Captives and Corporate Governance
October 2006
As discussions about corporate governance
are carried on throughout the business world, the issue has been largely ignored
in captives and risk retention groups. The rigors of Sarbanes-Oxley (SOx) have
not descended on the insurance, and therefore captive, world. That is about
to change.
by Michael
R. Mead
M.R. Mead &
Company, LLC
For captives owned by large companies, the thought has been that effective
corporate governance at the parent level is sufficient. As millions are spent
on SOx issues, corporations have satisfied themselves that all subsidiaries
and affiliates are sufficiently in compliance. For captives of associations,
groups, and smaller private companies, it has been a nonissue. After all, "it
is my money" has been the thinking.
Several events have raised the profile of governance in the eyes of regulators,
notably in risk retention groups but also in the overall captive world. The
much-discussed and dissected report on risk retention groups by the Government
Accountability Office has served to bring forward the question of governance
when an entrepreneur establishes a risk retention group (RRG) for profit. This
has been viewed as improper by regulators, though by no means is illegal.
To some regulators, the idea that an individual or group of individuals would
set up an insurance vehicle for profit and not include fundamental governance
rights for the basic policyholders is wrong. That issue is fodder for another
day. While I understand the point, I do not agree that in all cases such a structure
is a bad thing. In fact, such structures have been around for decades with no
harm done.
But the issue has been aired, discussed, and will prevail as the National
Association of Insurance Commissioners (NAIC), a nonprofit trade association
with visions of regulatory grandeur, has proposed specific rules. If these rules
are not followed by a domicile in granting a license to a risk retention group,
there exists the possibility that the NAIC could rescind recognition of the
domicile causing untold headaches in the marketplace.
Among other things, these rules require that a majority of the board of directors
of the RRG be independent of any management or vendor relationship with the
RRG. Independence is defined by the NAIC as being first determined by the RRG's
board of directors, and a direct or indirect policyholder/shareholder is automatically
deemed independent if they have no material relationship.
A material relationship includes but is not limited to: the receipt of compensation
of more than 5 percent of the annual gross written premium or 2 percent of the
surplus; or is the auditor of the risk retention group; or involves an interlocking
directorate.
In addition, service provider contracts shall not exceed 5 years. These contracts
must be approved by the risk retention group's board. Service providers include
captive managers, auditors, lawyers, actuaries, investment advisers, and any
other person(s) providing services for fees.
The risk retention group shall have a written charter for the board of directors
and establish an audit committee. It shall adopt corporate governance standards
and a code of business conduct and ethics. All of these will be certified annually.
Enforcement of any violations will be against not only the directors and
officers of the risk retention group but also the captive manager. Some domiciles
are reviving the discussion about licensing captive managers. Managers will
be forced to inject themselves into the details of their clients, perhaps to
an unprecedented degree. This may not be welcomed by the clients. It may increase
the cost of managing the structures.
These moves will of course raise the stakes in the directors and officers
(D&O) markets. Obtaining D&O for startups or captives/RRGs is difficult now.
These regulations will not help availability.
While these regulations are merely proposed at this time, it is considered
highly likely that they will be adapted to one degree or another. The independence
issue is essentially nonnegotiable.
Okay for risk retention groups, but what about captives? I submit that similar
regulations are not too far away for captives. Once a regulator starts, stopping
is unheard of. Many captives today, large and small, publicly held and group,
have boards that are tied in many ways to the parent or the captive. Their expertise
is valuable to the captive or RRG. Achieving independence will require a lot
of thought, time, and effort.
In the claims arena, the captive may occasionally make an "ex gratia" payment
which is in the best interests of the owner, but not the entity. These moves
will come under stricter scrutiny and may be unwound to satisfy outside parties.
It will also likely raise costs as these newly minted independent directors
will expect compensation.
Throughout the world of commerce today we see examples over and over of a
strengthening of corporate governance. It is clear that such rules are needed
and appropriate for publicly held firms with a large exposure to the public.
But what of the downside? Parts of these regulations are quite impractical.
In my experience, few "entrepreneurs" who started alternative risk structures
were thoroughly versed in the intricacies of a captive while those who were
so proficient began the structures precisely to profit from filling a void in
the marketplace.
Locating independent directors is one thing; finding those willing to serve,
particularly on an onerous task like an audit committee, will be tougher. If
you are a contractor fighting to get your contracts complete and on time, or
a doctor busily involved in the intricacies of healthcare, not only are you
not interested in spending time on your captive's audit, you may feel terribly
unqualified and exposed in doing so.
So these regulations may create a whole new endeavor for retired captive
and insurance executives. That is not a bad thing.
As the process moves forward I don't expect much action in an election year,
but I do foresee quite a bit in the coming year. This gives the thoughtful captive
owner/operator and "entrepreneurial" risk retention group manager some time
to seek out friendly directors and knowledgeable service providers. The time
has past to go to your legislator to fight it.
Opinions expressed in Expert Commentary articles are those of the author and are
not necessarily held by the author's employer or IRMI. Expert Commentary articles
and other IRMI Online content do not purport to provide legal, accounting, or other
professional advice or opinion. If such advice is needed, consult with your attorney,
accountant, or other qualified adviser.