Expert Commentary

Captives and Corporate Governance

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.


Captives
October 2006

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.

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