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Regulating risk retention groups Part II: closing the loopholes.

Part I of this article, which appeared in the January 2003 issue of Risk Management Magazine, made the case for reforming the Liability Risk Retention Act of 1986 (LRRA) so that state regulators could no longer use the legislation's loopholes to constrain the operations of risk retention groups (RRGs) and discourage their formation. Part II of this article will recommend in detail how the LRRA should be changed, and how efficient dispute resolution options can be implemented when RRGs and state regulators inevitably butt heads.

The Need for Reform

At the heart of this regulatory tangle is the state's desire to protect its citizens from the risk of insurance carrier insolvencies. Clearly, state regulatory authorities have a rightful role to protect policyholders and members of the public from financially vulnerable RRGs, since about 10.6 percent of the RRGs formed to date have been liquidated or rehabilitated. The failure rate of RRGs, however, is only marginally higher than that of mainstream commercial carriers. Furthermore, an analysis of the LRRA suggests that nonchartering states already have sufficient regulatory powers to protect policyholders and members of the public without going after RRGs.

* In cases where an RRG is financially shaky, a state regulatory authority can seek an injunction to shut it down. Data reporting requirements imposed on RRGs provide state regulatory authorities with ample information to identify those RRGs in a hazardous financial condition.

* Financial responsibility laws already protect the public from insolvent insurance carriers. Policyholders are required to secure liability insurance from an authorized insurance carrier. A state regulatory authority can disqualify a particular RRG on the grounds that it lacks sufficient financial strength.

* A policy issued by an RRG must include a prominent notice indicating that guaranty fund coverage is inapplicable. In electing to become an owner or member of an RRG, the policyholder voluntarily exposes itself to the risk of insolvency in exchange for the benefits in terms of rates and forms that freedom from regulation entails: It would be unreasonable for a policyholder to expect the benefits of regulation (i.e., guaranty fund coverage) without being subject to that same regulation.

The LRRA need not be amended to grant non-chartering states more control over the operation of RRGs. Rather, limited state regulatory resources should be focused on identifying, surveilling and examining financially vulnerable RRGs. If enough resources are directed toward detecting these RRGs, the incidence of insolvency will be reduced.

Points of Clarification

Unfortunately, in a growing number of states--Delaware, Georgia, Louisiana, Michigan and Oregon--state regulatory authorities have launched what may be considered a frontal assault on RRGs. As a result of a strained interpretation of the LRRA, regulatory barriers have been erected. Clarification of the act is in order. The following clarifications are consistent with the intent of the U.S. Congress, and should remove some of the uncertainty concerning the scope of the preemption provided under the LRRA.

1. Clarify the exception stipulating that a nonchartering state has the power to specify the means by which an organization may prove financial responsibility. In doing this, a non-chartering state should only be allowed to use objective financial criteria that pertains strictly to the financial soundness of an insurance carrier, and nondiscriminatory criteria that may exclude not only a particular RRG, but also a domestic insurance carrier.

RRGs are not financially unsound by nature, so they should not be disparately impacted by insurance carriers' financial responsibility requirements. If they are, the financial responsibility criteria are probably unlawful. In such a scenario, the nonchartering state would be required to submit proof indicating that use of the criteria in question is the only efficient way to identify financially unsound insurance carriers.

2. Clarify the primary activity requirements in terms of what they entail. These requirements should specify that an RRG is permitted to administer a self-insurance program for its members so long as the provision of liability insurance for the common exposure is not incidental; and provide other value-added ancillary services for its members, including loss control and claims administration services.

The determination of incidental liability insurance should depend on the mix of claims paid under the self-insurance program and those claims paid under the insurance program. In applying this objective standard, non-chartering states should be required to use dollars as a unit of measurement rather than number of claims paid; and national rather than state data in calculating whether the standard is met. Finally, a benchmark figure should be specified in terms of a minimum standard that must be met.

3. Clarify ownership and control requirements. These should specify that all owners must be insured by the RRG; the RRG cannot underwrite liability coverage for nonowners; and the composition of the board of directors of the RRG must be such that the owners collectively possess the majority of the votes.

The standard for determining whether an entity qualifies as an owner should be defined solely in terms of whether the organization is entitled to a residual share of the assets of the RRG in the event of liquidation.

4. Clarify the provision pertaining to permissible commercial liability exposures that may be insured by an RRG. The exclusion pertaining to an employer's liability with respect to its employees should be deleted and replaced with an exclusion identifying only those exposures covered under a workers' compensation policy. This clarification will eliminate disputes over the permissibility of exposures such as directors' and officers' and employment practices liability.

5. Clarify the provision exempting RRGs from indirect regulation. Indirect regulation should include the imposition of fees, as opposed to taxes, on RRGs. Taxes and fees need to be defined since taxes may be imposed on RRGs on a nondiscriminatory basis, and fees may not be imposed on RRGs at all. Although the state legislature has the authority to assess both taxes and fees, a fee is collected by a regulatory agency rather than the state treasury. A fee is assessed only on regulated entities for the purpose of discouraging a particular type of conduct, or more generally, helping to defray the cost of regulating these same entities. It is also deposited in a segregated account that funds regulatory initiatives, not a general fund that provides initiatives for general public benefit.

Resolving Disputes

Even if these clarifications become law, states' positions on their regulatory role for RRGs is likely to remain unchanged. They believe that subjecting RRGs to the oversight of multiple state agencies is not onerous and, thus, disagree with a key premise (i.e., lead state regulation) upon which the LRRA is based. Indeed, they view the LRRA as an encroachment on their jurisdiction since states historically have been free to regulate the business of insurance without interference from the federal government.

Given this philosophical position, when regulatory issues arise, nonchartering states are unlikely to defer to the chartering state, or any other state, that already has addressed the particular regulatory issue in question. Also, they are unlikely to defer to legal precedent where a regulatory issue has been resolved in favor of an RRG.

This situation calls for a mechanism that can provide for the efficient resolution of regulatory issues. The LRRA should be amended to create a presumption that the chartering state has the sole authority to determine whether an entity qualifies as a RRG. Unless a chartering state has been derelict in the regulation of RRGs, nonchartering states would not be permitted to encroach on its authority.

Furthermore, the judicial authority to resolve such issues should be vested in a single, federal court designated by the U.S. Congress. The decisions rendered by this court should be binding on a nationwide basis.

The importance of vesting authority in a single court is highlighted by the reluctance that has been displayed by the U.S. Supreme Court to hear RRG cases. Vesting authority in a single court would eliminate unnecessary, redundant regulation of RRGs.

Coverage Possibilities

Finally, it is imperative to reform the LRRA in light of current efforts by the National Risk Retention Association (NRRA) to expand the lines of coverage that may be underwritten by an RRG. Under the NRRA proposal, RRGs would be allowed to underwrite coverage for property exposures. RRGs would also be permitted to provide excess workers' compensation insurance coverage in those cases where a member self-insures its workers' compensation exposure.

In light of escalating in property insurance rates following September 11, members of both parties in the U.S. Congress seem to be receptive to the proposal.

This article is a summary of one that appeared in the August 2002 issue of the CPCU e Journal (www.cpcusociety.org).

William Warfel, Ph.D., CPCU, CLU, is professor of insurance and risk management at Indiana State University.
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Title Annotation:Liability Risk Retention Act of 1986 reform
Author:Warfel, William J.
Publication:Risk Management
Date:Feb 1, 2003
Words:1451
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