Expert Commentary

Using Captives and Risk Retention Groups Together

The numbers of captive explorations and formations continues to grow as virtually every domicile reports new formations. Captives are being used in ever more creative and exciting ways to address problems which the traditional market still struggles to solve. Following is a discussion of one of the more creative structures proposed recently.

January 2005

Hopefully the efforts of the National Association of Insurance Commissioners (NAIC) will begin to assist in traditional areas such as speed to market and rate and form freedom. The fear is the distraction of addressing other people's agendas, such as broker compensation. But captives, largely transparent, see more and more activity in terms of formations.

We have previously discussed the fact that although risk retention groups (RRGs) are often categorized together with captives as being differing forms of alternative risk transfer, they are in fact quite different. Despite these real differences, risk retention groups are likewise seeing innovative structures and approaches.

A relatively new structure has been seen increasingly in the past year. By combining captives with risk retention groups, some proposers have obtained admissibility without fronting, and gained the flexibility of a captive as a reinsurer.

Fronting and Reinsurance

The issues confronting captives in 2004, which will continue in large part in 2005, are fronting and reinsurance. Risk sharing partners who issue paper for regulatory and certification purposes, fronting to some, have to devote increasing amounts of top management time to regulatory investigations, probing, and compliance. The unforeseen costs of compliance with Sarbanes-Oxley and Spitzkriegs are becoming significant and are largely unbudgeted.

Risk sharing partners still dictate that captives are either irrelevant through the issuance of absolute excess policies, or insist on levels of collateral that threaten the efficiency of the deal. Some of that posture is made necessary by regulation, some by opportunity. But such practices are unlikely to change in the coming year.

While captives were seeking fronting solutions, proposers of risk retention groups found a form of fronting through the admission of risk retention groups under federal exemptions and exceptions. No one responsibly suggests that this is a substitute for a qualified risk sharing partner. However, in particular situations, this structure can be very useful.

To reiterate, captives are regulated by specific jurisdictions, known as domiciles. As most captives are not admitted in any other jurisdiction, nor rated by any rating agency (there are exceptions, yes), to gain the greatest effectiveness, the captive must use a risk sharing partner, or front. This not only adds to the cost, but is often difficult to put together.

Risk retention groups, being created by a federal act, are exempt from some state regulations and excepted from others, other than their home domicile. Other states are required to admit these risk retention groups. Again, often more difficult in fact than in law, but that is the theory.

If a qualified group established a risk retention group, properly funded and regulated, it must be allowed to write business in other states. This is a frequently challenged fact, and often the actual execution is more difficult than the organization. But this group could then establish a captive, perhaps offshore, which could bring in outside capital and offer reinsurance to the RRG. This could include offering coverage at the reinsurance level that the RRG is legally unable to offer.

The Challenge of Money

The current reinsurance challenge quite simply is money. Reinsurers have suffered enormous losses, from natural disasters and the usual problems. Some have had their capital threatened. One understands that they must spend their capital wisely. Most underwriters compute a dollar figure related to the risk against their capital, or rate-on-line. If the proposers' structure, be it captive or risk retention group, takes too much of the premium dollars, there isn't enough money left to support participation by the underwriter. Or, not enough premium for the risk equals "Good bye, no interest."

Not to be unfair at all, any business person can understand the compelling reasons put forth by reinsurers in regard to making a profit on their capital. But for smallish structures, this becomes a real challenge. How does one split a small pie and still invite friends over who have large appetites? And ask them to bring even bigger friends to provide diet control? Creative baking is the answer.

This structure of linking risk retention groups with captives, with many variations, is seen more and more as necessity dictates and the opportunity is seen to be real. Clearly this is not a structure for those needing certification, at any level. This will also not be efficient when frictional costs are too large a part of the structure.

Some medical groups have completed this structure successfully. This has enabled individual doctors to obtain professional liability coverage while their group obtains additional limits from a captive. The captive is then able to enter the reinsurance market to obtain risk transfer products at various levels depending on the need and goals of the individuals and group.

Rules and Regulations

This is decidedly an aggressive approach, but well within existing regulations and guidelines. In an era of transparency, if all elements of cost are disclosed, there should be few objections from regulators and participants.

Caution is required so that RRG rules are followed especially as regards ownership and risks insured. The captive owners have more freedom, but may require more capital to advance their goals. If outside investors are brought in, then disclosure issues arise and all parties should know each others' expectations and limitations.

Regulators must be fully informed as to the true nature of the structure, and the goals and intentions of the proposers. While this approach is creative and flexible, and approved, it is not the vehicle with which to circumvent good risk management or regulation.

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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