This is the accessible text file for GAO report number GAO-05-536 
entitled 'Risk Retention Groups: Common Regulatory Standards and 
Greater Member Protections Are Needed' which was released on September 
14, 2005. 

This text file was formatted by the U.S. Government Accountability 
Office (GAO) to be accessible to users with visual impairments, as part 
of a longer term project to improve GAO products' accessibility. Every 
attempt has been made to maintain the structural and data integrity of 
the original printed product. Accessibility features, such as text 
descriptions of tables, consecutively numbered footnotes placed at the 
end of the file, and the text of agency comment letters, are provided 
but may not exactly duplicate the presentation or format of the printed 
version. The portable document format (PDF) file is an exact electronic 
replica of the printed version. We welcome your feedback. Please E-mail 
your comments regarding the contents or accessibility features of this 
document to Webmaster@gao.gov. 

This is a work of the U.S. government and is not subject to copyright 
protection in the United States. It may be reproduced and distributed 
in its entirety without further permission from GAO. Because this work 
may contain copyrighted images or other material, permission from the 
copyright holder may be necessary if you wish to reproduce this 
material separately. 

Report to the Chairman, Committee on Financial Services, House of 
Representatives: 

August 2005: 

Risk Retention Groups: 

Common Regulatory Standards and Greater Member Protections Are Needed: 

GAO-05-536: 

GAO Highlights: 

Highlights of GAO-05-536, a report to the Chairman, Committee on 
Financial Services, House of Representatives: 

Why GAO Did This Study: 

Congress authorized the creation of risk retention groups (RRG) to 
increase the availability and affordability of commercial liability 
insurance. An RRG is a group of similar businesses that creates its own 
insurance company to self-insure its risks. Through the Liability Risk 
Retention Act (LRRA), Congress partly preempted state insurance law to 
create a single-state regulatory framework for RRGs, although RRGs are 
multistate insurers. Recent shortages of affordable liability insurance 
have increased RRG formations, but recent failures of several large 
RRGs also raised questions about the adequacy of RRG regulation. This 
report (1) examines the effect of RRGs on insurance availability and 
affordability; (2) assesses whether LRRA’s preemption has resulted in 
significant regulatory problems; and (3) evaluates the sufficiency of 
LRRA’s ownership, control, and governance provisions in protecting the 
best interests of the RRG insureds. 

What GAO Found: 

RRGs have had a small but important effect in increasing the 
availability and affordability of commercial liability insurance for 
certain groups. While RRGs have accounted for about $1.8 billion or 
about 1.17 percent of all commercial liability insurance in 2003, 
members have benefited from consistent prices, targeted coverage, and 
programs designed to reduce risk. A recent shortage of affordable 
liability insurance prompted the creation of many new RRGs. More RRGs 
formed in 2002–2004 than in the previous 15 years—and about three-
quarters of the new RRGs offered medical malpractice coverage. 

LRRA’s partial preemption of state insurance laws has resulted in a 
regulatory environment characterized by widely varying state standards. 
In part, state requirements differ because some states charter RRGs as 
“captive” insurance companies, which operate under fewer restrictions 
than traditional insurers. As a result, most RRGs have domiciled in six 
states that offer captive charters (including some states that have 
limited experience in regulating RRGs) rather than in the states where 
they conduct most of their business. Additionally, because most RRGs 
(as captives) are not subject to the same uniform, baseline standards 
for solvency regulation as traditional insurers, state requirements in 
important areas such as financial reporting also vary. For example, 
some regulators may have difficulty assessing the financial condition 
of RRGs operating in their state because not all RRGs use the same 
accounting principles. Further, some evidence exists to support 
regulator assertions that domiciliary states may be relaxing chartering 
or other requirements to attract RRGs. 

Because LRRA does not specify characteristics of ownership and control, 
or establish governance safeguards, RRGs can be operated in ways that 
do not consistently protect the best interests of their insureds. For 
example, LRRA does not explicitly require that the insureds contribute 
capital to the RRG or recognize that outside firms typically manage 
RRGs. Thus, some regulators believe that members without “skin in the 
game” will have less interest in the success and operation of their RRG 
and that RRGs would be chartered for purposes other than self-
insurance, such as making profits for entrepreneurs who form and 
finance an RRG. LRRA also provides no governance protections to 
counteract potential conflicts of interest between insureds and 
management companies. In fact, factors contributing to many RRG 
failures suggest that sometimes management companies have promoted 
their own interests at the expense of the insureds. 

The combination of single-state regulation, growth in new domiciles, 
and wide variance in regulatory practices has increased the potential 
that RRGs would face greater solvency risks. As a result, GAO believes 
RRGs would benefit from uniform, baseline regulatory standards. Also, 
because many RRGs are run by management companies, they could benefit 
from corporate governance standards that would establish the insureds’ 
authority over management. 

What GAO Recommends: 

To strengthen the overall regulation of RRGs, GAO recommends that state 
insurance regulators adopt consistent regulatory standards for RRGs. 
Moreover, GAO suggests that Congress consider (1) granting the partial 
preemption only to states that adopt the standards and (2) establishing 
minimum corporate governance standards for RRGs. 

www.gao.gov/cgi-bin/getrpt?GA0-05-536. 

To view the full product, including the scope and methodology, click on 
the link above. For more information, contact Richard J. Hillman at 
(202) 512-8678 or hillmanr@gao.gov. 

[End of section] 

Contents: 

Letter: 

Results in Brief: 

Background: 

RRGs Have Had a Small but Important Effect on Increasing the 
Availability and Affordability of Commercial Liability Insurance: 

LRRA's Regulatory Preemption Has Resulted in Widely Varying 
Requirements among States and Limited Confidence in RRG Regulation: 

RRG Failures Have Raised Questions about the Sufficiency of LRRA 
Provisions for RRG Ownership, Control, and Governance: 

Conclusions: 

Recommendations for Executive Action: 

Matters for Congressional Consideration: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Objectives, Scope, and Methodology: 

Appendix II: Survey of State Regulators on Risk Retention Groups: 

Appendix III: Selected Differences between Statutory and Generally 
Accepted Accounting Principles as They Relate to Financial Reporting 
for RRGs: 

Appendix IV: Liquidated Risk Retention Groups (RRG), from 1990 through 
2003: 

Appendix V: Comments from the National Association of Insurance 
Commissioners: 

Appendix VI: GAO Contact and Staff Acknowledgments: 

Tables: 

Table 1: Characteristics of States We Interviewed, Based on Years of 
Regulatory Experience and Number of RRGs Domiciled: 

Table 2: Differences in Regulatory Actions When Calculating Risk-Based 
Capital for Three RRGs, Modified GAAP Compared with SAP: 

Figures: 

Figure 1: RRG Gross Premiums Written in 2003, by Time (Years) in 
Business: 

Figure 2: Number of RRGs, by Business Area for Selected Years: 

Figure 3: Percentage of Estimated Gross Premiums RRGs Collected in 
2004, by Business Area: 

Figure 4: Number of RRGs, by Formation Date: 

Figure 5: Number of RRGs, by Captive or Noncaptive Charter and State of 
Domicile, as of the End of 2004: 

Figure 6: Number of RRGs Chartered, by State, as of the End of 2004, 
and Amount of Direct Premiums Written by RRGs, by State, 2003: 

Figure 7: State Regulators' Opinion of the Adequacy of the Regulatory 
Protections or Safeguards Built into LRRA: 

Figure 8: Permitted Wording of Guaranty Fund Disclosure in LRRA: 

Figure 9: The Effect of Differences in Accounting for Acquisition Costs 
on Assets, Capital, and Surplus, GAAP Compared with SAP: 

Figure 10: Impact of Counting an LOC and Prepaid Expenses as Assets on 
the Balance Sheet, Modified GAAP Compared with SAP: 

Figure 11: Impact of Counting Acquisition Costs, LOCs, and Prepaid 
Expenses as Assets on the Balance Sheet, Modified GAAP Compared with 
SAP: 

Figure 12: Differences in the Calculation of Net Premiums Written to 
Policyholders' Surplus Ratio, Modified GAAP Compared with SAP: 

Figure 13: Differences in the Calculation of Reserves to Policyholders' 
Surplus Ratio, Modified GAAP Compared with SAP: 

Abbreviations: 

ANLIR: American National Lawyers Insurance: 

Reciprocal Risk Retention Group: 

BRICO: Beverage Retailers Insurance Company: 

Risk Retention Group: 

CEO: chief executive officer: 

CIC: Corporate Insurance Consultants: 

DIR: Doctors Insurance Risk Retention Group: 

FAST: Financial Analysis Solvency Tools: 

GAAP: generally accepted accounting principles: 

IRIS: Insurance Regulatory Information System: 

LOC: letter of credit: 

LRRA: Liability Risk Retention Act: 

NAIC: National Association of Insurance Commissioners: 

NPW:PS: net premiums written to policyholders' surplus: 

PMIC: Professional Mutual Insurance Company Risk Retention Group: 

RBC: risk-based capital: 

ROA: Reciprocal of America: 

RPG: risk purchasing group: 

RRG: risk retention group: 

RRR: Risk Retention Reporter: 

SAP: statutory accounting principles: 

SEC: Securities and Exchange Commission: 

TAC: total adjusted capital: 

TRA: The Reciprocal Alliance Risk Retention Group: 

TRG: The Reciprocal Group: 

VSC: vehicle service contract: 

Letter August 15, 2005: 

The Honorable Michael G. Oxley: 
Chairman, Committee on Financial Services: 
House of Representatives: 

Dear Mr. Chairman: 

In 1981, in response to recurring shortages of liability insurance, 
Congress passed the Product Risk Retention Liability Act, now known as 
the Liability Risk Retention Act (LRRA), which authorized the creation 
of risk retention groups (RRG) to increase the availability and 
affordability of commercial liability insurance.[Footnote 1] An RRG is 
a group of similar businesses with similar risk exposures, such as 
educational institutions or building contractors, which create their 
own insurance company to self-insure their risks on a group 
basis.[Footnote 2] Through LRRA, Congress first established a flexible 
framework that allowed states to develop their own standards for the 
formation and operation of RRGs. In light of the recent unavailability 
of affordable liability insurance, especially for medical malpractice 
coverage, interest in forming RRGs has greatly increased. In addition, 
some industry advocates now propose that RRGs be permitted to offer 
property coverage as well. However, the recent and notable failures of 
several large RRGs have raised questions about the adequacy of the RRG 
regulatory environment and whether existing safeguards, such as the 
requirement that each RRG provide copies of operational plans and 
annual financial statements to each state in which it operates, are 
sufficient to ensure that RRGs are operated and governed adequately to 
protect their insureds. 

LRRA, expanded in 1986, facilitates the creation and operation of RRGs 
in several ways.[Footnote 3] Most notably, LRRA partially preempts 
state insurance laws by allowing an RRG's formation and operations to 
be regulated primarily by the state in which it is chartered, its 
domiciliary state, even when it sells insurance in other states. LRRA 
largely limits the oversight role of insurance regulators from 
nondomiciliary states (all states other than the chartering state) to 
the right to receive copies of an RRG's operational plans and annual 
financial statements. In having only one regulator, RRGs differ from 
"traditional" insurance companies, which are subject to licensing and 
oversight by regulators in each state in which they operate. 
Additionally, LRRA prohibits RRGs from participating in state guaranty 
funds, which are available to settle the claims of insureds of a 
traditional insurance company should that company fail. 

LRRA's legislative history indicates a view that single-state 
regulation would provide adequate supervision of RRGs, largely because 
RRGs would be providing insurance coverage only to their own members, 
and not the public at large. While preemption is central to LRRA's 
objective of facilitating the formation and efficient interstate 
operation of RRGs, Congress also expressed a view that LRRA's 
prohibition on participating in guaranty funds would provide a strong 
incentive for RRGs to set adequate premiums and establish adequate 
reserves, as each RRG member would know that there would be no other 
source of funds (other than the RRG's own assets) from which to pay 
claims.[Footnote 4]

RRGs are not the only mechanism by which businesses may establish self- 
insurance coverage. States also charter and regulate captive insurance 
companies, which are established by single companies or groups of 
companies to self-insure their own risks. Traditional insurance 
companies sell insurance to the general public and are licensed in all 
states in which they do business. In contrast, captive insurance 
companies largely insure only their owners, who have the ability to 
manage and retain their own risk. Thus, the degree of regulatory 
oversight required for captives is different than that which is 
required for commercial insurers. States chartering captives offer some 
regulatory relief to these companies, based on the presumption that the 
owners of captive companies have sophisticated knowledge about managing 
their own risks and are motivated to protect their own interests. The 
captive is licensed in only one state and operates under the captive 
insurance law of that domicile. However, should the captive choose to 
conduct business outside its state of domicile, it would be subject to 
the licensing and oversight of each state because captives that are not 
also RRGs do not benefit from the partial preemption. Many states have 
recognized RRGs as a form of captive and charter them under their 
captive regulations. 

In light of proposals to expand LRRA, and recent shortages of 
affordable liability insurance, you requested that we assess how well 
RRGs have achieved LRRA's legislative goals of making commercial 
liability insurance available and affordable. This report (1) examines 
the effect RRGs have had on the availability and affordability of 
commercial liability insurance; (2) assesses whether LRRA's partial 
preemption of state insurance laws has resulted in any significant 
regulatory problems; and (3) evaluates the sufficiency of LRRA's 
ownership, control, and governance provisions for protecting the best 
interests of the insureds. 

To ascertain the effect of RRGs on the availability and affordability 
of commercial liability insurance, we surveyed regulators in all 50 
states and the District of Columbia and interviewed representatives 
from eight RRGs serving different markets. In addition, we obtained 
information from the National Association of Insurance Commissioners 
(NAIC) that estimated the share of the commercial liability insurance 
market that RRGs held in 2003.[Footnote 5] To determine if LRRA's 
partial preemption of state insurance laws has resulted in significant 
regulatory problems, we surveyed all state insurance departments to 
obtain information on their regulatory experiences and obtained more 
specific information from regulators in 14 states, including some that 
do not domicile RRGs. To understand the regulatory framework, 
especially the capitalization and financial reporting standards under 
which most RRGs are regulated, we compared the regulatory standards of 
the six states (Arizona, the District of Columbia, Hawaii, Nevada, 
South Carolina, and Vermont) that had chartered the most RRGs as of 
June 30, 2004. To assess the sufficiency of LRRA's ownership, control, 
and governance provisions in protecting the best interests of the 
insureds, we identified provisions in LRRA that relate to these issues 
and reviewed LRRA's legislative history to ascertain Congress' concerns 
about these issues.[Footnote 6] Since LRRA largely delegates the 
regulation of the formation and operation of RRGs to the domiciliary 
states, we reviewed the statutory provisions of the six leading 
domiciliary states to determine whether they addressed ownership, 
control, and governance, and interviewed their regulators to identify 
insurance departmental policies. To understand how the regulators 
implemented these statutes and policies, we reviewed the chartering 
documents of the three RRGs most recently domiciled by each of the 
leading domiciliary states. Finally, we identified whether factors 
related to the ownership, control, or governance of RRGs contributed 
or, in some cases, were alleged to have contributed to RRG failures. We 
conducted our review from November 2003 through July 2005 in accordance 
with generally accepted government auditing standards. Appendix I 
contains a more detailed description of our objectives, scope, and 
methodology. 

Results in Brief: 

RRGs have had a small but important effect in increasing the 
availability and affordability of commercial liability insurance for 
certain groups with limited access to insurance. In 2003, according to 
NAIC estimates, RRGs provided about $1.8 billion or 1.17 percent of all 
commercial liability insurance. While the overall impact on the 
liability market has been small, most state regulators we surveyed 
believed that RRGs have increased the availability and affordability of 
insurance for groups that have had difficulties obtaining affordable 
coverage such as healthcare providers, building contractors, and 
commercial trucking firms. According to state regulators and RRG 
industry representatives, members have benefited in several important 
ways by using RRGs to self-insure their risks.[Footnote 7] These 
benefits include controlling their costs by targeting their coverage to 
the specific needs of members and designing programs to reduce risks. 
The representatives indicated that RRGs might not always benefit from 
the lowest insurance prices but could benefit from prices that remained 
stable over time. In recent years, a shortage of affordable liability 
insurance also prompted the creation of many new RRGs. From 2002 
through 2004, 117 RRGs were formed, more than the total formed over the 
previous 15 years. In particular, a shortage of affordable medical 
malpractice insurance prompted healthcare providers to form about three-
quarters of the new RRGs. As a result, more than half of all currently 
operating RRGs provide insurance in healthcare-related areas. 

LRRA's partial preemption of state insurance laws has resulted in a 
regulatory environment characterized by widely varying state standards 
and limited regulator confidence in the system. In part, state 
requirements differ because some states charter RRGs as captive 
insurance companies, which operate under less restrictive regulation 
than traditional insurers. A captive charter offers RRGs several 
advantages: For example, initial capitalization standards are usually 
easier to meet because states allow captives to start their operations 
with less capital than traditional insurers and use letters of credit 
rather than cash to meet capitalization requirements. As a result of 
these and other advantages, the majority of RRGs have domiciled in six 
states--Arizona, the District of Columbia, Hawaii, Nevada, South 
Carolina, and Vermont--that allow them to be chartered as captive 
insurers rather than in the states where they conduct most of their 
business. In addition, states chartering RRGs as captives also vary in 
how they regulate RRGs on an ongoing basis. These variations exist 
because LRRA grants domiciliary states the discretion and authority to 
regulate the formation and multistate operation of RRGs and because as 
captives most RRGs are not subject to uniform, baseline standards, such 
as those set forth in NAIC's financial accreditation standards for 
regulation of traditional multistate insurers. For example, five of the 
six leading domiciliary states allow RRGs to use a modified version of 
generally accepted accounting principles (GAAP), rather than statutory 
accounting principles (SAP), when filing financial statements. As a 
result, some nondomiciliary state regulators have difficulty 
interpreting these reports, especially since traditional insurers must 
file using SAP. Additionally, only 8 regulators of 42 responding to a 
particular survey question considered that LRRA's provisions adequately 
protected RRG insureds, often because of their concerns about a lack of 
uniform, baseline standards and perception that they needed additional 
regulatory authority. Finally, some evidence exists to support 
regulator assertions that some domiciliary states may be creating 
lenient regulatory environments to encourage RRGs to domicile in their 
state. For example, in the past 4 years, two leading domiciliary states 
have allowed RRGs to relocate their charters, even though the RRGs were 
subject to unresolved regulatory actions in their original state of 
domicile. 

Because (other than requiring that owners must also be insureds) LRRA 
does not impose minimum characteristics of ownership and control for 
RRGs or establish minimum governance requirements, RRGs can be operated 
in ways that do not consistently protect the best interests of their 
insureds. While RRGs were authorized for the purpose of providing self- 
insurance, LRRA does not explicitly require that all of the insureds 
contribute toward the capitalization of the RRG. Consequently, some of 
the six leading domiciliary states do not expect RRG insureds to 
contribute anything more than insurance premiums, and some regulators 
are concerned that members without "skin in the game" will have less 
interest in the success of their RRG. In addition, even though LRRA's 
legislative history indicates that the single-state regulatory 
framework was premised, in part, on insureds having adequate incentives 
to exercise control over their RRG, some of the six leading domiciliary 
states do not expect insureds to have the ability to elect their 
governing body (such as a board of directors). Because not all insureds 
actually participate in the formation or financing of their RRGs, some 
regulators are concerned that those RRGs may be operated for the 
financial benefit of the "entrepreneurs" who do provide the financing. 
An entrepreneur could be an individual insured or the company hired to 
manage the daily operations of the RRG. LRRA also does not include 
provisions regarding the management of RRGs, such as governance 
protections to counteract potential conflicts of interest between 
management companies and insureds. In contrast, Congress previously 
addressed a similar situation within the mutual fund industry by 
passing legislation intended to minimize potential conflicts of 
interest between mutual fund shareholders and management companies. The 
circumstances surrounding more than half of past RRG failures we 
examined suggest that management companies or managers have promoted 
their own interests at the expense of the insureds--for example, by 
charging excessive management fees or promoting transactions 
unfavorable to the RRG. Regulators knowledgeable about these failures 
said that the insureds likely were more interested in obtaining 
affordable insurance than assuming the responsibilities of owning an 
insurance company. Consequently, even though an insured's insurance 
policy may have stated that the RRG lacked guaranty fund coverage, the 
insureds may not have been fully aware of this restriction or the 
consequences of lacking such protection. Further, LRRA does not require 
RRGs to disclose to prospective claimants, those who submit claims for 
loss, that the RRGs would not benefit from guaranty fund protection 
should they fail. This can be of special consequence to certain 
claimants--consumers who purchase extended service contracts from the 
insureds of RRGs--because contracts issued by these insureds take on 
the appearance of insurance when, in most cases, they are not. 

This report contains recommendations for the states, as well as matters 
for congressional consideration that, if implemented, would create a 
more consistent regulatory framework for overseeing the chartering and 
management of RRGs, provide more reliable information about the 
financial condition of RRGs, and provide RRG members needed protections 
to help ensure that companies managing RRGs operate in the insureds' 
best interests. In addition, enhancing the availability and contents of 
the guaranty fund disclosure would provide RRG insureds, as well as 
consumers who purchase extended service contracts from RRG insureds, a 
better understanding of the lack of guaranty fund coverage. Finally, 
these recommendations would strengthen NAIC's ability to achieve its 
goals of improving the quality and consistency of state insurance 
regulation. 

We requested comments on a draft of this report from NAIC. The 
Executive Vice President and CEO, National Association of Insurance 
Commissioners, provided written comments on a draft of this report. 
NAIC generally agreed with our approach and methodology and our 
description of the regulation of risk retention groups. NAIC's comments 
are discussed later in this report and are reprinted in appendix V. 
NAIC and several of the states also provided technical comments, which 
we incorporated as appropriate. 

Background: 

In the legislative history, RRGs were described as essentially 
insurance "cooperatives," whose members pool funds to spread and assume 
all or a portion of their own commercial liability risk exposure--and 
who are engaged in businesses and activities with similar or related 
risks.[Footnote 8] Specifically, RRGs may be owned only by individuals 
or businesses that are insured by the RRG or by an organization that is 
owned solely by insureds of the RRG.[Footnote 9] In the legislative 
history, Congress expressed the viewthat RRGs had the potential to 
increase the availability of commercial liability insurance for 
businesses and reduce liability premiums, at least when insurance is 
difficult to obtain (during hard markets) because members would set 
rates more closely tied to their own claims experience. In addition, 
LRRA was intended to provide businesses, especially small ones, an 
opportunity to reduce insurance costs and promote greater competition 
among insurers when they set insurance rates.[Footnote 10] Because RRGs 
are owned by insureds that may have business assets at risk should the 
RRG be unable to pay claims, they would have greater incentives to 
practice effective risk management both in their own businesses and the 
RRG. The elimination of duplicative and sometimes contradictory 
regulation by multiple states was designed to facilitate the formation 
and interstate operation of RRGs.[Footnote 11] "The (regulatory) 
framework established by LRRA attempts to strike a balance between the 
RRGs' need to be free of unjustified requirements and the public's need 
for protection from insolvencies."[Footnote 12]

RRGs are not the only form of self-insurance companies; "captive 
insurance companies" (captives) also self-insure the risks of their 
owners. States can charter RRGs under regulations intended for 
traditional insurers or for captive insurers. Non-RRG captives largely 
exist solely to cover the risks of their parent, which can be one large 
company (pure captive) or a group of companies (group 
captives).[Footnote 13] Group captives share certain similarities with 
RRGs because they also are composed of several companies, but group 
captives, unlike RRGs, do not have to insure similar risks. Further, 
captives may provide property coverage, which RRGs may not. Regulatory 
requirements for captives generally are less restrictive than those for 
traditional insurance companies because, for example, many pure 
captives are wholly owned insurance subsidiaries of a single business 
or organization. If a pure captive failed, only the assets of the 
parent would be at risk. Finally, unlike captive RRGs, other captive 
insurers generally cannot conduct insurance transactions in any state 
except their domiciliary state, unless they become licensed in that 
other state (just as a traditional company would) and subject to that 
state's regulatory oversight.[Footnote 14]

In contrast to the single-state regulation that LRRA provides for RRGs, 
traditional insurers, as well as other non-RRG captive insurers, are 
subject to the licensing requirements and oversight of each 
nondomiciliary state in which they operate. The licensing process 
allows states to determine if an insurer domiciled in another state 
meets the nondomiciliary state's regulatory requirements before 
granting the insurer permission to operate in its state. According to 
NAIC's uniform application process, which has been adopted by all 
states, an insurance company must show that it meets the nondomiciliary 
state's minimum statutory capital and surplus requirements, identify 
whether it is affiliated with other companies (that is, part of a 
holding company system), and submit biographical affidavits for all its 
officers, directors, and key managerial personnel.[Footnote 15] After 
licensing an insurer, regulators in nondomiciliary states can conduct 
financial examinations, issue an administrative cease and desist order 
to stop an insurance company from operating in their state, and 
withdraw the company's license to sell insurance in the state. However, 
most state regulators will not even license an insurance company 
domiciled in another state to operate in their state unless the company 
has been in operation for several years. As reflected in each state's 
"seasoning requirements," an insurance company must have successfully 
operated in its state of domicile for anywhere from 1 to 5 years before 
qualifying to receive a license from another state.[Footnote 16] RRGs, 
in contrast, are required only to register with the regulator of the 
state in which they intend to sell insurance and provide copies of 
certain documents originally provided to domiciliary regulators. 

Although RRGs receive regulatory relief under LRRA, they still are 
expected to comply with certain other laws administered by the states 
in which they operate, but are not chartered (nondomiciliary states), 
and are required to pay applicable premium and other taxes imposed by 
nondomiciliary states.[Footnote 17] In addition to registering with 
other states, LRRA also imposes other requirements that offer 
protections or safeguards to RRG members: LRRA requires each RRG to (1) 
provide a plan of operation to the insurance commissioner of each state 
in which it plans to do business prior to offering insurance in that 
state, (2) provide a copy of the group's annual financial statement to 
the insurance commissioner of each state in which it is doing business, 
and (3) submit to an examination by a nondomiciliary state regulator to 
determine the RRG's financial condition, if the domiciliary state 
regulator has not begun or refuses to begin an examination. 
Nondomiciliary, as well as domiciliary states, also may seek an 
injunction in a "court of competent jurisdiction" against RRGs that 
they believe are in hazardous financial condition.[Footnote 18]

In conjunction with the regulatory relief Congress granted to RRGs, it 
prohibited RRGs from participating in state guaranty funds, believing 
that this restriction would provide RRG members a strong incentive to 
establish adequate premiums and reserves. All states have established 
guaranty funds, funded by insurance companies, to pay the claims of 
policyholders in the event that an insurance company fails. Without 
guaranty fund protection, in the event an RRG becomes insolvent, RRG 
insureds and their claimants could be exposed to all losses resulting 
from claims that exceed the ability of the RRG to pay. 

Finally, in terms of structure, RRG and captive insurance companies 
bear a certain resemblance to mutual fund companies.[Footnote 19] For 
example, RRGs, captive insurance companies, and mutual fund companies 
employ the services of a management company to administer their 
operations. RRGs and captive insurers generally hire "captive 
management" companies to administer company operations, such as day-to- 
day operational decisions, financial reporting, liaison with state 
insurance departments, or locating sources of reinsurance.[Footnote 20] 
Similarly, a typical mutual fund has no employees but is created and 
operated by another party, the adviser, which contracts with the fund, 
for a fee, to administer operations. For example, the adviser would be 
responsible for selecting and managing the mutual fund's portfolio. 
However, Congress recognized that the external management of mutual 
funds by investment advisers creates an inherent conflict between the 
adviser's duties to the fund shareholders and the adviser's interests 
in maximizing its own profits, a situation that could adversely affect 
fund shareholders. One way in which Congress addressed this conflict is 
the regulatory scheme established by the Investment Company Act of 
1940, which includes certain safeguards to protect the interests of 
fund shareholders. For example, a fund's board of directors must 
contain a certain percentage of independent directors--directors 
without any significant relationship to the advisers. 

RRGs Have Had a Small but Important Effect on Increasing the 
Availability and Affordability of Commercial Liability Insurance: 

RRGs have had a small but important effect on increasing the 
availability and affordability of commercial liability insurance, 
specifically for groups that have had limited access to liability 
insurance. According to NAIC estimates, in 2003 RRGs sold just over 1 
percent of all commercial liability insurance in the United States. 
However, many state regulators, even those who had reservations about 
the regulatory oversight of RRGs, believe RRGs have filled a void in 
the market. Regulators from the six leading domiciliary states also 
observed that RRGs were important to certain groups that could not find 
affordable coverage from a traditional insurance company and offered 
RRG insureds other benefits such as tailored coverage. Furthermore, 
RRGs, while tending to be relatively small in size compared with 
traditional insurers, serve a wide variety of organizations and 
businesses, although the majority served the healthcare industry. 
Difficulties in finding affordable commercial liability insurance 
prompted the creation of more RRGs from 2002 through 2004 than in the 
previous 15 years. Three-quarters of the RRGs formed in this period 
responded to a recent shortage of, and high prices for, medical 
malpractice insurance. However, studies have characterized the medical 
malpractice industry as volatile because of the risks associated with 
providing this line of insurance. 

RRGs Have Represented a Small but Increasing Part of the Commercial 
Liability Insurance Market: 

RRGs have constituted a very small part of the commercial liability 
market. According to NAIC estimates, in 2003 a total of 115 RRGs sold 
1.17 percent of all commercial liability insurance in the United 
States. This accounted for about $1.8 billion of a total of $150 
billion in gross premiums for all commercial liability lines of 
insurance.[Footnote 21] We are focusing on 2003 market share to match 
the time frame of our other financial analyses of gross premiums. 

While RRGs' share of the commercial liability market was quite small, 
market share and the overall amount of business RRGs wrote increased 
since 2002. For example, RRG market share increased from 0.89 percent 
in 2002 to 1.46 percent in 2004.[Footnote 22] However, in terms of 
commercial liability gross premiums, the increase in the amount of 
business written by RRGs is more noticeable. The amount of business 
that RRGs collectively wrote about doubled, from $1.2 billion in 2002 
to $2.3 billion in 2004. During this same period, the amount of 
commercial liability written by traditional insurers increased by about 
21 percent, from $129 billion to $156 billion. In addition, RRGs 
increased their presence in the market for medical malpractice 
insurance. From 2002 through 2004, the amount of medical malpractice 
written by RRGs increased from $497 million to $1.1 billion, which 
increased their share of the medical malpractice market from 4.04 
percent to 7.27 percent. 

According to State Regulators, RRGs Have Filled Voids in Markets, 
Allowing Numerous Groups to Obtain Benefits of Coverage: 

Despite the relatively small share of the market that RRGs hold, most 
state regulators we surveyed who had an opinion--33 of 36--indicated 
that RRGs have expanded the availability and affordability of 
commercial liability insurance for groups that otherwise would have had 
difficulty in obtaining coverage.[Footnote 23] This consistency of 
opinion is notable because 18 of those 33 regulators made this 
assertion even though they later expressed reservations about the 
adequacy of LRRA's regulatory safeguards.[Footnote 24] About one-third 
of the 33 regulators also made more specific comments about the 
contributions of RRGs. Of these, five regulators reported that RRGs had 
expanded the availability of medical malpractice insurance for nursing 
homes, adult foster care homes, hospitals, and physicians. One 
regulator also reported that RRGs had assisted commercial truckers in 
meeting their insurance needs. 

Regulators from states that had domiciled the most RRGs as of the end 
of 2004--Arizona, the District of Columbia, Hawaii, Nevada, South 
Carolina, and Vermont--provided additional insights.[Footnote 25] 
Regulators from most of these states recognized that the overall impact 
of RRGs in expanding the availability of insurance was quite small. 
However, they said that the coverage RRGs provided was important 
because certain groups could not find affordable insurance from a 
traditional insurance company. All of these regulators cited medical 
malpractice insurance as an area where RRGs increased the affordability 
and availability of insurance but they also identified other areas. For 
example, regulators from Hawaii and Nevada reported that RRGs have been 
important in addressing a shortage of insurance for construction 
contractors. The six regulators all indicated (to some extent) that by 
forming their own insurance companies, RRG members also could control 
costs by designing insurance coverage targeted to their specific needs 
and develop programs to reduce specific risks. In contrast, as noted by 
the Arizona regulator, traditional insurers were likely to take a short-
term view of the market, underpricing their coverage when they had 
competition and later overpricing their coverage to recoup losses. He 
also noted insurers might exit a market altogether if they perceived 
the business to be unprofitable, as exemplified in the medical 
malpractice market. Regulators from Vermont and Hawaii, states that 
have the most experience in chartering RRGs, added that successful RRGs 
have members that are interested in staying in business for the "long 
haul" and are actively involved in running their RRGs. RRG 
representatives added that RRG members, at any given time, might not 
necessarily benefit from the cheapest insurance prices but could 
benefit from prices that were stable over time. Additionally, as 
indicated by trade group representatives, including the National Risk 
Retention Association, RRGs have proved especially advantageous for 
small and midsized businesses. 

In order to obtain more specific information about how RRGs have 
benefited their membership, we interviewed representatives of and 
reviewed documents supplied by six RRGs that have been in business for 
more than 5 years, as well as two more recently established RRGs. 
Overall, these eight RRGs had anywhere from 2 to more than 14,500 
members.[Footnote 26] They provided coverage to a variety of insureds, 
including educational institutions, hospitals, attorneys, and building 
contractors. The following three examples illustrate some of the 
services and activities RRGs provide or undertake. 

* An RRG that insures about 1,100 schools, universities, and related 
organizations throughout the United States offers options tailored to 
its members, such as educators' legal liability coverage and coverage 
for students enrolled in courses offering off-campus internships. 
According to an RRG representative, the RRG maintains a claims database 
to help it accurately and competitively price its policies. Members 
also benefit from risk-management services, such as training and 
courses on sexual harassment and tenure litigation, and work with 
specialists to develop loss-control programs. 

* An RRG that reported that it insures 730 of the nation's 
approximately 3,000 public housing authorities provides coverage for 
risks such as pesticide exposure, law enforcement liability, and lead- 
based paint liability. The RRG indicated that while premium rates have 
fluctuated, they are similar to prices from about 15 years ago. The RRG 
also offers risk-management programs, such as those for reducing fires, 
and also reported that as a result of conducting member inspections it 
recently compiled more than 2,000 recommendations on how to reduce 
covered risks. 

* An RRG that primarily provides insurance to about 45 hospitals in 
California and Nevada offers general and professional coverage such as 
personal and bodily injury and employee benefit liability. The RRG also 
offers a variety of risk-management services specifically aimed at 
reducing losses and controlling risks in hospitals. According to an RRG 
official, adequately managing risk within the RRG has allowed for more 
accurate pricing of the liability coverage available to members. 

RRGs Have Remained Relatively Small in Size Compared with Traditional 
Insurers but Serve a Wide Variety of Markets: 

Generally, RRGs have remained relatively small compared with 
traditional insurers. Based on our analysis of 2003 financial data 
submitted to NAIC, 47 of the 79 RRGs (almost 60 percent) that had been 
in business at least 1 year, wrote less than $10 million in gross 
premiums, whereas only 644 of 2,392 traditional insurers (27 percent) 
wrote less than $10 million. In contrast, 1,118 traditional insurers 
(almost 47 percent) wrote more than $50 million in gross premiums for 
2003 compared with six RRGs (8 percent). Further, these six RRGs (all 
of which had been in business for at least 1 year) accounted for 52 
percent of all gross premiums that RRGs wrote in 2003. This information 
suggests that just a few RRGs account for a disproportionate amount of 
the RRG market. 

Additionally, RRGs that wrote the most business tended to have been in 
business the longest. For example, as measured by gross premiums 
written, of the 16 RRGs that sold more than $25 million annually, 14 
had been in business 5 years or more (see fig. 1). Yet, the length of 
time an RRG has been in operation is not always the best predictor of 
an RRG's size. For example, of the 51 RRGs that had been in business 
for 5 or more years, 27 still wrote $10 million or less in gross 
premiums. 

Figure 1: RRG Gross Premiums Written in 2003, by Time (Years) in 
Business: 

[See PDF for image] 

[A] This figure compares the amount of gross premiums written in 2003 
by the 79 RRGs that had been in business for at least 1 year. Of the 
79, 51 had at least 5 years of business experience, and 28 had between 
1 and 5 years. 

[End of figure] 

According to the Risk Retention Reporter (RRR), a trade journal that 
has covered RRGs since 1986, RRGs insure a wide variety of 
organizations and businesses.[Footnote 27] According to estimates 
published in RRR, in 2004 105 RRGs (more than half of the 182 in 
operation at that time) served the healthcare sector (for example, 
hospitals, nursing homes, and doctors). In 1991, RRGs serving 
physicians and hospitals accounted for about 90 percent of healthcare 
RRGs. However, by 2004, largely because of a recent increase in nursing 
homes forming RRGs, this percentage decreased to about 74 
percent.[Footnote 28] In addition, in 2004, 21 RRGs served the property 
development area (for example, contractors and homebuilders), and 20 
served the manufacturing and commerce area (for example, manufacturers 
and distributors). Other leading business areas that RRGs served 
include professional services (for example, attorneys and architects), 
and government and institutions (for example, educational and religious 
institutions). Figure 2 shows how the distribution of RRGs by business 
area has changed since 1991. 

Figure 2: Number of RRGs, by Business Area for Selected Years: 

[See PDF for image] 

[A] The RRG numbers that RRR projected for 2004 are based on the number 
of RRGs the journal identified operating as of the end of September 
2004. For each year, we show only the four business areas with the 
highest number of RRGs, and group all other areas in a fifth category. 

[End of figure] 

Additionally, according to RRR's estimates, almost half of all RRG 
premiums collected in 2004 were in the healthcare area (see fig. 3). 
The professional services and government and institutions business 
areas accounted for the second and third largest percentage of 
estimated gross premiums collected, respectively.[Footnote 29]

Figure 3: Percentage of Estimated Gross Premiums RRGs Collected in 
2004, by Business Area: 

[See PDF for image] 

Note: Gross premium data estimates are based on information RRR 
collected from RRGs during a 2004 survey. RRR reported projections for 
all of 2004 in October 2004. 

[End of figure] 

In looking at other characteristics of RRGs, according to an NAIC 
analysis, the average annual failure rate for RRGs was somewhat higher 
than the average annual failure rate for all other property and 
casualty insurers. Between 1987 and 2003, the average annual failure 
rate for RRGs was 1.83 percent compared with the 0.78 percent failure 
rate for property and casualty insurers.[Footnote 30] Over this period, 
NAIC determined that a total of 22 RRGs failed, with between no and 
five RRGs failing each year.[Footnote 31] In comparison, NAIC 
determined that a total of 385 traditional insurers failed, with 
between 5 and 57 insurance companies failing each year. Although the 
difference in failure rates was statistically significant, it should be 
noted that the comparison may not be entirely parallel. NAIC compared 
RRGs that can sell only commercial liability insurance to businesses 
with insurers that can sell all lines of property and casualty 
(liability) for commercial and personal purposes.[Footnote 32] 
Moreover, because NAIC included all property-casualty insurers, no 
analysis was done to adjust for size and longevity. 

Recent Market Conditions Have Prompted the Creation of Many RRGs, 
Especially to Provide Medical Malpractice Insurance: 

In creating RRGs, companies and organizations are generally responding 
to market conditions. As the availability and affordability of 
insurance decreased (creating a "hard" market), some insurance buyers 
sought alternatives to traditional insurance and turned to 
RRGs.[Footnote 33] In response, more RRGs formed from 2002 through 2004 
than in the previous 15 years (1986-2001). This increase is somewhat 
similar in magnitude to an increase that occurred in 1986-1989 in 
response to an earlier hard market for insurance (see fig. 4).[Footnote 
34] The 117 RRGs formed from January 1, 2002, through December 31, 
2004, represent more than half of all RRGs in operation as of December 
31, 2004. 

Figure 4: Number of RRGs, by Formation Date: 

[See PDF for image] 

Note: This figure represents the number of RRGs formed during different 
periods, regardless of whether they are currently active or not, and 
includes only those RRGs for which NAIC has data. According to NAIC 
data, four companies either formed as RRGs or converted to RRGs after 
the passage of the Product Liability Risk Retention Act of 1981. 

[End of figure] 

More specifically, RRGs established to provide medical malpractice 
insurance accounted for most of the increase in RRG numbers in 2002- 
2004.[Footnote 35] Healthcare providers sought insurance after some of 
the largest medical malpractice insurance providers exited the market 
because of declining profits, partly caused by market instability and 
high and unpredictable losses--factors that have contributed to the 
high risks of providing medical malpractice insurance.[Footnote 36] 
From 2002 through 2004, healthcare RRGs accounted for nearly three- 
fourths of all RRG formations. Further, 105 RRGs were insuring 
healthcare providers as of the end of 2004, compared with 23 in 
previous years (see again fig. 2). These RRGs serve a variety of 
healthcare providers. For example, during 2003, 23 RRGs formed to 
insure hospitals and their affiliates, 13 formed to insure physician 
groups, and 11 formed to insure long-term care facilities, including 
nursing homes and assisted living facilities. However, the dramatic 
increase in the overall number of RRGs providing medical malpractice 
insurance may precipitate an increase in the number of RRGs vulnerable 
to failure. Studies have characterized the medical malpractice 
insurance industry as volatile because the risks of providing medical 
malpractice insurance are high.[Footnote 37]

Finally, many of the recently formed healthcare-related RRGs are 
selling insurance in states where medical malpractice insurance rates 
for physicians have increased the most.[Footnote 38] For example, since 
April 30, 2002, the Pennsylvania Insurance Department has registered 32 
RRGs to write medical malpractice products. In addition, since the 
beginning of 2003, the Texas Department of Insurance has registered 15 
RRGs to write medical malpractice insurance, more than the state had 
registered in the previous 16 years. Other states where recently formed 
RRGs were insuring doctors include Illinois and Florida, states that 
have also experienced large increases in medical malpractice insurance 
premium rates. 

LRRA's Regulatory Preemption Has Resulted in Widely Varying 
Requirements among States and Limited Confidence in RRG Regulation: 

LRRA's regulatory preemption has allowed states to set regulatory 
requirements that differ significantly from those of traditional 
insurers, and from each other, producing limited confidence among 
regulators in the regulation of RRGs. Many of the differences arise 
because some states allow RRGs to be chartered as captive insurance 
companies, which typically operate under a set of less restrictive 
rules than traditional insurers. As a result, RRGs generally domicile 
in those states that permit their formation as captive insurance 
companies, rather than in the states in which they conduct most of 
their business. For example, RRGs domiciled as captive insurers usually 
can start their operations with smaller amounts of capital and surplus 
than traditional insurance companies, use letters of credit to meet 
minimum capitalization requirements, or meet fewer reporting 
requirements. Regulatory requirements for captive RRGs vary among 
states as well, in part because regulation of RRGs and captives are not 
subject to uniform, baseline standards, such as the NAIC accreditation 
standards that define a state's regulatory structure for traditional 
companies. As one notable example, states do not require RRGs to follow 
the same accounting principles when preparing their financial reports, 
making it difficult for some nondomiciliary state regulators, as well 
as NAIC analysts, to reliably assess the financial condition of RRGs. 
Regulators responding to our survey also expressed concern about the 
lack of uniform, baseline standards. Few (eight) indicated that they 
believed LRRA's regulatory safeguards and protections, such as the 
right to file a suit against an RRG in court, were adequate. Further, 
some regulators suggested that some domiciliary states were modifying 
their regulatory requirements and practices to make it easier for RRGs 
to domicile in their state. We found some evidence to support these 
concerns based on differences among states in minimum capitalization 
requirements, willingness to charter RRGs to insure parties that sell 
extended service contracts to consumers, or willingness to charter RRGs 
primarily started by service providers, such as management companies, 
rather than insureds. 

Most RRGs Have Domiciled in States That Charter Them as Captives but 
Have Conducted Most of Their Business in Other States: 

Regulatory requirements for captive insurers are generally less 
restrictive than those for traditional insurers and offer RRGs several 
financial advantages. For example, captive laws generally permit RRGs 
to form with smaller amounts of required capitalization (capital and 
surplus), the minimum amount of initial funds an insurer legally must 
have to be chartered.[Footnote 39] While regulators reported that their 
states generally require traditional insurance companies to have 
several millions of dollars in capital and surplus, they often reported 
that RRGs chartered as captives require no more than $500,000.[Footnote 
40] In addition, unlike requirements for traditional insurance 
companies, the captive laws of the six leading domiciliary states 
permit RRGs to meet and maintain their minimum capital and surplus 
requirements in the form of an irrevocable letter of credit (LOC) 
rather than cash.[Footnote 41] According to several regulators that 
charter RRGs as captives, LOCs may provide greater protection to the 
insureds than cash when only the insurance commissioner can access 
these funds. The insurance commissioner, who would be identified as the 
beneficiary of the LOC, could present the LOC to the bank and 
immediately access the cash, but a representative of the RRG could not. 
However, other state regulators questioned the value of LOCs because 
they believed cash would be more secure if an RRG were to experience 
major financial difficulties. One regulator noted that it becomes the 
regulator's responsibility, on a regular basis, to determine if the RRG 
is complying with the terms of the LOC. In addition, in response to our 
survey, most regulators from states that would charter RRGs as captives 
reported that RRGs would not be required to comply with NAIC's risk- 
based capital (RBC) requirements.[Footnote 42] NAIC applies RBC 
standards to measure the adequacy of an insurer's capital relative to 
their risks. Further, RRGs chartered as captives may not be required to 
comply with the same NAIC financial reporting requirements, such as 
filing quarterly and annual reports with NAIC, that regulators expect 
traditional insurance companies to meet.[Footnote 43] For example, 
while the statutes of all the leading domiciliary states require RRGs 
chartered as captives to file financial reports annually with their 
insurance departments, as of July 2004, when we conducted our survey, 
the statutes of only half the leading domiciliary states--Hawaii,

South Carolina, and Vermont--explicitly require that these reports also 
be provided to NAIC on an annual basis.[Footnote 44]

In addition, when RRGs are chartered as captive insurance companies 
they may not have to comply with the chartering state's statutes 
regulating insurance holding company systems. All 50 states and the 
District of Columbia substantially have adopted such statutes, based on 
NAIC's Model Insurance Holding Company System Regulatory Act.[Footnote 
45]

As in the model act, a state's insurance holding company statute 
generally requires insurance companies that are part of holding company 
systems and doing business in the state to register with the state and 
annually disclose to the state insurance regulator all the members of 
that system. Additionally, the act requires that transactions among 
members of a holding company system be on fair and reasonable terms, 
and that insurance commissioners be notified of and given the 
opportunity to review certain proposed transactions, including 
reinsurance agreements, management agreements, and service contracts. 
For 2004, NAIC reviewed RRG annual reports and identified 19 RRGs that 
reported themselves as being affiliated with other companies (for 
example, their management and reinsurance companies). However, since 
only two of the six leading domiciliary states, Hawaii, and to some 
extent South Carolina, actually require RRGs to comply with this act, 
we do not know whether more RRGs could be affiliated with other 
companies.[Footnote 46] The Hawaii regulator said that RRGs should 
abide by the act's disclosure requirements so that regulators can 
identify potential conflicts of interests with service providers, such 
as managers or insurance brokers. Unless an RRG is required to make 
these disclosures, the regulator would have the added burden of 
identifying and evaluating the nature of an RRG's affiliations. He 
added that such disclosures are important because the individual 
insureds of an RRG, in contrast to the single owner of a pure captive, 
may not have the ability to control potential conflicts of interest 
between the insurer and its affiliates. (See the next section of this 
report for examples of how affiliates of an RRG can have conflicts of 
interest with the RRG.)

Because of these regulatory advantages, RRGs are more likely to 
domicile in states that will charter them as captives than in the 
states where they sell insurance. Figure 5 shows that 18 states could 
charter RRGs as captives. The figure also shows that most RRGs have 
chosen to domicile in six states--Arizona, the District of Columbia, 
Hawaii, Nevada, South Carolina, and Vermont--all of which charter RRGs 
as captives and market themselves as captive domiciles.[Footnote 47] Of 
these states, Vermont and Hawaii have been chartering RRG as captives 
for many years, but Arizona, the District of Columbia, Nevada, South 
Carolina, and five additional states have adopted their captive laws 
since 1999.[Footnote 48] In contrast to an RRG chartered as a captive, 
a true captive insurer generally does not directly conduct insurance 
transactions outside of its domiciliary state. 

Figure 5: Number of RRGs, by Captive or Noncaptive Charter and State of 
Domicile, as of the End of 2004: 

[See PDF for image] 

Note: States, with the exception of Maryland, provided us information 
about their captive laws as part of our survey. We did not 
independently verify the information provided or whether RRGs domiciled 
in the state were chartered as captives, although we updated some of 
the survey results to reflect states that have adopted captive statutes 
since the time of our survey. In addition, (1) the State of Maine 
indicated that while it had a captive law, the question of whether or 
not an RRG could form under it had not been formally considered and (2) 
the State of Kansas indicated that while it could charter RRGs as 
captives, its captive law does not explicitly permit RRGs to be 
chartered as captives. 

[End of figure] 

However, states of domicile are rarely the states in which RRGs sell 
much, or any, insurance. According to NAIC, 73 of the 115 RRGs active 
in 2003 did not write any business in their state of domicile, and only 
10 wrote more than 30 percent of their business in their state of 
domicile.[Footnote 49] The states in which RRGs wrote most of their 
business in 2003--Pennsylvania ($238 million), New York ($206 million), 
California ($156 million), Massachusetts ($98 million)--did not charter 
any RRGs. Texas, which chartered only one RRG, had $87 million in 
direct written premiums written by RRGs. For more information on the 
number of RRGs chartered by state and the amount of direct premiums 
written by RRGs, see figure 6. 

Figure 6: Number of RRGs Chartered, by State, as of the End of 2004, 
and Amount of Direct Premiums Written by RRGs, by State, 2003: 

[See PDF for image] 

Note: The numbers displayed on some states in the map represent the 
number of RRGs domiciled in the state. For 2003, RRGs also wrote 
business in places such as Puerto Rico, Guam, and Canada (less than $17 
million). 

[End of figure] 

Inconsistent Regulation of RRGs Resembles Earlier Regulation of 
Traditional Insurers, Which Suffered from Lack of Uniform, Baseline 
Standards: 

The current regulatory environment for RRGs, characterized by the lack 
of uniform, baseline standards, offers parallels to the earlier 
solvency regulation of multistate traditional insurers. Uniformity in 
solvency regulation for multistate insurers is important, provided the 
regulation embodies best practices and procedures, because it 
strengthens the regulatory system across all states and builds trust 
among regulators. After many insurance companies became insolvent 
during the 1980s, NAIC and the states recognized the need for uniform, 
baseline standards, particularly for multistate insurers.[Footnote 50] 
To alleviate this situation, NAIC developed its Financial Regulation 
Standards and Accreditation Program (accreditation standards) in 1989 
and began the voluntary accreditation of most state regulators in the 
1990s. Prior to accreditation, states did not uniformly regulate the 
financial solvency of traditional insurers, and many states lacked 
confidence in the regulatory standards of other states. By becoming 
accredited, state regulators demonstrated that they were willing to 
abide by a common set of solvency standards and practices for the 
oversight of the multistate insurers chartered by their state. As a 
result, states currently generally defer to an insurance company's 
domiciliary state regulator, even though each state retains the 
authority, through its licensing process, to regulate all traditional 
insurance companies selling in the state. 

NAIC's accreditation standards define baseline requirements that states 
must meet for the regulation of traditional companies in three major 
areas: First, they include minimum standards for the set of laws and 
regulations necessary for effective solvency regulation.[Footnote 51] 
Second, they set minimum standards for practices and procedures, such 
as examinations and financial analysis, which regulators routinely 
should do.[Footnote 52] Third, they establish expectations for resource 
levels and personnel practices, including the amount of education and 
experience required of professional staff, within an insurance 
department.[Footnote 53] However, NAIC does not have a similar set of 
regulatory standards for regulation of RRGs, which also are multistate 
insurers. 

According to NAIC officials, when the accreditation standards 
originally were developed, relatively few states were domiciling RRGs 
as captive insurers, and the question of standards for the regulation 
of captives and RRGs did not materialize until NAIC began its 
accreditation review of Vermont in 1993. NAIC completely exempted the 
regulation of captive insurers from the review process but included 
RRGs because, unlike pure captives, RRGs have many policyholders and 
write business in multiple states. NAIC's accreditation review of 
Vermont lasted about 2 years and NAIC and Vermont negotiated an 
agreement that only part of the accreditation standards applied to 
RRGs.[Footnote 54] As a result of the review, NAIC determined that RRGs 
were sufficiently different from traditional insurers so that the 
regulatory standards defining the laws and regulations necessary for 
effective solvency regulation should not apply to RRGs.[Footnote 55] 
However, NAIC and Vermont did not develop substitute standards to 
replace those they deemed inappropriate. Subsequently, other states 
domiciling RRGs as captives also have been exempt from enforcing the 
uniform set of laws and regulations deemed necessary for effective 
solvency regulation under NAIC's accreditation standards. As a result, 
some states chartering RRGs as captives do not obligate them, for 
example, to adopt a common set of financial reporting procedures and 
practices, abide by NAIC's requirements for risk-based capital, or 
comply with requirements outlined in that state's version of NAIC's 
Model Insurance Holding Company System Regulatory Act.[Footnote 56]

In contrast, while NAIC's standards for the qualifications of an 
insurance department's personnel apply to RRGs, they do not distinguish 
between the expertise needed to oversee RRGs and traditional insurance 
companies. Because half of the 18 states that are willing to charter 
RRGs as captives have adopted captive laws since 1999, few domiciliary 
state insurance departments have much experience regulating RRGs as 
captive insurance companies. Further, in response to our 2004 survey, 
only three states new to chartering captives--Arizona, the District of 
Columbia, and South Carolina--reported that they have dedicated certain 
staff to the oversight of captives.[Footnote 57] However, the State of 
Nevada later reported to us that it dedicated staff to the oversight of 
captives as of June 2005. 

The importance of standards that address regulator education and 
experience can be illustrated by decisions made by state insurance 
departments or staff relatively new to chartering RRGs. In 1988, 
Vermont chartered Beverage Retailers Insurance Co. Risk Retention Group 
(BRICO). Launched and capitalized by an outside entity, BRICO did not 
have a sufficient number of members as evidenced by the need for an 
outside entity to provide the capital. It failed in 1995 in large part 
because it wrote far less business than originally projected and 
suffered from poor underwriting. Further, according to regulators, 
BRICO began to write business just as the market for its product 
softened, and traditional licensed insurers began to compete for the 
business. As a result, the Vermont regulators said that Vermont would 
not charter RRGs unless they had a sufficient number of insureds at 
start-up to capitalize the RRG and make its future operations 
sustainable. More recently, in 2000, shortly after it adopted its 
captive statutes, South Carolina chartered Commercial Truckers Risk 
Retention Group Captive Insurance Company. This RRG, which also largely 
lacked members at inception, failed within a year because it had an 
inexperienced management team, poor underwriting, and difficulties with 
its reinsurance company. The regulators later classified their 
experience with chartering this RRG, particularly the fact that the RRG 
lacked a management company, as "lessons learned" for their department. 
Finally, as reported in 2004, the Arizona insurance department 
inadvertently chartered an RRG that permitted only the brokerage firm 
that formed and financed the RRG to have any ability to control the RRG 
through voting rights. The Arizona insurance department explained that 
they approved the RRG's charter when the insurance department was 
operating under an acting administrator and that the department would 
make every effort to prevent similar mistakes. 

According to NAIC officials, RRGs writing insurance in multiple states, 
like traditional insurers, would benefit from the adoption of uniform, 
baseline standards for state regulation, and they plan gradually to 
develop them. NAIC representatives noted that questions about the 
application of accreditation standards related to RRGs undoubtedly 
would be raised again because several states new to domiciling RRGs 
will be subject to accreditation reviews in the next few 
years.[Footnote 58] However, the representatives also noted, that 
because the NAIC accreditation team can review the oversight of only a 
few of the many insurance companies chartered by a state, the team 
might not select an RRG. 

Variations in RRG Reporting Requirements Have Impeded Assessments of 
Their Financial Condition: 

As discussed previously, states domiciling RRGs as captives are not 
obligated to require that RRGs meet a common set of financial reporting 
procedures and practices. Moreover, even among states that charter RRGs 
as captives, the financial reporting requirements for RRGs vary. Yet, 
the only requirement under LRRA for the provision of financial 
information to nondomiciliary regulators is that RRGs provide annual 
financial statements to each state in which they operate. Further, 
since most RRGs sell the majority of their insurance outside their 
state of domicile, insurance commissioners from nondomiciliary states 
may have only an RRG's financial reports to determine if an examination 
may be necessary.[Footnote 59] As we have reported in the past, to be 
of use to regulators, financial reports should be prepared under 
consistent accounting and reporting rules and provided in a timely 
manner that results in a fair presentation of the insurer's true 
financial condition.[Footnote 60]

One important variation in reporting requirements is the use by RRGs of 
accounting principles that differ from those used by traditional 
insurance companies. The statutes of the District of Columbia, Nevada, 
South Carolina, and Vermont require their RRGs to use GAAP; Hawaii 
requires RRGs to use statutory accounting principles (SAP); and Arizona 
permits RRGs to use either.[Footnote 61] The differences in the two 
sets of accounting principles reflect the different purposes for which 
each was developed and each produces a different--and not necessarily 
comparable--financial picture of a business. In general, SAP is 
designed to meet the needs of insurance regulators, the primary users 
of insurance financial statements, and stresses the measurement of an 
insurer's ability to pay claims (remain solvent) in order to protect 
insureds. In contrast, GAAP provides guidance that businesses follow in 
preparing their general purpose financial statements, which provide 
users such as investors and creditors with useful information that 
allows them to assess a business' ongoing financial performance. 
However, inconsistent use of accounting methodologies by RRGs could 
affect the ability of nondomiciliary regulators to determine the 
financial condition of RRGs, especially since regulators are used to 
assessing traditional insurers that must file reports using 
SAP.[Footnote 62]

In addition, the statutes of each of the six domiciliary states allow 
RRGs, like other captive insurers, to modify whichever accounting 
principles they use by permitting the use of letters of credit (LOC) to 
meet statutory minimum capitalization requirements. Strictly speaking, 
neither GAAP nor SAP would permit a company to count an undrawn LOC as 
an asset because it is only a promise of future payment--the money is 
neither readily available to meet policyholder obligations nor is it 
directly in the possession of the company. In addition to allowing 
LOCs, according to a review of financial statements by NAIC, the 
leading domiciliary states that require RRGs to file financial 
statements using GAAP also allow RRGs to modify GAAP by permitting them 
to recognize surplus notes under capital and surplus. This practice is 
not ordinarily permitted by GAAP. A company filing under GAAP would 
recognize a corresponding liability for the surplus note and would not 
simply add it to the company's capital and surplus.[Footnote 63] See 
appendix III for more specific information on the differences between 
SAP and GAAP, including permitted modifications, and how these 
differences could affect assessments of a company's actual or risk- 
based capital. 

Variations in the use of accounting methods have consequences for 
nondomiciliary regulators who analyze financial reports submitted by 
RRGs and illustrate some of the regulatory challenges created by the 
absence of uniform standards. Most nondomiciliary states responding to 
our survey of all state regulators indicated that they performed only a 
limited review of RRG financial statements.[Footnote 64] To obtain more 
specific information about the impact of these differences, we 
contacted the six states--Pennsylvania, California, New York, 
Massachusetts, Texas, and Illinois--where RRGs collectively wrote 
almost half of their business in 2003 (see fig. 6). Regulators in 
Massachusetts and Pennsylvania reported that they did not analyze the 
financial reports and thus had no opinion about the impact of the 
accounting differences, but three of the other four states indicated 
that the differences resulted in additional work. Regulators from 
California and Texas told us that the use of GAAP, especially when 
modified, caused difficulties because insurance regulators were more 
familiar with SAP, which they also believed better addressed solvency 
concerns than GAAP. The regulator from Illinois noted that RRG annual 
statements were not marked as being filed based on GAAP and, when staff 
conducted their financial analyses, they took the time to disregard 
assets that would not qualify as such under SAP. The Texas regulator 
reported that, while concerned about the impact of the differences, his 
department did not have the staffing capability to convert the numbers 
for each RRG to SAP and, as a result, had to prioritize their efforts. 

Further, NAIC staff reported that the use by RRGs of a modified version 
of GAAP or SAP distorted the analyses they provided to state 
regulators. One of NAIC's roles is to help states identify potentially 
troubled insurers operating in their state by analyzing insurer 
financial reports with computerized tools to identify statistical 
outliers or other unusual data. In the past, we have noted that NAIC's 
solvency analysis is an important supplement to the overall solvency 
monitoring performed by states and can help states focus their 
examination resources on potentially troubled companies.[Footnote 65] 
NAIC uses Financial Analysis Solvency Tools (FAST), such as the ratios 
produced by the Insurance Regulatory Information System (IRIS) and the 
Insurer Profile Reports, to achieve these objectives and makes the 
results available to all regulators through a central 
database.[Footnote 66] However, NAIC analysts reported that differing 
accounting formats undermined the relative usefulness of these tools 
because the tools were only designed to analyze data extracted from 
financial reports based on SAP. Similarly, when we attempted to analyze 
some aspects of the financial condition of RRGs to compare them with 
traditional companies, we found that information produced under 
differing accounting principles diminished the usefulness of the 
comparison (see app. III). 

Lack of Uniform, Baseline Regulatory Standards Has Concerned Many 
Regulators: 

The lack of uniform, baseline regulatory standards for the oversight of 
RRGs contributed to the concerns of many state regulators, who did not 
believe the regulatory safeguards and protections built into LRRA (such 
as requiring RRGs to file annual financial statements with regulators 
and allowing regulators to file suit if they believe the RRG is 
financially unsound) were adequate.[Footnote 67] Only 8 of 42 
regulators who responded to our survey question about LRRA's regulatory 
protections indicated that they thought the protections were adequate 
(see fig. 7).[Footnote 68] Eleven of the 28 regulators who believed 
that the protections were inadequate or very inadequate focused on the 
lack of uniform, regulatory standards or the need for RRGs to meet 
certain minimum standards--particularly for minimum capital and surplus 
levels. In addition, 9 of the 28 regulators, especially those from 
California and New York, commented that they believed state regulators 
needed additional regulatory authority to supervise the RRGs in their 
states. While RRGs, like traditional insurers, can sell in any or all 
states, only the domiciliary regulator has any significant regulatory 
oversight. 

Figure 7: State Regulators' Opinion of the Adequacy of the Regulatory 
Protections or Safeguards Built into LRRA: 

[See PDF for image] 

Note: In addition, seven regulators responded that they had no opinion 
on this question, and one regulator did not respond at all. 

[End of figure] 

In addition, the regulators from the six leading domiciliary states-- 
Arizona, the District of Columbia, Hawaii, Nevada, South Carolina, and 
Vermont--did not agree on the adequacy of LRRA safeguards. For example, 
while the regulators from the District of Columbia, Hawaii, Nevada, and 
Vermont thought the protections adequate, the regulator from South 
Carolina reported that LRRA's safeguards were "neither adequate nor 
inadequate" because LRRA delegates the responsibility of establishing 
safeguards to domiciliary states, which can be either stringent or 
flexible in establishing safeguards. The other leading domiciliary 
state--Arizona--had not yet formed an opinion on the adequacy of LRRA's 
provisions. The regulator from Hawaii also noted that the effectiveness 
of the LRRA provisions was dependent upon the expertise and resources 
of the RRG's domiciliary regulator. 

While many regulators did not believe LRRA's safeguards were adequate, 
few indicated that they had availed themselves of the tools LRRA does 
provide nondomiciliary state regulators. These tools include the 
ability to request that a domiciliary state undertake a financial 
examination and the right to petition a court of "competent 
jurisdiction" for an injunction against an RRG believed to be in a 
hazardous financial condition. Recent cases involving state regulation 
of RRGs typically have centered on challenges to nondomiciliary state 
statutes that affect operations of the RRGs, rather than actions by 
nondomiciliary states challenging the financial condition of RRGs 
selling insurance in their states.[Footnote 69] Finally, in response to 
another survey question, nearly half of the regulators said they had 
concerns that led them to contact domiciliary state regulators during 
the 24 months preceding our survey, but only five nondomiciliary states 
indicated that they had ever asked domiciliary states to conduct a 
financial examination.[Footnote 70]

However, according to the survey, many state regulators availed 
themselves of the other regulatory safeguards that LRRA provides--that 
RRGs submit to nondomiciliary states feasibility or operational plans 
before they begin operations in those states and thereafter a copy of 
the same annual financial statements that the RRG submits to its 
domiciliary state.[Footnote 71] Almost all the state regulators 
indicated that they reviewed these documents to some extent, although 
almost half of the state regulators indicated that they provided these 
reports less review than those submitted by other nonadmitted 
insurers.[Footnote 72] In addition, nine states indicated that RRGs 
began to conduct business in their states before supplying them with 
copies of their plans of operations or feasibility studies, but most 
indicated that these occurrences were occasional. Similarly, 15 states 
identified RRGs that failed to provide required financial statements 
for review, but most of these regulators indicated that the failure to 
file was an infrequent occurrence.[Footnote 73]

Some Evidence Suggests That States Have Set Their Captive Regulatory 
Standards to Attract RRGs to Domicile in Their States: 

Some regulators, including those from New York, California, and Texas-
-states where RRGs collectively wrote about 26 percent of all their 
business but did not domicile--expressed concerns that domiciliary 
states were lowering their regulatory standards to attract RRGs to 
domicile in their states for economic development purposes. They 
sometimes referred to these practices as the "regulatory race to the 
bottom." RRGs, like other captives, can generate revenue for a 
domiciliary state's economy when the state taxes RRG insurance premiums 
or the RRG industry generates jobs in the local economy. The question 
of whether domiciliary states were competing with one another 
essentially was moot until about 1999, when more states began adopting 
captive laws. Until then, Vermont and Hawaii were two of only a few 
states that were actively chartering RRGs and through 1998 had 
chartered about 55 percent of all RRGs. However, between the beginning 
of 1999 and the end of 2004, they had chartered only 36 percent of all 
newly chartered RRGs.[Footnote 74]

The six leading domiciliary states actively market their competitive 
advantages on Web sites, at trade conferences, and through 
relationships established with trade groups. They advertise the 
advantages of their new or revised captive laws and most describe the 
laws as "favorable"; for example, by allowing captives to use letters 
of credit to meet their minimum capitalization requirements. Most of 
these states also describe their corporate premium tax structure as 
competitive and may describe their staff as experienced with or 
committed to captive regulation. Vermont emphasizes that it is the 
third-largest captive insurance domicile in the world and the number 
one in the United States, with an insurance department that has more 
than 20 years of experience in regulating RRGs. South Carolina, which 
passed its captive legislation in 2000, emphasizes a favorable premium 
tax structure and the support of its governor and director of insurance 
for its establishment as a domicile for captives. Arizona describes its 
state as "business friendly," highlighting the lack of premium taxes on 
captive insurers and the "unsurpassed" natural beauty of the state. 

However, in addition to general marketing, some evidence exists to 
support the concern that the leading domiciliary states are modifying 
policies and procedures to attract RRGs. We identified the following 
notable differences among the states, some of which reflect the 
regulatory practices and approaches of each state and others, statute: 

* Willingness to domicile vehicle service contract (VSC) providers: 
Several states, including California, New York, and Washington, 
questioned whether RRGs consisting of VSC providers should even qualify 
as RRGs and are concerned about states that allow these providers to 
form RRGs. VSC providers issue extended service contracts for the costs 
of future repairs to consumers (that is, the general public) who 
purchase automobiles. Until 2001, almost all of these RRGs were 
domiciled in Hawaii but after that date, all the new RRGs formed by VSC 
providers have domiciled in the District of Columbia and South 
Carolina.[Footnote 75] The Hawaii regulator said that the tougher 
regulations it imposed in 2001 (requiring that RRGs insuring VSC 
providers annually provide acceptable proof that they were financially 
capable of meeting VSC claims filed by consumers) dissuaded these 
providers from domiciling any longer in Hawaii. In addition, one of the 
leading domiciliary states, Vermont, refuses to domicile any of these 
RRGs because of the potential risk to consumers. Consumers who purchase 
these contracts, not just the RRG insureds, can be left without 
coverage if the RRG insuring the VSC provider's ability to cover VSC 
claims fails. (We discuss RRGs insuring service contract providers and 
consequences to insureds and consumers more fully later in this report.)

* Statutory minimum capitalization requirements: Differences in the 
minimum amount of capital and surplus (capitalization) each insurer 
must have before starting operations make it easier for smaller RRGs to 
domicile in certain states and reflect a state's attitude towards 
attracting RRGs. For example, in 2003, Vermont increased its minimum 
capitalization amount from $500,000 to $1 million--according to 
regulators, to ensure that only RRGs that are serious prospects, with 
sufficient capital, apply to be chartered in the state. On the other 
hand, effective in 2005, the District of Columbia lowered its minimum 
capitalization amount for a RRG incorporated as a stock insurer (that 
is, owned by shareholders who hold its capital stock) from $500,000 to 
$400,000 to make it easier for RRGs to charter there. 

* Corporate forms: In 2005, one of the six leading domiciliary states-
-the District of Columbia--enacted legislation that permits RRGs to 
form "segregated accounts." The other leading domiciliary states permit 
the formation of segregated accounts or "protected cells" for other 
types of captives but not for their RRGs. According to the District's 
statute, a captive insurer, including an RRG, may fund separate 
accounts for individual RRG members or groups of members with common 
risks, allowing members to segregate a portion of their risks from the 
risks of other members of the RRG.[Footnote 76] According to the 
District regulator, RRG members also would be required to contribute 
capital to a common account that could be used to cover a portion of 
each member's risk. The District regulator also noted that the 
segregated cell concept has never been tested in insolvency; as a 
result, courts have not yet addressed the concept that the cells are 
legally separate. 

* Willingness to charter entrepreneurial RRGs: RRGs may be formed with 
only a few members, with the driving force behind the formation being, 
for example, a service provider, such as the RRG's management company 
or a few members. These RRGs are referred to as "entrepreneurial" RRGs 
because their future success is often contingent on recruiting 
additional members as insureds. In 2004, South Carolina regulators 
reported they frequently chartered entrepreneurial RRGs to offset what 
they described as the "chicken and egg" problem--their belief that it 
can be difficult for RRGs to recruit new members without having the RRG 
already in place. Regulators in several other leading domiciliary 
states have reported they would be willing to charter such RRGs if 
their operational plans appeared to be sound but few reported having 
done so. However, regulators in Vermont said that they would not 
charter entrepreneurial RRGs because they often were created to make a 
profit for the "entrepreneur," rather than helping members obtain 
affordable insurance. (We discuss entrepreneurial RRGs later in the 
report.)

Finally, the redomiciling of three RRGs to two of the leading 
domiciliary states, while subject to unresolved regulatory actions in 
their original state of domicile, also provides some credibility to the 
regulators' assertions of "regulatory arbitrage." In 2004, two RRGs 
redomiciled to new states while subject to regulatory actions in their 
original states of domicile. One RRG, which had been operating for 
several years, redomiciled to a new state before satisfying the terms 
of a consent order issued by its original domiciliary state and without 
notifying its original state of domicile.[Footnote 77] Although the RRG 
satisfied the terms of the consent order about 3 months after it 
redomiciled, the regulator in the original domiciliary state reported 
that, as provided by LRRA, once redomiciled, the RRG had no obligation 
to do so. The second RRG, one that had been recently formed, was issued 
a cease and desist order by its domiciliary state because the 
regulators had questions about who actually owned and controlled the 
RRG. As in the first case, the original domiciliary state regulator 
told us that this RRG did not advise them that it was going to 
redomicile and, once redomiciled, was under no legal obligation to 
satisfy the terms of the cease and desist order. The redomiciling, or 
rather liquidation, of the third RRG is more difficult to characterize 
because its original state of domicile (Hawaii) allowed it to transfer 
some of its assets to a new state of domicile (South Carolina) after 
issuing a cease and desist order to stop it from selling unauthorized 
insurance products directly to the general public, thereby violating 
the provisions of LRRA.[Footnote 78] More specifically, Hawaii allowed 
the RRG to transfer its losses and related assets for its "authorized" 
lines of insurance to South Carolina and required the Hawaiian company 
to maintain a $1 million irrevocable LOC issued in favor of the 
insurance commissioner until such time as the "unauthorized" insurance 
matter was properly resolved. South Carolina permitted the owners of 
these assets to form a new RRG offering a similar line of coverage and 
use a name virtually identical to its predecessor in Hawaii. Had these 
RRGs been chartered as traditional insurance companies, they would not 
have had the ability to continue operating in their original state of 
domicile after redomiciling in another state without the original 
state's express consent. Because traditional companies must be licensed 
in each state in which they operate, the original state of domicile 
would have retained its authority to enforce regulatory actions. 

RRG Failures Have Raised Questions about the Sufficiency of LRRA 
Provisions for RRG Ownership, Control, and Governance: 

Because LRRA does not comprehensively address how RRGs may be owned, 
controlled, or governed, RRGs may be operated in ways that do not 
consistently protect the best interests of their insureds. For example, 
while self-insurance is generally understood as risking one's own money 
to cover losses, LRRA does not specify that RRG members, as owners, 
make capital contributions beyond their premiums or maintain any degree 
of control over their governing bodies (such as boards of directors). 
As a result, in the absence of specific federal requirements and using 
the latitude LRRA grants them, some leading domiciliary regulators have 
not required all RRG insureds to make at least some capital 
contribution or exercise any control over the RRG. Additionally, some 
states have allowed management companies or a few individuals to form 
what are called "entrepreneurial" RRGs. Consequently, some regulators 
were concerned that RRGs were being chartered primarily for purposes 
other than self-insurance, such as making a profit for someone other 
than the collective insureds. Further, LRRA does not recognize that 
separate companies typically manage RRGs. Yet, past RRG failures 
suggest that sometimes management companies have promoted their own 
interests at the expense of the insureds. Although LRRA does not 
address governance issues such as conflicts of interest between 
management companies and insureds, Congress previously has enacted 
safeguards to address similar issues in the mutual fund industry. 
Finally, some of these RRG failures have resulted in thousands of 
insureds and their claimants losing coverage, some of whom may not have 
been fully aware that their RRG lacked state insurance insolvency 
guaranty fund coverage or the consequences of lacking such coverage. 

While RRGs Are a Form of Self-Insurance, Not All RRG Insureds Are 
Equity Owners or Have the Ability to Exercise Control: 

While RRGs are a form of self-insurance on a group basis, LRRA does not 
require that RRG insureds make a capital investment in their RRG and 
provides each state considerable authority to establish its own rules 
on how RRGs will be chartered and regulated. Most of the regulators 
from the leading domiciliary states reported that they require RRGs to 
be organized so that all insureds make some form of capital 
contribution but other regulators do not, or make exceptions to their 
general approach.[Footnote 79] Regulators from Vermont and Nevada 
emphasized that it was important for each member to have "skin in the 
game," based on the assumption that members who make a contribution to 
the RRG's capital and surplus would have a greater interest in the 
success of the RRG. The regulator from Nevada added that if regulators 
permitted members to participate without making a capital contribution, 
they were defeating the spirit of LRRA. However, another of the leading 
domiciliary states, the District of Columbia, does not require insureds 
to make capital contributions as a condition of charter approval and 
has permitted several RRGs to be formed accordingly. The District 
regulator commented that LRRA does not require such a contribution and 
that some prospective RRG members may not have the financial ability to 
make a capital contribution. Further, despite Vermont's position that 
RRG members should make a capital contribution, the Vermont regulators 
said they occasionally waive this requirement under special 
circumstances; for example, if the RRG was already established and did 
not need any additional capital. In addition, several of the leading 
domiciliary states, including Arizona, the District of Columbia, and 
Nevada, would consider allowing a nonmember to provide an LOC to fund 
the capitalization of the RRG. 

However, as described by several regulators, including those in Hawaii 
and South Carolina, even when members do contribute capital to the RRG, 
the amount contributed can vary and be quite small. For instance, an 
investor with a greater amount of capital, such as a hospital, could 
initially capitalize an RRG, and expect smaller contributions from 
members (for example, doctors) with less capital. Or, in an RRG largely 
owned by one member, additional members might be required only to make 
a token investment, for example, $100 or less. As a result, an 
investment that small would be unlikely to motivate members to feel 
like or behave as "owners" who were "self-insuring" their risks. 

LRRA also does not have a requirement that RRG insureds retain control 
over the management and operation of their RRG. However, as discussed 
previously, the legislative history indicates that some of the act's 
single-state regulatory framework and other key provisions were 
premised not only on ownership of an RRG being closely tied to the 
interests of the insureds, but also that the insureds would be highly 
motivated to ensure proper management of the RRG. Yet, in order to make 
or direct key decisions about a company's operations, the insureds 
would have to be able to influence or participate in the company's 
governing body (for example, a board of directors).[Footnote 80] A 
board of directors is the focal point of an insurer's corporate 
governance framework and ultimately should be responsible for the 
performance and conduct of the insurer.[Footnote 81] Governance is the 
manner in which the boards of directors and senior management oversee a 
company, including how they are held accountable for their 
actions.[Footnote 82]

Most leading state regulators said they expect members of RRGs to exert 
some control over the RRG by having the ability to vote for directors, 
even though these rights sometimes vary in proportion to the size of a 
member's investment in the RRG or by share class.[Footnote 83] Most of 
the leading state regulators generally define "control" to be the power 
to direct the management and policies of an RRG as exercised by an 
RRG's governing body, such as its board of directors. However, 
regulators from the District of Columbia asserted that they permit RRGs 
to issue nonvoting shares to their insureds because some members are 
capable of making a greater financial contribution than others and, in 
exchange for their investment, will seek greater control over the RRG. 
The regulators noted that allowing such arrangements increases the 
availability of insurance and has no adverse effect on the financial 
solvency of the RRG. Further, the District of Columbia permits 
nonmembers (that is, noninsureds) to appoint or vote for directors. In 
addition, we found that even regulators who expect all RRG members to 
have voting rights (that is, at a minimum a vote for directors) 
sometimes make exceptions. For example, an RRG domiciled in Vermont was 
permitted to issue shares that did not allow insureds to vote for 
members of the RRG's governing body. The Vermont regulators reported 
that the attorney forming the RRG believed issuing the shares was 
consistent with the department's position that RRG members should have 
"voting rights" because under Vermont law all shareholders are 
guaranteed other minimal voting rights.[Footnote 84]

While most regulators affirmed that they expect RRG members to own and 
control their RRGs, how these expectations are fulfilled is less clear 
when an organization, such as an association, owns an RRG. Four states-
-Arizona, District of Columbia, South Carolina, and Vermont--reported 
that they have chartered RRGs that are owned by a single or multiple 
organizations, rather than individual persons or businesses.[Footnote 
85] One of these states--the District of Columbia--permits noninsureds 
to own the organizations that formed the RRG. However, the District 
regulator said that while the noninsureds may own the voting or 
preferred stock of the association, they do not necessarily have an 
interest in controlling the affairs of the RRG. In addition, Arizona 
has permitted three risk purchasing groups (RPGs) to own one 
RRG.[Footnote 86] While the three RPGs, organized as domestic 
corporations in another state, collectively have almost 8,000 
policyholders, four individuals, all of whom are reported to be RRG 
insureds by the Arizona regulator, are the sole owners of all three 
RPGs.[Footnote 87]

Regulators Expressed Concerns That Some RRGs Might Be Operated to Make 
Money for an Entrepreneur, Rather Than to Provide Self-Insurance: 

The chartering of an "entrepreneurial" RRG--which regulators generally 
define as formed by an individual member or a service provider, such as 
a management company, for the primary purpose of making profits for 
themselves--has been controversial. According to several regulators, 
entrepreneurial RRGs are started with a few members and need additional 
members to remain viable. The leading domiciliary regulators have taken 
very different positions on entrepreneurial RRGs, based on whether they 
thought the advantages entrepreneurs could offer (obtaining funding and 
members) outweighed the potential adverse influence the entrepreneur 
could have on the RRG. We interviewed regulators from the six leading 
domiciliary states to obtain their views on entrepreneurial RRGs. In 
2004, South Carolina regulators reported they firmly endorsed 
chartering entrepreneurial RRGs because they believed that already 
chartered RRGs stand a better chance of attracting members than those 
in the planning stages.[Footnote 88] They cited cases of 
entrepreneurial RRGs they believe have met the insurance needs of 
nursing homes and taxicab drivers. However, regulators from Vermont and 
Hawaii had strong reservations about this practice because they believe 
the goal of entrepreneurs is to make money for themselves--and that the 
pursuit of this goal could undermine the financial integrity of the RRG 
because of the adverse incentives that it creates. Vermont will not 
charter entrepreneurial RRGs and has discouraged them from obtaining a 
charter in Vermont by requiring RRGs (before obtaining their charter) 
to have a critical mass of members capable of financing their own RRG. 
In addition, the Vermont regulators said they would not permit an 
entrepreneur, if just a single owner, to form an RRG as a means of 
using LRRA's regulatory preemption to bypass the licensing requirements 
of the other states in which it planned to operate. Two of the other 
leading domiciliary states--Arizona and Nevada--were willing to charter 
entrepreneurial RRGs, providing they believed that the business plans 
of the RRGs were sound.[Footnote 89]

Finally, some of the leading state regulators that have experience with 
chartering entrepreneurial RRGs told us that they recognized that the 
interests of the RRG insureds have to be protected and that they took 
measures to do so. For example, the regulators from South Carolina said 
that even if one member largely formed and financed an RRG, they would 
try to ensure that the member would not dominate the operations. 
However, they admitted that the member could do so because of his or 
her significant investment in the RRG. Alternatively, the regulator 
from Hawaii reported that the state's insurance division, while 
reluctant to charter entrepreneurial RRGs, would do so if the RRG 
agreed to submit to the division's oversight conditions. For example, 
to make sure service providers are not misdirecting money, the division 
requires entrepreneurial RRGs to submit copies of all vendor contracts. 
The Hawaii regulator also told us that the insurance division requires 
all captives to obtain the insurance commissioner's approval prior to 
making any distributions of principal or interest to holders of surplus 
notes. However, he concluded that successful oversight ultimately 
depended on the vigilance of the regulator and the willingness of the 
RRG to share documentation and submit to close supervision. 

LRRA Lacks Governance Standards to Protect RRG Insureds from Management 
Companies with Potential Conflicts of Interest: 

LRRA imposes no governance requirements that could help mitigate the 
risk to RRG insureds from potential abuses by other interests, such as 
their management companies, should they choose to maximize their 
profits at the expense of the best interests of the RRG insureds. 
Governance rules enhance the independence and effectiveness of 
governing bodies, such as boards of directors, and improve their 
ability to protect the interests of the company and insureds they 
serve. Unlike a typical company where the firm's employees operate and 
manage the firm, an RRG usually is operated by a management company and 
may have no employees of its own. However, while management companies 
and other service providers generally provide valuable services to 
RRGs, the potential for abuse arises if the interests of a management 
company are not aligned with the interests of the RRG insureds to 
consistently obtain self-insurance at the most affordable price 
consistent with long-term solvency. 

These inherent conflicts of interest are exemplified in the 
circumstances surrounding 10 of 16 RRG failures that we 
examined.[Footnote 90] For example, members of the companies that 
provided management services to Charter Risk Retention Group Insurance 
Company (Charter) and Professional Mutual Insurance Company Risk 
Retention Group (PMIC) also served as officers of the RRGs' boards of 
directors, which enabled them to make decisions that did not promote 
the welfare of the RRG insureds. In other instances, such as the 
failure of Nonprofits Mutual Risk Retention Group, Inc. (Nonprofits), 
the management company negotiated terms that made it difficult for the 
RRG to terminate its management contract and place its business 
elsewhere. Regulators knowledgeable about these and other failures 
commented that the members, while presumably self-insuring their risks, 
were probably more interested in satisfying their need for insurance 
than actually running their own insurance company. 

The 2003 failure of three RRGs domiciled in Tennessee--American 
National Lawyers Insurance Reciprocal Risk Retention Group (ANLIR), 
Doctors Insurance Reciprocal Risk Retention Group (DIR), and The 
Reciprocal Alliance Risk Retention Group (TRA)--further illustrates the 
potential risks and conflicts of interest associated with a management 
company operating an RRG.[Footnote 91] In pending litigation, the State 
of Tennessee's Commissioner of Commerce and Insurance, as receiver for 
the RRGs, has alleged that the three RRGs had common characteristics, 
such as (1) being formed by Reciprocal of America (ROA), a Virginia 
reciprocal insurer, which also served as the RRGs' reinsurance company; 
(2) having a management company, The Reciprocal Group (TRG), which also 
served as the management company and attorney-in-fact for ROA; (3) 
receiving loans from ROA, TRG, and their affiliates; and (4) having 
officers and directors in common with ROA and TRG.[Footnote 92] The 
receiver has alleged that through the terms of RRGs' governing 
instruments, such as its bylaws, management agreements with TRG (which 
prohibited the RRGs from replacing TRG as their exclusive management 
company for as long as the loans were outstanding), and the common 
network of interlocking directors among the companies, TRG effectively 
controlled the boards of directors of the RRGs in a manner inconsistent 
with the best interests of the RRGs and their insureds.[Footnote 93] As 
alleged in the complaint filed by the Tennessee regulator, one such 
decision involved a reinsurance agreement, in which the RRGs ceded 90- 
100 percent of their risk to ROA with a commensurate amount of 
premiums--conditions that according to the regulator effectively 
prevented the RRGs from ever operating independently or retaining 
sufficient revenue to pay off their loans with ROA and TRG and thus 
remove TRG as their management company.[Footnote 94] Within days after 
the Commonwealth of Virginia appointed a receiver for the 
rehabilitation or liquidation of ROA and TRG, the State of Tennessee 
took similar actions for the three RRGs domiciled in 
Tennessee.[Footnote 95]

The following failures of other RRGs also illustrate behavior 
suggesting that management companies and affiliated service providers 
have promoted their own interests at the expense of the RRG insureds: 

* According to the Nebraska regulators, Charter failed in 1992 because 
its managers, driven to achieve goals to maximize their profits, 
undercharged on insurance rates in an effort to sell more policies. One 
board officer and a company manager also held controlling interests in 
third-party service providers, including the one that determined if 
claims should be paid. Further, the board officer and a company 
manager, as well as the RRG, held controlling interests in the RRG's 
reinsurance company. A Nebraska regulator noted that when a reinsurance 
company is affiliated with the insurer it is reinsuring: (1) the 
reinsurer's incentive to encourage the insurer to adequately reserve 
and underwrite is reduced and (2) the insurer also will be adversely 
affected by any unprofitable risk it passes to the reinsurer. 

* PMIC, which was domiciled in Missouri and formed to provide medical 
malpractice insurance coverage for its member physicians, was declared 
insolvent in 1994. The RRG's relationship with the companies that 
provided its management services undermined the RRG in several ways. 
The president of PMIC was also the sole owner of Corporate Insurance 
Consultants (CIC), a company with which PMIC had a marketing service 
and agency agreement. As described in the RRG's examination reports, 
the RRG paid CIC exorbitant commissions for services that CIC failed to 
provide, but allowed CIC to finance collateral loans made by the 
reinsurance company to CIC. In turn, CIC had a significant ownership 
stake in the RRG's reinsurance company, which also provided PMIC with 
all of its personnel. The reinsurer's own hazardous financial condition 
resulted in the failure of PMIC. 

* In the case of Nonprofits, Vermont regulators indicated that 
essentially the excessive costs of its outsourced management company 
and outsourced underwriting and claims operations essentially 
contributed to its 2000 failure. The regulators said that the 
management company was in a position to exert undue influence over the 
RRG's operations because the principals of the management company 
loaned the RRG its start-up capital in the form of irrevocable LOCs. In 
addition to charging excessive fees, the management company also locked 
the RRG into a management contract that only allowed the RRG to cancel 
the contract 1 year before its expiration. If the RRG did not, the 
contract would automatically renew for another 5 years, a requirement 
of which the RRG insureds said they were unaware. 

Although LRRA has no provisions that address governance controls, 
Congress has acted to provide such controls in similar circumstances in 
another industry. In response to conditions in the mutual fund 
industry, Congress passed the Investment Company Act of 1940 (1940 
Act). The 1940 Act, as implemented by the Securities and Exchange 
Commission (SEC), establishes a system of checks and balances that 
includes participation of independent directors on mutual fund boards, 
which oversee transactions between the mutual fund and its investment 
adviser.[Footnote 96] A mutual fund's structure and operation, like 
that of an RRG, differs from that of a traditional corporation. In a 
typical corporation, the firm's employees operate and manage the firm; 
the corporation's board of directors, elected by the corporation's 
stockholders, oversees its operation. Unlike a typical corporation, but 
similar to many RRGs, a typical mutual fund has no employees and 
contracts with another party, the investment adviser, to administer the 
mutual fund's operations. 

Recognizing that the "external management" of most mutual funds 
presents inherent conflicts between the interests of the fund 
shareholders and those of the fund's investment adviser, as well as 
potential for abuses of fund shareholders, Congress included several 
safeguards in the 1940 Act. For example, with some exceptions, the act 
requires that at least 40 percent of the board of directors of a mutual 
fund be disinterested (that is, that directors be independent of the 
fund's investment adviser as well as certain other persons having 
significant or professional relationships with the fund) to help ensure 
that the fund is managed in the best interest of its 
shareholders.[Footnote 97] The 1940 Act also regulates the terms of 
contracts with investment advisers by imposing a maximum contract term 
and by guaranteeing the board's and the shareholders' ability to 
terminate an investment adviser contract.[Footnote 98] The act also 
requires that the terms of any contract with the investment adviser and 
the renewal of such contract be approved by a majority of directors who 
are not parties to the contract or otherwise interested persons of the 
investment adviser. Further, the 1940 Act imposes a fiduciary duty upon 
the adviser in relation to its level of compensation and provides the 
fund and its shareholders with the right to sue the adviser should the 
fees be excessive.[Footnote 99] The management controls imposed on 
mutual fund boards do not supplant state law on duties of "care and 
loyalty" that oblige directors to act in the best interests of the 
mutual fund, but enhance a board's ability to perform its 
responsibilities consistent with the protection of investors and the 
purposes of the 1940 Act. 

RRG Members May Not Realize They Lack Guaranty Fund Protection: 

In addition to lacking comprehensive provisions for ownership, control, 
and governance of RRGs, LRRA does not mandate that RRGs disclose to 
their insureds that they lack state insurance insolvency guaranty fund 
protection. LRRA's legislative history indicates that the prohibition 
on RRGs participating in state guaranty funds (operated to protect 
insureds when traditional insurers fail) stemmed, in part, from a 
belief that the lack of protection would help motivate RRG members to 
manage the RRG prudently. LRRA does provide nondomiciliary state 
regulators the authority to mandate the inclusion of a specific 
disclosure, which informs RRG insureds that they lack guaranty fund 
coverage, on insurance policies issued to residents of their state (see 
fig. 8).[Footnote 100] However, LRRA does not provide nondomiciliary 
states with the authority to require the inclusion of this disclaimer 
in policy applications or marketing materials. For example, of 40 RRGs 
whose Web sites we were able to identify, only 11 disclosed in their 
marketing material that RRGs lack guaranty fund protection. In 
addition, 11 of the RRGs omitted the words "Risk Retention Group" from 
their names.[Footnote 101]

Figure 8: Permitted Wording of Guaranty Fund Disclosure in LRRA: 

[See PDF for image] 

[End of figure] 

All of the six leading domiciliary states have adopted varying 
statutory requirements that RRGs domiciled in their states include the 
disclosure in their policies, regardless of where they operate. The 
statutes of Hawaii, South Carolina, and the District of Columbia 
require that the disclosure be printed on applications for insurance, 
as well as on the front and declaration page of each policy. By 
requiring that the disclosure be printed on insurance applications, 
prospective RRG insureds have a better chance of understanding that 
they lack guaranty fund protection. Regulators in South Carolina, based 
on their experience with the failure of Commercial Truckers RRG in 
2001, also reported that they require insureds, such as those of 
transportation and trucking RRGs, to place their signature beneath the 
disclosure. The regulators imposed this additional requirement because 
they did not believe that some insureds would be as likely to 
understand the implications of not having guaranty fund coverage as 
well as other insureds (for example, hospital conglomerates). In 
contrast, the statutes of Arizona and Vermont require only that the 
disclosure be printed on the insurance policies. The six leading 
domiciliary state regulators had mixed views on whether the contents of 
the disclosure should be enhanced, but none recommended that LRRA be 
changed to permit RRGs to have guaranty fund protection. 

It is unclear whether RRG insureds who obtain insurance through 
organizations that own RRGs understand that they will not have guaranty 
fund coverage. Four states--Arizona, the District of Columbia, South 
Carolina, and Vermont--indicated that they have chartered RRGs owned by 
single organizations. When an organization is the insured of the RRG, 
the organization receives the insurance policy with the disclosure 
about lack of guaranty fund protection. Whether the organization's 
members, who are insured by the RRG, understand that they lack guaranty 
fund coverage is less clear. The Vermont regulators indicated that 
members typically are not advised that they lack guaranty fund coverage 
before they receive the policy. Thus, the regulators recommended that 
applications for insurance should contain the disclosure as well. The 
Arizona regulator reported that the insurance applications signed by 
the insureds of the Arizona-domiciled RRG owned by three RPGs did not 
contain a disclosure on the lack of guaranty fund coverage, although 
the policy certificates did. Further, he reported that the practices of 
RPGs were beyond his department's jurisdiction and that he does not 
review them. 

Not understanding that RRG insureds are not protected by guaranty funds 
has serious implications for RRG members and their claimants, who have 
lost coverage as a result of RRG failures. For example, of the 21 RRGs 
that have been placed involuntarily in liquidation, 14 either have or 
had policyholders whose claims remain or are likely to remain partially 
unpaid (see app. IV).[Footnote 102] Member reaction to the failure of 
the three RRGs domiciled in Tennessee further illustrates that the 
wording and the placement of the disclosure may be inadequate.[Footnote 
103] In 2003, an insurance regulator from Virginia, a state where many 
of the RRG insureds resided, reported that he received about 150-200 
telephone calls from the insureds of these RRGs and the insureds did 
not realize they lacked "guaranty fund" coverage, asking instead why 
they didn't have "back-up" insurance when their insurance company 
failed. He explained that the insureds were "shocked" to discover they 
were members of an RRG, rather than a traditional insurance company and 
that they had no guaranty fund coverage. According to the regulator, 
they commented, "Who reads their insurance policies?" Regulators in 
Tennessee also noted that insureds of the RRGs, including attorneys, 
hospitals, and physicians did not appear to understand the implications 
of self-insuring their risks and the lack of guaranty fund coverage. In 
2004, the State of Tennessee estimated that the potential financial 
losses from these failures to the 50,000 or so hospitals, doctors, and 
attorneys that were members of the Tennessee RRGs could exceed $200 
million, once the amount of unpaid claims were fully known.[Footnote 
104]

Other regulators, including those in Missouri, in response to our 
survey, and New York, in an interview, also expressed concern that some 
RRG members might not fully understand the implications of a lack of 
guaranty fund protection and were not the "sophisticated" consumers 
that they believe may have been presumed by LRRA. In addition, in 
response to our survey, regulators from other states including New 
Mexico and Florida expressed specific concerns about third-party 
claimants whose claims could go unpaid when an RRG failed and the 
insured refused or was unable to pay claims. The Florida regulator 
noted that the promoters of the RRG could accentuate the "cost savings" 
aspect of the RRG at the expense of explaining the insured's potential 
future liability in the form of unpaid claims due to the absence of 
guaranty funds should the RRG fail. In addition, regulators who thought 
that protections in LRRA were inadequate, such as those in Wyoming, 
Virginia, and Wisconsin, tended to view lack of guaranty fund 
protection as a primary reason for developing and implementing more 
uniform regulatory standards or providing nondomiciliary states greater 
regulatory authority over RRGs. 

Lack of Guaranty Fund Protection Also Has Consequences for Consumers 
Who Purchase Extended Service Contracts: 

Lack of guaranty fund protection also can have unique consequences for 
consumers who purchase extended service contracts from service contract 
providers. Service contract providers form RRGs to insure their ability 
to pay claims on extended service contracts--a form of insurance also 
known as contractual liability insurance--and sell these contracts to 
consumers.[Footnote 105] In exchange for the payment (sometimes 
substantial) made by the consumer, the service contract provider 
commits to performing services--for example, paying for repairs to an 
automobile. Service contract providers may be required to set aside 
some portion of the money paid by consumers in a funded "reserve 
account" to pay resulting claims and may have to buy insurance (for 
example, from the RRG they have joined) to guarantee their ability to 
pay claims.[Footnote 106] However, potential problems result from the 
perception of consumers that what they have purchased is insurance, 
since the service contract provider pays for repairs or other service, 
when in fact it is not.[Footnote 107] Only the service contract 
provider purchases insurance, the consumer signs a contract for 
services. 

The failure of several RRGs, including HOW Insurance Company RRG (HOW) 
in 1994 and National Warranty RRG in 2003, underscores the consequences 
that failures of RRGs that insure service contract providers can have 
on consumers: 

* In 1994, the Commonwealth of Virginia liquidated HOW and placed its 
assets in receivership. This RRG insured the ability of home builders 
to fulfill contractual obligations incurred by selling extended service 
contracts to home buyers. While settled out of court, the Commonwealth 
of Virginia asserted that the homeowners who purchased the contracts 
against defects in their homes had been misled into believing that they 
were entitled to first-party insurance benefits--that is, payment of 
claims.[Footnote 108] A Virginia regulator said that while his 
department received few calls from the actual insureds (that is, the 
home builders) at the time of failure, they received many calls from 
home owners who had obtained extended service contracts when they 
purchased their home and thought they were insured directly by the RRG. 

* In 2003, National Warranty Insurance RRG failed, leaving behind 
thousands of customers with largely worthless vehicle service contracts 
(VSCs). This RRG, domiciled in the Cayman Islands, insured the ability 
of service contract providers to honor contractual liabilities for 
automobile repairs. Before its failure, National Warranty insured at 
least 600,000 VSCs worth tens of millions of dollars. In 2003, the 
liquidators of National Warranty estimated that losses could range from 
$58 to $74 million.[Footnote 109] National Warranty's failure also 
raised the question of whether RRGs were insuring consumers directly, 
which LRRA prohibits--for example, because the laws of many states, 
including Texas, require that the insurance company become directly 
responsible for unpaid claims in the event a service contract provider 
failed to honor its contract.[Footnote 110]

The failure of National Warranty also raised the question of whether 
RRGs should insure service contract providers at all because of the 
potential direct damage to consumers. Several regulators, including 
those in California, Wisconsin, and Washington, went even further. In 
response to our survey, they opined that LRRA should be amended to 
preclude RRGs from offering "contractual liability" insurance because 
such policies cover a vehicle service contract provider's financial 
obligations to consumers.[Footnote 111] At a minimum, regulators from 
New York and California, in separate interviews, recommended that 
consumers who purchase extended service contracts insured by RRGs at 
least be notified in writing that the contracts they purchase were not 
insurance and would not qualify for state guaranty fund coverage. 

Conclusions: 

In establishing RRGs, Congress intended to alleviate a shortage of 
affordable commercial liability insurance by enabling commercial 
entities to create their own insurance companies to self-insure their 
risks on a group basis. RRGs, as an industry, according to most state 
insurance regulators, have fulfilled this vision--and the intent of 
LRRA--by increasing the availability and affordability of insurance for 
members that experienced difficulty in obtaining coverage. While 
constituting only a small portion of the total liability insurance 
market, RRGs have had a consistent presence in this market over the 
years. However, the number of RRGs has increased dramatically in recent 
years in response to recent shortages of liability insurance. While we 
were unable to evaluate the merits of individual RRGs, both state 
regulators and advocates of the RRG industry provided specific examples 
of how they believe RRGs have addressed shortages of insurance in the 
marketplace. This ability is best illustrated by the high number of 
RRGs chartered over the past 3 years to provide medical malpractice 
insurance, a product which for traditional insurers historically has 
been subject to high or unpredictable losses with resulting failures. 

However, the regulation of RRGs by a single state, in combination with 
the recent increase in the number of states new to domiciling RRGs, the 
increase in the number of RRGs offering medical malpractice insurance, 
and a wide variance in regulatory practices, has increased the 
potential for future solvency risks. As a result, RRG members and their 
claimants could benefit from greater regulatory consistency. Insurance 
regulators have recognized the value of having a consistent set of 
regulatory laws, regulations, practices, and expertise through the 
successful implementation of NAIC's accreditation program for state 
regulators of multistate insurance companies. Vermont and NAIC 
negotiated the relaxation of significant parts of the accreditation 
standards for RRGs because it was unclear how the standards, designed 
for traditional companies, applied to RRGs. However, this agreement 
allowed states chartering RRGs as captives considerable latitude in 
their regulatory practices, even though most RRGs were multistate 
insurers, raising the concerns of nondomiciliary states. With more RRGs 
than ever before and with a larger number of states competing to 
charter them, regulators, working through NAIC, could develop a set of 
comprehensive, uniform, baseline standards for RRGs that would provide 
a level of consistency that would strengthen RRGs and their ability to 
meet the intent of LRRA. While the regulatory structure applicable to 
RRGs need not be identical to that used for traditional insurance 
companies, uniform, baseline regulatory standards could create a more 
transparent and protective regulatory environment, enhancing the 
financial strength of RRGs and increasing the trust and confidence of 
nondomiciliary state regulators. These standards could include such 
elements as the use of a consistent accounting method, disclosing 
relationships with affiliated businesses as specified by NAIC's Model 
Insurance Holding Company System Regulatory Act, and the qualifications 
and number of staff that insurance departments must have available to 
charter RRGs. These standards could reflect the regulatory best 
practices of the more experienced RRG regulators and address the 
concerns of the states where RRGs conduct the majority of their 
business. Further, such standards could reduce the likelihood that RRGs 
would practice regulatory arbitrage, seeking departments with the most 
relaxed standards. While it may not be essential for RRGs to follow all 
the same rules that traditional insurers follow, it is difficult to 
understand why all RRGs and their regulators, irrespective of where 
they are domiciled, should not conform to a core set of regulatory 
requirements. Developing and implementing such standards would 
strengthen the foundation of LRRA's flexible framework for the 
formation of RRGs. 

LRRA's provisions for the ownership, control, and governance of RRGs 
may not be sufficient to protect the best interests of the insureds. 
While acknowledging that LRRA has worked well to promote the formation 
of RRGs in the absence of uniform, baseline standards, this same 
flexibility has left some RRG insureds vulnerable to misgovernance. In 
particular, how RRGs are capitalized is central to concerns of 
experienced regulators about the chartering of entrepreneurial RRGs 
because a few insureds or service providers, such as management 
companies, that provide the initial capital also may retain control 
over the RRG to benefit their personal interests. Further, RRGs, like 
mutual fund companies, depend on management companies to manage their 
affairs, but RRGs lack the federal protections Congress and SEC have 
afforded mutual fund companies. As evidenced by the circumstances 
surrounding many RRG failures, the interests of management companies 
inherently may conflict with the fundamental interests of RRGs--that 
is, obtaining stable and affordable insurance. Moreover, these 
management companies may have the means to promote their own interests 
if they exercise effective control over an RRG's board of directors. 
While RRGs may need to hire a management company to handle their day- 
to-day operations, principles drawn from legislation such as the 
Investment Company Act of 1940 would strongly suggest that an RRG's 
board of directors would have a substantial number of independent 
directors to control policy decisions. In addition, these standards 
would strongly suggest that RRGs retain certain rights when negotiating 
the terms of a management contract. Yet, LRRA has no provisions that 
establish the insureds' authority over management. Without these 
protections, RRG insureds and their third-party claimants are uniquely 
vulnerable to abuse because they are not afforded the oversight of a 
multistate regulatory environment or the benefits of guaranty fund 
coverage. Nevertheless, we do not believe that RRGs should be afforded 
the protection of guaranty funds. Providing such coverage could further 
reduce any incentives insureds might have to participate in the 
governance of their RRG and at the same time allow them access to funds 
supplied by insurance companies that do not benefit from the regulatory 
preemption. On the other hand, RRG insureds have a right to be 
adequately informed about the risks they could incur before they 
purchase an insurance policy. Further, consumers who purchase extended 
service contracts (which take on the appearance of insurance) from RRG 
insureds likewise have a right to be informed about these risks. The 
numerous comments that regulators received from consumers affected by 
RRG failures illustrate how profoundly uninformed the consumers were. 

Finally, while opportunities exist to enhance the safeguards in LRRA, 
we note again the affirmation provided by most regulators responding to 
our survey--that RRGs have increased the availability and affordability 
of insurance. That these assertions often came from regulators who also 
had concerns about the adequacy of LRRA's regulatory safeguards 
underscores the successful track record of RRGs as a self-insurance 
mechanism for niche groups. However, as the RRG