How Do Risk Retention Groups Work?
Let’s take a look at an example of a gym owner.
Dale owns a group of gymnasiums. Lucky for Dale, his new gym innovated a new way of exercising that just became the next big thing. Swimming in cash and good fortune, Dale is expanding across the country by licensing out his brand name to new gym owners and training the owners in his way of exercising. Unfortunately for Dale, someone dropped a barbell on their foot while in a gym with his name on it.
Dale’s insurance company paid the claim.
A few days later Dale receives word of another incident at another gym.
His insurance company pays the claim.
The next day he gets notice of 10 claims across the country. His insurance company pays all of the claims. This continues throughout the year until it becomes time to renew his insurance premium. His insurance carrier informs him that he’ll either need to pay double the insurance premiums for the following year or he’ll have to find another solution. In addition, he’s receiving complaints from the licensees that their insurance premiums are simply unaffordable.
What should Dale do? Should Dale set up a captive insurance company? Or is there another opportunity for Dale?
Risk Retention Groups or Captive Insurance?
Captive insurance companies are excellent vehicles for managing risk, but they are not the only way. Captives can manage exotic risks exposed under most carrier’s policies and create tax advantages typically only afforded to Fortune 500 Companies. However, many companies have no legitimate insurance needs to cover exotic liabilities as their core businesses are relatively traditional.
This is where the risk retention group shines. Risk retention groups (“RRG”) are creatures of Congress. In 1986 Congress passed the Liability Risk Retention Act which provides, inter alia, that organizations may band together to create an entity to provide commercial liability insurance for all of its members. Unlike traditional insurance companies, once an RRG obtains its license it may operate in all 50 states without the necessity of a license.
An RRG must be owned by the insureds and requires the insureds to have similar or related financial exposure. So, going back to Dale’s example, we can see how his gym would be a great fit for an RRG. He has a tremendous amount of traditional types of professional liability (slips, falls, etc.). All of the gyms purchasing his license fee would be able to purchase shares in the RRG. All of the gyms have virtually identical types of exposure.
Forming an RRG for Dale’s gym would not only allow the gyms to purchase much cheaper insurance, it also gives the owners a say in the claim. With an RRG, Dale can select insurance defense counsel and determine which claims to take to trial. Traditional insurance generally results in a notice of settlement being mailed to the insured party. RRG’s provide greater risk management for the owner. This power allows the gym owners to challenge fraudulent claims without the pressure of settlement from adjusters.
Risk Retention Groups and Reinsurance
Section 3901(a)(4)(G) of the RRG Act provides that an RRG may not engage in any activities aside from liability insurance and reinsurance with respect to the similar or related liability …of any…risk retention group. In other words, Dale’s RRG may also engage in the business of reinsurance for similar gyms across the country. This is a tremendous financial opportunity for Dale’s RRG to market itself to admitted (licensed) insurers in states. If the state’s law permit it, then the traditional insurer may cede to the RRG all or a substantial portion of the risk assumed under those policies. This not only helps other admitted insurers manage their liabilities, but creates an opportunity for the RRG to expand its economic footprint in the marketplace.
Risk Retention Groups and Ownership
All policyholders of the RRG must be owners of the company. While this sounds complicated, it’s actually very simple in practice. Dale will either finance the entire company by himself or bring in business partners to finance the RRG. The paid in capital caries from jurisdiction to jurisdiction, but Dale and his business partners should expect to pay in no less than $1.5 million – $2 million to get their RRG started. All of the initial business owners will receive Class A Shares in exchange for funding the company.
Any additional policyholders who are brought into the RRG will receive non-voting Class B Shares in exchange for a small membership fee. These shares are not transferable. This is similar to how mutuals and reciprocal inter-insurance exchanges operate (see, e.g., USAA or Farmers).
This primer should generally show you how an RRG works and when it may be a good idea for a business. While gyms are great candidates for RRGs, the reality is that these businesses are a great solution for many different types of risk. To evaluate your risk and see if your business is a good fit for an RRG, contact us today to get started!