Risk Retention Groups (RRG's) and Types of Captives

• Single-parent captive.

Sometimes referred to as a “pure captive,” it is a company that insures the risk of its parent company and its affiliates. Because it functions solely for the parent organization, it can set rates and provide loss control and risk-management plans that are closely tied to the company’s structure, product and corporate culture.

• Association captive.

As its name implies, this mechanism generally covers the risk of members of an association. Akin to a group or industrial captive (whose members might be from various industries), it operates much as a single-parent captive.

• Cell captive.

Also known as a sponsored captive or a protected cell captive, this version is operated by one or more sponsors, who provide the capital and surplus minimums required by the applicable laws. The captive covers the risk of each participant, segregating the participant’s liability in “protected cells,” so failure of one participant does not have an adverse effect on the others.

• Agency captive.

A captive formed and operated by an insurance agency, often with the backing of a carrier or reinsurer, it allows an agency to provide alternative risk mechanisms to its clients, and to share in the management and financial benefits of the service.

• Rent-a-captive.

An organization can reap the benefits of a captive without creating an insurance subsidiary. To do so, it rents capital and surplus from the rent-a-captive (RAC), which often is run by an insurance company or reinsurer. The purchasing organization may be able to reap underwriting profits and investment income. Higher costs are expected, as the RAC will charge fees for its operation, and unless it’s focused on one industry, its underwriting and loss control programs are not expected to be as attuned to the purchasing company’s industry. Regardless of type, the captive uses insurance-industry mechanisms to create and sustain its program. Many captives utilize a fronting company, which is an insurer that agrees to contract with a captive to provide an insurance policy acceptable to regulators. The fronting carrier provides services such as underwriting and claims handling, but cedes most if not all risk back to the captive through a reinsurance arrangement.

Often a fronting arrangement is used in states that do not allow captives to issue policies, and often used by smaller organizations that do not have the size or expertise to create a captive for themselves. A fee for providing the front, along with collateralization to offset the increased leverage required, will be sought by the fronting carrier. As the policy is reinsured by the captive carrier itself or by a reinsurer, the fronting carrier may assume little or no risk. Conversely, the long-tail nature of some risks and the potential for instability or failure of other parties to the alternative mechanism may mean the fronting carrier will experience risk well beyond the policy period. This has meant a recent tightening of the marketplace for fronting, with fewer carriers offering the service. A.M. Best estimated that six carriers accounted for 75 percent of the fronting market in 2002.

In an uncertain future that makes captives more attractive, risk managers must scrutinize the health of fronting carriers and fronting carriers must ensure that captive risks are adequately collateralized. But today, many captives are operating without fronts. This scenario is possible when regulators allow it and when the captive’s parent company can gain agreement with any parties of interest. For instance, when a lender or a landlord is the sole party requiring coverage, that party may agree to coverage from a non-fronted captive if the parent firm can show evidence of sufficient capitalization.

Using sound underwriting criteria as would a conventional insurance company is key to proving that the captive is bona fide. Some jurisdictions and foreign domiciles are particularly welcoming to captives. While Bermuda, the Cayman Islands and other foreign locations have traditionally been the domicile of choice, increasingly U.S. states are attracting captive formation. Vermont and Hawaii have had captive laws on their books for many years, but today 23 states have enacted captive “Using sound underwriting criteria as would a conventional insurance company is key to proving that the captive is bona fide.”

Aggressive development of state-based captive domiciles is expected to continue, by one estimate reaching 40 states by 2009. In recent years, premium volume for captives domiciled within the U.S. has grown by 20 to 25 percent annually. In 2002 a record number of new captives – more than 460 companies -- were formed.

By mid-2004, according to the Captive Insurance Companies Association, 4,835 captives existed worldwide. Bermuda holds by far the top domicile spot with 1,330 captives, the Cayman Islands has 644 and Vermont houses 507. Up-and-coming domestic venues include South Carolina, Arizona, and the District of Columbia. The nation’s capital city passed a captives law in 2001, and today has more than 30 captives registered, while South Carolina has licensed 89 captives since formation in 2000. There is a particular type of captive, called a risk retention group (RRG), that is not available in all domiciles.

RRG Popularity Resurges

RRGs are the most recently enabled form of alternative risk financing. Made possible by a federal law, the Products Liability Risk Retention Act of 1981, this mechanism was created initially by Congress to address a shortage of coverage for products liability. The law’s scope was expanded in a 1986 revision to become the Liability Risk Retention Act (LRRA).

According to the National Risk Retention Association, federal legislators felt the law was needed to facilitate group insurance programs. “It was presumed that this expansion would reduce costs, provide alternative mechanisms for coverage, and promote greater premium competition among general liability insurers,” says a primer from the NRRA. “It was believed that this expansion would encourage insurers to set premiums that would compete with the new formations created under the revised law.” RRGs were not commonly used in the 1990s due to the broader availability of liability insurance in an extended soft market, but with the turn to a hard market in 2000, their formation once again shot up, and their numbers are still rising at record rates. In 2003, 58 RRGs were formed and seven were retired, bringing the year-end total to an all-time high of 141.

Unique to the U.S., an RRG can be domiciled in any state, but typically will choose a state with captive laws, which will provide more favorable conditions to formation. Currently the federal statute allows RRGs to cover only liability exposures, although Congressional hearings were proposed in 2004 to discuss the statute’s expansion. 16 states permit RRGs, and two more have captive laws that are silent on their formation. Like the one created by doctors in central Pennsylvania, RRGs are formed by groups who have a similar business or profession and a vexing insurance problem. Medical malpractice is a good example of a significant problem being addressed by RRGs. In fact, A.M. Best reports that, of its 24 rated RRGs, 44 percent of the aggregate written premium covers medical malpractice. Under the LRRA, once an RRG is licensed in its domiciled state, it can cover members across the U.S. To do business in a state, it must submit a copy of its feasibility study created for its chartering state, and an annual financial statement. In an RRG, all policyholders also are shareholders. In addition to a premium, each member also pays a capitalization fee. Because it operates under federal statute and is exempt from most state laws, an RRG differs from a captive in that it does not need a fronting carrier. However, most states that allow RRGs require them to comply with capital and surplus requirements similar to a captive.



Purchasing Groups Wield Power

If a company or industry does not go the route of creating captives or risk retention groups, another hybrid option exists for managing their insurance costs. Purchasing groups buy coverage from traditional insurance carriers or risk retention groups, allowing insured to band together and negotiate for better rates or more favorable terms. Unlike an RRG, a purchasing group is not an insurance company, so its members do not underwrite the coverage or capitalize the group, and it does not buy reinsurance. But like an RRG, it is subject to rules governing the group, such as types of liability coverage available and membership requirements.

SPVs Tap Into Wall Street

In some cases, the insurance industry is perceived to not have enough capital to underwrite a particular risk, or is not willing to commit that capital, and involvement is being sought from the larger capital markets. Special purpose vehicles (SPVs) seek to tap into Wall Street through the mechanism of risk securitization. With an SPV, a captive or traditional insurance company is created to participate in a securitization for a specific risk, under the laws of a state that allows it. South Carolina recently created a securitization law to allow for such mechanisms. A pool of funds will be created by investors underwriting the risk, providing essentially the same function as reinsurance. The capital market analyzes the risk as it would a corporate credit risk and, using a bankruptcy trigger, prices its involvement commensurate with a bond issue. The outcome of risk determines the return on investment. For instance, if an SPV is created to underwrite hurricane coverage, investors will realize a greater return if no hurricane payouts are necessary within the coverage period.