Going naked: what to consider when getting ready to drop your liability insurance.

In the senior living industry, the price of liability insurance has been at a crisis level for several years. As insurance becomes unaffordable for more long-term care facilities, many small and mid-sized companies have faced the ultimate question: "Can I afford to do business without coverage?"

For some long-term care providers, dropping insurance altogether, commonly referred to as "going naked," has become the only viable option for continuing in the business.

Operating without liability insurance raises several important issues, however, and any company considering going naked should evaluate at least five critical factors: (1) its lending relationships, (2) state regulatory requirements, (3) the effects of tort reform, (4) the availability of alternative insurance vehicles, and last, but far from least, (5) asset protection.

For the operator who ultimately decides to drop insurance, there are several asset protection steps you can take to reduce potential exposure going forward.

First consideration: Banking covenants

The foremost issue for any senior living company considering dropping its liability coverage should be the effect on the company's relationship with its senior lender. Bank loan documents usually include several covenants, and they almost universally require that the borrower have liability coverage in specific amounts customary for the industry.

Being surprised by a bank's default letter makes for a bad day for any owner, and you should evaluate this issue far in advance of dropping coverage. It is important to note that other contracts may contain insurance covenants as well--real estate and equipment lease documents are prime suspects for these covenants.

In the current environment, the response of lenders to a long-term care provider that is going naked can vary widely. Some lenders recognize that requiring borrowers to purchase unaffordable insurance is financially unrealistic and will agree to some waivers or to the purchase of more minimal coverage. Other lenders may be willing to quietly ignore the breach without giving a formal waiver.

For some lenders, however, insurance is an issue they cannot overlook. Thus, the operator is left to either find a way to purchase acceptable coverage or move its financing relationships to another bank. Healthcare lending is extremely competitive at the moment due to excess liquidity, so for the time being, an operator may have negotiating leverage when asking its lender for concessions on insurance covenants.

Second consideration: Medicare/Medicaid licensure 

Ah, those pesky regulatory issues that permeate all of healthcare, just because you are going naked doesn't mean you can forget about them. Although many states do not require liability insurance as a mandatory prerequisite to licensing, some do.

It is important to research whether your state requires insurance before you make the decision to drop coverage. In a state where insurance is mandated, a company has little choice: It must either obtain the minimum level of traditional insurance required for compliance or find financially accessible coverage through an alternate insurance vehicle that satisfies the regulations. Potential strategies for obtaining reasonably priced insurance are discussed later in this story.

Third consideration: Tort reform

In December 2006, the cover of The American Lawyer magazine depicted a slain goose lying next to a golden egg. The caption: "It's Over: How business interests and plaintiffs' lawyers killed the mass torts money machine." Tort reform has become a reality in many states, with a significant effect on liability risks for senior housing operators.

In 2003, for example, Texas passed sweeping tort reform. Under Texas law, noneconomic damages in medical negligence cases are now capped at $250,000. Because few residents of senior living facilities are still active members of the work force, the result is that most claims against skilled nursing facilities in Texas are now limited to $250,000.

As reported recently in the American Bar Association Journal, tort reform has dramatically thinned the ranks of the plaintiffs' bar in Texas because there is little profit to be made in bringing medical tort claims. And although insurance rates in Texas appear to be coming down as a result, some nursing homes are opting to go without coverage because of the reduced risk of being sued.

Others are buying so-called "wasting policies," in which defense costs are subtracted from the total insurance coverage amount, leaving less insurance for plaintiffs in the event of a judgment--and creating a significant disincentive to protracted litigation.

Thus, tort reform is an important issue to consider in the equation of whether to go naked. Reform schemes vary from state to state, and under some healthcare tort reform structures, having the minimum insurance coverage levels can be a prerequisite to benefiting from the liability caps. In other words, going naked might actually exclude a facility from the benefits of the tort reform law. Consider carefully the parameters of tort reform in your state before dropping insurance.

Fourth consideration: Emerging insurance vehicles, new pricing opportunities

The exit of many traditional insurers from the senior housing market does not mean that insurance is not available. Before dropping coverage, it is worth considering the alternatives--and there are several.

First, insurance policies are not what they used to be. There are a number of alternative vehicles (e.g., insurance captives, and self-insured, matching deductible policies), that may be available. However, these are usually most accessible to larger operators that can spread risk across multiple facilities. In addition, captives have not always been as protective as intended. Underfunding can be a significant problem, leaving an operator unexpectedly exposed.

When a senior living operator makes the decision to go naked, it should consider adopting an asset-protection strategy that will guard its most valuable possessions.

Second, surplus lines coverage--a form of unregulated insurance product that insurance companies are allowed to sell when other policies are economically unavailable--may be an option for some operators, including small to mid-sized operators. By negotiating specifically on the scope of coverage, it may be possible to acquire a surplus line policy that is less expensive than traditional insurance.

Third, there are a number of managing general agents that serve as wholesalers of insurance and have a developed expertise in the senior living industry. Through them, some reasonably affordable insurance products may be available. These syndicates work as agents for insurers and, based on their expertise at calculating risk in the industry, may be able to craft a policy on acceptable terms.

Similarly, the market for insurance brokers has expanded in recent years. Differing from agents, which work for insurance companies, brokers work on behalf of the insurance buyer--in this case the long-term care provider--and search the market for the best price on an appropriate insurance product. A broker can be a valuable resource in negotiating and acquiring acceptable insurance for an operator in a tough market.

Finally, and most important, the market for liability coverage appears to be softening in the senior housing market, and more traditional insurers are reentering the market. There may be traditional insurance products available now that were not available at the height of the liability crisis.

There are several options available and considerations to think about, so make sure you explore the range of insurance products available before deciding to go naked.

Fifth consideration: Asset-protection strategies

When a senior living operator makes the important decision to go naked, it should consider carefully how to adopt an asset protection strategy that will guard its most valuable possessions. Western commerce is based on the idea of limited liability--indeed, the corporation was developed for exactly this purpose--and there is nothing wrong with legitimate forms of asset protection. In fact, the asset protection strategies that follow are probably useful ideas for any senior living company, even those that continue to carry insurance.

First, as an initial step in any asset protection strategy, an operator with multiple facilities should usually have each facility operated by, and licensed to, a different subsidiary, all under a holding company structure. This structure is the industry standard and probably goes without saying in most cases.

However, some smaller operators may have built their companies without branching the corporate structure into a corporate tree. For these companies, this is an important current consideration. The transfer of licenses and provider numbers may make it prohibitively difficult to divide the existing company. If this is the case, the strategy of creating subsidiaries can be adopted to protect new acquisitions in the future.

Second, the real estate underlying a senior living facility is often an operator's most valuable asset. Therefore, where possible, the operator should consider moving the real estate into a separate entity and then leasing the facility back to the operating entity. The reverse is also possible--to leave the real estate in the current entity and move the operations to a separate entity--but because the license, provider number, and potentially the certificate of need may be tied to the operator rather than the real estate, moving the operations can be more complex.

Tax consequences are often the chief consideration in determining whether an operator can restructure its corporate organizational chart to spin the real estate out from the operating arm. Without overcomplicating matters, partnerships and limited-liability companies can usually transfer real estate to a separate entity and then lease it back to the operator on a tax-neutral basis.

For corporations, transferring the real estate is more involved, but you can usually accomplish the same results on a tax-neutral basis through a type of transaction similar to what is called an "inversion." This transaction involves creating a holding company and subsidiary, transferring the real estate, and then subsequently transferring the subsidiary's stock.

Once the real estate is separated from the operations and leased back to the operator, the result is that tort claims against the operator will usually not reach the owner of the real estate. Thus, a catastrophic loss to the operating company may still leave the owners with a valuable real estate asset. Existing creditors at the time of the real estate spin out usually can still reach the property, but future creditors probably cannot, as long as the operating entity is more than a fraudulent shell. Because the operating entity is the owner of all of the accounts receivable generated from resident services, it still has significant assets that are available for future creditors.

Third and finally, an important step in any asset protection strategy is to institute appropriate risk management procedures at the operating company level to try to minimize liabilities. Training programs, internal record-keeping, and similar practices are key. Indeed, some states require that senior living operators appoint an employee to the position of risk manager. There is no substitute for proper planning, and the senior living operator should take the initiative to demonstrate its commitment to resident care and compassion.

Editor's note 

Welcome to the first of a two-part discussion on "going naked," which refers to the practice of dropping liability insurance. It's a contentious issue, growing ever more so, and the very mention of it engenders a wide range of both critics and defenders.

Here at CLTC, we're happy to stoke the debate. This month, our team of experts from Waller Lansden Dortch and Davis gives you some of the positives of going naked. Watch your mailbox for your June issue, in which you'll hear from the other side.

--Chad Berndtson

Bobby Guy, Jeff Calk, and Wes Shofner are partners in the law firm of Waller Lansden Dortch & Davis, LLP, headquartered in Nashville, TN. Their practices encompass healthcare and its related disciplines, including real estate, mergers and acquisitions, corporate restructuring, and insolvency. They can be reached at [e-mail], [e-mail], [e-mail] or by calling 615/244-6380.