from  14 different states that we selected based on several characteristics that  would capture the range of experiences regulators have had with RRGs. In  addition, we interviewed representatives from eight RRGs serving different  business areas and reviewed documentation they provided describing their  operations and how they served their members. Second, we asked the  National Association of Insurance Commissioners (NAIC) to calculate the  overall market share of RRGs in the commercial liability insurance market  as of the end of 2003. We used 2003 data for all financial analyses because it  constituted the most complete data set available at the time of our analysis.  Using its Financial Data Repository, a database containing annual and  quarterly financial reports and data submitted by most U.S. domestic  insurers, NAIC compared the total amount of gross premiums written by  RRGs with the total amount of gross premiums generated by the sale of commercial liability insurance by all insurers. For the market share  analysis, as well as for our analysis of gross premiums written by RRGs, we  only included the 115 RRGs that wrote premiums during 2003.  NAIC  officials reported that while they perform their own consistency checks on  this data, state regulators were responsible for validating the accuracy and  reliability of the data for insurance companies domiciled in their state. We  conducted tests for missing data, outliers, and consistency of trends in  reporting and we found these data to be sufficiently reliable for the  purposes of this report. Third, to determine the number of RRGs that states  have chartered since 1981, we obtained data from NAIC that documented  the incorporation and commencement of business dates for each RRG and  identified the operating status of each RRG—for example, whether it was  actively selling insurance or had voluntarily dissolved. Finally, to determine  which business sectors RRGs were serving and the total amount of gross  premiums written in each sector, we obtained information from a trade  journal—the Risk Retention Reporter—because NAIC does not collect this  information by business sector.
subsections: section_title: Failure Analysis
paragraphs: We also requested that NAIC analyze their annual reporting data to  calculate the “failure” rate for RRGs and compare it with that of traditional  property and casualty insurance companies from 1987 through 2003. In  response, NAIC calculated annual “failure” rates for each type of insurer,  comparing the number of insurers that “failed” each year with the total  number of active insurers that year. The analysis began with calendar year  1987 because it was the first full year following the passage of LRRA. NAIC  classified an insurance company as having failed if a state regulator  reported to NAIC that the state had placed the insurer in a receivership for  the purpose of conserving, rehabilitating, or liquidating the insurance company. Since NAIC officials classified an insurance company subject to  any one of these actions as having failed, the failure date for each insurance  company reflects the date on which a state first took regulatory action. We  independently verified the status of each RRG that NAIC classified as failed  by cross-checking the current status of each RRG with information from  two additional sources— state insurance departments’ responses to our  survey, with follow-up interviews as necessary, and the Risk Retention  Group Directory and Guide. To determine if the differences in annual  failure rates of the RRGs and traditional companies were statistically  significant, NAIC performed a paired T-test. They concluded that the  average annual RRG failure rates were higher than those for traditional  property and casualty insurers. We also obtained a similar statistically  significant result when testing for the difference across the 18-year period  for RRGs and traditional insurers active in a given year. We recognize that,  although these tests indicated statistically significantly different failure  rates, the comparison between these insurer groups is less than optimal  because the comparison group included all property and casualty insurers,  which do not constitute a true “peer group” for RRGs. First, RRGs are only  permitted to write commercial liability insurance, but NAIC estimated that only 34 percent of insurers exclusively wrote liability insurance. Further,  NAIC’s peer group included traditional insurers writing both commercial  and personal insurance. Second, we noted that the paired T-test  comparison is more sensitive to any single RRG failing than any failure of a  traditional insurer because of the relatively small number of RRGs. Finally,  most RRGs are substantially smaller in size (that is, in terms of premiums  written) than many insurance companies and may have different  characteristics than larger insurance companies. Given the data available  to NAIC, it would have been a difficult and time-consuming task to  individually identify and separate those property and casualty insurers with  similar profiles for comparison with RRGs.
section_title: Selection of Regulators for Interviews
paragraphs: In choosing which regulators to interview, we first selected regulators from  the six states that had domiciled the highest number of active RRGs as of  June 30, 2004, including two with extensive regulatory experience and four  new to chartering RRGs. The six leading domiciliary states were Arizona,  the District of Columbia, Hawaii, Nevada, South Carolina, and Vermont.  Second, we selected regulators from eight additional states, including four  that had domiciled just a few RRGs and four that had domiciled no RRGs.  For states that had domiciled just a few or no RRGs, we identified and  selected those where RRGs, as of the end of 2003, were selling some of the  highest amounts of insurance. Finally, we also considered geographic  dispersion in selecting states across the United States. In total, we selected  14 regulators (see table 1 for additional information).
section_title: Effects of Partial Preemption of State Insurance Laws
paragraphs: To determine if any significant regulatory problems have resulted from  LRRA’s partial preemption of state insurance laws, as part of our survey we  asked regulators to evaluate the adequacy of LRRA’s protections, describe  how they reviewed RRG financial reports, and report whether their state  had ever asked a domciliary state to conduct an examination. To obtain an  in-depth understanding of how state regulators viewed the adequacy of  LRRA’s regulatory protections and identify specific problems, if any, we  interviewed regulators from each of our selected 14 states. We made visits  to the insurance departments of five of the six leading domiciliary states— Arizona, the District of Columbia, Hawaii, South Carolina, and Vermont— and five additional states—Nebraska, New York, Tennessee, Texas, and  Virginia. To assess the regulatory framework for regulating RRGs in the six  leading domiciliary states (the five we visited plus Nevada), we also  reviewed state statutes and obtained from regulators detailed descriptions  of their departments’ practices for chartering and regulating RRGs. To  determine how the RRG regulatory framework created in these states  compared with that of traditional insurers, we identified key components  of NAIC’s accreditation program for traditional insurance companies,  based on documentation provided by NAIC and our past reports. Finally,  our survey also included questions about RRGs consisting of businesses  that issued vehicle service contracts (VSC) to consumers because this type  of arrangement is associated with two failed RRGs.
In reviewing how RRGs file financial reports, we assessed how the use or  modification of two sets of accounting standards, generally accepted  accounting principles (GAAP) and statutory accounting principles (SAP),  could affect the ability of NAIC and regulators to analyze the reports. For  the year 2003, we also obtained from NAIC the names of RRGs that used  GAAP to file their financial reports and those that used SAP. To obtain an  understanding of differences between these accounting principles, we  obtained documentation from NAIC that identified key differences and  specific examples of how each could affect an RRG’s balance sheet. We  relied on NAIC for explanations of SAP because NAIC sets standards for  the use of this accounting method as part of its accreditation program. The  purpose of the accreditation program is to make monitoring and regulating  the solvency of multistate insurance companies more effective by ensuring  that states adhere to basic recommended practices for an effective state  regulatory department. Specifically, NAIC developed the Accounting  Practices and Procedures Manual, a comprehensive guide on SAP, for  insurance departments, insurers, and auditors to use. To better understand  GAAP and its requirements, we reviewed concept statements from the  Financial Accounting Standards Board (FASB), which is the designated  private-sector organization that establishes standards for financial  accounting and reporting. We also consulted with our accounting experts  to better understand how GAAP affected the presentation of financial  results.
section_title: Sufficiency of LRRA Provisions in Protecting RRG Insureds
paragraphs: To determine if LRRA’s ownership, control, and governance requirements  adequately protect the interests of RRG insureds, we analyzed the statute  to identify provisions relevant to these issues. In addition, we reviewed the  insurance statutes of the six leading domiciliary states—Arizona, the  District of Columbia, Hawaii, Nevada, South Carolina, and Vermont— related to the chartering of RRGs to determine if those states imposed any  statutory requirements on RRGs with respect to ownership, control, or  governance of RRGs. To identify additional expectations that state  insurance departments might have set for the ownership, control, or  governance of RRGs, we interviewed regulators from the six leading  domiciliary states and reviewed the chartering documents, such as articles  of incorporation and bylaws, of RRGs recently chartered in five of those  states. One state insurance department, South Carolina, would not provide  us access to these documents although we were able to obtain articles of  incorporation from the Office of the South Carolina Secretary of State. In  addition, we looked at past failures (and the public documentation that  accompanies failures) to assess whether factors related to the ownership,  control, and governance of RRGs played a role, or were alleged to have  played a role, in the failures, particularly with respect to inherent conflicts  of interest between the RRG and its management company or managers. To  identify these factors, we first selected 16 of the 22 failures to review,  choosing the more recent failures from a variety of states. As available for  each failure, we reviewed relevant documentation, such as examination  reports, liquidation petitions and orders, court filings (for example,  judgments, if relevant), and interviewed knowledgeable state officials.  Because some of the failures were more than 5 years old, the amount of  information we could collect about a few of the failures was more limited  than for others. In the case of National Warranty RRG, we reviewed  publicly available information as supplied by the liquidator of National  Warranty on its Web site; we also interviewed insurance regulators in  Nebraska where National Warranty’s offices were located and reviewed  court documents. We used these alternative methods of obtaining  information because National Warranty RRG’s liquidators would not supply  us any additional information. To determine how frequently RRGs include  the lack of guaranty fund disclosure on their Web sites and if they use the  words “risk retention group” in their name, we searched the Internet to  identify how many RRGs had Web sites as of August 2004, based on a listing  of 160 RRGs NAIC identified as active as of the beginning of June 2004.  When we identified Web sites, we noted whether the words “risk retention  group” or the acronym “RRG” appeared in the RRG’s name and reviewed  the entire site for the lack of guaranty fund disclosure. We updated the  results of our initial search in May 2005, using the original group of RRGs.
section_title: Survey of State Regulators on Risk Retention Groups
paragraphs: The Liability Risk Retention Act of 1986 permits risk retention groups (RRGs) to offer  most types of commercial liability insurance.  RRGs are unique because unlike most  insurance companies, they are regulated only by the state that chartered them and are  largely exempt from the oversight of the states in which they operate.  At the request of  Chairman Michael G. Oxley, Chairman of House Financial Services, we are conducting a  review of RRGs to determine how they have met the insurance needs of businesses and  whether the exemption of RRGs from most state regulations, other than those of the  state in which they are domiciled, has resulted in any regulatory concerns.
We believe that you can make an important contribution to this study, and ask that you  respond to this survey so we can provide the most complete information about RRGs to  Congress.  The survey should take about 90 minutes to complete, although additional  time may be required if your state has chartered several RRGs.   Please note that  attached to the e-mail that transmitted this survey is a file that identifies all the RRGs  operating in your state, as of year-end 2003.  You will need to review this list in order to  answer questions 23 and 24.
As indicated in the survey, we would like you to provide us  information about insurance  statutes and regulations that apply to RRGs chartered in your state.  For the regulations  only, we are requesting that you provide a hyperlink to the regulation, but you are also  welcome to send us a copy of the regulation attached to the e-mail message that contains  your completed survey instrument.  Please complete the survey in MS-Word and return it  via e-mail to GAOrrgSurvey@gao.gov -- no later than July 23, 2004.
If you encounter any technical difficulties please contact: William R. Chatlos  Phone: (202) 512-7607  e-mail: chatlosw@gao.gov NOTE: The number of states responding to an item is generally printed left of the   response.  No responses are provided in this Appendix when the answers are too  diverse to summarize or present briefly.
Definitions of acronyms and terms used in this questionnaire  Risk Retention Group (RRG):  An RRG is a group of members with similar risks that  join to create an insurance company to self-insure  their risks.  The Liability Risk Retention Act permits  RRGs to provide commercial liability insurance and  largely exempts them from regulatory oversight other  than that performed by their chartering state.
The state that charters an RRG and is responsible for  performing regulatory oversight, including  examinations. (“State” includes the District of  Columbia, and for RRGs chartered before 1985,  Bermuda and the Cayman Islands.)
Any state in which an RRG operates but is not chartered.
A vehicle service contract, purchased by consumers   when they buy cars, is for maintaining and   repairing an automobile beyond its manufacturer's   warranty coverage.   1.  Please use your mouse to navigate throughout the survey by clicking on the field   you wish to answer or filling in the requested field .        2.  To select a check box, simply click or double click on the center of the box. 3.  To change or deselect a response, simply click on the check box and the ‘X’  should disappear.  4.  Consult with others as needed to complete any section.  5.  After each section, there is a place for you to make comments.
2.  Please provide the name, title, phone number, and email address of the person completing the  survey so we might contact them if there are questions.
Part II: Requirements for Domiciling RRGs in Your State  In Part II (Questions 3-12), we are asking about the role of your state as a  “domiciliary” state for RRGs, the state responsible for chartering and regulating an  RRG.   This information is important, even if your state has not actually chartered  an RRG, because the laws and regulations for domiciling RRGs vary from state to  state.  In contrast, Section III contains questions pertaining to RRGs operating but  not domiciled in your state.
In addition, in some states RRGs can be chartered under more than one set of  laws.  When responding to the questions below, please respond for each law under  which a RRG could be chartered, even if a RRG or you the regulator would prefer  a RRG be chartered under one law (e.g., a captive law) rather than another (e.g.,  traditional insurance company law).
3. In your state, under which of the following domiciliary laws and/or regulations would RRGs  be chartered, if domiciled and chartered in your state? (Check all that apply.)
Traditional insurance law and/or regulations    Captive law and/or regulations; with or without specific provisions for RRGs   Other (Specify):  4.  If your state has a captive law and/or regulations, please provide the following information:     Not applicable, we do not use a captive law and/or regulations (Skip to Question #5.)  a. Year captive law enacted:   b. Year regulations created:   c. Citation for Statute:          d. Citation for regulations (Please include website link below.) e.  Does this law/regulation permit RRGs to be chartered as a captive?.   5. If your state uses its traditional insurance law to charter RRGs, please provide the following     Not applicable, we do not use traditional laws and/or regulations to charter RRGs. (Skip to Question #6.)  a. Citation for statute under which RRGs are chartered:          b. Citation for regulations (Please include website link below.)  website link:    6.  In your state, what are the minimum initial capital and/or surplus requirements for a RRG  domiciled in your state under any of the following laws/regulations that are applicable? (RRGs Cannot Be Chartered  Regulations in this State) a. Traditional Insurance Laws/Regs  c. Other (Specify):    7. In your state, under which of the following laws and/or regulations would RRGs domiciled in  your state be required to comply with the National Association of Insurance Commissioners’  (NAIC) risk-based capital requirements? (RRGs Cannot Be  this State) a. Traditional Insurance Laws/Regs  c. Other (Specify):   8.  In your state, under which of the following laws and/or regulations would RRGs domiciled in  your state be required to submit the same financial information as traditional insurance  companies to the NAIC? (RRGs Cannot Be  this State) a. Traditional Insurance Laws/Regs  c. Other (Specify):   *If you indicated that your state does not require RRGs to file financial information with NAIC,  please explain:  9.  How many RRGs have ever domiciled in your state?
Number of domiciled RRGs:   (If this number is greater than “0”, please                                                                                       complete Appendix A.) = 1 – 5 RRGs  10.  Does your state have staff who are exclusively dedicated to overseeing matters related to  captives and/or RRGs domiciled in your state?
No (Skip to Q12.)  11.  If you answered “Yes” to Question 10, about how many full-time-equivalent (FTE) staff are  currently dedicated to working with captives and RRGs domiciled in your state?
Part III: Your Role as a Host State Regulator For RRGs Operating in Your State  But Domiciled in Another State  In Part III (Questions 13–24), we are asking about the role of your state as a “host state”  regulator.  A host state is one in which RRGs operate but are not domiciled.   The 1986  Liability Risk Retention Act limits the amount of oversight that “host state” regulators  can perform over RRGs operating but not domiciled in their states.  This section  pertains only to requirements for RRGs operating but not domiciled in your state.
A. Submission of Operational Plans or Feasibility Studies to Host State Regulators  The Liability Risk Retention Act, 15 U.S.C. §3902, requires that each RRG submit  to the insurance commissioner of each state in which it intends to do business, copy of a plan of operation or a feasibility study which includes the coverages,  deductibles, coverage limits, rates and rating classification systems for each line of insurance the group intends to offer, and a copy of any revisions to such plan or  study.
13.  As of year-end 2003, how many RRGs were registered with your state to conduct  business?
14.  What steps, if any, does your state routinely take to ensure that RRGs submit plans of  operation or feasibility studies?
16. Are you aware of any RRG that substantially changed its business plan but did not provide  your state a copy of the altered plan? insurers (i.e., surplus lines insurers)?
Please briefly describe the review that you conduct:   18. If you have any comments related to this section, please write them here:  B.  Submission of Annual Financial Statements to Host State Regulators  The Risk Retention Act, 15 U.S.C. §3902, requires that each RRG submit to the  insurance commissioner of each State in which it is doing business, a copy of the  group’s annual financial statement submitted to the State in which the group is  chartered as an insurance company, which statement shall be certified by an  independent public accountant and contain a statement of opinion on loss and loss  adjustment expense reserves made by a member of the American Academy of  Actuaries, or a qualified loss reserve specialist.  19.  What steps, if any, does your state routinely take to ensure that RRGs operating but not  domiciled in your state submit annual financial statements?
20.  To the best of your knowledge, has any RRG operating in your state ever failed to provide copies of its annual financial statement to your state insurance department? insurers (i.e., surplus line insurers)?
INSTRUCTIONS: The e-mail inviting you to respond to this survey contained two  attachments:  (1) the survey itself, including Appendix A and (2) Appendix B--a list  of all RRGs that reported financial data to NAIC for 2003.  The RRGs appearing  first in Appendix B identified themselves to NAIC as writing premiums in your state  during 2003 and those appearing second did not.  To respond to the questions below,  please compare the list of RRGs in Appendix B that reported to NAIC that they wrote  premiums in your state in 2003 with your internal records.  23.  To the best of your knowledge, were all of the RRGs reporting to NAIC that they wrote  premiums in your state in 2003, also registered to conduct business in your state in 2003?
No -- If  “No”, please indicate:    The names of  RRGs that wrote premiums in your state but were not     registered in your state:    Not sure --   Some RRGs may have written premiums in our state without first     registering with our department but we are double-checking   NAIC’s information directly  with the RRGs in question. (Request:    Please let GAO know if you identify RRGs  that operated but were    not registered in your state in 2003, even if you have already   submitted your survey.)  24.  Based on a review of your internal records, did you identify any RRGs that wrote premiums  in your state in 2003 but were not listed on NAIC’s list?
Part IV:   Regulatory Experiences and Opinions on the Risk Retention Act  INSTRUCTIONS:     If your state has never chartered RRGs, go to Question 29.
Otherwise, please begin with Question 25.   25. During the past 24 months, about how many states that host RRGs have contacted your state to seek information about RRGs domiciled in your state?
Number of States contacting you:    =  0    contacts  26.  To the best of your knowledge, has your state ever been asked by a host state regulator to  conduct an examination of an RRG domiciled in your state?
No (Skip to Q29)
No  (Please explain why you did not comply):  29.  During the past 24 months, have concerns about an RRG led your department to contact the  RRG’s domiciliary state regulators?
If  yes, how many different RRGs have you called about (excluding   calls about National Warranty RRG)?
30. To the best of your knowledge, as a host state for RRGs, has your state ever asked a  domiciliary state to conduct an examination?
31. Please identify each request your state has made, including the name of the RRG, the date of  request, the domiciliary state to which you made the request, and a brief explanation of the  circumstances.  32.  Did the domiciliary state comply with your state’s request(s)?
33.  Do you have any additional comments on questions 25 through 32?     34.  For the record, does your State believe RRGs have expanded the availability and  affordability of commercial liability insurance for groups that would otherwise have had  difficulty in obtaining coverage?
Please offer any comments on your response:  35.  For the record, what is your State’s opinion as to whether the Risk Retention Act should be  expanded to permit RRGs to provide property insurance?
Please offer any comments on your response:  36. In your opinion, how adequate or inadequate are the regulatory protections or safeguards  built into the Risk Retention Act?  (Check one.)
Please offer any comments on your response:   37.  Does your state have an opinion as to whether the Risk Retention Act should be clarified or  amended in any way? (Continue on next page.)
Part IV (Questions 38-48) is about vehicle service contracts (VSCs).  An increasing number of  risk retention groups have been established to insure VSC obligors.  These obligors—whether  auto dealers or third party administrators—issue VSCs to consumers.  Because of this trend, and  the recent failure of National Warranty RRG, we are seeking a limited amount of information on  how states regulate insurance companies that insure obligors who issue VSCs.
INSTRUCTIONS: Please complete Questions 38 to 47.  If VSCs are regulated in another  office, please ask for assistance.  If someone other than the person identified in question 2  answered these questions, please provide the appropriate contact information.    38. Please provide the name, title, office and phone number of the person who completed this  part of the survey unless the name is the same as shown in question 2:  39.  Are vehicle service contracts (VSCs) regulated as insurance in your state?
Yes, but under certain conditions (Specify conditions):         Citation for regulation:   website link:    40.  Has your state adopted the NAIC Service Contracts model law?
Somewhat – please explain:   41.  Does your state permit third-party administrators, rather then just auto dealers, to issue  VSCs?
42.  Do any of your state agencies license obligors—whether auto dealers or third-party  administrators—before obligors can issue vehicle service contracts in your state?
43.  Which of the following requirements, if any, does your state require of obligors  before they issue VSCs in your state?  (Check all that apply.)
Insure VSCs under a reimbursement or other insurance policy    Maintain a funded reserve account for its obligations  Place in trust with the commissioner a financial security deposit (e.g., a surety bond)
Maintain a net worth of $100 million or another amount:   (If checked, identify amount: ) 44.  If obligors in your state purchase insurance for their VSCs, does your state require that in the  event the obligor fails to perform, the insurer issuing the policy must either pay on behalf of the  obligor any sums the obligor is legally obligated to pay, or provide any service which the obligor  is legally obligated to provide?
No  (Skip to Question 46)
Yes, but under certain conditions  45.  If you answered “yes” to question 44, does that mean that the insurer is required to pay 100  percent of the loss (i.e., first dollar coverage) or does the insurer’s risk not attach until some  deductible amount is met, such as a loss in excess of the obligor’s reserves?
Yes, but under certain conditions      Please explain:  46.  Does your state require that in the event an obligor fails to pay or provide service on a VSC  claim within a certain number of days (e.g., 60) after proof of loss has been filed, the contract  holder is entitled to make a claim directly against the insurance company?
Yes, but under certain conditions  47.  Are VSCs covered by your guarantee fund?
Have you completed Appendix A and/or Appendix B?  (Please save this document as an MSWord document,   then attach it to an email and send it to GAOrrgSurvey@gao.gov)
Thank you for your assistance.
Appendix A: Identification of RRGs Domiciled in Your State  For each RRG that your state has chartered since 1981, please provide the following information:  (Duplicate the table as many times as needed to complete for all RRG domiciled in your state.)
NAIC   Status  Code  (See  below)
section_title: Selected Differences between Statutory and Generally Accepted Accounting Principles as They Relate to Financial Reporting for RRGs
paragraphs: On an annual basis, traditional insurance companies, as well as risk  retention groups (RRG), file various financial data, such as financial  statements and actuarial opinions, with their respective state regulatory  agencies and the National Association of Insurance Commissioners  (NAIC). More specifically, RRGs—although subject to the regulation of one  state (their domiciliary state)—can and do sell insurance in multiple states  and are required to provide their financial statements to each state in which  they sell insurance. Unless exempted by the state of domicile, RRGs  generally file their financial statements with NAIC as well. Additionally,  although insurance companies generally are required to file their financial  statements based on statutory accounting principles (SAP), captive  insurance companies (a category that in many states includes RRGs) are  generally permitted, and in some cases required, to use generally accepted  accounting principles (GAAP), the accounting and reporting principles  generally used by private-sector (nongovernmental) entities.  Thus, while  some RRGs report their financial information using SAP, others report  using GAAP or variations of GAAP and SAP.
However, the use or modification of two different sets of accounting  principles can lead to different interpretations of an RRG’s financial  condition. For example, differences in the GAAP or SAP treatment of  assets and acquisition costs can significantly change the reported levels of  total assets, capital, and surplus. Because regulators, particularly those in  nondomiciliary states, predicate their review and analysis of insurance  companies’ financial statements on SAP reporting, the differing accounting  methods that RRGs may use could complicate analyses of their financial  condition. For instance, based on whatever accounting basis is filed with  them, the different levels of surplus reported under GAAP, or SAP, or  modifications of each, can change radically the ratios NAIC uses to analyze  the financial condition of insurers—undercutting the usefulness of the  analyses. Similarly, the accounting differences also affect calculations for  NAIC’s risk-based capital standards and may produce significantly different  results. For example, an RRG could appear to have maintained capital  adequacy under GAAP but would require regulatory action or control if the  calculations were based on SAP.
subsections: section_title: Differences in Accounting Principles Produce Different Financial Statements
paragraphs: Differences in the two sets of accounting principles reflect the different  purposes for which each was developed and may produce different  financial pictures of the same entity. GAAP (for nongovernmental entities)  provides guidance that businesses follow in preparing their general  purpose financial statements, which provide users such as investors and  creditors with a variety of useful information for assessing a business’s  financial performance. GAAP stresses measurement of a business’s  earnings from period to period and the matching of revenue and expenses  to the periods in which they are incurred. In addition, these financial  statements provide information to help investors, creditors, and others to  assess the amounts, timing, and uncertainty of future earnings from the  business. SAP is designed to meet the needs of insurance regulators, who  are the primary users of insurers’ financial statements, and stresses the  measurement of an insurer’s ability to pay claims—to protect policyholders  from an insurer becoming insolvent (that is, not having sufficient financial  resources to pay claims).
Additionally, while RRGs may be permitted to report their financial  condition using either GAAP or SAP, some regulators permit RRGs to  report using nonstandard variants of both sets of accounting principles—to  which we refer as modified GAAP and modified SAP. The use of variants  further constrains the ability of NAIC and nondomiciliary state analysts to  (1) understand the financial condition of the RRGs selling insurance to  citizens of their state and (2) compare the financial condition of RRGs with  that of traditional insurers writing similar lines of insurance. In some cases,  RRGs are permitted to count letters of credit (LOC) as assets as a matter of  permitted practice under modified versions of GAAP and SAP, although neither accounting method traditionally permits this practice.   Further, regulators in some states have allowed RRGs filing under GAAP to  modify their financial statements and count surplus notes as assets and add  to surplus, another practice which GAAP typically does not allow.
According to NAIC, the key differences between GAAP and SAP as they  relate to financial reporting of RRGs are the treatment of acquisition costs  and assets, differences that affect the total amount of surplus an RRG  reports on the balance sheet. This is important because surplus represents  the amount of assets over and above liabilities available for an insurer to  meet future obligations to its policyholders. Consequently, the  interpretation of an RRG’s financial condition can vary based on the set of  accounting principles used to produce the RRG’s balance sheet.
subsections: section_title: Acquisition Costs
paragraphs: According to NAIC, GAAP and SAP differ most in their treatment of  acquisition costs, which represent expenditures associated with selling  insurance such as the commissions, state premium taxes, underwriting,  and issuance costs that an insurer pays to acquire business. Under GAAP,  firms defer and capitalize these costs as an asset on the balance sheet, then  report them as expenses over the life of the insurance policies. This  accounting treatment seeks to match the expenses incurred with the  related income from policy premiums that will be received over time.  Under SAP, firms “expense” all acquisition costs in the year they are  incurred because these expenses do not represent assets that are available  to pay future policyholder obligations. As illustrated in figure 9, the  different accounting treatments of acquisition costs have a direct impact on  the firm’s balance sheet. Under GAAP, a firm would defer acquisition costs  and have a higher level of assets, capital, and surplus than that same firm  would have if reporting under SAP. Under SAP, these acquisition costs  would be fully charged in the period in which they are incurred, thereby  reducing assets, capital, and surplus.
GAAP and SAP also treat some assets differently. Under GAAP, assets are  generally a firm’s property, both tangible and intangible, and claims against  others that may be applied to cover the firm’s liabilities. SAP uses a more  restrictive definition of assets, focusing only on assets that are available to  pay current and future policyholder obligations—key information for  regulators. As a result, some assets that are included on a GAAP balance  sheet are excluded or “nonadmitted” under SAP. Examples of nonadmitted  assets include equipment, furniture, supplies, prepaid expenses (such as  prepayments on maintenance agreements), and trade names or other  intangibles.
Some RRGs also modify GAAP to count undrawn LOCs as assets. More  specifically, the six leading domiciliary states for RRGs—Arizona, the  District of Columbia, Hawaii, Nevada, South Carolina, and Vermont—allow  RRGs to count undrawn LOCs as assets, thus increasing their reported  assets, capital, and surplus, even though undrawn LOCs are not recognized  as an asset under GAAP or SAP.  For example, in 2002–2003, state  regulators permitted about one-third of RRGs actively writing insurance to  count undrawn LOCs as assets and supplement their reported capital.
Figure 10 illustrates the impact of different asset treatments for undrawn  LOCs. In this example, the RRG had a $1.5 million LOC that was counted as  an asset under a modified version of GAAP but was not counted as an asset  under a traditional use of SAP.  In addition, the RRG treated $363,750 in  prepaid expenses as an asset, which it would not be able to do under SAP.  Under a modified version of GAAP, the RRG’s total assets would be  $17,914,359 instead of $16,050,609 under a traditional use of SAP, a  difference of $1,863,750.
Figure 11 illustrates different treatments of acquisition costs and assets,  using a modified version of GAAP and a traditional version of SAP. In this  example, under a modified version of GAAP, undrawn LOCs ($2.2 million),  acquisition costs ($361,238), and prepaid expenses ($15,724) are valued as  an additional $2,576,962 in assets with a corresponding increase in capital  and surplus. The overall impact of treating each of these items as assets  under a modified version of GAAP is significant because the RRG reported  a total of $2,603,656 in capital and surplus, whereas it would report only  $26,694 under a traditional use of SAP. Under traditional GAAP, capital and  surplus would be reported as $403,656 ($2,603,656 minus the $2,200,000  undrawn LOC).
Additionally, the two accounting principles treat surplus notes differently.  Although SAP restricts certain assets, it permits (with regulatory approval)  the admission of surplus notes as a separate component of statutory  surplus, which GAAP does not. When an insurance company issues a  surplus note, it is in effect making a promise to repay a loan, but one that  the lender has agreed cannot be repaid without regulatory approval. Both  SAP and GAAP recognize the proceeds of the loan as an asset to the extent  they have been borrowed but not expended (are still available). However,  since the insurer cannot repay the debt without approval, the regulator  knows that the proceeds of the loan are available to pay claims, if  necessary. Thus, under SAP, with its emphasis on the ability of an insurer to  pay claims, the proceeds are added to capital and surplus rather than  recognizing a corresponding liability to repay the debt. GAAP, on the other  hand, requires companies issuing surplus notes to recognize a liability for  the proceeds of the loan, rather than adding to capital and surplus since the  insurer still has to repay the debt. However, according to NAIC data, four  state regulators have allowed RRGs to modify GAAP and report surplus  notes as part of capital and surplus during either 2002 or 2003. A total of 10  RRGs between the four states modified GAAP in this manner and were able  to increase their reported level of capital and surplus.
section_title: Other Differences
paragraphs: Finally, in addition to the differences between GAAP and SAP already  discussed, and as they have been modified by RRGs, other differences  between the two accounting methods include the treatment of investments,  goodwill (for example, an intangible asset such as a company’s reputation),  and deferred income taxes. According to NAIC, while these differences  may affect a company’s financial statement, they generally do not have as  great an impact as the differences in the treatment of acquisition costs and  assets.
section_title: The Different Results under Each Permitted Accounting Method Can Affect Analysis of an RRG’s Financial Condition
paragraphs: Use or modification of GAAP and the modification of SAP can also affect  the ability of NAIC and regulators to evaluate the financial condition of  some RRGs. Although subject to the regulation of one state (their  domiciliary state), RRGs can and do sell insurance in multiple states and  are required to provide financial statements to each state in which they sell  insurance. In almost all cases, RRGs also provide financial statements to  NAIC for analysis and review.
NAIC uses financial ratios and risk-based capital standards to evaluate the  financial condition of insurance companies and provides this information  to state regulators in an effort to help them better target their regulatory  efforts. NAIC calculates the ratios using the data from the financial  statements as they are filed by the companies. However, since both the  formulas and the benchmarks for the financial ratios are based on SAP, the  ratio information may not be meaningful to NAIC or the state regulators if  the benchmarks are compared with the ratios derived from financial  information based on a standard or modified version of GAAP, or a  modified version of SAP. Further, the use of GAAP, modified GAAP, or  modified SAP could make risk-based capital standards less meaningful  because these standards also are based on SAP. (We discuss accounting  differences in relation to risk-based capital standards in more detail at the  end of this appendix.)
To illustrate how the use of two different accounting methods can impede  an assessment of an RRG’s financial condition, we selected two financial  ratios that NAIC commonly uses to analyze the financial condition of  insurers—net premiums written to policyholders’ surplus (NPW:PS) and  reserves to policyholders’ surplus. Using SAP, NAIC has established a  “usual range” or benchmark for these financial indicators from studies of  the ratios for companies that became insolvent or experienced financial  difficulties in recent years. As part of its review process, NAIC compares  insurers’ ratios with these benchmarks. We selected these two ratios  because of the emphasis regulators place on insurance companies having  an adequate amount of surplus to meet claims and because policyholders’  surplus is affected by the different accounting treatments used by RRGs.
subsections: section_title: Net Premiums Written to Policyholders’ Surplus Ratio
paragraphs: The NPW:PS ratio is one of the 12 ratios in NAIC’s Insurance Regulatory  Information System (IRIS) and measures the adequacy of a company’s  ability to pay unanticipated future claims on that portion of its risk that it  has not reinsured. The higher the NPW:PS ratio, which is typically  expressed as a percentage, the more risk a company bears in relation to the  policyholders’ surplus available to absorb unanticipated claims. In other  words, the higher the NPW:PS, the more likely an insurance company could  experience difficulty paying unanticipated claims. Since surplus, as  reflected by the availability of assets to pay claims, is a key component of  the ratio, the use of GAAP, modified GAAP, or modified SAP instead of SAP  may affect the results substantially.
As shown in figure 12, each of the three RRGs has a lower NPW:PS ratio  when the ratio is calculated using balance sheet information based on a  modified version of GAAP than when the same ratio is based on SAP. In  other words, under modified GAAP, each of these three RRGs would  appear to have a greater capability to pay unanticipated claims than under  SAP. However, one RRG (RRG from figure 9) is below the NAIC benchmark  regardless of which accounting method is used.
Some of the higher NPW:PS ratios under SAP could provide a basis for  regulatory concern. NAIC considers NPW:PS ratios of 300 percent or less as  “acceptable” or “usual.” However, according to NAIC staff, companies that  primarily provide liability insurance generally should maintain lower  NPW:PS ratios than insurers with other lines of business because  estimating potential losses for liability insurance is more difficult than  estimating potential losses for other types of insurance. Since RRGs only  can provide liability insurance, NAIC staff believe a value above 200  percent (in conjunction with other factors) could warrant further  regulatory attention. Using this lower benchmark, two RRGs (from figures  9 and 11) meet the benchmark criteria under modified GAAP, but all three  RRGs fail to meet the benchmark under SAP. Thus, an analysis of an RRG’s  financial condition as reported under modified GAAP could be misleading,  particularly when compared with other insurers that report under SAP.
section_title: Reserves to Policyholders’ Surplus Ratio
paragraphs: The reserves to policyholders’ surplus ratio is one of NAIC’s Financial  Analysis Solvency Tools ratios and represents a company’s loss and loss  adjustment expense reserves in relation to policyholders’ surplus.  This  ratio, which is typically expressed as a percentage, provides a measure of  how much risk each dollar of surplus supports and an insurer’s ability to  pay claims, because if reserves were inadequate, the insurer would have to  pay claims from surplus. The higher the ratio, the more an insurer’s ability  to pay claims is dependent upon having and maintaining reserve adequacy.  Again, surplus is a key component of the ratio and the use of GAAP,  modified GAAP, or modified SAP rather than SAP could affect the ratio.
As shown in figure 13, each of the three RRGs has higher reserves to  policyholders’ surplus ratios when the calculations are derived from  balance sheet numbers based on SAP rather than modified GAAP. Under  the modified version of GAAP, each of the three RRGs reports higher levels  of surplus and consequently less risk being supported by each dollar of  surplus (a lower ratio) compared with SAP.
Higher reserves to policyholders’ surplus ratios could provide a basis for  regulatory concerns. According to NAIC, ratios of 200 percent or less are  considered “acceptable” or “usual” for RRGs. However, although the RRG  from figure 11 meets NAIC’s benchmark under modified GAAP, it  significantly exceeds NAIC’s benchmark when the ratio is calculated based  on SAP—a condition that could warrant further regulatory attention.
section_title: Risk-Based Capital
paragraphs: NAIC applies risk-based capital standards to insurers in order to measure  their capital adequacy relative to their risks. Monitoring capital levels with  other financial analyses helps regulators identify financial weaknesses.  However, since risk-based capital standards are based on SAP, numbers  used to calculate capital adequacy that are derived from any other  accounting basis (GAAP, modified GAAP, or modified SAP) could distort  the application of the standards and make resulting assessments less  meaningful.
NAIC uses a formula that incorporates various risks to calculate an  “authorized control level” of capital, which is used as a point of reference.  The authorized control level is essentially the point at which a state  insurance commissioner has legal grounds to rehabilitate (that is, assume  control of the company and its assets and administer it with the goal of  reforming and revitalizing it) or liquidate the company to avoid insolvency.  NAIC establishes four levels of company and regulatory action that depend  on a company’s total adjusted capital (TAC) in relation to its authorized  control level, with more severe action required as TAC decreases. They are  Company action level. If an insurer’s TAC falls below the company  action level, which is 200 percent of the authorized control level, the  insurer must file a plan with the insurance commissioner that explains  its financial condition and how it proposes to correct the capital  deficiency.
Regulatory action level. If an insurer’s TAC falls below the regulatory  action level, which is 150 percent of its authorized control level, the  insurance commissioner must examine the insurer and, if necessary,  institute corrective action.
Authorized control level. If an insurer’s TAC falls below its authorized  control level, the insurance commissioner has the legal grounds to  rehabilitate or liquidate the company.
Mandatory control level. If an insurer’s TAC falls below the mandatory  control level, which is 70 percent of its authorized control level, the  insurance commissioner must seize the company.
Because the differences between GAAP and SAP, as well as the  modification of both accounting bases, affect an RRG’s capital, the  differences also affect the TAC calculation for an RRG, and when  compared to the control levels, could lead an analyst to draw different  conclusions about the level of regulatory intervention needed.  For  example, in table 2, we place the three RRGs that we have been using as  examples in the action categories that would result from calculating each  TAC under the two accounting methods or their variants. The accounting  methods used have no effect in terms of regulator action for the first RRG  (because the RRG maintained a TAC level of more than 200 percent of the  authorized control level). The other two RRGs change to categories that  require more severe actions.
section_title: Liquidated Risk Retention Groups (RRG), from 1990 through 2003
paragraphs: Open liquidations   (estimates)
As of 2003, the  liquidators reported  that losses could  reach about $74  million. The liquidators  have not updated their  loss estimate since  2003.
As of May 2005, timely  claims against the  RRG numbered 1,990  but it is not known  what percentage of  approved claims will  be paid.
As of May 2005, timely  claims against the  RRG numbered 2,420  but it is not known  what percentage of  approved claims will  be paid.
As of May 2005, timely  claims against the  RRG numbered 2,150,  but it is not known  what percentage of  approved claims will  be paid.
As of July 2005, the  liquidation was  expected to be closed  within a few months.  No claims have been  paid yet for the  unauthorized  insurance.
Open liquidations   (estimates)
As of May 2005, the  receivership estimated  that the RRG had  about 350 outstanding  claims, valued at  about $6 million. The  receiver expected to  pay claims at 50 cents  on the dollar.
As of July 2005, the  overall estimated loss  was undetermined.  Claims are being paid  at 86 cents on the  dollar.
The RRG’s business  was assumed by  another insurance  company, pursuant to  an approved plan of  rehabilitation.
As of July 2005, the  overall loss estimate  was about $1.5 million.  Claims have been paid  at 82.5 cents on the  dollar.
As of April 2005, the  overall loss was  estimated at $4.2  million with about 260  claims filed.  Distribution to date is  32 cents on the dollar  and may increase to  42 cents on the dollar.
Open (but  expected to  close soon)
As of June 2005,  claims were expected  to be paid at 63 cents  on the dollar.
Open liquidations   (estimates)
Claims paid in full.
As of June 2005, the  claims were expected  to be paid in full.
The claims have been  paid in full, and the  receivership is  expected to close in a  few years.
Claims paid in full.
The overall loss was  about $6 million, and  claims were paid at  75 cents on the  dollar.
The loss was  estimated at $5  million, and claims  were paid at 65 cents  on the dollar.
As of July 2005,  claims were being paid  at 50 cents on the  dollar and will pay an  estimated additional 7  cents at closing. The  overall estimated loss  is about $27 million.
Open liquidations   (estimates)
Payments have been  made at 60 cents on  the dollar, with a  possible final  distribution of 4 cents  on the dollar.
Liquidated claims have  been paid in full, and  money has been  reserved to pay the  estimated amount of  unliquidated claims  (as they become  payable).
The overall loss  estimate is $945,000,  and claims were paid  at 61 cents on the  dollar.
According to a Tennessee official, as of December 31, 2004, TRA had approximately $17 million in  assets and $61 million in liabilities in expected losses for policy claims.
section_title: Comments from the National Association of Insurance Commissioners
paragraphs: Richard J. Hillman, Director  Financial Markets and Community Investment  441 G. Street N.W.
RE:  GAO Report on Risk Retention Groups  The National Association of Insurance Commissioners (NAIC) appreciates this opportunity to  review the GAO draft report on Risk Retention Groups. As you know, the NAIC is a voluntary  organization of the chief insurance regulatory officials of the 50 states, the District of Columbia  and  five  U.S.  territories.  The  association’s  overriding  objective  is  to  assist  state  insurance  regulators in protecting consumers and helping maintain the financial stability of the insurance  industry  by  offering  financial,  actuarial,  legal,  computer,  research,  market  conduct  and  economic expertise. Formed in 1871, it is the oldest association of state officials.
Several members of the NAIC staff and Director L. Tim Wagner in his capacity as chair of the  NAIC’s Property and Casualty Insurance Committee reviewed the draft report and a consensus  opinion  among  them  was  that  the  report  was  well  thought  out  and  well  documented.  The  research  methods  employed  were  solid  and  the  results  obtained  were  carefully  interpreted  to  obtain  a  clear  picture  of  how  states  are  undertaking  their  responsibilities  with  regard  to  regulation of risk retention groups. It explored the issues that are pertinent to the protection of  risk  retention  group  members  and  the  third  party  claimants  that  are  affected  by  the  coverage  provided by the risk retention groups.
Overall,  the  reviewers  believed  that  the  report  was  materially  accurate.  The  reviewers  agree  with  the  recommendations  contained  in  the  report  for  Congress  and  for  insurance  regulators.
Attached to this letter are several editorial suggestions and clarifications that we believe would  improve the final document.
Thanks  again  for  all  your  hard  work  in  making  government  accountable  to  the  public  that  it  serves.
section_title: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: Lawrence D. Cluff was the Assistant Director for this report. In addition,  Sonja J. Bensen, James R. Black, William R. Chatlos, Tarek O. Mahmassani,  Omyra M. Ramsingh, and Barbara M. Roesmann made key contributions to  this report.