Risk Retention Groups: Clarifications Could Facilitate States' Implementation of the Liability Risk Retention Act
Published: 2011-12-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Congress authorized the creation of risk retention groups (RRG)--a group of similar businesses that creates its own insurance company to insure its risk--to increase the affordability and availability of commercial liability insurance. Through the Liability Risk Retention Act (LRRA), Congress partially preempted state insurance laws to allow RRGs licensed in one state (the domiciliary state) to operate in all other states (nondomiciliary states) with minimal additional regulation. In a 2005 report (GAO-05-536), GAO noted concerns with the adequacy of RRG regulation. This report (1) describes changes in the financial condition of the RRG industry from 2004 to 2010; (2) examines the regulatory treatment of RRGs across domiciliary and nondomiciliary states; and (3) examines changes to federal and state regulatory practices regarding RRGs since 2004. GAO analyzed RRG financial data, surveyed state insurance regulators (96 percent response rate), and interviewed RRG industry representatives.
section_title: What GAO Found
paragraphs: Certain indicators suggest that the financial condition of the RRG industry in aggregate generally has remained profitable. In 2003, RRGs wrote about $1.8 billion, or 1.17 percent of commercial liability insurance. In 2010, RRGs continued to comprise a small percentage of the total market, writing about $2.5 billion--or about 3 percent of commercial liability coverage. Other financial indicators, such as ratios of RRG premiums earned compared to claims paid--also suggest profitability. In addition, the number of RRGs has increased since 2004, with the most growth occurring in health care-related lines. In 2010, more than 80 percent of RRGs were domiciled in Vermont, South Carolina, the District of Columbia, Nevada, Hawaii, and Arizona, but RRGs wrote about 95 percent of their premiums outside their state of domicile. Evidence suggests that RRGs may choose to domicile in a particular state, partly due to some financial and regulatory advantages such as lower minimum capitalization requirements. RRG representatives opined that RRGs have expanded the availability of commercial liability insurance--particularly in niche markets--but differed in their opinions of whether RRGs have improved its affordability. Different interpretations of LRRA have led to varying state regulatory practices and requirements in nondomiciliary states and disputes between state regulators and RRGs in areas such as registration requirements, fees, and types of coverage RRGs may write. For example, while some states have interpreted LRRA to permit RRGs to write contractual liability coverage, others have not, and therefore may not allow RRGs to write this coverage in their state. RRGs have challenged requirements established by nondomiciliary states that RRGs assert are not permitted by LRRA. However courts also have differed in their interpretations of LRRA. Some regulators with whom GAO spoke indicated that their actions toward nondomiciled RRGs reflect an effort to use their limited regulatory authority to protect insureds in their states as well as address concerns about RRG solvency. Some state regulatory practices for RRGs have changed since 2004, and federal legislation has been proposed. In 2005, GAO recommended implementation of more uniform, baseline state regulatory standards, including corporate governance standards to better protect RRG insureds. The National Association of Insurance Commissioners (NAIC) has since revised its accreditation standards to more closely align with those for traditional insurers which are subject to oversight in each state in which they operate. For example, all financial examinations of RRGs that have commenced during or after 2011 should use the risk-focused examination process. NAIC also has begun developing corporate governance standards that it plans to implement in the next few years. Proposed legislation would amend LRRA to allow RRGs to provide commercial property insurance and also include a federal arbitrator to resolve disputes between RRGs and state insurance regulators. While some RRG representatives and state regulators supported this legislation, others expressed concerns about whether RRGs would be adequately capitalized to write commercial property insurance and about federal involvement in state regulation.
section_title: What GAO Recommends
paragraphs: To further facilitate states' implementation and help reduce the varying interpretations of LRRA, Congress should consider the merits of clarifying certain LRRA provisions regarding registration requirements, fees, and coverage. NAIC concurred with this matter for congressional consideration.

section_title: Letter
paragraphs: Responding to shortages that constrained the availability and affordability  of commercial liability insurance, Congress passed the Product Liability  Risk Retention Act of 1981 (PLRRA) to authorize creation of risk retention  groups (RRG)—similar businesses with similar risk exposures that create  their own insurance company to self-insure their commercial liability risks  on a group basis. In 1986 Congress amended PLRRA by passing the  Liability Risk Retention Act of 1986 (LRRA), which allows RRGs to extend  coverage beyond product liability into most of the commercial liability  market and establishes a regulatory framework that partially preempts  state insurance laws.
LRRA allows an RRG to be regulated primarily by its chartering  (domiciliary) state, even when it sells insurance in other (nondomiciliary)  states. With one regulator, RRGs differ from “traditional” insurers, which  are subject to licensing and oversight by regulators in each state in which  they operate. While LRRA requires RRGs to provide to nondomiciliary  state regulators copies of the RRG’s business plan or feasibility study and  annual financial statements, it neither explicitly permits nor prohibits  nondomiciliary states from requesting additional documentation or  charging fees. LRRA preempts the laws of nondomiciliary states to  oversee RRGs selling insurance in their states except in specified  circumstances.
Congress intended for the regulatory framework established by LRRA “to  strike a balance between the RRGs’ need to be free of unjustified  requirements and the public’s need for protection from insolvencies.” The  legislative history indicates that Congress viewed RRGs as having  incentives to practice effective risk management both in their own  businesses and the RRG because the RRG is owned by insureds, who  may have business assets at risk should the RRG become insolvent. To  further encourage RRG members to establish adequate premiums and  reserves, LRRA prohibits RRGs from participation in state guaranty  funds. According to recent data from the National Association of  Insurance Commissioners (NAIC), eight RRGs became insolvent from  2004 to year-end 2010.
Our 2005 report on RRGs noted that RRGs played a small but important  role in increasing the availability and affordability of commercial liability  insurance in niche markets, but that they operated in a regulatory  environment characterized by varying state standards due to the partial  preemption of state insurance laws by LRRA. We found that RRGs might  not consistently protect the best interest of owners/insureds due to a lack  of uniform corporate governance standards. Our report was prompted by  a rise in the formation of RRGs coupled with the failure of several large  RRGs—22 RRGs failed between 1987 and 2003—which raised questions  about the adequacy of the RRG regulatory environment and safeguards  to protect RRG members/insureds and consumers. We recommended  that the NAIC develop and implement a set of broad-based, uniform,  baseline standards for RRG regulation. These standards should include  regularly filing financial reports using a uniform accounting method,  because both NAIC and some nondomiciliary states reported difficulty  assessing the financial condition and solvency of RRGs reporting under  generally accepted accounting principles (GAAP) as compared with the  condition of RRGs reporting under statutory accounting principles  (SAP). We also recommended establishing minimum corporate  governance standards, such as independent members on an RRG’s  board of directors.
As we also reported in 2005, some states may have modified policies and  procedures to attract RRGs to domicile in the state, such as lowering  statutory minimum capital and surplus requirements. Some regulators  also expressed concerns over aspects of RRGs’ operations that they  would not be able to influence, such as minimum capital and surplus  requirements for RRGs operating in but not domiciled in their state. The  various interpretations of LRRA by state insurance regulators have led to  disputes and in some cases litigation between RRGs and states. More  recently, legislation has been proposed to develop a federal mechanism  to arbitrate disputes between RRGs and states as well as to permit RRGs  to offer commercial property coverage in addition to commercial liability  coverage. Some state insurance regulators expressed concerns about  the capital adequacy of RRGs wishing to incorporate commercial property  coverage into their business lines.
In light of regulatory and industry concerns, as well as recent proposals to  expand LRRA, you asked us to update our analysis from our 2005 report.  This report (1) describes changes in the financial condition of the RRG  industry from 2004 through 2010; (2) examines the regulatory treatment  of RRGs across domiciliary and nondomiciliary states; and (3) examines  changes to federal and state regulatory practices regarding RRGs since  2004.
To determine the financial condition of the RRG industry, we analyzed  data on the commercial liability insurance market such as trends in the  types of coverage provided, concentration of domiciled RRGs, and  financial ratios based on data from NAIC. We also reviewed  documentation from 2004 through 2010 from NAIC and the Risk  Retention Reporter, a trade journal and industry data source. We  determined that the data were sufficiently reliable for the purposes of our  report. To evaluate the differences in regulatory treatment of RRGs  across states, we reviewed and analyzed LRRA and its legislative history.  We conducted a web-based survey of insurance regulators in the 50  states and the District of Columbia (96 percent response rate) and  interviewed 13 domiciliary and nondomiciliary state insurance regulators  from a nonstatistical sample. States were selected based on the number  of domiciled RRGs or the amount of premiums written by RRGs and  perceived differences in regulatory treatment of RRGs in these states. We  held two discussion groups with multiple RRG representatives that  volunteered to participate and interviewed representatives from a  nonstatistical sample of 11 RRGs. These RRGs were selected based on  the amount of premiums written, state of domicile, number of states in  which they operated, and type of insurance coverage provided. We are  not able to generalize results from this sample to the entire RRG industry.  Further, we interviewed representatives of two industry associations on  their members’ regulatory experiences operating in domiciliary and  nondomiciliary states. We reviewed correspondence from state insurance  regulators to RRG representatives about topics such as registration  processes and fees charged to RRGs. To examine changes in regulatory  practices since 2004, we analyzed documentation on and interviewed  NAIC officials about changes to the accreditation process affecting RRGs  and measures to develop corporate governance standards for RRGs. We  also asked representatives of RRGs and state insurance departments, as  well as an actuarial expert, about the potential impact of these efforts. Our  web-based survey also asked about regulatory changes. Finally, we  reviewed key legislation concerning RRGs that had been introduced at  the federal and state levels since 2004. We conducted this performance  audit from October 2010 to December 2011 in accordance with generally  accepted government auditing standards. Those standards require that  we plan and perform the audit to obtain sufficient, appropriate evidence to  provide a reasonable basis for our findings and conclusions based on our  audit objectives. We believe that the evidence obtained provides a  reasonable basis for our findings and conclusions based on our audit  objectives. Appendix I provides additional details about our objectives,  scope, and methodology.
subsections: section_title: Background
paragraphs: Traditional insurance companies sell insurance to the public and are  subject to the licensing requirements and oversight of each state in which  they operate. The licensing process allows states to determine if an  insurer domiciled in another state but operating in their state meets the  nondomiciliary state’s regulatory requirements before granting the insurer  permission to operate in their 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. In addition, most nondomiciliary states have  “seasoning requirements” that call for an insurance company to  successfully have operated in its state of domicile for anywhere from 1 to  5 years before it can qualify for a license.
subsections: section_title: Regulatory Framework for RRGs
paragraphs: Although RRGs have some regulatory relief due to the lead state  regulatory framework established under LRRA, they still are expected to  comply with certain other laws administered by nondomiciliary states.
For example, RRGs must pay applicable taxes on premiums and other  taxes imposed by nondomiciliary (as well as domiciliary) states. LRRA  also imposes other measures that offer protections or safeguards to RRG  members including the requirement that each RRG must submit to the  domiciliary state insurance regulator a plan of operation or feasibility  study that includes the coverages, deductibles, coverage limits, rates, and  rating classification system for each line of insurance the RRG intends to  offer. The RRG must (1) provide a copy of the plan or study to the  insurance regulator in the nondomiciliary states in which the RRG intends  to conduct business before it can write any insurance coverage in that  state; (2) provide a copy of the group’s annual financial statement  (certified by an independent public accountant) to the insurance  commissioner of each state in which it is doing business (the financial  statement should include a statement of opinion on loss and loss  adjustment expense reserves by a qualified loss reserve specialist or  actuary); 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.
section_title: Other Self-Insurance Structures
paragraphs: RRGs are not the only form of self-insurers. “Captive insurance  companies” (captives), also chartered and regulated by states, are  established by single companies or groups of companies to self-insure  their own risks. States chartering captives offer some regulatory relief to  these companies based on the presumption that owners of captive  companies have sophisticated knowledge about managing their risks and  would protect their own interests. States can charter RRGs under  regulations intended for traditional insurers or for captives. Non-RRG  captives exist largely 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  comprise several companies, but group captives, unlike RRGs, do not  have to insure similar risks. Further, captives may provide property  coverage, while RRGs currently may not. Regulatory requirements for  captives generally are less restrictive than those for traditional insurers.  However, non-RRG captives, like traditional insurance companies,  generally cannot conduct insurance transactions in any state except their  domiciliary state, unless they become licensed in that other state.
section_title: NAIC and State Coordination
paragraphs: State insurance regulators that oversee both traditional insurers and  RRGs participate in NAIC’s voluntary accreditation program for the  regulation of insurers’ financial solvency. NAIC accreditation is a  certification given to a state insurance department once it has  demonstrated it has met and continues to meet an assortment of legal,  financial, and organizational standards. According to NAIC officials, all 50  state insurance departments and the District of Columbia were accredited  as of March 2011. NAIC developed its Financial Regulation Standards  and Accreditation Program in 1989 and adopted its formal accreditation  program in June 1990. The mission of the program is to establish and  maintain standards to promote sound insurance company financial  solvency regulation. To execute this mission, NAIC assesses how each  state insurance department reviews and monitors the solvency regulation  of multistate insurance companies and RRGs to ensure states have   (1) adequate solvency laws and regulations to protect consumers,   (2) effective financial analysis and examination processes, and   (3) appropriate organizational and personnel practices.
section_title: RRGs Generally Reported Increased Profitability and Continue to Write the Majority of Their Business in Nondomiciliary States
subsections: section_title: Premiums Written by RRGs Generally Increased, Particularly in Health Care- Related Lines
paragraphs: Based on data reported by RRGs to NAIC since 2004, RRGs in  aggregate have shown an increase in premiums written and in their share  of the broader commercial liability market. In 2005, we reported that  RRGs wrote about $1.8 billion of commercial liability coverage, which  constituted about 1.17 percent of the overall market in 2003. According  to NAIC data, in 2010 RRGs wrote about $2.5 billion in premiums, which  was about 3 percent of the total $92 billion of commercial liability  insurance coverage written industrywide. An analysis of direct written  premiums by dollar amount indicates that between 2004 and 2010, the  largest percentage of RRGs (31 to 37 percent) wrote premiums between  $1 million and $5 million (see fig. 1).
Of the almost $92 billion of commercial liability insurance written industrywide  in 2010, about $10.6 billion was written in the medical professional liability  line—also known as medical malpractice. In an analysis of the premiums  written for the medical professional liability line, RRGs had a higher share of  this specific market compared with their share of the overall commercial  liability market. RRGs wrote about 13 percent ($1.4 billion of the total $10.6  billion) of medical professional liability insurance in 2010 (see fig. 2). We  further discuss growth in the number of RRGs offering health care-related  insurance later in this section.
Based on several measures of financial strength or profitability, the RRG  industry as a whole generally reported year-to-year gains from 2004 to  2010 (see fig. 3). A key factor in determining an insurer’s overall financial  strength is capital and surplus—also known as policyholder surplus— which reflects the amount by which an insurer’s assets exceed its  liabilities. Regulators require insurers to maintain adequate surplus so  that an insurer can remain solvent even in the face of greater losses than  predicted or lower earnings than projected. One of the indicators used to  measure the adequacy of policyholder surplus is the ratio of an insurer’s  premiums written to its policyholder surplus, which measures an insurer’s  ability to pay claims given the volume of premiums written. A lower ratio  of premiums written to surplus means an insurer has more net assets  available relative to the amount of premiums written. According to the  NAIC’s Financial Analysis Handbook–Property/Casualty Edition and other  general benchmarking guidelines from NAIC officials, the net written  premium-to-surplus ratios for property/casualty insurers in general would  receive regulatory scrutiny for excessive leverage risk concerns for ratios  greater than 250 to 300 percent, depending on the particular line of  insurance. If an insurer’s ratio exceeds this range, a state regulator may  conduct additional analyses of the insurer’s financial solvency. According  to NAIC officials, there is not an established benchmark for an acceptable  premium-to-surplus ratio for the RRG industry. An analysis of NAIC data  shows that on average, the industry’s net written premium to policyholder  surplus declined from 2004 to 2010, indicating that the financial strength  of the industry during this time period has likely either improved or  remained stable (see fig. 3).
Another indicator of financial strength is return on policyholder surplus, or  return on equity (ROE). ROE is generally calculated as the ratio of net  income to equity, or in the case of insurers, policyholder surplus. From  2004 to 2010, the average ROE in the RRG industry fluctuated, with a  high of 13.4 percent in 2008 and a low of 5.1 percent in 2010 (see fig. 4).  While no clear trend was visible over the 7-year period we analyzed, the  average ROE for each year generally indicated profitability for the RRG  industry.
The combined ratio is another measure of an insurer’s financial strength  and profitability. This ratio shows the claims and related expenses  incurred by an insurer as a percentage of the premiums earned.  According to NAIC officials, a combined ratio of less than 100 indicates  an underwriting profit (gain)—that is, premiums collected were higher  than the claims paid and related expenses—while a combined ratio above  100 can be an indicator of an unprofitable insurer that could be in a  hazardous financial condition. An analysis of NAIC data shows that the  average combined ratio for RRGs that filed financial statements ranged  from a high of 92.6 percent in 2005 to a low of 88 percent in 2008 (see  fig. 5). The average combined ratio in 2010 was 90.2.
Also based on NAIC data, the percentage of RRGs with a combined ratio  above 100 fluctuated from 2006 to 2010 (see fig. 6). For example, 36  percent of the RRGs writing premiums in 2006 had a combined ratio  above 100. These percentages increased from 2007 to 2009, with a high  of 43 percent in 2009, and decreased to about 37 percent in 2010.  Together, these data indicate that while most RRGs appear to have been  profitable in any one year, a sizeable but relatively stable percentage in  each year could have experienced some financial challenges.
Although the reported financial condition of RRGs appeared favorable in  most years since 2004, according to NAIC officials, the recent financial  crisis also affected the RRG industry. Capital sources for RRGs became  more constrained as banks became more stressed and tightened their  lending practices, prompting concern by state regulators about the financial  condition of some RRGs. Industry participants with whom we spoke said  that some RRGs may have found the experience especially challenging,  particularly in instances in which the RRGs were in part capitalized by  letters of credit from financial institutions adversely affected by the recent  financial crisis. An NAIC official said that similar to the rest of the  insurance industry, RRGs have earned less income on their investments.  In addition, one insurance regulator said that some RRGs had invested in  the real estate market, and the resulting devaluation of these assets  affected their balance sheets, particularly those of smaller RRGs.
section_title: The Total Number of RRGs Increased Since 2004, with Most Growth Occurring in Health Care-Related RRGs
paragraphs: In 2004 and 2010, most RRGs were concentrated on health care-related  lines of business. According to data from the Risk Retention Reporter, in  both years the top four business lines for RRGs in terms of gross  premiums were (1) health care; (2) professional services; (3) government  and institutions; and (4) property development (see fig. 7).
The majority of RRGs licensed in 2004 and 2010 offered health care- related insurance (see fig. 8). According to our analysis of data from the  Risk Retention Reporter, 148 of the 153 health care-related RRGs (97  percent) wrote medical malpractice coverage in 2010. The medical  malpractice industry generally has been characterized as volatile because  of the risks associated with providing this line of insurance. Health care  providers sought alternative sources of 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 contribute to the high risk of  providing medical malpractice insurance.
According to an RRG industry representative, although the overall liability  insurance market currently is soft—which may be described as a period  during which premiums are low, capital and competition are high, and  demand for RRGs is lower—the RRG industry has continued to grow,  especially in the area of medical malpractice coverage. Nine of the 13  state insurance regulators we interviewed affirmed that the majority of  RRGs domiciled or operating in their states provide insurance for various  health care-related lines, such as medical malpractice and liability  insurance for nursing homes.
section_title: Although Most RRGs Are Domiciled in One of a Few States, They Wrote the Majority of Business Outside Their State of Domicile
paragraphs: Although they conducted business nationwide, similar to what we  reported in 2005 more than 80 percent of active RRGs in 2010 were  domiciled in five states and the District of Columbia. Based on an  analysis of data from NAIC, the states with the most domiciled RRGs as  of 2010 were Vermont, South Carolina, the District of Columbia, Nevada,  Arizona, and Hawaii (see fig. 9). Montana, which was not one of the  leading domiciliary states when we reported in 2005, accounted for about  16 percent of the increase of domiciled RRGs in 2010. As of 2010, 24  states had domiciled RRGs.
RRGs may decide to domicile in a particular state for one or more  reasons. First, RRGs are more likely to domicile in a state that permits  their formation as a captive, which may not be one of the states in which  the RRGs write the majority of their business. Some states allow RRGs to  be chartered as captives because they only provide coverage to their  owners and do not sell insurance to the public. Further, regulatory  requirements for captive insurers generally are less restrictive than those  for traditional insurers. According to the Risk Retention Reporter, about  20 states charter and regulate RRGs under captive legislation. Second,  according to NAIC officials with whom we spoke, states that allow RRGs  to operate under captive laws often have less stringent financial  requirements. NAIC officials also said that RRGs tend to gravitate to  states that have lower capitalization requirements and in which the  regulators are looking to promote the RRG industry as a source of  revenue for the state. Finally, according to 9 of 13 state insurance  regulators we interviewed, in addition to lower minimum capital and  surplus requirements, RRGs may choose to domicile in certain states  because of the state’s expertise with regulating RRGs and knowledge of  the industry.
Evidence from our interviews and survey of state insurance regulators  also suggests that lower capitalization requirements were a factor in  RRGs choosing to domicile in those states. For example, in our interviews  with insurance regulators representing 8 of the top 10 domiciliary states, 4  regulators reported that the minimum amount of capital required to  domicile in their state was $500,000, 3 regulators reported a minimum  requirement of $1 million, and 1 regulator reported $400,000. However,  six of the regulators also reported that additional capital could be  required. Our interviews and state regulator survey also indicated that  two domiciliary states reduced their minimum capital and surplus  requirement since our 2005 report. For example, one domiciliary state’s  minimum capital requirement decreased from $500,000 to $400,000,  while another state’s decreased from $700,000 to $500,000. While RRGs  tend to domicile in a few states, they operate and write business in all 50  states and the District of Columbia (see fig. 10). Collectively, between  2004 and 2010, the number of operating RRGs increased by about 50  percent.
NAIC data also show that more than half of the RRGs in both 2004 and  2010 wrote premiums in two or fewer states, and two-thirds of the RRGs  wrote premiums in fewer than 10 states in both years. Of all the direct  premiums written by RRGs, about 97 percent and 95 percent were written  outside the state of domicile in 2004 and 2010, respectively (see fig. 11).  The nondomiciliary states in which RRGs wrote most of their business in  2004 were Pennsylvania ($308 million), New York ($226 million),  California ($210 million) and Massachusetts ($114 million). In 2010,  RRGs again wrote the majority of their business in these states: $369  million in Pennsylvania, $366 million in New York, $230 million in  California, and $172 million in Massachusetts. In 2005, we noted that,  according to NAIC, 73 of 115 RRGs active in 2003 (63 percent) did not  write any business in their state of domicile. According to data from NAIC,  168 of the 249 RRGs active in 2010 (67 percent) did not write any  business in their state of domicile.
Nondomiciliary state insurance regulators we interviewed expressed  concerns about the amount of RRG business in their states and their  limited authority to regulate RRGs providing coverage to their state’s  insureds. In our 2005 report, some nondomiciliary regulators expressed  concerns that domiciliary states were lowering their regulatory standards  to attract RRGs for economic development purposes. Similarly, NAIC  officials we interviewed said that when RRGs write the majority of their  business outside their state of domicile, the domiciliary state regulator  does not have “skin in the game” and cannot protect insureds who might  be affected if an RRG became insolvent. According to an NAIC official,  these states may allow actions that RRGs find favorable, but that are not  in the best interest of the insureds.
section_title: Industry Participants’ Views Differed on the Impact of RRGs on the Availability and Affordability of Commercial Liability Insurance
paragraphs: Based on our interviews and survey of state insurance regulators, RRG  industry participants had different views about the effects RRGs have had  on the availability and, to a lesser extent, the affordability of commercial  liability insurance. RRG representatives with whom we spoke generally  believed that RRGs have increased the availability of such insurance.  According to industry participants, RRGs have been providing coverage in  niche markets in which consumers otherwise might not be able to obtain  insurance (that is, from traditional insurers). However, one insurance  regulator with whom we spoke said that commercial liability insurance has  been readily available through traditional insurers, and therefore  questioned the need for mechanisms such as RRGs to obtain this type of  insurance. Our survey of state insurance regulators further suggests that  regulators generally had different views than RRG representatives about  the impact of RRGs on availability. In our survey, 17 out of the 49 state  insurance regulators who responded (35 percent) said that RRGs have  expanded the availability of commercial liability insurance for groups that  would otherwise have difficulty obtaining coverage. Conversely, 8 of the  regulators (16 percent) responded that RRGs have not expanded  availability, while 24 regulators (49 percent) did not have an opinion.
Industry participants were unsure of the impact of RRGs on the  affordability of commercial liability insurance. Some industry participants  with whom we spoke said that RRGs would not continue to exist if their  rates were not affordable. Other industry participants said that it was  difficult for them to assess the impact of RRGs on affordability, but  acknowledged that RRGs played a role in the insurance market. NAIC  officials with whom we spoke said that the affordability of rates offered by  RRGs has not been determined, as RRGs are not required to file their  premium rates with nondomiciliary state regulators. Therefore, an  analysis has not been conducted to compare RRG rates to those of  traditional insurers. In addition, an actuarial expert with whom we spoke  said that the rates and language included in each policy written by  traditional commercial insurers and by RRGs would need to be obtained  to make a true comparison, because this information differs among  insurers and among RRGs. In our survey, 13 of 48 respondents (27  percent) said that RRGs have improved affordability of commercial  liability insurance for groups that would otherwise have difficulty obtaining  coverage. Nine regulators (19 percent) responded that RRGs have not  improved affordability while 27 regulators (54 percent) did not have an  opinion.
section_title: Varying Interpretations of LRRA Result in Different Regulatory Treatment of RRGs across States
subsections: section_title: State Insurance Regulators and RRGs Have Differed on Registration Processes and Requirements LRRA Allows in Nondomiciliary States
paragraphs: Apart from the submission of required documentation, LRRA does not  provide for a specific process for RRGs to register to conduct business in  nondomiciliary states. States and RRGs have disagreed on issues  relating to registration such as the level of documentation required and  review and approval processes.
Interpretations about what documentation can be required vary by state.  Based on our analysis of interview and survey responses, some RRG  industry representatives and state insurance regulators interpreted  LRRA’s failure to mention registration as an indication that submission of  the specified documents in LRRA is all that can be required by a  nondomiciliary state before allowing an RRG to operate in that state.  Others interpreted LRRA’s silence on registration in nondomiciliary states  to mean that states can impose their own requirements. Responses to  our survey of state insurance regulators indicate that states have varying  registration requirements and practices, but respondents generally  reported that RRGs must submit required documentation as outlined in  LRRA. However, regulators also provided information on additional  information and documentation their states required to fulfill individual  state registration processes. For example, a few states will accept NAIC’s  uniform application form, while another state requires a state-specific  registration form. An RRG representative with whom we spoke said that  using NAIC’s uniform application form instead of state-specific forms  would simplify the registration process and make it more beneficial to  RRGs.
An RRG representative said that one state requires a listing of all other  states in which the RRG is registering and the status of the registration in  each state; copies of any condition or contingencies placed on the RRG  by its domiciliary state; copies of requirements or restrictions placed on  RRG members; copies of soliciting and marketing materials including  membership and subscription agreements; and projected premiums for  the next 3 years for the state in which the RRG is applying as well as  nationwide, among other requirements. According to another RRG  representative, one nondomiciliary state requires specific forms for  biographical affidavits of officers and directors, including Social Security  numbers. In documentation from state insurance regulators that we  received from an RRG industry association, as a part of the registration  process one state required the name, physical address and mailing  address of all agents or brokers for the RRG, and a copy of each  examination of the RRG, among other requirements. Representatives  from the RRG industry maintain that state regulatory practices such as  registration requirements beyond what is specified in LRRA “encroached”  on LRRA’s partial preemption of state insurance laws.
RRG representatives said that there is a fear among RRGs that repeated  objections to states’ requests for information will lead to RRGs being  targeted by state insurance offices. They also feared that providing  information would lead to more onerous requests. However, one state  insurance regulator with whom we spoke said that the additional  document requests were intended to provide the regulators with  necessary information to understand the operations of the RRGs  providing coverage in their states. Further, the regulator stated that  information requested is often the same information provided to the  domiciliary state regulator and that domiciliary regulators may be slow to  send the information or sometimes may not provide it. Two state  insurance regulators said that sometimes the information requested is  subject to a confidentiality agreement between the state and the RRG,  which makes it challenging for regulators to share information. To  alleviate this issue, one state insurance regulator suggested developing a  mechanism that would allow for a central repository of RRG financial data  for information-sharing purposes.
States and RRGs also have disagreed about registration and approval  processes. While some states require certain information in order to  approve RRGs’ registrations, RRG representatives with whom we spoke  said that LRRA does not require RRGs to go through a regulatory review  and approval process by state regulators to conduct business in  nondomiciliary states. In 2009, the Risk Retention Reporter surveyed  captive managers representing 260 RRGs to determine whether  nondomiciliary states were “encroaching” on LRRA preemptions. In the  2009 survey, 44 percent of RRGs responded that states made operation  contingent upon regulatory review and approval, while 56 percent found  that states did not. Also in the 2009 survey, 47 percent of respondents  said they were subject to “impermissible” requests for information, while  53 percent said that they were not subject to such requests.
RRG representatives with whom we spoke said that even after completing  the registration process for some nondomiciliary states, the RRG still may  not be recognized as registered, or such recognition may take several  years. For example, according to an RRG representative with whom we  spoke, an RRG sent a letter to a nondomiciliary state in May 2006 with  notification of its intent to do business. The RRG did not receive a letter  approving its registration until April 2008. Another RRG representative said  that an RRG filed the documents required by LRRA to register in about 40  states. About one-third of the states responded affirmatively to the  submissions for this RRG without any further questions. Another one-third  of states responded to the RRG with additional questions before allowing  the RRG to conduct business in those states. The remaining states did not  respond to the RRG’s registration filings.
Some states have mandatory waiting periods before a traditional insurer,  domiciled RRG, or nondomiciled RRG can begin writing business in their  state. In our survey of state insurance regulators, 3 of 49 states reported  having such a waiting period. However, the waiting period can be longer for  traditional insurers and domiciled RRGs than for nondomiciled RRGs. For  example, one state reported that its mandatory waiting period for traditional  insurers and domiciled RRGs was 90 to 120 days, and 15 to 30 days for  nondomiciled RRGs. Another state did not have a minimum or maximum  waiting period, but traditional insurers and domiciled RRGs could not write  business until their state issued a license, and the waiting period for  nondomiciled RRGs to begin writing business in the state was 60 days. A  third state reported no waiting period for traditional insurers and domiciled  RRGs and a waiting period of 30 to 60 days for nondomiciled RRGs.
NAIC has not taken a position on the legality or utility of different state  approaches to the interpretation of LRRA or state regulation of RRG  activities. NAIC published its Risk Retention and Purchasing Group  Handbook in 1999 to provide guidance to domiciliary states that have  adopted NAIC’s Model Risk Retention Act. The purpose of the  handbook is to present advisory information on issues that have arisen or  can be expected to arise when regulating RRGs under LRRA. For  example, while the handbook provides information on the notice and  registration process for nondomiciliary states, it does not take a position  on different state approaches.
As a result of state regulators’ varying interpretations of LRRA,  registration requirements may differ across states. As previously noted,  some RRGs believe that some states have registration requirements that  go beyond what is allowed under LRRA, and in some cases, these  requirements have caused delays in an RRG’s ability to begin operating  in those states. Conversely, some state regulators believe such  requirements are necessary as well as allowable under LRRA. These  differing interpretations have resulted in an environment of uncertainty for  both RRGs and regulators and, according to RRGs, are a potential  regulatory burden not intended by LRRA.
section_title: State Insurance Regulators and RRGs Differ on Their Interpretation of Fees Allowed under LRRA
paragraphs: LRRA allows nondomiciliary states to require RRGs to pay premium and  other taxes but does not explicitly state whether nondomiciliary insurance  regulators can or cannot charge fees. The silence of LRRA on fees has  prompted state insurance regulators and RRG representatives to interpret  the law differently. Both domiciliary and nondomiciliary state insurance  regulators routinely charge RRGs one-time registration fees, annual  renewal fees, and filing fees. Based on our survey of state insurance  regulators, the amount of fees charged varies across states and may  differ based on whether the RRG is domiciled in the state. Among the  respondents, most reported that they charged RRGs (domiciled and  nondomiciled) initial and annual fees to operate in their state. Specifically,  among the 37 states identifying specific fees charged to insurers, most  reported that they charged RRGs with some of the same types of fees  applicable to traditional property/casualty insurers.
In addition, the responses indicated that premium taxes—which LRRA  specifically authorizes—vary across states and in some cases have a  complex structure. For example, premium tax rates may be different for  domiciled or nondomiciled RRGs or for traditional property/casualty  insurers. In addition, a few states reported incremental tax rates based on  the volume of premiums written by the RRG. Further, some states  implement a “retaliatory” premium tax rate—meaning a state taxes out-of- state insurance companies operating in its jurisdiction in the same way  that the state’s own insurance companies are taxed by other states.
A majority of RRG representatives with whom we spoke said that varying  fees other than premium taxes that nondomiciliary states charged RRGs  were expensive and a financial burden and were also inconsistent with  LRRA. For example, one RRG representative said that the insurer, which  operates in 50 states and the District of Columbia with total national  premiums of $124 million, paid in excess of $500,000 in combined state fees  to conduct business outside its domiciliary state. A smaller RRG that wrote  premiums of about $1 million said it paid $6,000 to $7,000 in additional fees.  Three RRG representatives said that their RRGs often “pay fees under  protest,” while other RRG representatives said that they often paid the fees  because paying was less expensive than litigation against the states.
RRGs have challenged requirements established by nondomiciliary states  that RRGs believe are preempted, and therefore not permitted, by LRRA.  For example, in National Risk Retention Association v. Brown, a U.S.  district court found that LRRA does not authorize a nondomiciliary state to  require RRGs domiciled in another state to pay annual, application, or  policy form review fees as part of registration or examination  requirements before being allowed to do business in that state.
However, the court did not hold that all fees nondomiciliary states  charged necessarily were prohibited but that the types of fees charged in  that case were broader than those allowed by the registration and  examination requirements enumerated in LRRA. In Attorneys’ Liability  Assurance Society, Inc. v. Fitzgerald the court also addressed the issue  of fees. In that case, a state statute required nondomiciled RRGs to pay  a fee of a certain percentage of their business written in that state. The  court held that such a fee was not permitted, as LRRA permits only taxes  by nondomiciliary states, and such a fee was not considered a tax. The  fee in this case was to be used for regulatory purposes only, and  therefore was considered an impermissible attempt to regulate an RRG  by a nondomiciliary state.
As a result of differing interpretations of LRRA, fee structures vary across  states. While some RRGs believe some of these fees go beyond what is  allowed by LRRA, state regulators believe these fees are permissible.  While the impact on RRGs of fees charged in some states is not clear,  several RRG industry participants with whom we spoke said that fees  may be more challenging for smaller RRGs and RRGs operating in  multiple states. In addition, this variation of fees across states also  contributes to the uncertainty under which RRGs and state regulators  operate.
section_title: Regulators, RRGs, and Courts Also Differed on the Types of Coverage That RRGs Can Offer and What Constitutes Discrimination as Prohibited by LRRA
paragraphs: LRRA allows RRGs to provide commercial liability insurance and provides  a general definition of liability. However, beyond its general definition,  LRRA is silent on the specific types of liability insurance that RRGs can  provide, which has resulted in differences of interpretation by RRGs and  state insurance regulators about the types of liability coverage permitted  under LRRA. In our survey of state insurance regulators, 6 of 49 regulators  responded that they had between one and five differences of interpretation  with other state insurance regulators about the definition of commercial  liability insurance in the last 24 months. One regulator reported more than  10 differences. In our interviews, five regulators said they believed that  insurance lines such as contractual liability (for example, vehicle service or  builder warranties) and stop-loss coverage were not permitted under  LRRA. In some cases, nondomiciliary state insurance regulators have not  allowed RRGs to provide insurance in their state that they believe does not  fit the definition of liability under LRRA. For example, one nondomiciliary  state regulator said it denied the registration of an RRG that planned to  offer contractual liability insurance. In addition, an RRG representative  reported its registration application was denied in five states because  regulators did not believe contractual liability coverage fell within the  definition of liability in LRRA. Further, one domiciliary state insurance  regulator we interviewed said the state believed contractual liability  coverage was permitted under LRRA; however, the state generally did not  allow this coverage to be offered in the state to “avoid the politics of the  issue.” This regulator, along with three other regulators with whom we  spoke, said that the RRG industry needed a clearer definition of contractual  liability or the types of coverage permissible under LRRA. Differences in  interpretation of the types of coverage permitted under LRRA have led to  litigation between states and RRGs.
States and federal courts also have differed in their interpretations. For  example, in Auto Dealers RRG v. Steve Poizner, an RRG provided stop- loss insurance that covered liability by its members, employees of  California automobile dealers that maintained self-funded employee  benefit plans. The California insurance office issued a cease-and-desist  order because it believed that the RRG was providing health insurance,  not liability insurance as defined by LRRA. The RRG challenged the  California insurance office’s cease-and-desist order in federal court, and  the court issued a preliminary injunction blocking the cease-and-desist  order. However, the court never decided the case on its merits—that is,  the court never decided whether the RRG was issuing valid liability  insurance policies—because the RRG decided to stop pursuing the case  and instead stopped issuing policies in California. In Attorneys’ Liability  Assurance Society, Inc. v. Fitzgerald (discussed previously), the court  held that LRRA permitted an RRG to cover liability by its members for  wrongful employment practices. The court held that while RRGs  specifically were not to cover workers’ compensation, the types of  coverage provided by the RRG at issue in the case were permissible  under the broad scope of LRRA.
Federal courts have rendered varying decisions relating to what is  considered prohibited discrimination per LRRA’s state financial  responsibility requirements. These financial responsibility requirements  consist of state or local provisions that establish conditions for obtaining a  license or undertaking certain activities. For example, many states require  that anyone registering a motor vehicle demonstrate proof of financial  responsibility (show that the owner of the vehicle has financial means  sufficient to compensate any injured persons). State laws may provide  that financial responsibility can be shown by coverage in a liability  insurance policy by an insurer that is regulated by the state and protected  by the state’s guaranty fund. LRRA does not preempt state authority to  apply financial responsibility standards as long as those standards do not  discriminate against RRGs within the meaning of LRRA. For example, in  National Warranty Insurance Company RRG v. Greenfield, the U.S. Court  of Appeals for the Ninth Circuit held that LRRA preempted provisions of  the Oregon Service Contract Act that required automobile dealers to  obtain liability insurance from an insurer that was a member of the  Oregon Insurance Guaranty Association. Because RRGs do not  participate in state guaranty associations, the Oregon law effectively  excluded RRGs from providing liability insurance to automobile dealers.  Thus, the court held that Oregon could not exclude coverage from all  RRGs because that would discriminate against RRGs. However, Oregon  could exclude coverage from a particular RRG if it could show that the  RRG was financially unsound or otherwise dangerous to those who relied  on insurance purchased pursuant to the Oregon Service Contract Act. In  another case, Charter Risk Retention Group Insurance Company v.  Rolka, a U.S. district court noted similarly that discrimination against  RRGs as a whole is prohibited under LRRA. However, state laws  relating specifically to financial responsibility requirements could be valid,  if they caused a particular RRG to be excluded if it lacked acceptable  evidence of financial responsibility for a state license or permit, as long as  they did not discriminate against RRGs as a whole.
Other courts have interpreted the provisions of LRRA prohibiting  discrimination against RRGs differently. In Ophthamalic Mutual Insurance  Company v. Musser, the U.S. Court of Appeals for the Seventh Circuit  affirmed a district court decision that LRRA does not preempt a Wisconsin  requirement that health providers offer proof of financial responsibility to  do business in the state by obtaining professional liability insurance  coverage from insurers authorized to do business in Wisconsin, although  it effectively excludes nondomiciliary RRGs from operating in that state.  The court found that the challenged statute neither impermissibly  regulated RRGs nor was intended to discriminate against them, and  therefore is not preempted by LRRA. The court concluded that the  Wisconsin requirement fit within the saving clause of LRRA providing that  states are not bound by LRRA when crafting statutes concerning financial  responsibility, as long as the statutes were not intended to discriminate  against RRGs. Similarly, in Mears Transport Group v. State, the U.S.  Court of Appeals for the Eleventh Circuit held that LRRA did not preempt  a Florida law requiring owners or operators of for-hire passenger  transportation vehicles to provide evidence of financial responsibility by  having a motor vehicle liability policy issued by an insurer that is a  member of the Florida Insurance Guaranty Association. Although RRGs  effectively are disallowed from doing business in Florida under this law,  as they are not permitted to be members of guaranty associations under  LRRA, the court held that the Florida law does not single out RRGs for  exclusion, as RRGs are one of many types of insurance carriers ineligible  for membership in the guaranty association. Therefore, the court held that  the Florida law was not intended to be discriminatory. Since the Florida  law is “precisely the type of state financial responsibility law that  Congress expressly exempted from the preemption provisions of LRRA,”  according to the court, it is allowed and not preempted by LRRA.
Different interpretations of the types of coverage permitted under LRRA  have resulted in the inability of some RRGs to provide coverage in certain  states. And, in cases in which RRGs choose to pursue legal action when  states deny their ability to provide that coverage, the RRGs may incur  substantial legal fees. As previously noted, different interpretations by  federal courts on issues such as permissible coverage types and what  constitutes discrimination under LRRA can further contribute to an  uncertain regulatory environment for RRGs and state insurance  regulators.
section_title: State Insurance Regulators Have Expressed Concerns about the Capitalization and Solvency of Some RRGs
paragraphs: Because LRRA does not comprehensively address the capitalization or  solvency requirements of RRGs, states can develop their own statutory  minimum capital and surplus requirements for RRGs domiciled in their  state. According to some state insurance regulators with whom we spoke,  these requirements are based on the type of insurance coverage offered,  the volume of business the RRG intends to write, and other factors. Two  nondomiciliary state insurance regulators with whom we spoke indicated  concerns about the capitalization and solvency of RRGs operating in their  states, and two regulators support increasing the minimum capital  requirement. In addition, some states allow RRGs, unlike traditional  insurers, to meet and maintain their minimum capital and surplus  requirements in the form of an irrevocable letter of credit rather than cash.  Data from NAIC show that as of June 2010, 62 RRGs were capitalized  with letters of credit.
Although RRGs write most of their business outside their state of  domicile, nondomiciliary state insurance regulators must rely on  domiciliary regulators to establish minimum capitalization and solvency  requirements for their domiciled RRGs—and ensure that the  requirements are commensurate with the type of coverage provided and  the volume of premiums written. Some RRG representatives with whom  we spoke believed that there is a lack of confidence in the RRG  regulatory environment or that some states prefer their own authority to  regulate RRGs writing business in their state. Two state insurance  regulators and four RRG representatives said they believed that some of  these issues will be resolved through NAIC’s efforts to develop uniform,  baseline standards for the regulation of RRGs.
section_title: NAIC Actions Address Some Regulatory Concerns, While Recent Federal and State Proposals May Affect Future RRG Operations
subsections: section_title: Revised Accreditation Standards Address Some Regulatory Concerns with RRGs’ Financial Solvency Practices
paragraphs: Our 2005 report found that the wide variance in solvency regulation  among domiciliary states, along with the growth of the RRG industry,  increased the potential for future solvency risks. In response to  recommendations from our 2005 report to provide a more uniform  regulatory environment for RRGs, NAIC revised its accreditation  standards to include standards for the way in which states regulate RRG  solvency. These new standards went into effect on January 1, 2011.  NAIC also began to address our recommendations to develop corporate  governance standards concerning ownership and operational issues  within RRGs. Initial discussions in 2005 led to the development of draft  corporate governance standards by 2007, and later in 2010 NAIC working  groups initiated steps toward integrating these standards into the RRG  oversight process. In addition, NAIC has started the process to integrate  corporate governance standards into its accreditation standards, so that  states would be required to review RRG’s corporate governance  standards to be accredited. The groups’ discussions were open to  interested parties, including RRG representatives. For instance, the  National Risk Retention Association (NRRA), told us it actively  participated in NAIC working groups. The revisions to the financial  accreditation standards for state insurance departments’ oversight of  domiciled RRGs more closely align the standards applied to the oversight  of RRGs with those that are applied to traditional insurers. The revisions  affect key areas of RRGs’ financial solvency oversight, including revising  accounting requirements for annual financial reporting and making  financial examinations risk-focused.
Among the recent revisions to NAIC’s accreditation standards is a new  requirement that applies to RRGs that do not file their annual financial  statements using SAP: these statements must contain a reconciliation to  SAP, effective January 1, 2011. According to NAIC, in 2010, 72 RRGs  reported filing their financial statement using SAP and 177 reported using  another accounting principle such as GAAP. The reconciliation is  designed to indicate to regulators how the accounting principles used in  financial statements result in figures different from those that SAP would  have produced. RRGs can include this reconciliation in the footnotes to  the financial statement. This new standard aims to address some of the  challenges identified in our 2005 report that arose from the use of  different accounting principles, such as difficulties in assessing the  financial condition of RRGs reported by some nondomiciliary state  insurance regulators more accustomed to SAP. The new standards also  move financial reporting requirements for RRGs closer to those of  traditional insurers. Our survey responses from state insurance  regulators showed that 32 state regulators reported requiring SAP for  financial reporting, 14 reported requiring GAAP or a modified version of  GAAP and 3 reported a choice of accounting principles within their  requirements.
Financial reporting practices for RRGs still vary and the choice of  accounting method can produce different conclusions about a company’s  financial strength. NAIC analysts continue to report that allowing  financial statements using different accounting principles, even when  reconciled to SAP in the footnotes, diminishes the usefulness of their  underlying data and analysis tools because the tools were designed  around data extracted from financial statements based on SAP.  Statements filed using other accounting principles can produce distorted  results when looked at through traditional computerized analysis tools. As  a result, NAIC must then revise the analyses to produce information  useful to state regulators, which requires more staff resources. In prior  reports 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, including flagging financial ratios that are outside the usual  range for additional regulatory attention. Further, the choice of  accounting method can have important repercussions for certain RRGs.  For example, representatives of two RRGs with whom we spoke reported  letters of credit to be critical for some RRGs to meet minimum  capitalization requirements; and as a result, they often preferred to file  their financial statements using GAAP where letters of credit can, in some  states, improve the RRG’s appearance of financial solvency.
The revised accreditation standards also require all RRGs to have risk- focused examinations in an effort to implement more uniform baseline  standards for RRG regulation, applicable to all financial examinations of  RRGs commencing on or after January 1, 2011. Risk-focused  examinations emphasize reviews of higher-risk areas and tend to be  more specialized and tailored to individual companies. Risk-focused  examinations are already a regulatory requirement for traditional insurers.  Nondomiciliary states have the right to review the results of these  examinations for RRGs.
Three representatives of RRGs with whom we spoke supported the move  to risk-focused examinations because they believed more uniform  regulatory activities among domiciliary states would result in more trust  among state regulators and ultimately would benefit the RRG industry.  However, six representatives also acknowledged some potential  challenges in implementing risk-focused examinations for some RRGs,  particularly the smaller ones. For example, they said it could increase  financial costs and regulatory burden for these RRGs because state  regulators might need to hire more specialized auditors for more detailed  reviews, and pass on the associated costs to the RRGs in the form of  examination fees. NRRA also expressed its concern about the efficiency  and effectiveness of risk-focused examinations for small liability insurance  companies, which compose the majority of RRGs. NRRA characterized  the impact on small RRGs as excessively expensive without yielding  commensurate benefit, and held that implementing risk-focused  examinations for small RRGs would run counter to the intent of LRRA. In  its letter to NAIC, NRRA questioned the cost-effectiveness of the more  rigorous examinations for certain RRGs based on characteristics such as  the RRG’s size, its impact in nondomiciliary states, and the structure of its  membership.
Four state insurance regulators with whom we spoke also said that  requiring risk-focused examinations might not be an efficient use of  resources, particularly for small RRGs that represent the majority of the  RRG population. Three state insurance departments we interviewed  reported having already implemented risk-focused examinations for their  domiciled RRGs. Based on its experience conducting risk-focused  examinations, one domiciliary state regulator recommended that criteria  be used to determine the efficiency and effectiveness of applying a risk- focused examination to an RRG. For example, the regulator  recommended that risk-focused examinations should be required for  RRGs with more than $10 million in direct written premiums, owned and  operated by a group of shareholders with unrestricted membership, and  registered to operate in at least 15 states. Alternatively, the regulator  suggested leaving it at the discretion of the domiciliary state regulator to  decide whether the risk-focused approach would be the most efficient  approach to oversee a particular RRG.
According to NAIC officials, the possibility of exempting certain types of  RRGs from the risk-focused examination requirement was considered in  working groups. However, they also expressed concern about whether  alternative examinations would qualify as full-scope examinations in  accordance with NAIC’s guidance on examinations as outlined in the  Financial Condition Examiners Handbook. The guidance requires RRGs  to undergo full-scope examinations at least once every 5 years, or in  accordance with the respective state law if it requires more frequent  examinations. NAIC decided that the risk-focused examination process  was flexible enough to allow examiners to tailor examinations to fit the  unique characteristics of RRGs.
section_title: RRG Oversight Could be Affected by Future Developments with NAIC and Federal Legislation
subsections: section_title: NAIC Plans to Incorporate Risk-Based Capital Analyses into RRG Oversight, as Already Done for Traditional Insurers
paragraphs: NAIC’s risk-based capital (RBC) system was created to provide a capital  adequacy standard for traditional insurers that creates a financial safety  net, is uniform among the states, and provides regulatory authority for  timely action. The RBC formulas can be technical and involve a number  of components. Each of the primary insurance types—such as  property/casualty, life or health—has a separate RBC formula that  emphasizes the material risks common for that particular insurance type.  Regulatory actions may be triggered by the RBC calculation for an  insurer, and actions may include requiring the insurance company to  issue comprehensive financial plans, issue corrective orders, or authorize  the take-over of the insurer.
NAIC officials said that they are pursuing the use of RBC calculations in  the oversight of RRGs as part of the accreditation process. While  regulators may voluntarily include RBC calculations in the financial  examinations of RRGs, these calculations are not specifically required.  According to NAIC officials, it is expected that RBC will be incorporated  into the accreditation standards. If incorporated into the accreditation  standards, regulators would be expected to incorporate RBC calculations  into their broader financial analyses to determine whether any actions  would be necessary, although, unlike traditional insurers, the RBC  calculations for RRGs do not automatically trigger regulatory actions.
While five RRG representatives we interviewed generally supported  NAIC’s revisions to the accreditation standards in the RRG industry, three  representatives expressed some concern about how meaningful an RBC  analysis would be as a requirement in RRG oversight. For example, they  said that the use of RBC for small RRGs, which tend to use GAAP  accounting and rely more heavily on letters of credit to meet their  capitalization requirements, might not be useful. Five state insurance  regulators we interviewed were also unsure of the usefulness of  incorporating RBC calculations into the accreditation standards,  particularly in situations in which otherwise healthy RRGs could fare  poorly when RBC calculations were applied. An actuarial expert we  interviewed also expressed concern that an RBC requirement could lead  to an overemphasis on the RBC figures for regulators and undue  pressure on otherwise sound RRGs to increase capital. According to an  NAIC working group analysis, an RBC formula using figures based on  GAAP could result in different numbers compared with RBC calculations  using figures based on SAP, potentially changing the picture of that  RRG’s financial condition. However, the working group also said that  using figures determined under GAAP might not unreasonably alter the  RBC conclusions for most RRGs and still could be meaningful.
In response to our 2005 recommendations to establish minimum  corporate governance standards for the RRG industry, NAIC developed  such standards for RRGs but has not yet implemented them with a model  act or through their accreditation standards. NAIC officials reported that  they expect these corporate governance standards to be incorporated  into the Model Risk Retention Act by the end of 2011. Further, the officials  said that in 2012 they will consider adopting corporate governance  standards as part of the accreditation standards.
An RRG is often operated by a management company or another service  provider that generally supplies key services. However, the potential for  abuse arises if the interests of a management company are not aligned  with the interests of the RRG insureds to achieve long-term solvency and  obtain self-insurance at an affordable price. In our 2005 report, we found  behavior suggesting that management companies and affiliated service  providers promoted their own interests at the expense of the RRG  insureds in 10 of the 16 cases of RRG failures we examined. LRRA  includes no provisions for governance controls that could help mitigate  the risk to RRG insureds from potential abuses by other interests, such as  their management companies, should these companies choose not to  operate in the best interest of RRG insureds.
In response to GAO’s recommendations, NAIC’s working groups have  included corporate governance standards as part of their efforts to  develop uniform baseline standards for RRGs. NAIC first adopted  corporate governance standards for RRGs in June 2007 as a separate  stand-alone guidance that was not incorporated into the accreditation  standards. As of October 2011, the revisions to the Model Risk Retention  Act that include corporate governance standards had been reviewed, but  not yet approved, by the NAIC member states. As of November 2011  these revisions were approved and NAIC had adopted corporate  governance standards into the Model Risk Retention Act. However,  corporate governance standards are not yet a part of the accreditation  standards and NAIC officials said that they will not begin discussions on  adopting these standards into the accreditation requirements until 2012.
Three state insurance regulators with whom we spoke expressed support  for corporate governance standards as a requirement for RRGs because  they felt it would improve transparency of the management of RRGs.  While five regulators generally did not think implementing corporate  governance standards would be burdensome for RRGs, one regulator did  expect that some RRGs, depending on their size, could find the  implementation of some standards, such as the requirement for an audit  committee, to be a challenge. Representatives of two large RRGs with  whom we spoke supported corporate governance standards as good  business practice. However, four representatives of RRGs also  expressed concern about the cost of implementing these standards for  smaller RRGs, particularly those without their own internal counsel.
Recent federal legislative proposals to amend LRRA, if passed, would  offer new options to RRGs. One proposed change would expand the  type of insurance RRGs may provide to include commercial property  coverage. RRG representatives with whom we spoke generally favored  amending LRRA to allow RRGs to provide commercial property insurance  coverage. For example, one representative said the differences in the risk  profile between commercial property coverage and commercial liability  coverage is a potential opportunity to manage their risks more  strategically.
In addition, six RRG representatives we interviewed felt that allowing  coverage of commercial property insurance constituted a removal of  restrictions on providing insurance products that could be a natural  extension of their core line of business. For example, an RRG that offers  professional liability coverage to dentists currently cannot underwrite  coverage for dental equipment. Similarly, one representative of an RRG  offering commercial liability insurance products to the construction  business said that the RRG could not offer property insurance related to  the same homes constructed under their insurance coverage. Another  RRG representative said their clients would like the option to bundle their  property coverage with a wide range of specialized insurance products  they purchase from the RRG for both convenience and cost-  effectiveness. Eight RRG representatives we interviewed were concerned  that some RRGs entering the commercial property market might not have  adequate capital to cover the potentially severe losses that are a part of  that line of coverage. Four RRG representatives also said that they would  expect the domiciliary state regulator to review any changes to an RRG’s  business plan to ensure that it had an appropriate capital base for its  underwriting coverage and risk profile.
Ten regulators with whom we spoke expressed concerns about RRGs  entering the commercial property insurance market because of the  potential risks to owner/insureds and consumers. For example, six  regulators expressed concern that if an RRG was unable to pay the  potentially severe losses associated with some lines of property  insurance, the RRG members could be at financial risk. RRGs cannot  participate in state guaranty funds that otherwise could help pay losses in  such cases. In our survey of state insurance regulators, we asked  whether they thought LRRA should be amended to enable RRGs to  provide commercial property insurance. Among the responses, 32  regulators did not think LRRA should be so amended while 5 thought  LRRA should be amended to allow RRGs to provide property insurance.  Three of the five regulators that favored amending LRRA in this way were  from the 10 states with the highest RRG gross premiums in 2010.
The proposed legislation also would grant authority to a federal entity,  such as the recently created Federal Insurance Office in the Department  of the Treasury, to oversee state compliance with the regulatory  preemptions in LRRA. For example, the office would resolve  disagreements about whether LRRA preempts any regulatory actions by  a state. Among the state insurance regulators we surveyed, 29 said that  the federal government should not have a primary role in arbitrating  disputes between state regulators and RRGs, while 6 said that the federal  government should have a primary role. We also asked regulators which  department or agency they thought should have this authority if the  federal government were to arbitrate disputes between states and RRGs.  Twenty-nine regulators responded with no opinion, while 13 regulators  indicated their preference for the Federal Insurance Office and 6  regulators indicated other agencies including the Department of  Commerce.
Another proposed change would have the Federal Insurance Office issue  corporate governance standards for RRGs that would preempt any  corporate governance standards under state laws. Five state regulators  with whom we spoke also favored developing an arbitration mechanism,  while five regulators did not think corporate governance standards would  be burdensome for RRGs to implement. While seven RRG  representatives we interviewed generally supported establishing a federal  arbitration mechanism as a more efficient and cost-effective way of  resolving disputes, four representatives also expressed concern about  potential encroachment into state regulatory activities by a federal entity.
section_title: Conclusions
paragraphs: In establishing the Liability Risk Retention Act, Congress allowed RRGs  to provide commercial liability insurance to RRG members and  established a lead-state regulatory framework. While constituting a small  portion of the total liability insurance market, the amount of premiums  written by RRGs increased from 2004 to 2010 and the financial condition  of the RRG industry generally has remained profitable during this same  period. Based on our analysis, RRGs appear to have maintained a  relatively consistent presence in the market, primarily providing coverage  in niche markets such as medical professional liability insurance and  other health care-related insurance lines.
RRGs have continued to domicile in one of a few states but write most of  their business in other states, highlighting the importance of LRRA’s  provisions governing the rights and actions available to regulators in  nondomiciliary states as well as the types of coverage allowed under  LRRA. However, states have interpreted these provisions differently, due  in part to LRRA’s silence on certain issues such as registration  requirements, fees, and the types of insurance coverage RRGs can write,  sometimes resulting in litigation between state insurance regulators and  RRGs. In addition, some federal courts to which these disputes have  been brought also have interpreted LRRA differently. As a result, RRGs  and state insurance regulators have continued to operate in an  environment with some uncertainty, potentially affecting RRGs’  operations as well as the ability of state regulators to take actions  deemed necessary to protect insureds in their states.
To establish a more consistent regulatory environment for the members  of RRGs and their claimants, our previous report recommended the  development of broad-based, uniform, baseline standards for the  regulation of RRGs. NAIC has made progress addressing these  concerns, including requiring accredited states to implement risk-focused  examinations and risk-based capital analyses, as well as developing  corporate governance standards for the RRG industry. Further, NAIC has  made efforts to more closely align the accreditation standards for RRGs  with those of traditional insurance companies. Because some of these  standards only recently were implemented or have not yet been  implemented, it is too early to evaluate their effect on the RRG industry  and its regulation.
section_title: Matter for Congressional Consideration
paragraphs: To reduce the varying interpretations of LRRA, which have led to  uncertainty and disagreements among RRGs and state insurance  regulators, and at the same time continue to facilitate the formation and  efficient operation of RRGs, Congress should consider clarifying certain  LRRA provisions. For example, clarifying whether (1) RRG registration  requirements beyond those currently specified in LRRA are permitted in  nondomiciliary states and (2) fees in addition to premium and other taxes  could be charged to RRGs by nondomiciliary states in which they  operate. Congress also should consider providing a more specific  definition of the types of insurance coverage permitted under LRRA.
section_title: Agency Comments and Our Evaluation
paragraphs: We requested comments on a draft of this report from the National  Association of Insurance Commissioners. NAIC provided written  comments, which are reproduced in full in appendix II. NAIC also  provided technical comments, which we incorporated as appropriate.
NAIC agreed that Congress should consider the merits of clarifying  certain aspects of LRRA, in particular by providing more specific  definitions of the type of insurance coverage permitted under the LRRA.  NAIC further recommended that the definition of “commercial liability  insurance” be included for consideration since disagreements concerning  the scope of this definition have led to disputes between the states and  RRGs that, without further clarification, may continue. NAIC also provided  several additional comments.     NAIC provided clarification regarding the status of their Risk Based  Capital Models (RBC) and corporate governance standards as it  relates to NAIC’s accreditation standards for RRGs, which we  incorporated into the draft.     NAIC expressed concern with the methodology we used to calculate  the annual average ratios in figures 3 and 4, and suggested we either  use an alternate methodology or more clearly describe the one we  used.  We added a more detailed description of our methodology to  each of the figures.    NAIC clarified that when analyzing the ratio of premiums to  policyholder surplus, whether or not a state allows a letter of credit as  an admitted asset can change the results of such an analysis. We  agree and added an explanatory footnote.
As agreed with your offices, unless you publicly release its contents  earlier, we plan no further distribution of this report until 30 days from its  date of issue. At that time, we will send copies of this report to the  Chairman and Ranking Member of the Senate Committee on Banking,  Housing and Urban Affairs; the Chairman and Ranking Member of the  House Financial Services Committee; the Ranking Member of the  Subcommittee on Oversight and Investigations, House Financial  Services; and to the Chief Executive Officer of NAIC. In addition, the  report will be available at no charge on the GAO website at  http://www.gao.gov.
If you or your staff members have any questions about this report, please  contact me at (202) 512-7022 or cackleya@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 key contributions to  this report are listed in appendix III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: Our objectives were to (1) describe changes in the financial condition of  the risk retention group (RRG) industry from 2004–2010; (2) examine the  regulatory treatment of RRGs across domiciliary and nondomiciliary  states; and (3) examine changes to federal and state regulatory practices  regarding RRGs since 2004.
To determine the extent to which the financial condition of the RRG  industry has changed since 2004, we examined previous GAO reports,  various financial indicators from data provided by the National Association  of Insurance Commissioners (NAIC) and the Risk Retention Reporter, a  trade journal and data source for the industry. We interviewed  representatives of two industry associations on their members’ regulatory  experiences operating in domiciliary and nondomiciliary states. We  reviewed correspondence from state insurance regulators to RRG  representatives about topics such as registration processes and fees  charged to RRGs. NAIC officials calculated the overall market share of  RRGs in the commercial liability insurance market for each year during  2004–2010 and the overall market share of RRGs in the medical  professional liability line for 2007–2010 only. We examined the amount of  premiums written by RRGs and traditional property/casualty insurers for  commercial liability insurance in all 50 states, the District of Columbia, the  U.S. territories (American Samoa, Guam, Northern Mariana Islands,  Puerto Rico, and the Virgin Islands), and Canada. To ensure data were  comparable, we limited our analysis to commercial liability lines of  insurance that RRGs are allowed write. We examined and analyzed RRG  industry data on financial indicators of profitability and ability to pay  claims, such as policyholder surplus, return on equity and combined ratio  for 2004–2010. To determine the number of RRGs domiciled in and  operating by state, and the percentage of direct written premiums written  outside the state of domicile, we analyzed information provided by NAIC.
To assess the reliability of NAIC data we received, we (1) performed  electronic testing for obvious errors in accuracy and completeness; and  (2) worked with agency officials to identify any data concerns. When we  found discrepancies, such as data that were inconsistent, we notified  agency officials and worked with these officials to correct the  discrepancies before conducting our analysis. We determined that the  data were sufficiently reliable for the purposes of our report.
To compare the concentration of RRGs by business area, we used data  from 2004 and 2010 from the Risk Retention Reporter. We also obtained  data from this source for the number of RRGs licensed by business area.  Data from the Risk Retention Reporter were as of April 2010. We did not  attempt to verify these data, but did interview officials of the Risk  Retention Reporter to discuss their data collection methods. We  determined that the data were sufficiently reliable for the purposes of our  report.
Overall, we used interviews, a Web-based survey, and analysis of the  Liability Risk Retention Act of 1986 (LRRA) with other available  documentation to determine potential inconsistencies in the regulatory  treatment and regulatory environment of RRGs in domiciliary and  nondomiciliary states. We reviewed and analyzed LRRA and its  legislative history. To determine states’ rules and regulations for RRGs  domiciled or operating in those states, we designed and administered a  Web-based survey of state insurance regulators in all 50 states and the  District of Columbia. Specifically, the survey asked about each state’s   (1) requirements for RRGs domiciled in state; (2) role as a host  (nondomiciliary) state regulator for RRGs operating in state; (3) applicable  fees, taxes, and registration requirements; (4) regulatory experiences  such as conducting examinations of, taking administrative actions  against, and filing civil or criminal lawsuits against RRGs; and (5) opinions  on LRRA. A copy of the questionnaire and results are available in the e- supplement to this report, GAO-12-17SP. The Web-based survey was  administered from May 19, 2011, through July 25, 2011. Respondents  were sent an e-mail invitation to complete the survey on a GAO Web  server using a unique username and password. Throughout the data  collection period, nonrespondents received reminder e-mails and  telephone calls. The final response rate was 49 out of 51 states including  the District of Columbia (96 percent).
The practical difficulties of conducting any survey may introduce  nonsampling errors, such as difficulties interpreting a particular question,  which can introduce unwanted variability into the survey results. We took  steps to minimize nonsampling errors by pretesting the questionnaire  over the telephone in March and April 2011 with four state insurance  regulators (in both domiciliary and nondomiciliary states) and with NAIC  officials. We conducted pretests to make sure that the questions were  clear and unbiased, the data and information were readily obtainable, and  the questionnaire did not place an undue burden on respondents. We  made appropriate revisions to the content and format of the questionnaire  after the pretests. After the data were collected, we identified unanswered  questions and inconsistencies in some responses. We conducted follow- up with the specific states by e-mail and telephone to obtain responses to  unanswered survey questions and confirm the accuracy of responses to  several key questions, including applicable fees, premium tax rates,  waiting periods, and regulatory actions. We received a 100 percent  response rate to our follow-up questions and response confirmations.
While many of the questions on the 2004 and 2011 surveys are similar,  slight differences in wording or question format could result in slightly  different responses between the two surveys. All data analysis programs  used for this report were independently verified for accuracy. Due to the  wide variety of responses to some of our open-ended questions,  preparing statistics and summary presentation of findings to these  questions was not possible in some cases. Therefore, in some cases we  provided qualitative explanations with examples of responses we  received.
To obtain the information and opinions on the regulatory treatment of  RRGs across domiciliary and nondomiciliary states, we interviewed 13  regulators from domiciliary and nondomiciliary states representing a  nonstatistical sample of states selected for RRG business activity and  perceived differences in their regulatory treatment of RRGs. The nine  domiciliary states—Delaware, Florida, Hawaii, Illinois, Montana, Nevada,  South Carolina, Vermont, and the District of Columbia—included eight  that were among the top 10 states that domiciled the highest number of  RRGs or had the highest amounts of written premiums as of December  31, 2010. For states that do not have domiciled RRGs, we identified and  selected those in which RRGs were writing the highest amounts of total  premiums as of year-end 2010. Those four states were California,  Massachusetts, New York and Pennsylvania. Views of other domiciliary  and nondomiciliary insurance regulators were obtained through our Web- based survey. To obtain comparable data, the same topics were included  in the Web-based survey and in interviews with domiciliary and  nondomiciliary state insurance regulators.
We also obtained information and opinions on the regulatory treatment of  RRGs across states from RRG representatives. First, we conducted two  discussion groups at the 2011 annual conference for a captive industry  association. We coordinated with the industry association to determine  which conference participants had specific knowledge of and were  representatives of the RRG industry. To determine which individuals to  select to participate in our discussion groups, we developed an invitation  letter that the industry association e-mailed to the identified RRG industry  representatives. The letter also included a questionnaire to aid in  identifying the organization name, title, and industry type of the RRG  representative. We received 10 completed questionnaires from  conference registrants expressing interest in participating in the  discussion groups. Based on the information provided in the  questionnaire, we assembled discussion group volunteers into two  groups: (1) RRG owner/insureds and (2) captive/RRG managers. For  conference attendees who did not respond to the questionnaire by the  deadline in the invitation but wanted to participate, we provided blank  questionnaires at the registration table and before the discussion groups.  Those who met the criteria for either group were allowed to participate in  the discussion groups. We excluded individuals from industry  associations whom we previously interviewed and state insurance  regulatory agencies, as their views were captured in the GAO- administered Web survey. Second, we selected a non-statistical sample  of 11 RRGs that operate on a multistate basis and represent a variety of  business areas, insurance products, domiciliary states, and a range of  direct written premiums to obtain their perspectives on the regulatory  treatment of RRGs across domiciliary and nondomiciliary states. We  excluded RRGs that we previously interviewed and RRGs that domiciled  and operated only in their domiciliary state. We are not able to generalize  results from this sample to the entire RRG industry. To obtain comparable  data, we covered the same topics in these interviews as in the discussion  groups noted above.
To determine the extent to which state and federal regulatory practices  affecting RRGs have changed since 2004, we reviewed regulations,  guidance, and legislative and regulatory proposals and interviewed  stakeholders. More specifically, we reviewed NAIC literature and  guidance to state insurance departments about RRG oversight. We also  interviewed NAIC officials about efforts to address recommendations from  our 2005 report, including revisions to NAIC’s state accreditation process  and progress with developing and implementing corporate governance  standards for RRGs. We attended NAIC working group meetings  concerning implementation of accreditation standards and approval of  updates to the RRG Handbook and corporate governance standards for  RRGs. We also obtained information about RRGs’ regulatory  environment and views on the potential impact of NAIC’s changes to the  accreditation standards from the 13 select domiciliary and nondomiciliary  state insurance regulators mentioned above. In addition, we obtained  information on any changes to state regulations affecting RRGs since  2004 through our Web-based survey of regulators. We interviewed an  actuarial expert about the revisions to the accreditation standards.  Furthermore, we obtained views from representatives of RRGs on their  primary challenges and NAIC’s efforts to establish broad based uniform  standards for the oversight of RRGs. More specifically, we spoke with the  discussion group participants and representatives from 11 select RRGs  mentioned in the previous paragraph. The criteria for selection of these  RRGs are described above. We excluded those RRGs we already  interviewed and RRGs that domiciled and operated in only their home  state. We are not able to generalize results from this sample to the entire  RRG industry. We also reviewed documentation we received from RRG  representatives related to their regulatory experiences and the expected  impact of the revised accreditation standards. Finally, we reviewed key  legislation concerning RRGs that had been introduced at the federal and  state level since 2004 to identify recent changes in laws and regulations  affecting RRGs.
We conducted this performance audit from October 2010 to December  2011 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: Comments from the National Association of Insurance Commissioners
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, Patrick A. Ward, Assistant  Director; Susan Baker ;William Chatlos; Shamiah Kerney; Jill Lacey; May  Lee; Marc Molino; Patricia Moye; Daniel Newman; Jasminee Persaud;  and Barbara Roesmann also made major contributions to this report.