By Fran Roggenbaum, Esq.
Shocking premium increases, severely diminished availability, strained insurer capacity. Not since the 1970s has Pennsylvania experienced a medical malpractice insurance crisis of such enormous proportions. Then and now, efforts at tort reform present the opportunity for long-term benefits, but have not brought insurers back to the marketplace.
In response to this crisis of cost and availability, a number of alternative risk mechanisms are emerging, including a domestic reciprocal exchange, risk retention groups (RRGs) and captives. What are these alternatives and how do they compare to traditional insurance? What should health care providers expect from participation in an alternative risk mechanism?
A reciprocal exchange that is licensed in Pennsylvania either as a domestic or admitted insurer is most similar to traditional insurance. For example, an exchange’s premium rates, capitalization levels and trade practices are regulated under Pennsylvania law in the same manner as a stock insurer, and insureds of an exchange qualify for protection under the Pennsylvania Guaranty Fund. Moreover, an exchange is an “approved” insurer for providing “basic limits” coverage required by Act 13 of 2002 (MCARE Act). And, unless an exchange issues “assessable” policies and/or requires a participation commitment, an insured is free to move its insurance coverage from the exchange at any time with no ongoing funding requirements beyond insurance premiums already paid.
Reciprocal exchanges differ from traditional insurers in certain aspects of start-up, funding and operations. For example, while a stock insurer can become licensed prior to obtaining any applications for insurance coverage, Pennsylvania law requires an exchange to have applications from at least 100 “separate risks” in order to obtain a license.
In addition, many start-up exchanges require initial subscribers (policyholders of an exchange) to make capital contributions in addition to the payment of premiums for insurance coverage. Capital contributions also may be required from insureds who subscribe for a certain period after start-up of an exchange. Such contributions may be returned to current or past subscribers when approved by the exchange (but, generally, not until the exchange achieves profitability and the funds are no longer needed to support existing insurance business or anticipated growth).
Finally, exchanges traditionally have no employees. Instead, the exchange contracts with a separate entity—an “attorney-in-fact”—to manage the insurance operations of the exchange. Current insureds, as subscribers to the exchange, have the opportunity to periodically vote on major operational or transactional decisions, but have little or no input on day-to-day operations of the exchange.
The “rules” for a particular exchange may differ and health care providers who are considering participation in an exchange should consider the following:
• The level of capital contributions, if any, required from subscribers.
• Whether the exchange intends to issue “assessable” policies to provide for contingent funding liability from subscribers.
• Whether subscribers must commit to buying insurance from the exchange for a specified period.
• The adequacy of capitalization and experience of management, especially if subscribers must commit to buying insurance for several years.
• What provisions exist for subscribers to be eligible to receive a refund of any required capital contributions.
This and other information regarding subscriber rights and obligations should be should be set forth in the organizational documents of the exchange and/or in subscriber agreements.
Risk Retention Groups
An RRG is an insurance company formed and operated under provisions of the Federal Liability Risk Retention Act of 1986 (LRRA), which was passed in response to the commercial liability insurance crisis of the mid-1980s. Its intent was to increase the availability of commercial liability insurance by preempting most state insurance regulations for groups of insurance buyers that meet certain requirements.
Under the LRRA, insurance buyers with similar or related liability exposures are permitted to form an insurance company (stock, mutual or exchange) in any state in the U.S. As long as the insurer is owned by its insureds and writes only certain lines of commercial liability insurance or reinsurance, the insurer can then sell insurance in any other state by merely “registering” with the state as an RRG. (Since registration does not involve a state’s approval or licensing, there is no Guaranty Fund protection for insureds in registered states.) In addition to exemption from multi-state licensing requirements, registered RRGs are exempt from virtually all state insurance regulatory requirements, including rate, financial and trade practices regulations.
Most of the newly forming medical malpractice RRGs are licensed under the captive insurer laws of Vermont or South Carolina (two of the more favorable “on-shore” jurisdictions for captive formation with respect to both flexibility of captive regulation and strength of captive services). Captive laws frequently permit lower capitalization than for traditional insurers and are more lenient as to what qualifies for permissible capital and surplus. For example, letters of credit qualify in some states. While RRGs normally must meet the capitalization requirements only of the state of formation, an RRG will qualify as an “approved” basic limits carrier in Pennsylvania only if it meets Pennsylvania’s statutory minimum capital and surplus requirements for liability insurers, currently $1,125,000.
Similar to an exchange, RRGs require participants to make capital contributions in addition to the payment of premiums for insurance coverage. Returns or dividends on these contributions may be paid to participants only if, and when, approved by the RRG. In addition, most RRGs require a participation commitment of three to five years. Finally, RRGs often have no employees but are operated by a separate management company under contract to the RRG.
Where RRGs differ from traditional insurers and exchanges is in the ownership of the RRG and the management and funding obligations of the insureds. As owners of an RRG, the insureds are ultimately responsible for all management and operational decisions of the insurer, including the assurance of adequate funding for (1) all expenses of the RRG (e.g., for management services, claims-handling, risk management, actuarial services, reinsurance premiums, financial reporting requirements, etc.) as well as (2) the claims costs for all participants up to the attachment point of any reinsurance coverage. Each participant must pay its fair share of the total operational and claims costs of all participants, and the commitment of all participants to loss and expense management is vital to controlling the cost of participation in an RRG.
Thus, RRGs provide a formalized way of self-funding the group’s losses, with the added benefit of providing direct access to reinsurance to limit loss exposures. Health care providers who establish Self-Insurance Trusts to meet Pennsylvania mandates do not have access to the reinsurance mechanism since reinsurance may be sold only to insurance companies. Nonetheless, because the reinsurance market also is experiencing an availability and affordability “crunch,” newly forming RRGs should expect both high attachment points and costs for any available reinsurance.
As part of participants’ management and operational obligations, RRGs often establish a participants’ advisory committee to provide direction to the management company and to evaluate and select prospective participants in the RRG. The initial evaluation process requires each participant to share operational and loss information with other participants. Information-sharing is essential for initially screening out prospective participants with unfavorable loss experience or who otherwise are incompatible with the objectives of the RRG and for determining estimated funding costs for all participants on an ongoing basis. However, such information-sharing may be a deterrent to health care providers that function as competitors to other participants in the RRG.
In addition to the factors listed above for evaluating an exchange, health care providers who are considering participation in an RRG should determine the following:
• Estimated ongoing funding requirements during participation, and obligations for continued funding after termination of participation.
• In addition to commitments for participation for a specified period, whether the RRG has other requirements for participation, including commitments to risk management and expense control.
• The makeup, compatibility and claims experience of participants in the RRG.
• The specific information that must be shared with the RRG for the participant selection process and ongoing underwriting requirements, and limitations on use and disclosure of such information.
• The types, levels and cost of reinsurance coverage in place to limit the liabilities of participants in the RRG.
A captive is generally defined as an insurance company that is formed by one or more non-insurance entities to write the insurance business of its owners. Captive insurers can be formed in the U.S. or “off-shore.” A captive that is formed within the U.S. and that meets other requirements and limitations under the LRRA can operate as an RRG. As with RRGs, captives provide a formalized way of self-funding one’s own losses, with the added benefit of providing direct access to reinsurance to limit loss exposures.
Captives can be established in a variety of forms, including single parent captives (formed by and for the exclusive use of a sole owner); group captives (similar to an RRG, group captives are formed by multiple non-insurance entities and who then “pool” their losses and expenses); and rent-a-captives or protected cell captives (formed by investor/owners who then “rent” space in the captive to other participants who want to fund their own losses, but do not want to either incur the start-up costs of forming a captive or pool their losses with other participants in the captive).
Many of the same considerations applicable to RRGs are important for health care providers evaluating the formation of, or participation in, a captive. With single parent captives and rent-a-captives/protected-cell captives there is no pooling of losses and expenses with other participants, so the makeup, compatibility and claims experience of other participants in the captive is not a consideration. However, without cost sharing, participants in these captives must be able to fully fund their own expenses and losses up to any reinsurance attachment point.
Additional considerations for participation in a captive include:
Use of a “fronting” carrier. Unless a captive meets the requirements of, and is registered as, an RRG, it does not qualify as an “approved” basic limits carrier in Pennsylvania. As a result, a captive participant must use a fronting carrier (i.e., a traditional insurance company that issues an approved medical malpractice policy which is then 100 percent “reinsured” by the captive insurer). While fronting carriers were readily available to captives during most of the past decade, only several traditional insurers continue to be willing to front for medical malpractice captives. Those that do are demanding fronting fees that are substantially higher than fees charged in the past. Increases of 300 percent or more have been reported by several medical malpractice captives.
Guaranty Fund protection and effect of insolvency of fronting carrier. Pennsylvania Guaranty Fund protection will be available for claims under a fronted policy if the fronting carrier is domiciled or admitted in Pennsylvania. However, since the fronting carrier is fully reinsured by the captive, a captive participant should carefully assess the fronting carrier’s financial viability. For example, if a fronting carrier becomes insolvent, the state liquidator will be able to demand payments from the captive, as reinsurer, for the full value of each claim, even though the claimant likely will be paid only a small percentage of the claim’s value. In addition, as part of the process of gathering all assets of the insolvent insurer, the liquidator is able to demand payments from reinsurers before claims are finally resolved. Therefore, captive participants may be required to fund claims much sooner than would have been required if the claim proceeded to final resolution.
Unlike traditional insuring entities, each of the alternatives discussed above requires participants to contribute some or all of the initial capitalization of the insuring entity, or pay a fee for the privilege of participating in the insuring entity—in addition to the payment of insurance premiums. Thus, health care providers should expect that the costs of participation, at least in the short run, may be as high or higher than the cost of traditional insurance. In addition, because participants in RRGs and captives become “owners” of the insuring entity, participants must be prepared to fund the operational and claims costs of the insurer, and to commit to claims and expense management to control funding requirements. The need to evaluate the adequacy of funding, knowledge of management, underwriting integrity, compatibility of participants and level and cost of available reinsurance protection is far greater than with traditional insurance. And, with captives, there is the added consideration of availability and cost of a “fronting” carrier.
Nonetheless, alternative risk mechanisms present some options to health care providers in the current insurance availability crisis. In addition, health care providers who commit to long-term participation in an RRG or captive may obtain protection from the variability of the traditional insurance marketplace as well as possible cost savings if all participants are dedicated to loss control, expense savings and the long-term strength and viability of the entity.
Fran Roggenbaum, Esq., is Special Counsel in the Harrisburg Office of Saul Ewing, LLP, and a member of the firm’s Insurance Group.