Risk Retention Groups: Common Regulatory Standards and Greater	 
Member Protections Are Needed (15-AUG-05, GAO-05-536).		 
                                                                 
Congress authorized the creation of risk retention groups (RRG)  
to increase the availability and affordability of commercial	 
liability insurance. An RRG is a group of similar businesses that
creates its own insurance company to self-insure its risks.	 
Through the Liability Risk Retention Act (LRRA), Congress partly 
preempted state insurance law to create a single-state regulatory
framework for RRGs, although RRGs are multistate insurers. Recent
shortages of affordable liability insurance have increased RRG	 
formations, but recent failures of several large RRGs also raised
questions about the adequacy of RRG regulation. This report (1)  
examines the effect of RRGs on insurance availability and	 
affordability; (2) assesses whether LRRA's preemption has	 
resulted in significant regulatory problems; and (3) evaluates	 
the sufficiency of LRRA's ownership, control, and governance	 
provisions in protecting the best interests of the RRG insureds. 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-536 					        
    ACCNO:   A33017						        
  TITLE:     Risk Retention Groups: Common Regulatory Standards and   
Greater Member Protections Are Needed				 
     DATE:   08/15/2005 
  SUBJECT:   Federal regulations				 
	     Federal/state relations				 
	     Insurance companies				 
	     Insurance regulation				 
	     Liability insurance				 
	     Standards						 

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GAO-05-536

     

     * Report to the Chairman, Committee on Financial Services, House of
       Representatives
          * August 2005
     * RISK RETENTION GROUPS
          * Common Regulatory Standards and Greater Member Protections Are
            Needed
     * Contents
          * Results in Brief
          * Background
          * RRGs Have Had a Small but Important Effect on Increasing the
            Availability and Affordability of Commercial Liability Insurance
               * RRGs Have Represented a Small but Increasing Part of the
                 Commercial Liability Insurance Market
               * According to State Regulators, RRGs Have Filled Voids in
                 Markets, Allowing Numerous Groups to Obtain Benefits of
                 Coverage
               * RRGs Have Remained Relatively Small in Size Compared with
                 Traditional Insurers but Serve a Wide Variety of Markets
               * Recent Market Conditions Have Prompted the Creation of Many
                 RRGs, Especially to Provide Medical Malpractice Insurance
          * LRRA's Regulatory Preemption Has Resulted in Widely Varying
            Requirements among States and Limited Confidence in RRG
            Regulation
               * Most RRGs Have Domiciled in States That Charter Them as
                 Captives but Have Conducted Most of Their Business in Other
                 States
               * Inconsistent Regulation of RRGs Resembles Earlier Regulation
                 of Traditional Insurers, Which Suffered from Lack of
                 Uniform, Baseline Standards
               * Variations in RRG Reporting Requirements Have Impeded
                 Assessments of Their Financial Condition
               * Lack of Uniform, Baseline Regulatory Standards Has Concerned
                 Many Regulators
               * Some Evidence Suggests That States Have Set Their Captive
                 Regulatory Standards to Attract RRGs to Domicile in Their
                 States
          * RRG Failures Have Raised Questions about the Sufficiency of LRRA
            Provisions for RRG Ownership, Control, and Governance
               * While RRGs Are a Form of Self-Insurance, Not All RRG
                 Insureds Are Equity Owners or Have the Ability to Exercise
                 Control
               * Regulators Expressed Concerns That Some RRGs Might Be
                 Operated to Make Money for an Entrepreneur, Rather Than to
                 Provide Self- Insurance
               * LRRA Lacks Governance Standards to Protect RRG Insureds from
                 Management Companies with Potential Conflicts of Interest
               * RRG Members May Not Realize They Lack Guaranty Fund
                 Protection
               * Lack of Guaranty Fund Protection Also Has Consequences for
                 Consumers Who Purchase Extended Service Contracts
          * Conclusions
          * Recommendations for Executive Action
          * Matters for Congressional Consideration
          * Agency Comments and Our Evaluation
     * Objectives, Scope, and Methodology
          * Effects on Availability and Affordability of Commercial Liability
            Insurance
               * Failure Analysis
               * Selection of Regulators for Interviews
          * Effects of Partial Preemption of State Insurance Laws
          * Sufficiency of LRRA Provisions in Protecting RRG Insureds
     * Survey of State Regulators on Risk Retention Groups
     * Selected Differences between Statutory and Generally Accepted
       Accounting Principles as They Relate to Financial Reporting for RRGs
          * Differences in Accounting Principles Produce Different Financial
            Statements
               * Acquisition Costs
               * Assets
               * Other Differences
          * The Different Results under Each Permitted Accounting Method Can
            Affect Analysis of an RRG's Financial Condition
               * Net Premiums Written to Policyholders' Surplus Ratio
               * Reserves to Policyholders' Surplus Ratio
               * Risk-Based Capital
     * Liquidated Risk Retention Groups (RRG), from 1990 through 2003
     * Comments from the National Association of Insurance Commissioners
     * GAO Contact and Staff Acknowledgments

                 United States Government Accountability Office

Report to the Chairman, Committee on Financial Services, House of
Representatives

August 2005

RISK RETENTION GROUPS

     Common Regulatory Standards and Greater Member Protections Are Needed

                                       a

RISK RETENTION GROUPS

Common Regulatory Standards and Greater Member Protections Are Needed

  What GAO Found

RRGs have had a small but important effect in increasing the availability
and affordability of commercial liability insurance for certain groups.
While RRGs have accounted for about $1.8 billion or about 1.17 percent of
all commercial liability insurance in 2003, members have benefited from
consistent prices, targeted coverage, and programs designed to reduce
risk. A recent shortage of affordable liability insurance prompted the
creation of many new RRGs. More RRGs formed in 2002-2004 than in the
previous 15 years-and about three-quarters of the new RRGs offered medical
malpractice coverage.

LRRA's partial preemption of state insurance laws has resulted in a
regulatory environment characterized by widely varying state standards. In
part, state requirements differ because some states charter RRGs as
"captive" insurance companies, which operate under fewer restrictions than
traditional insurers. As a result, most RRGs have domiciled in six states
that offer captive charters (including some states that have limited
experience in regulating RRGs) rather than in the states where they
conduct most of their business. Additionally, because most RRGs (as
captives) are not subject to the same uniform, baseline standards for
solvency regulation as traditional insurers, state requirements in
important areas such as financial reporting also vary. For example, some
regulators may have difficulty assessing the financial condition of RRGs
operating in their state because not all RRGs use the same accounting
principles. Further, some evidence exists to support regulator assertions
that domiciliary states may be relaxing chartering or other requirements
to attract RRGs.

Because LRRA does not specify characteristics of ownership and control, or
establish governance safeguards, RRGs can be operated in ways that do not
consistently protect the best interests of their insureds. For example,
LRRA does not explicitly require that the insureds contribute capital to
the RRG or recognize that outside firms typically manage RRGs. Thus, some
regulators believe that members without "skin in the game" will have less
interest in the success and operation of their RRG and that RRGs would be
chartered for purposes other than self-insurance, such as making profits
for entrepreneurs who form and finance an RRG. LRRA also provides no
governance protections to counteract potential conflicts of interest
between insureds and management companies. In fact, factors contributing
to many RRG failures suggest that sometimes management companies have
promoted their own interests at the expense of the insureds.

The combination of single-state regulation, growth in new domiciles, and
wide variance in regulatory practices has increased the potential that
RRGs would face greater solvency risks. As a result, GAO believes RRGs
would benefit from uniform, baseline regulatory standards. Also, because
many RRGs are run by management companies, they could benefit from
corporate governance standards that would establish the insureds'
authority over management.

                 United States Government Accountability Office

                                    Contents

Letter                                                                   1 
          Results in Brief                                                  5 
          Background                                                        8 
              RRGs Have Had a Small but Important Effect on Increasing the 
               Availability and Affordability of Commercial Liability      
          Insurance                                                        12 
            LRRA's Regulatory Preemption Has Resulted in Widely Varying    
                   Requirements among States and Limited Confidence in RRG 
          Regulation                                                       25 
          RRG Failures Have Raised Questions about the Sufficiency of LRRA 
               Provisions for RRG Ownership, Control, and Governance       48 
          Conclusions                                                      65 
          Recommendations for Executive Action                             68 
                      Matters for Congressional Consideration              68 
          Agency Comments and Our Evaluation                               70 

Appendixes                                                             
                Appendix I: Objectives, Scope, and Methodology             72 
              Appendix II:  Survey of State Regulators on Risk Retention   79 
                            Groups                                        
              Appendix III: Selected Differences between Statutory and        
                            Generally Accepted Accounting Principles as   
                            They Relate to Financial Reporting for RRGs    94
              Appendix IV:  Liquidated Risk Retention Groups (RRG), from      
                            1990 through 2003                             109
                Appendix V: Comments from the National Association of         
                            Insurance Commissioners                       113
              Appendix VI:  GAO Contact and Staff Acknowledgments         114 

Tables  Table 1: Characteristics of States We Interviewed, Based on Years
                      of Regulatory Experience and Number of RRGs
                         Domiciled                                         76
           Table 2: Differences in Regulatory Actions When Calculating
                    Risk-Based Capital for Three RRGs, Modified GAAP
                      Compared with SAP                                   108 
Figures  Figure 1: RRG Gross Premiums Written in 2003, by Time (Years)     
                      in Business                                          17

                                    Contents

Figure 2:  Number of RRGs, by Business Area for Selected Years          19 
Figure 3:  Percentage of Estimated Gross Premiums RRGs               
              Collected in 2004, by Business Area Number of RRGs, by    20 23 
Figure 4:  Formation Date Number of RRGs, by Captive or Noncaptive   
Figure 5:  Charter and                                               
              State of Domicile, as of the End of 2004                     30 
Figure 6:  Number of RRGs Chartered, by State, as of the End of      
              2004, and Amount of Direct Premiums Written by RRGs,      
              by State, 2003 State Regulators' Opinion of the Adequacy  32 41 
Figure 7:  of the Regulatory Protections or Safeguards Built into    
              LRRA                                                      
Figure 8:  Permitted Wording of Guaranty Fund Disclosure in LRRA        60 
Figure 9:  The Effect of Differences in Accounting for Acquisition   
              Costs on Assets, Capital, and Surplus, GAAP Compared with       
              SAP                                                          97

Figure 10: Impact of Counting an LOC and Prepaid Expenses as         
              Assets on the Balance Sheet, Modified GAAP Compared       
with SAP                                                                99 
Figure 11: Impact of Counting Acquisition Costs, LOCs, and Prepaid   
                 Expenses as Assets on the Balance Sheet, Modified GAAP 
Compared with SAP                                                      100 
Figure 12: Differences in the Calculation of Net Premiums Written to 
                   Policyholders' Surplus Ratio, Modified GAAP Compared 
with SAP                                                               104 
Figure 13: Differences in the Calculation of Reserves to             
                   Policyholders' Surplus Ratio, Modified GAAP Compared 
with SAP                                                               106 

Contents

Abbreviations           
ANLIR                   American National Lawyers Insurance            
                           Reciprocal Risk Retention Group                
BRICO                   Beverage Retailers Insurance Company           
                           Risk Retention Group                           
CEO                     chief executive officer                        
CIC                     Corporate Insurance Consultants                
DIR                     Doctors Insurance Risk Retention Group         
FAST                    Financial Analysis Solvency Tools              
GAAP                    generally accepted accounting principles       
IRIS                    Insurance Regulatory Information System        
LOC                     letter of credit                               
LRRA                    Liability Risk Retention Act                   
NAIC                    National Association of Insurance              
                           Commissioners                                  
NPW:PS                  net premiums written to policyholders'         
                           surplus                                        
PMIC                    Professional Mutual Insurance Company          
                           Risk Retention Group                           
RBC                     risk-based capital                             
ROA                     Reciprocal of America                          
RPG                     risk purchasing group                          
RRG                     risk retention group                           
RRR                     Risk Retention Reporter                        
SAP                     statutory accounting principles                
SEC                     Securities and Exchange Commission             
TAC                     total adjusted capital                         
TRA                     The Reciprocal Alliance Risk Retention         
                           Group                                          
TRG                     The Reciprocal Group                           
VSC                     vehicle service contract                       

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A

United States Government Accountability Office Washington, D.C. 20548

August 15, 2005

The Honorable Michael G. Oxley Chairman, Committee on Financial Services
House of Representatives

Dear Mr. Chairman:

In 1981, in response to recurring shortages of liability insurance,
Congress passed the Product Risk Retention Liability Act, now known as the
Liability Risk Retention Act (LRRA), which authorized the creation of risk
retention groups (RRG) to increase the availability and affordability of
commercial liability insurance.1 An RRG is a group of similar businesses
with similar risk exposures, such as educational institutions or building
contractors, which create their own insurance company to self-insure their
risks on a group basis.2 Through LRRA, Congress first established a
flexible framework that allowed states to develop their own standards for
the formation and operation of RRGs. In light of the recent unavailability
of affordable liability insurance, especially for medical malpractice
coverage, interest in forming RRGs has greatly increased. In addition,
some industry advocates now propose that RRGs be permitted to offer
property coverage as well. However, the recent and notable failures of
several large RRGs have raised questions about the adequacy of the RRG
regulatory environment and whether existing safeguards, such as the
requirement that each RRG provide copies of operational plans and annual
financial statements to each state in which it operates, are sufficient to
ensure that RRGs are operated and governed adequately to protect their
insureds.

1Pub. L. No. 97-45, 95 Stat. 949 (1981) (codified as amended at 15 U.S.C.
S:S: 3901-3906). LRRA authorized the creation of RRGs and risk purchasing
groups (RPG). RPGs are businesses with similar risk exposures that join to
purchase liability insurance as a single entity. See 15

U.S.C. S: 3901(a)(5). We do not evaluate RPGs in this report. See also
GAO, Insurance: Activity under the Product Liability Risk Retention Act of
1981, GAO/HRD-86-120BR (Washington, D.C.: July 1986).

2The specific definitional requirements are set forth in 15 U.S.C. S:
3901(a)(4).

LRRA, expanded in 1986, facilitates the creation and operation of RRGs in
several ways.3 Most notably, LRRA partially preempts state insurance laws
by allowing an RRG's formation and operations to be regulated primarily by
the state in which it is chartered, its domiciliary state, even when it
sells insurance in other states. LRRA largely limits the oversight role of
insurance regulators from nondomiciliary states (all states other than the
chartering state) to the right to receive copies of an RRG's operational
plans and annual financial statements. In having only one regulator, RRGs
differ from "traditional" insurance companies, which are subject to
licensing and oversight by regulators in each state in which they operate.
Additionally, LRRA prohibits RRGs from participating in state guaranty
funds, which are available to settle the claims of insureds of a
traditional insurance company should that company fail.

LRRA's legislative history indicates a view that single-state regulation
would provide adequate supervision of RRGs, largely because RRGs would be
providing insurance coverage only to their own members, and not the public
at large. While preemption is central to LRRA's objective of facilitating
the formation and efficient interstate operation of RRGs, Congress also
expressed a view that LRRA's prohibition on participating in guaranty
funds would provide a strong incentive for RRGs to set adequate premiums
and establish adequate reserves, as each RRG member would know that there
would be no other source of funds (other than the RRG's own assets) from
which to pay claims.4

RRGs are not the only mechanism by which businesses may establish
self-insurance coverage. States also charter and regulate captive
insurance companies, which are established by single companies or groups
of companies to self-insure their own risks. Traditional insurance
companies sell insurance to the general public and are licensed in all
states in which they do business. In contrast, captive insurance companies
largely insure only their owners, who have the ability to manage and
retain their own risk. Thus, the degree of regulatory oversight required
for captives is different

3Prior to its expansion in 1986, LRRA only permitted RRGs to provide
product liability insurance. As amended in 1986, the act permits RRGs to
offer all types of liability insurance, excluding worker's compensation.
The 1986 amendments also expanded the ability of nondomiciliary states to
regulate RRGs doing business in their states.

4Insurance insolvency guaranty funds are maintained by contributions of
insurance companies operating in a particular state and made available to
pay the claims of insolvent insurance companies.

than that which is required for commercial insurers. States chartering
captives offer some regulatory relief to these companies, based on the
presumption that the owners of captive companies have sophisticated
knowledge about managing their own risks and are motivated to protect
their own interests. The captive is licensed in only one state and
operates under the captive insurance law of that domicile. However, should
the captive choose to conduct business outside its state of domicile, it
would be subject to the licensing and oversight of each state because
captives that are not also RRGs do not benefit from the partial
preemption. Many states have recognized RRGs as a form of captive and
charter them under their captive regulations.

In light of proposals to expand LRRA, and recent shortages of affordable
liability insurance, you requested that we assess how well RRGs have
achieved LRRA's legislative goals of making commercial liability insurance
available and affordable. This report (1) examines the effect RRGs have
had on the availability and affordability of commercial liability
insurance;

(2) assesses whether LRRA's partial preemption of state insurance laws has
resulted in any significant regulatory problems; and (3) evaluates the
sufficiency of LRRA's ownership, control, and governance provisions for
protecting the best interests of the insureds.

To ascertain the effect of RRGs on the availability and affordability of
commercial liability insurance, we surveyed regulators in all 50 states
and the District of Columbia and interviewed representatives from eight
RRGs serving different markets. In addition, we obtained information from
the National Association of Insurance Commissioners (NAIC) that estimated
the share of the commercial liability insurance market that RRGs held in
2003.5 To determine if LRRA's partial preemption of state insurance laws
has resulted in significant regulatory problems, we surveyed all state
insurance departments to obtain information on their regulatory
experiences and obtained more specific information from regulators in 14
states, including some that do not domicile RRGs. To understand the
regulatory framework, especially the capitalization and financial
reporting standards under which most RRGs are regulated, we compared the
regulatory standards of the six states (Arizona, the District of Columbia,
Hawaii, Nevada, South Carolina, and Vermont) that had chartered the most
RRGs as of June 30, 2004. To assess the sufficiency of LRRA's ownership,
control, and governance provisions in protecting the best interests of the
insureds, we identified provisions in LRRA that relate to these issues and
reviewed LRRA's legislative history to ascertain Congress' concerns about
these issues.6 Since LRRA largely delegates the regulation of the
formation and operation of RRGs to the domiciliary states, we reviewed the
statutory provisions of the six leading domiciliary states to determine
whether they addressed ownership, control, and governance, and interviewed
their regulators to identify insurance departmental policies. To
understand how the regulators implemented these statutes and policies, we
reviewed the chartering documents of the three RRGs most recently
domiciled by each of the leading domiciliary states. Finally, we
identified whether factors related to the ownership, control, or
governance of RRGs contributed or, in some cases, were alleged to have
contributed to RRG failures. We conducted our review from November 2003
through July 2005 in accordance with generally accepted government
auditing standards. Appendix I contains a more detailed description of our
objectives, scope, and methodology.

5NAIC is a voluntary association of the heads of insurance departments
from each state, the District of Columbia, and five U.S. territories. For
the purpose of this report, we refer to the District of Columbia as a
state. NAIC provides a national forum for addressing and resolving major
insurance issues, including those concerning RRGs, and for promoting the
development of consistent policies among the states.

6By governance, we mean the manner in which an RRG's governing body, such
as a board of directors, and management direct and control the RRG,
including the means by which directors and management are held accountable
for their actions.

  Results in Brief

RRGs have had a small but important effect in increasing the availability
and affordability of commercial liability insurance for certain groups
with limited access to insurance. In 2003, according to NAIC estimates,
RRGs provided about $1.8 billion or 1.17 percent of all commercial
liability insurance. While the overall impact on the liability market has
been small, most state regulators we surveyed believed that RRGs have
increased the availability and affordability of insurance for groups that
have had difficulties obtaining affordable coverage such as healthcare
providers, building contractors, and commercial trucking firms. According
to state regulators and RRG industry representatives, members have
benefited in several important ways by using RRGs to self-insure their
risks.7 These benefits include controlling their costs by targeting their
coverage to the specific needs of members and designing programs to reduce
risks. The representatives indicated that RRGs might not always benefit
from the lowest insurance prices but could benefit from prices that
remained stable over time. In recent years, a shortage of affordable
liability insurance also prompted the creation of many new RRGs. From 2002
through 2004, 117 RRGs were formed, more than the total formed over the
previous 15 years. In particular, a shortage of affordable medical
malpractice insurance prompted healthcare providers to form about
three-quarters of the new RRGs. As a result, more than half of all
currently operating RRGs provide insurance in healthcare-related areas.

LRRA's partial preemption of state insurance laws has resulted in a
regulatory environment characterized by widely varying state standards and
limited regulator confidence in the system. In part, state requirements
differ because some states charter RRGs as captive insurance companies,
which operate under less restrictive regulation than traditional insurers.
A captive charter offers RRGs several advantages: For example, initial
capitalization standards are usually easier to meet because states allow
captives to start their operations with less capital than traditional
insurers and use letters of credit rather than cash to meet capitalization
requirements. As a result of these and other advantages, the majority of
RRGs have domiciled in six states-Arizona, the District of Columbia,
Hawaii, Nevada, South Carolina, and Vermont-that allow them to be
chartered as captive insurers rather than in the states where they conduct

7In order to obtain more specific examples about how RRGs have benefited
their membership, we interviewed and reviewed documents from eight RRGs
representing a variety of industries, most of which have been in business
for at least 5 years. See appendix I for more information.

Page 5 GAO-05-536 Risk Retention Groups

most of their business. In addition, states chartering RRGs as captives
also vary in how they regulate RRGs on an ongoing basis. These variations
exist because LRRA grants domiciliary states the discretion and authority
to regulate the formation and multistate operation of RRGs and because as
captives most RRGs are not subject to uniform, baseline standards, such as
those set forth in NAIC's financial accreditation standards for regulation
of traditional multistate insurers. For example, five of the six leading
domiciliary states allow RRGs to use a modified version of generally
accepted accounting principles (GAAP), rather than statutory accounting
principles (SAP), when filing financial statements. As a result, some
nondomiciliary state regulators have difficulty interpreting these
reports, especially since traditional insurers must file using SAP.
Additionally, only 8 regulators of 42 responding to a particular survey
question considered that LRRA's provisions adequately protected RRG
insureds, often because of their concerns about a lack of uniform,
baseline standards and perception that they needed additional regulatory
authority. Finally, some evidence exists to support regulator assertions
that some domiciliary states may be creating lenient regulatory
environments to encourage RRGs to domicile in their state. For example, in
the past 4 years, two leading domiciliary states have allowed RRGs to
relocate their charters, even though the RRGs were subject to unresolved
regulatory actions in their original state of domicile.

Because (other than requiring that owners must also be insureds) LRRA does
not impose minimum characteristics of ownership and control for RRGs or
establish minimum governance requirements, RRGs can be operated in ways
that do not consistently protect the best interests of their insureds.
While RRGs were authorized for the purpose of providing self-insurance,
LRRA does not explicitly require that all of the insureds contribute
toward the capitalization of the RRG. Consequently, some of the six
leading domiciliary states do not expect RRG insureds to contribute
anything more than insurance premiums, and some regulators are concerned
that members without "skin in the game" will have less interest in the
success of their RRG. In addition, even though LRRA's legislative history
indicates that the single-state regulatory framework was premised, in
part, on insureds having adequate incentives to exercise control over
their RRG, some of the six leading domiciliary states do not expect
insureds to have the ability to elect their governing body (such as a
board of directors). Because not all insureds actually participate in the
formation or financing of their RRGs, some regulators are concerned that
those RRGs may be operated for the financial benefit of the
"entrepreneurs" who do provide the financing. An entrepreneur could be an
individual insured or the company hired to manage the daily operations of
the RRG. LRRA also does not include provisions regarding the management of
RRGs, such as governance protections to counteract potential conflicts of
interest between management companies and insureds. In contrast, Congress
previously addressed a similar situation within the mutual fund industry
by passing legislation intended to minimize potential conflicts of
interest between mutual fund shareholders and management companies. The
circumstances surrounding more than half of past RRG failures we examined
suggest that management companies or managers have promoted their own
interests at the expense of the insureds-for example, by charging
excessive management fees or promoting transactions unfavorable to the
RRG. Regulators knowledgeable about these failures said that the insureds
likely were more interested in obtaining affordable insurance than
assuming the responsibilities of owning an insurance company.
Consequently, even though an insured's insurance policy may have stated
that the RRG lacked guaranty fund coverage, the insureds may not have been
fully aware of this restriction or the consequences of lacking such
protection. Further, LRRA does not require RRGs to disclose to prospective
claimants, those who submit claims for loss, that the RRGs would not
benefit from guaranty fund protection should they fail. This can be of
special consequence to certain claimants-consumers who purchase extended
service contracts from the insureds of RRGs-because contracts issued by
these insureds take on the appearance of insurance when, in most cases,
they are not.

This report contains recommendations for the states, as well as matters
for congressional consideration that, if implemented, would create a more
consistent regulatory framework for overseeing the chartering and
management of RRGs, provide more reliable information about the financial
condition of RRGs, and provide RRG members needed protections to help
ensure that companies managing RRGs operate in the insureds' best
interests. In addition, enhancing the availability and contents of the
guaranty fund disclosure would provide RRG insureds, as well as consumers
who purchase extended service contracts from RRG insureds, a better
understanding of the lack of guaranty fund coverage. Finally, these
recommendations would strengthen NAIC's ability to achieve its goals of
improving the quality and consistency of state insurance regulation.

We requested comments on a draft of this report from NAIC. The Executive
Vice President and CEO, National Association of Insurance Commissioners,
provided written comments on a draft of this report. NAIC generally agreed
with our approach and methodology and our description

                                   Background

of the regulation of risk retention groups. NAIC's comments are discussed
later in this report and are reprinted in appendix V. NAIC and several of
the states also provided technical comments, which we incorporated as
appropriate.

In the legislative history, RRGs were described as essentially insurance
"cooperatives," whose members pool funds to spread and assume all or a
portion of their own commercial liability risk exposure-and who are
engaged in businesses and activities with similar or related risks.8
Specifically, RRGs may be owned only by individuals or businesses that are
insured by the RRG or by an organization that is owned solely by insureds
of the RRG.9 In the legislative history, Congress expressed the view that
RRGs had the potential to increase the availability of commercial
liability insurance for businesses and reduce liability premiums, at least
when insurance is difficult to obtain (during hard markets) because
members would set rates more closely tied to their own claims experience.
In addition, LRRA was intended to provide businesses, especially small
ones, an opportunity to reduce insurance costs and promote greater
competition among insurers when they set insurance rates.10 Because RRGs
are owned by insureds that may have business assets at risk should the RRG
be unable to pay claims, they would have greater incentives to practice
effective risk management both in their own businesses and the RRG. The
elimination of duplicative and sometimes contradictory regulation by
multiple states was designed to facilitate the formation and interstate
operation of RRGs.11 "The (regulatory) framework established by LRRA
attempts to strike a balance between the RRGs' need to be free of

8Liability insurance includes coverage for all sums that the insured
becomes legally obligated to pay because of bodily injury, property
damage, or other wrongs to which an insurance policy could apply.

915 U.S.C. S: 3902(a)(4)(E).

10See H. Rep. No. 97-190, at 4 (1981), reprinted in 1981 U.S.C.A.A.N.
1432, 1441; S. Rep. No. 97-172, at 1 (1981).

11See H. Rep. No. 97-190, at 12 (1981), reprinted in 1981 U.S.C.A.A.N.
1432, 1441; S. Rep. 97172, at 11 (1981).

unjustified requirements and the public's need for protection from
insolvencies."12

RRGs are not the only form of self-insurance companies; "captive insurance
companies" (captives) also self-insure the risks of their owners. States
can charter RRGs under regulations intended for traditional insurers or
for captive insurers. Non-RRG captives largely exist solely to cover the
risks of their parent, which can be one large company (pure captive) or a
group of companies (group captives).13 Group captives share certain
similarities with RRGs because they also are composed of several
companies, but group captives, unlike RRGs, do not have to insure similar
risks. Further, captives may provide property coverage, which RRGs may
not. Regulatory requirements for captives generally are less restrictive
than those for traditional insurance companies because, for example, many
pure captives are wholly owned insurance subsidiaries of a single business
or organization. If a pure captive failed, only the assets of the parent
would be at risk. Finally, unlike captive RRGs, other captive insurers
generally cannot conduct insurance transactions in any state except their
domiciliary state, unless they become licensed in that other state (just
as a traditional company would) and subject to that state's regulatory
oversight.14

12See H. Rep. No. 99-865, at 12 (1986), reprinted in 1986 U.S.C.A.A.N.
5303, 5309; S. Rep. No. 99-294, at 13-14 (1986).

13Other variations of captive insurance companies exist. For example, a
hybrid form of the captive company is the trade association or industry
captive, which is formed and operated by a business fraternal organization
or trade association.

14To address the potential complexities of multiple state regulation, when
captives do need to sell in other states, they typically pay another
insurance company already admitted (that is, licensed to operate) by that
state, known as a fronting company, to issue policies. The fronting
company then insures the risks back to the captive.

In contrast to the single-state regulation that LRRA provides for RRGs,
traditional insurers, as well as other non-RRG captive insurers, are
subject to the licensing requirements and oversight of each nondomiciliary
state in which they operate. The licensing process allows states to
determine if an insurer domiciled in another state meets the
nondomiciliary state's regulatory requirements before granting the insurer
permission to operate in its state. According to NAIC's uniform
application process, which has been adopted by all states, an insurance
company must show that it meets the nondomiciliary state's minimum
statutory capital and surplus requirements, identify whether it is
affiliated with other companies (that is, part of a holding company
system), and submit biographical affidavits for all its officers,
directors, and key managerial personnel.15 After licensing an insurer,
regulators in nondomiciliary states can conduct financial examinations,
issue an administrative cease and desist order to stop an insurance
company from operating in their state, and withdraw the company's license
to sell insurance in the state. However, most state regulators will not
even license an insurance company domiciled in another state to operate in
their state unless the company has been in operation for several years. As
reflected in each state's "seasoning requirements," an insurance company
must have successfully operated in its state of domicile for anywhere from
1 to 5 years before qualifying to receive a license from another state.16
RRGs, in contrast, are required only to register with the regulator of the
state in which they intend to sell insurance and provide copies of certain
documents originally provided to domiciliary regulators.

15NAIC has developed an application process allowing insurers to file
copies of the same application for admission in numerous states. This
application is designed for established, solidly performing companies that
are in good standing in their domiciliary state.

16These requirements are known as "seasoning requirements for authority to
transact business."

Page 10 GAO-05-536 Risk Retention Groups

Although RRGs receive regulatory relief under LRRA, they still are
expected to comply with certain other laws administered by the states in
which they operate, but are not chartered (nondomiciliary states), and are
required to pay applicable premium and other taxes imposed by
nondomiciliary states.17 In addition to registering with other states,
LRRA also imposes other requirements that offer protections or safeguards
to RRG members: LRRA requires each RRG to (1) provide a plan of operation
to the insurance commissioner of each state in which it plans to do
business prior to offering insurance in that state, (2) provide a copy of
the group's annual financial statement to the insurance commissioner of
each state in which it is doing business, and (3) submit to an examination
by a nondomiciliary state regulator to determine the RRG's financial
condition, if the domiciliary state regulator has not begun or refuses to
begin an examination. Nondomiciliary, as well as domiciliary states, also
may seek an injunction in a "court of competent jurisdiction" against RRGs
that they believe are in hazardous financial condition.18

In conjunction with the regulatory relief Congress granted to RRGs, it
prohibited RRGs from participating in state guaranty funds, believing that
this restriction would provide RRG members a strong incentive to establish
adequate premiums and reserves. All states have established guaranty
funds, funded by insurance companies, to pay the claims of policyholders
in the event that an insurance company fails. Without guaranty fund
protection, in the event an RRG becomes insolvent, RRG insureds and their
claimants could be exposed to all losses resulting from claims that exceed
the ability of the RRG to pay.

17LRRA provides a list of powers retained by nondomiciliary states,
including the authority to require RRGs to comply with laws regarding
unfair claim settlement practices and unfair trade and deceptive
practices. See 15 U.S.C. S: 3902(a)(1). Further, LRRA's exemption does not
extend to laws governing business and industry generally, such as civil
rights laws, generally applicable criminal laws, and corporate laws.

18See 15 U.S.C. S: 3902(a)(1)(H).

Page 11 GAO-05-536 Risk Retention Groups

  RRGs Have Had a Small but Important Effect on Increasing the Availability and
  Affordability of Commercial Liability Insurance

Finally, in terms of structure, RRG and captive insurance companies bear a
certain resemblance to mutual fund companies.19 For example, RRGs, captive
insurance companies, and mutual fund companies employ the services of a
management company to administer their operations. RRGs and captive
insurers generally hire "captive management" companies to administer
company operations, such as day-to-day operational decisions, financial
reporting, liaison with state insurance departments, or locating sources
of reinsurance.20 Similarly, a typical mutual fund has no employees but is
created and operated by another party, the adviser, which contracts with
the fund, for a fee, to administer operations. For example, the adviser
would be responsible for selecting and managing the mutual fund's
portfolio. However, Congress recognized that the external management of
mutual funds by investment advisers creates an inherent conflict between
the adviser's duties to the fund shareholders and the adviser's interests
in maximizing its own profits, a situation that could adversely affect
fund shareholders. One way in which Congress addressed this conflict is
the regulatory scheme established by the Investment Company Act of 1940,
which includes certain safeguards to protect the interests of fund
shareholders. For example, a fund's board of directors must contain a
certain percentage of independent directors-directors without any
significant relationship to the advisers.

RRGs have had a small but important effect on increasing the availability
and affordability of commercial liability insurance, specifically for
groups that have had limited access to liability insurance. According to
NAIC estimates, in 2003 RRGs sold just over 1 percent of all commercial
liability insurance in the United States. However, many state regulators,
even those who had reservations about the regulatory oversight of RRGs,
believe RRGs have filled a void in the market. Regulators from the six
leading domiciliary states also observed that RRGs were important to
certain groups that could not find affordable coverage from a traditional
insurance company and offered RRG insureds other benefits such as tailored

19Mutual funds are distinct legal entities owned by their shareholders and
permit shareholders to invest in an array of securities such as stocks
issued by public corporations. See GAO, Mutual Fund Fees: Additional
Disclosure Could Encourage Price Competition, GAO/GGD-00-126 (Washington,
D.C.: June 2000) for additional information.

20Reinsurance is a form of insurance that insurance companies buy for
their own protection. Insurance companies purchase reinsurance to reduce
their possible maximum loss by giving (ceding) a portion of their
liability to reinsurance companies.

RRGs Have Represented a Small but Increasing Part of the Commercial
Liability Insurance Market

coverage. Furthermore, RRGs, while tending to be relatively small in size
compared with traditional insurers, serve a wide variety of organizations
and businesses, although the majority served the healthcare industry.
Difficulties in finding affordable commercial liability insurance prompted
the creation of more RRGs from 2002 through 2004 than in the previous 15
years. Three-quarters of the RRGs formed in this period responded to a
recent shortage of, and high prices for, medical malpractice insurance.
However, studies have characterized the medical malpractice industry as
volatile because of the risks associated with providing this line of
insurance.

RRGs have constituted a very small part of the commercial liability
market. According to NAIC estimates, in 2003 a total of 115 RRGs sold 1.17
percent of all commercial liability insurance in the United States. This
accounted for about $1.8 billion of a total of $150 billion in gross
premiums for all commercial liability lines of insurance.21 We are
focusing on 2003 market share to match the time frame of our other
financial analyses of gross premiums.

While RRGs' share of the commercial liability market was quite small,
market share and the overall amount of business RRGs wrote increased since
2002. For example, RRG market share increased from 0.89 percent in 2002 to
1.46 percent in 2004.22 However, in terms of commercial liability gross
premiums, the increase in the amount of business written by RRGs is more
noticeable. The amount of business that RRGs collectively wrote about
doubled, from $1.2 billion in 2002 to $2.3 billion in 2004. During this
same period, the amount of commercial liability written by traditional
insurers increased by about 21 percent, from $129 billion to $156 billion.
In addition, RRGs increased their presence in the market for medical
malpractice insurance. From 2002 through 2004, the amount of medical
malpractice written by RRGs increased from $497 million to $1.1 billion,

21In 2003, 127 RRGs were licensed to write business but we asked NAIC to
include only the 115 RRGs that actively wrote premiums. NAIC's analysis is
based on the amount of gross premiums written by RRGs divided by the total
amount of gross premiums written by all insurers for commercial liability
insurance. Gross premiums represent the total amount of business that an
insurance company sells (direct premiums) plus business assumed from other
carriers (assumed premiums).

22We verified that NAIC's 2003 data correctly listed RRGs-that is, did not
inadvertently include or omit any insurers. However, we did not perform
this verification for the 2002 or 2004 data.

According to State Regulators, RRGs Have Filled Voids in Markets, Allowing
Numerous Groups to Obtain Benefits of Coverage

which increased their share of the medical malpractice market from 4.04
percent to 7.27 percent.

Despite the relatively small share of the market that RRGs hold, most
state regulators we surveyed who had an opinion-33 of 36-indicated that
RRGs have expanded the availability and affordability of commercial
liability insurance for groups that otherwise would have had difficulty in
obtaining coverage.23 This consistency of opinion is notable because 18 of
those 33 regulators made this assertion even though they later expressed
reservations about the adequacy of LRRA's regulatory safeguards.24 About
one-third of the 33 regulators also made more specific comments about the
contributions of RRGs. Of these, five regulators reported that RRGs had
expanded the availability of medical malpractice insurance for nursing
homes, adult foster care homes, hospitals, and physicians. One regulator
also reported that RRGs had assisted commercial truckers in meeting their
insurance needs.

Regulators from states that had domiciled the most RRGs as of the end of
2004-Arizona, the District of Columbia, Hawaii, Nevada, South Carolina,
and Vermont-provided additional insights.25 Regulators from most of these
states recognized that the overall impact of RRGs in expanding the
availability of insurance was quite small. However, they said that the
coverage RRGs provided was important because certain groups could not find
affordable insurance from a traditional insurance company. All of these
regulators cited medical malpractice insurance as an area where RRGs
increased the affordability and availability of insurance but they also
identified other areas. For example, regulators from Hawaii and Nevada
reported that RRGs have been important in addressing a shortage of
insurance for construction contractors. The six regulators all indicated
(to some extent) that by forming their own insurance companies, RRG
members also could control costs by designing insurance coverage

23We surveyed insurance departments from all 50 states and the District of
Columbia about their regulatory experiences with RRGs. Of these, all but
one-the State of Maryland- responded to our survey. Of the respondents, 36
gave an opinion for the question on whether RRGs had expanded the
availability and affordability of insurance.

24For more information, see the next section where we present the results
of regulatory responses to the questions on the adequacy of LRRA's
safeguards.

25As of the end of 2004, these six states had chartered 88 percent of all
RRGs.

targeted to their specific needs and develop programs to reduce specific
risks. In contrast, as noted by the Arizona regulator, traditional
insurers were likely to take a short-term view of the market, underpricing
their coverage when they had competition and later overpricing their
coverage to recoup losses. He also noted insurers might exit a market
altogether if they perceived the business to be unprofitable, as
exemplified in the medical malpractice market. Regulators from Vermont and
Hawaii, states that have the most experience in chartering RRGs, added
that successful RRGs have members that are interested in staying in
business for the "long haul" and are actively involved in running their
RRGs. RRG representatives added that RRG members, at any given time, might
not necessarily benefit from the cheapest insurance prices but could
benefit from prices that were stable over time. Additionally, as indicated
by trade group representatives, including the National Risk Retention
Association, RRGs have proved especially advantageous for small and
midsized businesses.

In order to obtain more specific information about how RRGs have benefited
their membership, we interviewed representatives of and reviewed documents
supplied by six RRGs that have been in business for more than 5 years, as
well as two more recently established RRGs. Overall, these eight RRGs had
anywhere from 2 to more than 14,500 members.26 They provided coverage to a
variety of insureds, including educational institutions, hospitals,
attorneys, and building contractors. The following three examples
illustrate some of the services and activities RRGs provide or undertake.

     o An RRG that insures about 1,100 schools, universities, and related
       organizations throughout the United States offers options tailored to
       its members, such as educators' legal liability coverage and coverage
       for students enrolled in courses offering off-campus internships.
       According to an RRG representative, the RRG maintains a claims
       database to help it accurately and competitively price its policies.
       Members also benefit from risk-management services, such as training
       and courses on sexual harassment and tenure litigation, and work with
       specialists to develop loss-control programs.
     o An RRG that reported that it insures 730 of the nation's approximately
       3,000 public housing authorities provides coverage for risks such as
       pesticide exposure, law enforcement liability, and lead-based paint

26The RRG with more than 14,500 members serves attorneys.

RRGs Have Remained Relatively Small in Size Compared with Traditional
Insurers but Serve a Wide Variety of Markets

liability. The RRG indicated that while premium rates have fluctuated,
they are similar to prices from about 15 years ago. The RRG also offers
risk-management programs, such as those for reducing fires, and also
reported that as a result of conducting member inspections it recently
compiled more than 2,000 recommendations on how to reduce covered risks.

o  An RRG that primarily provides insurance to about 45 hospitals in
California and Nevada offers general and professional coverage such as
personal and bodily injury and employee benefit liability. The RRG also
offers a variety of risk-management services specifically aimed at
reducing losses and controlling risks in hospitals. According to an RRG
official, adequately managing risk within the RRG has allowed for more
accurate pricing of the liability coverage available to members.

Generally, RRGs have remained relatively small compared with traditional
insurers. Based on our analysis of 2003 financial data submitted to NAIC,
47 of the 79 RRGs (almost 60 percent) that had been in business at least 1
year, wrote less than $10 million in gross premiums, whereas only 644 of
2,392 traditional insurers (27 percent) wrote less than $10 million. In
contrast, 1,118 traditional insurers (almost 47 percent) wrote more than
$50 million in gross premiums for 2003 compared with six RRGs (8 percent).
Further, these six RRGs (all of which had been in business for at least 1
year) accounted for 52 percent of all gross premiums that RRGs wrote in
2003. This information suggests that just a few RRGs account for a
disproportionate amount of the RRG market.

Additionally, RRGs that wrote the most business tended to have been in
business the longest. For example, as measured by gross premiums written,
of the 16 RRGs that sold more than $25 million annually, 14 had been in
business 5 years or more (see fig. 1). Yet, the length of time an RRG has
been in operation is not always the best predictor of an RRG's size. For
example, of the 51 RRGs that had been in business for 5 or more years, 27
still wrote $10 million or less in gross premiums.

Figure 1: RRG Gross Premiums Written in 2003, by Time (Years) in Business
Number of RRGs

18

15 14

11 10 10 9

6

6

5

3 2

0

0 Less than $2 $2 to 10 Greater than $10 Greater than $25 Greater to 25 to
100 than $100

    Gross premiums (in millions)

1 year but less than 5 years

5 years or more Source: GAO analysis of NAIC data.

aThis figure compares the amount of gross premiums written in 2003 by the
79 RRGs that had been in business for at least 1 year. Of the 79, 51 had
at least 5 years of business experience, and 28 had between 1 and 5 years.

According to the Risk Retention Reporter (RRR), a trade journal that has
covered RRGs since 1986, RRGs insure a wide variety of organizations and
businesses.27 According to estimates published in RRR, in 2004 105 RRGs
(more than half of the 182 in operation at that time) served the
healthcare sector (for example, hospitals, nursing homes, and doctors). In
1991, RRGs serving physicians and hospitals accounted for about 90 percent
of healthcare RRGs. However, by 2004, largely because of a recent increase
in nursing homes forming RRGs, this percentage decreased to about 74
percent.28 In addition, in 2004, 21 RRGs served the property development
area (for example, contractors and homebuilders), and 20 served the
manufacturing and commerce area (for example, manufacturers and
distributors). Other leading business areas that RRGs served include
professional services (for example, attorneys and architects), and
government and institutions (for example, educational and religious
institutions). Figure 2 shows how the distribution of RRGs by business
area has changed since 1991.

27Since NAIC does not collect information on the business areas served by
insurance companies, including RRGs, we obtained this information from
RRR. Over the years, RRR has surveyed RRGs, for example, asking RRGs to
project their premiums. The 2004 data we cited are based on projections
published by RRR in its October 2004 issue. To arrive at these estimates,
RRR projected the total number of RRGs based on the number it identified
operating as of the end of September 2004 and the total amount of premium
based on information obtained from its annual survey of RRGs. For 2004,
RRR reported a survey response rate of about 75 percent.

28In 2004, according to our analysis of RRG information collected by RRR,
about 43 percent

(45) of healthcare RRGs insured hospitals and their affiliates, 31 percent
(33) insured physicians, and 18 percent (19) served nursing homes.
However, the number of RRGs covering hospitals and physicians has
increased since 1991. In 1991, 8 RRGs provided coverage to hospitals and
their affiliates, and 13 RRGs provided coverage to physicians.

         Figure 2: Number of RRGs, by Business Area for Selected Years

All other RRGs

Source: Risk Retention Reporter.

aThe RRG numbers that RRR projected for 2004 are based on the number of
RRGs the journal identified operating as of the end of September 2004. For
each year, we show only the four business areas with the highest number of
RRGs, and group all other areas in a fifth category.

Healthcare Manufacturing and commerce

Government and institutions Professional services

Transportation Property development

Additionally, according to RRR's estimates, almost half of all RRG
premiums collected in 2004 were in the healthcare area (see fig. 3). The
professional services and government and institutions business areas
accounted for the second and third largest percentage of estimated gross
premiums collected, respectively.29

Figure 3: Percentage of Estimated Gross Premiums RRGs Collected in 2004,
by Business Area 2% Environmental 3% Transportation 4% Manufacturing and
commerce Property development

Government and institutions

Professional services

Healthcare

Source: Risk Retention Reporter.

Note: Gross premium data estimates are based on information RRR collected
from RRGs during a 2004 survey. RRR reported projections for all of 2004
in October 2004.

29While relatively few in number, RRGs serving the professional services
business area still accounted for a high percentage of estimated gross
premiums written by RRGs. One reason may be membership numbers. According
to RRR, RRGs in the professional services business area had the highest
number of members of all business areas.

Page 20 GAO-05-536 Risk Retention Groups

In looking at other characteristics of RRGs, according to an NAIC
analysis, the average annual failure rate for RRGs was somewhat higher
than the average annual failure rate for all other property and casualty
insurers. Between 1987 and 2003, the average annual failure rate for RRGs
was 1.83 percent compared with the 0.78 percent failure rate for property
and casualty insurers.30 Over this period, NAIC determined that a total of
22 RRGs failed, with between no and five RRGs failing each year.31 In
comparison, NAIC determined that a total of 385 traditional insurers
failed, with between 5 and 57 insurance companies failing each year.
Although the difference in failure rates was statistically significant, it
should be noted that the comparison may not be entirely parallel. NAIC
compared RRGs that can sell only commercial liability insurance to
businesses with insurers that can sell all lines of property and casualty
(liability) for commercial and personal purposes.32 Moreover, because NAIC
included all property-casualty insurers, no analysis was done to adjust
for size and longevity.

30To determine the failure rate for RRGs and traditional insurance
companies, NAIC compared the total number of "failed" insurance companies
each year with the total number of insurance companies writing business in
each year. NAIC characterized insurance companies as "failed" if a state
regulator placed the company into rehabilitation, conservation, or
liquidation. See appendix I for more information about NAIC's methodology,
and definitions of rehabilitation, conservation, and liquidation. See
appendix IV for a list of the RRGs that have failed.

31According to NAIC data, between 1991 and 2003, 21 other RRGs voluntarily
dissolved (with all claims paid) and 4 other RRGs combined or merged with
other companies.

32Traditional insurance companies write both property and casualty (that
is, liability) insurance, but due to the time-intensive nature of the many
tasks involved in this analysis, NAIC could not create a peer group of
traditional companies that only wrote commercial liability insurance and
were similar in size to RRGs. For example, in 2003 the largest traditional
insurer wrote $32 billion in premiums, whereas the largest RRG wrote $308
million. See appendix I for more information.

Recent Market Conditions Have Prompted the Creation of Many RRGs,
Especially to Provide Medical Malpractice Insurance

In creating RRGs, companies and organizations are generally responding to
market conditions. As the availability and affordability of insurance
decreased (creating a "hard" market), some insurance buyers sought
alternatives to traditional insurance and turned to RRGs.33 In response,
more RRGs formed from 2002 through 2004 than in the previous 15 years
(1986-2001). This increase is somewhat similar in magnitude to an increase
that occurred in 1986-1989 in response to an earlier hard market for
insurance (see fig. 4).34 The 117 RRGs formed from January 1, 2002,
through December 31, 2004, represent more than half of all RRGs in
operation as of December 31, 2004.

33During a hard market, insurance prices rise and insurers tend to narrow
their coverage, tighten their underwriting standards, and withdraw from
certain markets. Soft and hard market cycles in the medical malpractice
market tend to be more extreme than in other insurance markets because of
the longer time required to resolve medical malpractice claims and other
factors, such as changes in investment income and reduced competition,
which can exacerbate price fluctuations. See GAO, Medical Malpractice
Insurance: Multiple Factors Have Contributed to Increased Premium Rates,
GAO-03-702 (Washington, D.C.: June 27, 2003).

34According to NAIC, during the mid-1980s, professionals, businesses,
nonprofit organizations, and governmental entities experienced significant
increases in their liability insurance premiums, while finding it more
difficult to obtain coverage. See NAIC, Cycles and Crises in
Property/Casualty Insurance: Cases and Implications for Public Policy

(Kansas City, Mo.: 1991).

Figure 4: Number of RRGs, by Formation Date Number of RRGs 120 117

100

80

60

40

20

4

0 Before 1986 -1990 -1994 -1998 -2002 - 1986 1989 1993 1997 2001 2004

Formation date

Source: GAO analysis of NAIC data.

Note: This figure represents the number of RRGs formed during different
periods, regardless of whether they are currently active or not, and
includes only those RRGs for which NAIC has data. According to NAIC data,
four companies either formed as RRGs or converted to RRGs after the
passage of the Product Liability Risk Retention Act of 1981.

More specifically, RRGs established to provide medical malpractice
insurance accounted for most of the increase in RRG numbers in 2002-
2004.35 Healthcare providers sought insurance after some of the largest
medical malpractice insurance providers exited the market because of
declining profits, partly caused by market instability and high and
unpredictable losses-factors that have contributed to the high risks of
providing medical malpractice insurance.36 From 2002 through 2004,
healthcare RRGs accounted for nearly three-fourths of all RRG formations.
Further, 105 RRGs were insuring healthcare providers as of the end of
2004, compared with 23 in previous years (see again fig. 2). These RRGs
serve a variety of healthcare providers. For example, during 2003, 23 RRGs
formed to insure hospitals and their affiliates, 13 formed to insure
physician groups, and 11 formed to insure long-term care facilities,
including nursing homes and assisted living facilities. However, the
dramatic increase in the overall number of RRGs providing medical
malpractice insurance may precipitate an increase in the number of RRGs
vulnerable to failure. Studies have characterized the medical malpractice
insurance industry as volatile because the risks of providing medical
malpractice insurance are high.37

35This observation was based on our review of formation statistics
provided in the March 2005 RRR. In 2002-2004, of the 117 newly formed
RRGs, 94 were formed to provide healthcare coverage.

36 GAO-03-702 . Medical malpractice insurance operates much like other
types of insurance, with insurers collecting premiums from policyholders
(physicians, hospitals, etc.) in exchange for an agreement to defend and
pay future claims within the limits set by the policy. Medical malpractice
insurance has become less profitable due to higher losses on medical
malpractice insurance claims, rising reinsurance rates, long lags between
the collection of premiums and the payment of claims, and other factors.

37 GAO-03-702 . We concluded that the medical malpractice insurance market
is more volatile than the property-casualty insurance market as a whole
because of the length of time involved in resolving medical malpractice
claims and the volatility of the claims themselves. Our analysis also
showed that annual loss ratios for medical malpractice insurers tended to
swing higher or lower than those for property-casualty insurers as a
whole, reflecting more extreme changes in insurers' expectations. See also
NAIC, Medical Malpractice Insurance Report: A Study of Market Conditions
and Potential Solutions to the Recent Crisis

(Kansas City, Mo.: Sept. 12, 2004). NAIC details statistical evidence
supporting the long-term volatility of the medical malpractice market and
describes several Conning and Company studies spanning nearly a decade
that reported increasing volatility, rapid deterioration in the market,
and rapidly deteriorating loss ratios.

  LRRA's Regulatory Preemption Has Resulted in Widely Varying Requirements among
  States and Limited Confidence in RRG Regulation

Finally, many of the recently formed healthcare-related RRGs are selling
insurance in states where medical malpractice insurance rates for
physicians have increased the most.38 For example, since April 30, 2002,
the Pennsylvania Insurance Department has registered 32 RRGs to write
medical malpractice products. In addition, since the beginning of 2003,
the Texas Department of Insurance has registered 15 RRGs to write medical
malpractice insurance, more than the state had registered in the previous
16 years. Other states where recently formed RRGs were insuring doctors
include Illinois and Florida, states that have also experienced large
increases in medical malpractice insurance premium rates.

LRRA's regulatory preemption has allowed states to set regulatory
requirements that differ significantly from those of traditional insurers,
and from each other, producing limited confidence among regulators in the
regulation of RRGs. Many of the differences arise because some states
allow RRGs to be chartered as captive insurance companies, which typically
operate under a set of less restrictive rules than traditional insurers.
As a result, RRGs generally domicile in those states that permit their
formation as captive insurance companies, rather than in the states in
which they conduct most of their business. For example, RRGs domiciled as
captive insurers usually can start their operations with smaller amounts
of capital and surplus than traditional insurance companies, use letters
of credit to meet minimum capitalization requirements, or meet fewer
reporting requirements. Regulatory requirements for captive RRGs vary
among states as well, in part because regulation of RRGs and captives are
not subject to uniform, baseline standards, such as the NAIC accreditation
standards that define a state's regulatory structure for traditional
companies. As one notable example, states do not require RRGs to follow
the same accounting principles when preparing their financial reports,
making it difficult for some nondomiciliary state regulators, as well as
NAIC analysts, to reliably assess the financial condition of RRGs.
Regulators responding to our survey also expressed concern about the lack
of uniform, baseline standards. Few (eight) indicated that they believed

38 GAO-03-702 . We examined selected states and determined that, since
1999, medical malpractice insurance rates for physicians in some states
increased dramatically for several reasons, including increased losses on
insurer medical malpractice claims, decreased insurer investment income,
the exit of some insurers from the medical malpractice market (either
voluntarily or because of insolvency), and increases in reinsurance rates
for medical malpractice insurers.

Page 25 GAO-05-536 Risk Retention Groups

Most RRGs Have Domiciled in States That Charter Them as Captives but Have
Conducted Most of Their Business in Other States

LRRA's regulatory safeguards and protections, such as the right to file a
suit against an RRG in court, were adequate. Further, some regulators
suggested that some domiciliary states were modifying their regulatory
requirements and practices to make it easier for RRGs to domicile in their
state. We found some evidence to support these concerns based on
differences among states in minimum capitalization requirements,
willingness to charter RRGs to insure parties that sell extended service
contracts to consumers, or willingness to charter RRGs primarily started
by service providers, such as management companies, rather than insureds.

Regulatory requirements for captive insurers are generally less
restrictive than those for traditional insurers and offer RRGs several
financial advantages. For example, captive laws generally permit RRGs to
form with smaller amounts of required capitalization (capital and
surplus), the minimum amount of initial funds an insurer legally must have
to be chartered.39 While regulators reported that their states generally
require traditional insurance companies to have several millions of
dollars in capital and surplus, they often reported that RRGs chartered as
captives require no more than $500,000.40 In addition, unlike requirements
for traditional insurance companies, the captive laws of the six leading
domiciliary states permit RRGs to meet and maintain their minimum capital
and surplus requirements in the form of an irrevocable letter of credit
(LOC) rather than cash.41 According to several regulators that charter
RRGs as captives, LOCs may provide greater protection to the

39Regulators identified their state's minimum statutory capital and
surplus requirements for their traditional and captive insurers in
response to our survey.

40However, according to the leading domiciliary state regulators,
regardless of the statutory minimum requirement, they determine an RRG's
actual operating capital and surplus needs based on an assessment of the
RRG's proposed business plan and the amount of capitalization necessary to
avoid financial difficulties. Also, the statutory minimum for capitalizing
new RRGs still may be higher than those for pure captives. For example,
for pure captives, Nevada requires $200,000 and Vermont $250,000, but for
RRGs, Nevada requires $500,000 and Vermont $1 million.

41For an RRG, an LOC is a document issued by a financial institution on
behalf of a beneficiary (for example, the insurance commissioner) stating
the amount of credit the customer has available, and that the institution
will honor drafts up to the amount written by the customer. An irrevocable
LOC could not be canceled or amended without the beneficiary's approval.
NAIC reviewed the financial statements of 49 RRGs that commenced business
in 2003 and identified 13 that were capitalized with LOCs.

insureds than cash when only the insurance commissioner can access these
funds. The insurance commissioner, who would be identified as the
beneficiary of the LOC, could present the LOC to the bank and immediately
access the cash, but a representative of the RRG could not. However, other
state regulators questioned the value of LOCs because they believed cash
would be more secure if an RRG were to experience major financial
difficulties. One regulator noted that it becomes the regulator's
responsibility, on a regular basis, to determine if the RRG is complying
with the terms of the LOC. In addition, in response to our survey, most
regulators from states that would charter RRGs as captives reported that
RRGs would not be required to comply with NAIC's risk-based capital (RBC)
requirements.42 NAIC applies RBC standards to measure the adequacy of an
insurer's capital relative to their risks. Further, RRGs chartered as
captives may not be required to comply with the same NAIC financial
reporting requirements, such as filing quarterly and annual reports with
NAIC, that regulators expect traditional insurance companies to meet.43
For example, while the statutes of all the leading domiciliary states
require RRGs chartered as captives to file financial reports annually with
their insurance departments, as of July 2004, when we conducted our
survey, the statutes of only half the leading domiciliary states-Hawaii,

42Almost all regulators responded that RRGs chartered as traditional
companies would have to comply with NAIC's RBC requirements, but only 7 of
19 regulators responded that RRGs chartered as captives would have to
comply with these requirements. See appendix II for more information about
the survey question and appendix III for more information about RBC
requirements.

43LRRA only requires that each RRG submit to the insurance commissioner of
each state in which it is doing business a copy of its annual financial
statement. 15 U.S.C. S: 3902(d)(1)(3). In response to our survey, 14 of 18
regulators indicated that the laws and regulations of their state would
require RRGs domiciled in their state to submit the same financial
information as traditional insurers to NAIC, but additional discussions
with regulators from the six leading domiciliary states suggested that
some regulators may have based their responses on their department's
practices, rather than the statutes of their state. Arkansas, Montana,
Rhode Island, and Utah were the four states that reported that RRGs would
not have to submit the same financial information to NAIC as traditional
insurers. See the next section for more information on NAIC's
accreditation standards and appendix II for more information about the
survey question.

South Carolina, and Vermont-explicitly require that these reports also be
provided to NAIC on an annual basis.44

In addition, when RRGs are chartered as captive insurance companies they
may not have to comply with the chartering state's statutes regulating
insurance holding company systems. All 50 states and the District of
Columbia substantially have adopted such statutes, based on NAIC's Model
Insurance Holding Company System Regulatory Act.45

As in the model act, a state's insurance holding company statute generally
requires insurance companies that are part of holding company systems and
doing business in the state to register with the state and annually
disclose to the state insurance regulator all the members of that system.
Additionally, the act requires that transactions among members of a
holding company system be on fair and reasonable terms, and that insurance
commissioners be notified of and given the opportunity to review certain
proposed transactions, including reinsurance agreements, management
agreements, and service contracts. For 2004, NAIC reviewed RRG annual
reports and identified 19 RRGs that reported themselves as being
affiliated with other companies (for example, their management and
reinsurance companies). However, since only two of the six leading
domiciliary states, Hawaii, and to some extent South Carolina, actually
require RRGs to comply with this act, we do not know whether more RRGs

44The District of Columbia has since amended its Risk Retention Act of
1993 (D.C. Law 1046, D.C. Code S:S: 31-4101 et seq.) to require RRGs
chartered as captives to file an annual statement with NAIC, on a form
prescribed by NAIC. Since its enactment in 1993, the District of Columbia
Risk Retention Act has required all RRGs chartered in the District to file
a copy of their annual statements with NAIC. According to the District
regulator, RRGs chartered as captives were not subject to this requirement
prior to the 2004 amendments to the act.

45NAIC Model Insurance Holding Company System Regulatory Act (2001). The
NAIC model act defines an "insurance holding company system" as consisting
of two or more affiliated entities, one or more of which is an insurer. An
"affiliate" of an insurer is defined as a person that directly or
indirectly controls, is controlled by, or is under common control with the
insurer. "Control" over a person is defined as the power to direct
management and policies of that person and is presumed to exist if one can
vote 10 percent or more of the voting securities of the other person. Some
states specifically exempt RRGs from the requirements of their insurance
holding company act, and some states give their insurance commissioners
discretionary authority to exempt RRGs from the requirements of the act.

could be affiliated with other companies.46 The Hawaii regulator said that
RRGs should abide by the act's disclosure requirements so that regulators
can identify potential conflicts of interests with service providers, such
as managers or insurance brokers. Unless an RRG is required to make these
disclosures, the regulator would have the added burden of identifying and
evaluating the nature of an RRG's affiliations. He added that such
disclosures are important because the individual insureds of an RRG, in
contrast to the single owner of a pure captive, may not have the ability
to control potential conflicts of interest between the insurer and its
affiliates. (See the next section of this report for examples of how
affiliates of an RRG can have conflicts of interest with the RRG.)

Because of these regulatory advantages, RRGs are more likely to domicile
in states that will charter them as captives than in the states where they
sell insurance. Figure 5 shows that 18 states could charter RRGs as
captives. The figure also shows that most RRGs have chosen to domicile in
six states-Arizona, the District of Columbia, Hawaii, Nevada, South
Carolina, and Vermont-all of which charter RRGs as captives and market
themselves as captive domiciles.47 Of these states, Vermont and Hawaii
have been chartering RRG as captives for many years, but Arizona, the
District of Columbia, Nevada, South Carolina, and five additional states
have adopted their captive laws since 1999.48 In contrast to an RRG

46According to NAIC, the annual statement instructions indicate that
companies must identify on the appropriate schedule (that is, Schedule Y)
whether they are part of a holding company if the "reporting company is
required to file a registration statement under the provisions of the
domiciliary state's Insurance Holding Company System Regulatory Act."
Thus, if the RRG is not subject to the act, it would not be required to
complete Schedule Y, Part I. South Carolina regulators reported that RRGs
now are subject to the Insurance Holding Company System Regulatory Act as
a result of changes made to their statute in 2004.

47The six leading domiciliary states had chartered 88 percent of all RRGs
operating as of December 31, 2004. This percentage is an estimate based on
data NAIC reported to us in February 2005. NAIC's database may have
excluded RRGs that had been chartered but had not yet filed with NAIC. For
example, the State of Nebraska reported that it had chartered an RRG in
2002 but this RRG did not appear on NAIC's list of RRGs. In addition, the
database included several RRGs that were no longer active as RRGs or were
mislabeled as RRGs.

48In response to our survey, 18 states reported that they had captive laws
under which RRGs could be chartered. Of these, nine reported that they
adopted their captive laws between the beginning of 1999 and mid-2004. In
addition, according to NAIC data, Vermont chartered its first RRG in 1987,
and Hawaii chartered its first RRG in 1988.

chartered as a captive, a true captive insurer generally does not directly
conduct insurance transactions outside of its domiciliary state.

    Figure 5: Number of RRGs, by Captive or Noncaptive Charter and State of
                        Domicile, as of the End of 2004

Sources: GAO and NAIC.

Note: States, with the exception of Maryland, provided us information
about their captive laws as part of our survey. We did not independently
verify the information provided or whether RRGs domiciled in the state
were chartered as captives, although we updated some of the survey results
to reflect states that have adopted captive statutes since the time of our
survey. In addition, (1) the State of Maine indicated that while it had a
captive law, the question of whether or not an RRG could form under it had
not been formally considered and (2) the State of Kansas indicated that
while it could charter RRGs as captives, its captive law does not
explicitly permit RRGs to be chartered as captives.

However, states of domicile are rarely the states in which RRGs sell much,
or any, insurance. According to NAIC, 73 of the 115 RRGs active in 2003
did not write any business in their state of domicile, and only 10 wrote
more than 30 percent of their business in their state of domicile.49 The
states in which RRGs wrote most of their business in 2003-Pennsylvania
($238 million), New York ($206 million), California ($156 million),
Massachusetts ($98 million)-did not charter any RRGs. Texas, which
chartered only one RRG, had $87 million in direct written premiums written
by RRGs. For more information on the number of RRGs chartered by state and
the amount of direct premiums written by RRGs, see figure 6.

49"Business" refers to direct written premiums. Direct written premiums
equals the total amount of premiums an insurer writes annually on all
policies without adjustments for ceding or assuming any portion of these
premiums to a reinsurance company.

Page 31 GAO-05-536 Risk Retention Groups

Inconsistent Regulation of RRGs Resembles Earlier Regulation of
Traditional Insurers, Which Suffered from Lack of Uniform, Baseline
Standards

The current regulatory environment for RRGs, characterized by the lack of
uniform, baseline standards, offers parallels to the earlier solvency
regulation of multistate traditional insurers. Uniformity in solvency
regulation for multistate insurers is important, provided the regulation
embodies best practices and procedures, because it strengthens the
regulatory system across all states and builds trust among regulators.
After many insurance companies became insolvent during the 1980s, NAIC and
the states recognized the need for uniform, baseline standards,
particularly for multistate insurers.50 To alleviate this situation, NAIC
developed its Financial Regulation Standards and Accreditation Program
(accreditation standards) in 1989 and began the voluntary accreditation of
most state regulators in the 1990s. Prior to accreditation, states did not
uniformly regulate the financial solvency of traditional insurers, and
many states lacked confidence in the regulatory standards of other states.
By becoming accredited, state regulators demonstrated that they were
willing to abide by a common set of solvency standards and practices for
the oversight of the multistate insurers chartered by their state. As a
result, states currently generally defer to an insurance company's
domiciliary state regulator, even though each state retains the authority,
through its licensing process, to regulate all traditional insurance
companies selling in the state.

50See also GAO, Insurance Regulation Assessment of the National
Association of the Insurance Commissioners, GAO/T-GGD 91-37 (Washington,
D.C.: May 22, 1991). We assessed the capability of NAIC to create and
maintain an effective national system for solvency regulation. As part of
this assessment, we observed that states varied widely in the quality of
their solvency regulation, and states did not have consistent solvency
laws and regulation.

Page 33 GAO-05-536 Risk Retention Groups

NAIC's accreditation standards define baseline requirements that states
must meet for the regulation of traditional companies in three major
areas: First, they include minimum standards for the set of laws and
regulations necessary for effective solvency regulation.51 Second, they
set minimum standards for practices and procedures, such as examinations
and financial analysis, which regulators routinely should do.52 Third,
they establish expectations for resource levels and personnel practices,
including the amount of education and experience required of professional
staff, within an insurance department.53 However, NAIC does not have a
similar set of regulatory standards for regulation of RRGs, which also are
multistate insurers.

According to NAIC officials, when the accreditation standards originally
were developed, relatively few states were domiciling RRGs as captive
insurers, and the question of standards for the regulation of captives and
RRGs did not materialize until NAIC began its accreditation review of
Vermont in 1993. NAIC completely exempted the regulation of captive
insurers from the review process but included RRGs because, unlike pure
captives, RRGs have many policyholders and write business in multiple
states. NAIC's accreditation review of Vermont lasted about 2 years and
NAIC and Vermont negotiated an agreement that only part of the
accreditation standards applied to RRGs.54 As a result of the review, NAIC
determined that RRGs were sufficiently different from traditional insurers
so that the regulatory standards defining the laws and regulations

51These accreditation standards also are known as Part A. To meet the
requirements of Part A, state legislatures must adopt all of NAIC's 18
model laws and regulations (or versions that are substantially similar)
and have authorized the state insurance regulators to implement
appropriate regulations.

52Also known as Part B, these accreditation standards cover the three
areas considered necessary for effective solvency regulation-financial
analysis, financial examinations, and communication with states-and
procedures for troubled companies.

53Also known as Part C, the purpose of these accreditation standards is to
ensure that state insurance departments have appropriate organizational
and personnel practices that encourage professional development, establish
minimum educational and experience requirements, and allow the departments
to attract and retain qualified personnel.

54Accreditation reviews of states vary in length; for example, they could
last a few weeks.

necessary for effective solvency regulation should not apply to RRGs.55
However, NAIC and Vermont did not develop substitute standards to replace
those they deemed inappropriate. Subsequently, other states domiciling
RRGs as captives also have been exempt from enforcing the uniform set of
laws and regulations deemed necessary for effective solvency regulation
under NAIC's accreditation standards. As a result, some states chartering
RRGs as captives do not obligate them, for example, to adopt a common set
of financial reporting procedures and practices, abide by NAIC's
requirements for risk-based capital, or comply with requirements outlined
in that state's version of NAIC's Model Insurance Holding Company System
Regulatory Act.56

In contrast, while NAIC's standards for the qualifications of an insurance
department's personnel apply to RRGs, they do not distinguish between the
expertise needed to oversee RRGs and traditional insurance companies.
Because half of the 18 states that are willing to charter RRGs as captives
have adopted captive laws since 1999, few domiciliary state insurance
departments have much experience regulating RRGs as captive insurance
companies. Further, in response to our 2004 survey, only three states new
to chartering captives-Arizona, the District of Columbia, and South
Carolina-reported that they have dedicated certain staff to the oversight
of captives.57 However, the State of Nevada later reported to us that it
dedicated staff to the oversight of captives as of June 2005.

The importance of standards that address regulator education and
experience can be illustrated by decisions made by state insurance
departments or staff relatively new to chartering RRGs. In 1988, Vermont
chartered Beverage Retailers Insurance Co. Risk Retention Group (BRICO).
Launched and capitalized by an outside entity, BRICO did not

55RRGs chartered as captive insurers are exempt from Part A requirements
but Vermont and NAIC agreed that the Part B standards regarding practices
and procedures, including financial examinations and analysis, should
apply to the regulation of RRGs. However, a state's examinations of an RRG
would be based on its own laws and regulations rather than the laws and
regulations required by the accreditation standards.

56For example, according to NAIC's Part A accreditation standards, state
statutes, regulations, or practices should require companies to file their
annual and quarterly financial statements with NAIC using procedures and
practices prescribed by the NAIC Accounting Practices and Procedures
Manual (for example, use of statutory accounting principles).

57Hawaii and Vermont also reported that they have staff specifically
dedicated to the oversight of captives.

have a sufficient number of members as evidenced by the need for an
outside entity to provide the capital. It failed in 1995 in large part
because it wrote far less business than originally projected and suffered
from poor underwriting. Further, according to regulators, BRICO began to
write business just as the market for its product softened, and
traditional licensed insurers began to compete for the business. As a
result, the Vermont regulators said that Vermont would not charter RRGs
unless they had a sufficient number of insureds at start-up to capitalize
the RRG and make its future operations sustainable. More recently, in
2000, shortly after it adopted its captive statutes, South Carolina
chartered Commercial Truckers Risk Retention Group Captive Insurance
Company. This RRG, which also largely lacked members at inception, failed
within a year because it had an inexperienced management team, poor
underwriting, and difficulties with its reinsurance company. The
regulators later classified their experience with chartering this RRG,
particularly the fact that the RRG lacked a management company, as
"lessons learned" for their department. Finally, as reported in 2004, the
Arizona insurance department inadvertently chartered an RRG that permitted
only the brokerage firm that formed and financed the RRG to have any
ability to control the RRG through voting rights. The Arizona insurance
department explained that they approved the RRG's charter when the
insurance department was operating under an acting administrator and that
the department would make every effort to prevent similar mistakes.

According to NAIC officials, RRGs writing insurance in multiple states,
like traditional insurers, would benefit from the adoption of uniform,
baseline standards for state regulation, and they plan gradually to
develop them. NAIC representatives noted that questions about the
application of accreditation standards related to RRGs undoubtedly would
be raised again because several states new to domiciling RRGs will be
subject to accreditation reviews in the next few years.58 However, the
representatives also noted, that because the NAIC accreditation team can
review the oversight of only a few of the many insurance companies
chartered by a state, the team might not select an RRG.

58NAIC officials provided us examples of states that would be accredited
over the next few years, but they also noted that NAIC generally does not
publish this information.

Page 36 GAO-05-536 Risk Retention Groups

Variations in RRG Reporting Requirements Have Impeded Assessments of Their
Financial Condition

As discussed previously, states domiciling RRGs as captives are not
obligated to require that RRGs meet a common set of financial reporting
procedures and practices. Moreover, even among states that charter RRGs as
captives, the financial reporting requirements for RRGs vary. Yet, the
only requirement under LRRA for the provision of financial information to
nondomiciliary regulators is that RRGs provide annual financial statements
to each state in which they operate. Further, since most RRGs sell the
majority of their insurance outside their state of domicile, insurance
commissioners from nondomiciliary states may have only an RRG's financial
reports to determine if an examination may be necessary.59 As we have
reported in the past, to be of use to regulators, financial reports should
be prepared under consistent accounting and reporting rules and provided
in a timely manner that results in a fair presentation of the insurer's
true financial condition.60

One important variation in reporting requirements is the use by RRGs of
accounting principles that differ from those used by traditional insurance
companies. The statutes of the District of Columbia, Nevada, South
Carolina, and Vermont require their RRGs to use GAAP; Hawaii requires RRGs
to use statutory accounting principles (SAP); and Arizona permits RRGs to
use either.61 The differences in the two sets of accounting principles
reflect the different purposes for which each was developed and each
produces a different-and not necessarily comparable-financial picture of a
business. In general, SAP is designed to meet the needs of insurance
regulators, the primary users of insurance financial statements, and
stresses the measurement of an insurer's ability to pay claims (remain
solvent) in order to protect insureds. In contrast, GAAP provides guidance
that businesses follow in preparing their general purpose financial
statements, which provide users such as investors and creditors with
useful information that allows them to assess a business' ongoing
financial performance. However, inconsistent use of accounting
methodologies by

59LRRA permits nondomiciliary states to conduct an examination to
determine an RRG's financial condition if the insurance commissioner of
the state of domicile has not begun or has refused to begin an examination
of the RRG. 15 U.S.C. S: 3902(a)(1)(E).

60GAO/T-GGD-91-37.

61According to NAIC, 79 of the 115 RRGs active as of the end of 2003 filed
financial statements using GAAP while the others filed using SAP. The RRGs
that filed their statements using SAP also were domiciled in states
besides Hawaii, such as Colorado, Florida, and Indiana.

RRGs could affect the ability of nondomiciliary regulators to determine
the financial condition of RRGs, especially since regulators are used to
assessing traditional insurers that must file reports using SAP.62

In addition, the statutes of each of the six domiciliary states allow
RRGs, like other captive insurers, to modify whichever accounting
principles they use by permitting the use of letters of credit (LOC) to
meet statutory minimum capitalization requirements. Strictly speaking,
neither GAAP nor SAP would permit a company to count an undrawn LOC as an
asset because it is only a promise of future payment-the money is neither
readily available to meet policyholder obligations nor is it directly in
the possession of the company. In addition to allowing LOCs, according to
a review of financial statements by NAIC, the leading domiciliary states
that require RRGs to file financial statements using GAAP also allow RRGs
to modify GAAP by permitting them to recognize surplus notes under capital
and surplus. This practice is not ordinarily permitted by GAAP. A company
filing under GAAP would recognize a corresponding liability for the
surplus note and would not simply add it to the company's capital and
surplus.63 See appendix III for more specific information on the
differences between SAP and GAAP, including permitted modifications, and
how these differences could affect assessments of a company's actual or
risk-based capital.

Variations in the use of accounting methods have consequences for
nondomiciliary regulators who analyze financial reports submitted by RRGs
and illustrate some of the regulatory challenges created by the absence of
uniform standards. Most nondomiciliary states responding to our survey of
all state regulators indicated that they performed only a limited review
of RRG financial statements.64 To obtain more specific information about
the impact of these differences, we contacted the six

62According to NAIC, some states require a reconciliation of GAAP to SAP
in the "note" sections of their financial statements.

63A surplus note is debt that an insurance company owes and that the
lender has agreed cannot be repaid without regulatory approval. See
appendix III for more information.

64In response to our survey, 22 state regulators indicated they gave RRG
financial statements less review than they gave for eligible nonadmitted
insurers (companies not licensed by a particular state to sell and service
insurance policies within that state). In contrast, 21 other regulators
indicated they provided RRGs the same level of review, and 5 indicated
they provided more review. Our evaluation of the 33 regulators who
provided written comments showed that many state reviews were limited.

states-Pennsylvania, California, New York, Massachusetts, Texas, and
Illinois-where RRGs collectively wrote almost half of their business in
2003 (see fig. 6). Regulators in Massachusetts and Pennsylvania reported
that they did not analyze the financial reports and thus had no opinion
about the impact of the accounting differences, but three of the other
four states indicated that the differences resulted in additional work.
Regulators from California and Texas told us that the use of GAAP,
especially when modified, caused difficulties because insurance regulators
were more familiar with SAP, which they also believed better addressed
solvency concerns than GAAP. The regulator from Illinois noted that RRG
annual statements were not marked as being filed based on GAAP and, when
staff conducted their financial analyses, they took the time to disregard
assets that would not qualify as such under SAP. The Texas regulator
reported that, while concerned about the impact of the differences, his
department did not have the staffing capability to convert the numbers for
each RRG to SAP and, as a result, had to prioritize their efforts.

Further, NAIC staff reported that the use by RRGs of a modified version of
GAAP or SAP distorted the analyses they provided to state regulators. One
of NAIC's roles is to help states identify potentially troubled insurers
operating in their state by analyzing insurer financial reports with
computerized tools to identify statistical outliers or other unusual data.
In the past, we have noted that NAIC's solvency analysis is an important
supplement to the overall solvency monitoring performed by states and can
help states focus their examination resources on potentially troubled
companies.65 NAIC uses Financial Analysis Solvency Tools (FAST), such as
the ratios produced by the Insurance Regulatory Information System (IRIS)
and the Insurer Profile Reports, to achieve these objectives and makes the
results available to all regulators through a central database.66 However,
NAIC analysts reported that differing accounting formats undermined the
relative usefulness of these tools because the tools were only designed to
analyze data extracted from financial reports based on SAP. Similarly,
when

65GAO, Insurance Regulation: The NAIC Accreditation Program Can be
Improved, GAO- 01-948 (Washington, D.C.: Aug. 31, 2001).

66According to NAIC, it stores IRIS ratios and Insurer Profile Reports,
and 10 years of annual and quarterly financial data for more than 4,800
individual insurers in its Financial Data Repository database. Nearly all
insurers, except for the smallest ones, submit their annual and quarterly
reports to NAIC and their domiciliary regulator. NAIC flags IRIS ratios
that are outside the "usual range" for additional regulatory attention. In
response to an increased focus on RRGs, NAIC recently made an adjustment
to the Insurer Profile Reports to notify the user if any RRG might have
filed using GAAP.

Lack of Uniform, Baseline Regulatory Standards Has Concerned Many
Regulators

we attempted to analyze some aspects of the financial condition of RRGs to
compare them with traditional companies, we found that information
produced under differing accounting principles diminished the usefulness
of the comparison (see app. III).

The lack of uniform, baseline regulatory standards for the oversight of
RRGs contributed to the concerns of many state regulators, who did not
believe the regulatory safeguards and protections built into LRRA (such as
requiring RRGs to file annual financial statements with regulators and
allowing regulators to file suit if they believe the RRG is financially
unsound) were adequate.67 Only 8 of 42 regulators who responded to our
survey question about LRRA's regulatory protections indicated that they
thought the protections were adequate (see fig. 7).68 Eleven of the 28
regulators who believed that the protections were inadequate or very
inadequate focused on the lack of uniform, regulatory standards or the
need for RRGs to meet certain minimum standards-particularly for minimum
capital and surplus levels. In addition, 9 of the 28 regulators,
especially those from California and New York, commented that they
believed state regulators needed additional regulatory authority to
supervise the RRGs in their states. While RRGs, like traditional insurers,
can sell in any or all states, only the domiciliary regulator has any
significant regulatory oversight.

67As noted previously, LRRA requires that RRGs file an initial plan of
operation or feasibility study in every state in which it is planning to
sell insurance and an annual financial statement with every state in which
it is selling insurance. In addition, each nondomiciliary state has the
right to (1) request that a domiciliary state examine an RRG, (2) examine
the RRG itself if the domiciliary state refuses to do so, and (3) file a
suit in a court of "competent jurisdiction" if the state believes that the
RRG is in hazardous financial condition.

68The states were Delaware, Hawaii, Kansas, Nevada, Ohio, South Dakota,
Vermont, and the District of Columbia.

Figure 7: State Regulators' Opinion of the Adequacy of the Regulatory
Protections or Safeguards Built into LRRA Number of responses 20 19

e

                         Adequate nor inadNeither adte

                                      ate

y adequat

                                    Inadequa

                                   y inadequ

Ver

                                      Ver

Source: GAO.

Note: In addition, seven regulators responded that they had no opinion on
this question, and one regulator did not respond at all.

In addition, the regulators from the six leading domiciliary
states-Arizona, the District of Columbia, Hawaii, Nevada, South Carolina,
and Vermont- did not agree on the adequacy of LRRA safeguards. For
example, while the regulators from the District of Columbia, Hawaii,
Nevada, and Vermont thought the protections adequate, the regulator from
South Carolina reported that LRRA's safeguards were "neither adequate nor
inadequate" because LRRA delegates the responsibility of establishing
safeguards to domiciliary states, which can be either stringent or
flexible in establishing safeguards. The other leading domiciliary
state-Arizona-had not yet formed an opinion on the adequacy of LRRA's
provisions. The regulator from Hawaii also noted that the effectiveness of
the LRRA provisions was dependent upon the expertise and resources of the
RRG's domiciliary regulator.

While many regulators did not believe LRRA's safeguards were adequate, few
indicated that they had availed themselves of the tools LRRA does provide
nondomiciliary state regulators. These tools include the ability to
request that a domiciliary state undertake a financial examination and the
right to petition a court of "competent jurisdiction" for an injunction
against an RRG believed to be in a hazardous financial condition. Recent
cases involving state regulation of RRGs typically have centered on
challenges to nondomiciliary state statutes that affect operations of the
RRGs, rather than actions by nondomiciliary states challenging the
financial condition of RRGs selling insurance in their states.69 Finally,
in response to another survey question, nearly half of the regulators said
they had concerns that led them to contact domiciliary state regulators
during the 24 months preceding our survey, but only five nondomiciliary
states indicated that they had ever asked domiciliary states to conduct a
financial examination.70

However, according to the survey, many state regulators availed themselves
of the other regulatory safeguards that LRRA provides-that RRGs submit to
nondomiciliary states feasibility or operational plans before they begin
operations in those states and thereafter a copy of the same annual
financial statements that the RRG submits to its domiciliary state.71
Almost all the state regulators indicated that they reviewed these
documents to some extent, although almost half of the state regulators
indicated that they provided these reports less review than those
submitted

69Many court cases have involved state financial responsibility statutes
that have the effect of precluding RRGs from offering insurance to certain
licensed professionals in a particular state, as well as the authority of
a state to impose minimum capital and surplus requirement and regulatory
fees on RRGs that are chartered in other states. See, e.g., National
Warranty Insurance Co. RRG v. Greenfield, 214 F.3d 1073 (9th Cir. 2000),
cert. den., 531 U.S. 1104 (2001); Ophthalmic Mutual Ins. Co. v. Musser,
143 F.3d 1062 (7th Cir. 1998); Mears Transportation Group v. Florida, 34
F.3d 1013 (11th Cir. 1994); National Home Ins. Co. v. King, 291 F.
Supp.2d. 518 (E.D. Ky. 2003); Attorneys' Liability Assur. Society v.
Fitzgerald, 174 F. Supp.2d 619 (W.D. Mich. 2001); National Risk Retention
Assoc. v. Brown, 927 F. Supp. 195 (1996), aff'd, 114 F.3d 1183 (5th Cir.
1997); and Charter Risk Retention Group v. Rolka et al., 796 F. Supp. 154
(M.D. Pa. 1992).

70These states were Arizona, California, Mississippi, New Mexico, and
Texas.

7115 U.S.C. S: 3902(d)(2). In addition, LRRA requires RRGs to submit a
copy of the group's annual financial statement, certified by an
independent public accountant and containing a statement of opinion on
loss and loss adjustment expense reserves made by a member of the American
Academy of Actuaries, or a qualified loss reserve specialist. 15 U.S.C. S:
3902(d)(3).

Some Evidence Suggests That States Have Set Their Captive Regulatory
Standards to Attract RRGs to Domicile in Their States

by other nonadmitted insurers.72 In addition, nine states indicated that
RRGs began to conduct business in their states before supplying them with
copies of their plans of operations or feasibility studies, but most
indicated that these occurrences were occasional. Similarly, 15 states
identified RRGs that failed to provide required financial statements for
review, but most of these regulators indicated that the failure to file
was an infrequent

73

occurrence.

Some regulators, including those from New York, California, and Texas-
states where RRGs collectively wrote about 26 percent of all their
business but did not domicile-expressed concerns that domiciliary states
were lowering their regulatory standards to attract RRGs to domicile in
their states for economic development purposes. They sometimes referred to
these practices as the "regulatory race to the bottom." RRGs, like other
captives, can generate revenue for a domiciliary state's economy when the
state taxes RRG insurance premiums or the RRG industry generates jobs in
the local economy. The question of whether domiciliary states were
competing with one another essentially was moot until about 1999, when
more states began adopting captive laws. Until then, Vermont and Hawaii
were two of only a few states that were actively chartering RRGs and
through 1998 had chartered about 55 percent of all RRGs. However,

72States call insurers that they have not licensed-but which may be
licensed in other states-"nonadmitted" insurers or carriers. States have
the ability to prohibit unlicensed insurers from selling in their state.
However, some states permit nonadmitted insurers to sell coverage that is
unavailable from licensed insurers within their borders. This kind of
coverage is also known as "surplus lines insurance." Historically,
policyholders bought surplus lines insurance when the insurance coverage
they were seeking was unavailable from admitted insurers. See appendix II
for more information about how states responded to these questions.

73In addition, for 2003, 10 regulators identified RRGs that had not
registered to conduct business in their states, although the RRGs reported
to NAIC that they had written premiums in these states. Most of the 10
state regulators identified just a few RRGs as having failed to register
and often the states referred to the same RRGs. In addition, while listed
as RRGs in the NAIC database, as of 2003 two of the insurance companies no
longer wrote insurance as RRGs.

between the beginning of 1999 and the end of 2004, they had chartered only
36 percent of all newly chartered RRGs.74

The six leading domiciliary states actively market their competitive
advantages on Web sites, at trade conferences, and through relationships
established with trade groups. They advertise the advantages of their new
or revised captive laws and most describe the laws as "favorable"; for
example, by allowing captives to use letters of credit to meet their
minimum capitalization requirements. Most of these states also describe
their corporate premium tax structure as competitive and may describe
their staff as experienced with or committed to captive regulation.
Vermont emphasizes that it is the third-largest captive insurance domicile
in the world and the number one in the United States, with an insurance
department that has more than 20 years of experience in regulating RRGs.
South Carolina, which passed its captive legislation in 2000, emphasizes a
favorable premium tax structure and the support of its governor and
director of insurance for its establishment as a domicile for captives.
Arizona describes its state as "business friendly," highlighting the lack
of premium taxes on captive insurers and the "unsurpassed" natural beauty
of the state.

However, in addition to general marketing, some evidence exists to support
the concern that the leading domiciliary states are modifying policies and
procedures to attract RRGs. We identified the following notable
differences among the states, some of which reflect the regulatory
practices and approaches of each state and others, statute:

74These percentages are estimates based on data that NAIC provided. Not
all RRGs, such as those domiciled in Bermuda and the Cayman Islands, or
even in the United States, report their chartering information to NAIC. In
addition, we found two insurance companies that were mislabeled as RRGs.

Page 44 GAO-05-536 Risk Retention Groups

     o Willingness to domicile vehicle service contract (VSC) providers:
       Several states, including California, New York, and Washington,
       questioned whether RRGs consisting of VSC providers should even
       qualify as RRGs and are concerned about states that allow these
       providers to form RRGs. VSC providers issue extended service contracts
       for the costs of future repairs to consumers (that is, the general
       public) who purchase automobiles. Until 2001, almost all of these RRGs
       were domiciled in Hawaii but after that date, all the new RRGs formed
       by VSC providers have domiciled in the District of Columbia and South
       Carolina.75 The Hawaii regulator said that the tougher regulations it
       imposed in 2001 (requiring that RRGs insuring VSC providers annually
       provide acceptable proof that they were financially capable of meeting
       VSC claims filed by consumers) dissuaded these providers from
       domiciling any longer in Hawaii. In addition, one of the leading
       domiciliary states, Vermont, refuses to domicile any of these RRGs
       because of the potential risk to consumers. Consumers who purchase
       these contracts, not just the RRG insureds, can be left without
       coverage if the RRG insuring the VSC provider's ability to cover VSC
       claims fails. (We discuss RRGs insuring service contract providers and
       consequences to insureds and consumers more fully later in this
       report.)
     o Statutory minimum capitalization requirements: Differences in the
       minimum amount of capital and surplus (capitalization) each insurer
       must have before starting operations make it easier for smaller RRGs
       to domicile in certain states and reflect a state's attitude towards
       attracting RRGs. For example, in 2003, Vermont increased its minimum
       capitalization amount from $500,000 to $1 million-according to
       regulators, to ensure that only RRGs that are serious prospects, with
       sufficient capital, apply to be chartered in the state. On the other
       hand, effective in 2005, the District of Columbia lowered its minimum
       capitalization amount for a RRG incorporated as a stock insurer (that
       is, owned by shareholders who hold its capital stock) from $500,000 to
       $400,000 to make it easier for RRGs to charter there.

75Since April 1995 Hawaii chartered seven RRGs to insure VSCs, approving
the last such charter in December 2000. As of June 2005, only three of
these RRGs remained domiciled in Hawaii. Since January 2001, South
Carolina has chartered six RRGs to insure VSCs, with the most recent
charter approval in April 2002. Since January 2004, the District of
Columbia has chartered three RRGs to insure VSCs, with two of these three
RRGs in 2005 redomiciling from Hawaii.

Page 45 GAO-05-536 Risk Retention Groups

     o Corporate forms: In 2005, one of the six leading domiciliary
       states-the District of Columbia-enacted legislation that permits RRGs
       to form "segregated accounts." The other leading domiciliary states
       permit the formation of segregated accounts or "protected cells" for
       other types of captives but not for their RRGs. According to the
       District's statute, a captive insurer, including an RRG, may fund
       separate accounts for individual RRG members or groups of members with
       common risks, allowing members to segregate a portion of their risks
       from the risks of other members of the RRG.76 According to the
       District regulator, RRG members also would be required to contribute
       capital to a common account that could be used to cover a portion of
       each member's risk. The District regulator also noted that the
       segregated cell concept has never been tested in insolvency; as a
       result, courts have not yet addressed the concept that the cells are
       legally separate.
     o Willingness to charter entrepreneurial RRGs: RRGs may be formed with
       only a few members, with the driving force behind the formation being,
       for example, a service provider, such as the RRG's management company
       or a few members. These RRGs are referred to as "entrepreneurial" RRGs
       because their future success is often contingent on recruiting
       additional members as insureds. In 2004, South Carolina regulators
       reported they frequently chartered entrepreneurial RRGs to offset what
       they described as the "chicken and egg" problem-their belief that it
       can be difficult for RRGs to recruit new members without having the
       RRG already in place. Regulators in several other leading domiciliary
       states have reported they would be willing to charter such RRGs if
       their operational plans appeared to be sound but few reported having
       done so. However, regulators in Vermont said that they would not
       charter entrepreneurial RRGs because they often were created to make a
       profit for the "entrepreneur," rather than helping members obtain
       affordable insurance. (We discuss entrepreneurial RRGs later in the
       report.)

76The core company would still be formed as a stock company, mutual, or a
reciprocal. A stock insurer is an incorporated entity with capital stock
divided into shares, which is owned by its shareholders. A mutual insurer
is an incorporated entity without capital stock, which is owned by its
policyholders. A reciprocal, also known as a reciprocal exchange, is an
unincorporated aggregation of subscribers (individual members) who insure
each other. Reciprocals are administered by an "attorney-in-fact" who, for
example, recruits members, pays losses, or exchanges insurance contracts.
The District regulator also indicated that the District would never permit
a single member of an RRG to have its own account, even though this
prohibition is not specifically stated in the District's statute.

Finally, the redomiciling of three RRGs to two of the leading domiciliary
states, while subject to unresolved regulatory actions in their original
state of domicile, also provides some credibility to the regulators'
assertions of "regulatory arbitrage." In 2004, two RRGs redomiciled to new
states while subject to regulatory actions in their original states of
domicile. One RRG, which had been operating for several years, redomiciled
to a new state before satisfying the terms of a consent order issued by
its original domiciliary state and without notifying its original state of
domicile.77 Although the RRG satisfied the terms of the consent order
about 3 months after it redomiciled, the regulator in the original
domiciliary state reported that, as provided by LRRA, once redomiciled,
the RRG had no obligation to do so. The second RRG, one that had been
recently formed, was issued a cease and desist order by its domiciliary
state because the regulators had questions about who actually owned and
controlled the RRG. As in the first case, the original domiciliary state
regulator told us that this RRG did not advise them that it was going to
redomicile and, once redomiciled, was under no legal obligation to satisfy
the terms of the cease and desist order. The redomiciling, or rather
liquidation, of the third RRG is more difficult to characterize because
its original state of domicile (Hawaii) allowed it to transfer some of its
assets to a new state of domicile (South Carolina) after issuing a cease
and desist order to stop it from selling unauthorized insurance products
directly to the general public, thereby violating the provisions of
LRRA.78 More specifically, Hawaii allowed the RRG to transfer its losses
and related assets for its "authorized" lines of insurance to South
Carolina and required the Hawaiian company to maintain a $1 million
irrevocable LOC issued in favor of the insurance commissioner until such
time as the "unauthorized" insurance matter was properly resolved. South
Carolina permitted the owners of these assets to form a

77A cease and desist order is a formal regulatory communication from an
insurance department ordering an insurance company to stop certain
activities, such as the issuance of new insurance policies.

78Heritage Warranty Mutual Insurance RRG, Inc., Hawaii Department of
Commerce and Consumer Affairs, Insurance Division, Cease and Desist Order
IC-01-003 (March 1, 2001). This order was issued about 2 months after
Heritage Warranty Mutual Insurance RRG, Inc., had entered into a consent
agreement in which the RRG voluntarily agreed to surrender its license.
(The State of Hawaii had earlier charged that the RRG had changed its
reinsurance program without approval of the insurance commissioner, as
required by law.) According to the Hawaii Department of Insurance, by
December 2000, when the consent order was issued, the RRG had already
secured preliminary approval from South Carolina to redomicile to that
state. Finally, in September 2002, the State of Hawaii liquidated Heritage
Warranty Mutual Insurance RRG, Inc., in response to its sale of
unauthorized lines of insurance.

  RRG Failures Have Raised Questions about the Sufficiency of LRRA Provisions
  for RRG Ownership, Control, and Governance

new RRG offering a similar line of coverage and use a name virtually
identical to its predecessor in Hawaii. Had these RRGs been chartered as
traditional insurance companies, they would not have had the ability to
continue operating in their original state of domicile after redomiciling
in another state without the original state's express consent. Because
traditional companies must be licensed in each state in which they
operate, the original state of domicile would have retained its authority
to enforce regulatory actions.

Because LRRA does not comprehensively address how RRGs may be owned,
controlled, or governed, RRGs may be operated in ways that do not
consistently protect the best interests of their insureds. For example,
while self-insurance is generally understood as risking one's own money to
cover losses, LRRA does not specify that RRG members, as owners, make
capital contributions beyond their premiums or maintain any degree of
control over their governing bodies (such as boards of directors). As a
result, in the absence of specific federal requirements and using the
latitude LRRA grants them, some leading domiciliary regulators have not
required all RRG insureds to make at least some capital contribution or
exercise any control over the RRG. Additionally, some states have allowed
management companies or a few individuals to form what are called
"entrepreneurial" RRGs. Consequently, some regulators were concerned that
RRGs were being chartered primarily for purposes other than
self-insurance, such as making a profit for someone other than the
collective insureds. Further, LRRA does not recognize that separate
companies typically manage RRGs. Yet, past RRG failures suggest that
sometimes management companies have promoted their own interests at the
expense of the insureds. Although LRRA does not address governance issues
such as conflicts of interest between management companies and insureds,
Congress previously has enacted safeguards to address similar issues in
the mutual fund industry. Finally, some of these RRG failures have
resulted in thousands of insureds and their claimants losing coverage,
some of whom may not have been fully aware that their RRG lacked state
insurance insolvency guaranty fund coverage or the consequences of lacking
such coverage.

While RRGs Are a Form of Self-Insurance, Not All RRG Insureds Are Equity
Owners or Have the Ability to Exercise Control

While RRGs are a form of self-insurance on a group basis, LRRA does not
require that RRG insureds make a capital investment in their RRG and
provides each state considerable authority to establish its own rules on
how RRGs will be chartered and regulated. Most of the regulators from the
leading domiciliary states reported that they require RRGs to be organized
so that all insureds make some form of capital contribution but other
regulators do not, or make exceptions to their general approach.79
Regulators from Vermont and Nevada emphasized that it was important for
each member to have "skin in the game," based on the assumption that
members who make a contribution to the RRG's capital and surplus would
have a greater interest in the success of the RRG. The regulator from
Nevada added that if regulators permitted members to participate without
making a capital contribution, they were defeating the spirit of LRRA.
However, another of the leading domiciliary states, the District of
Columbia, does not require insureds to make capital contributions as a
condition of charter approval and has permitted several RRGs to be formed
accordingly. The District regulator commented that LRRA does not require
such a contribution and that some prospective RRG members may not have the
financial ability to make a capital contribution. Further, despite
Vermont's position that RRG members should make a capital contribution,
the Vermont regulators said they occasionally waive this requirement under
special circumstances; for example, if the RRG was already established and
did not need any additional capital. In addition, several of the leading
domiciliary states, including Arizona, the District of Columbia, and
Nevada, would consider allowing a nonmember to provide an LOC to fund the
capitalization of the RRG.

However, as described by several regulators, including those in Hawaii and
South Carolina, even when members do contribute capital to the RRG, the
amount contributed can vary and be quite small. For instance, an investor
with a greater amount of capital, such as a hospital, could initially
capitalize an RRG, and expect smaller contributions from members (for
example, doctors) with less capital. Or, in an RRG largely owned by one
member, additional members might be required only to make a token
investment, for example, $100 or less. As a result, an investment that
small

79While the statutes of the six leading domiciliary states do not require
that RRG members make a minimum capital contribution to the RRG, the
regulators in some of these states, as a condition of granting an RRG's
application for a state charter, exercise their discretionary authority to
require RRG members to make capital contributions to the RRG.

Page 49 GAO-05-536 Risk Retention Groups

would be unlikely to motivate members to feel like or behave as "owners"
who were "self-insuring" their risks.

LRRA also does not have a requirement that RRG insureds retain control
over the management and operation of their RRG. However, as discussed
previously, the legislative history indicates that some of the act's
single-state regulatory framework and other key provisions were premised
not only on ownership of an RRG being closely tied to the interests of the
insureds, but also that the insureds would be highly motivated to ensure
proper management of the RRG. Yet, in order to make or direct key
decisions about a company's operations, the insureds would have to be able
to influence or participate in the company's governing body (for example,
a board of directors).80 A board of directors is the focal point of an
insurer's corporate governance framework and ultimately should be
responsible for the performance and conduct of the insurer.81 Governance
is the manner in which the boards of directors and senior management
oversee a company, including how they are held accountable for their
actions.82

80Membership: "[I]t is the committee's intent that `members' include the
equity owners of, or contributors to, the risk retention group, as well as
entities affiliated with or related to such owners or contributors.
Membership in a risk retention group should be limited to active
participants in a risk retention program." H. Rep. No. 97-190, at 10,
reprinted in 1981

U.S.C.A.A.N. at 1439; S. Rep. No. 97-172, at 9. Single-state regulation:
"Because risk retention groups will be providing insurance coverage only
to their own members, and not the public at large, it is believed that
regulation by the chartering jurisdiction will be sufficient to provide
adequate supervision of these groups." H. Rep. No. 97-190, at 15 (1981),
reprinted in 1981 U.S.C.A.A.N. at 1444; S. Rep. No. 97-172, at 13. Reasons
for exclusion from guaranty funds: "First, risk retention groups are not
full-fledged multi-line insurance companies, but limited operations
providing coverage only to member companies, and only for a narrow group
of coverages. Second, there will be a strong incentive for risk retention
groups to set adequate premiums and establish adequate reserves if each
member knows there is no other source of funds (other than its own
corporate assets) from which to pay claims." H. Rep. No. 97-190, at 16
(1981), reprinted in 1981 U.S.C.A.A.N. at 1445; S. Rep. No. 97-172, at 15
(1981).

81Generally speaking, a board of directors is a group of individuals
elected by shareholders that represents the owners of a company and
oversees the management of the company. RRG members who receive the right
to vote through the RRG's governing instruments (e.g., articles of
incorporation, bylaws) may elect some or all of the RRG's governing body,
providing the insureds with a means of influencing corporate policymaking.

82International Association of Insurance Supervisors, Insurance Core
Principles on Corporate Governance (Basel, Switzerland: 2004).

Most leading state regulators said they expect members of RRGs to exert
some control over the RRG by having the ability to vote for directors,
even though these rights sometimes vary in proportion to the size of a
member's investment in the RRG or by share class.83 Most of the leading
state regulators generally define "control" to be the power to direct the
management and policies of an RRG as exercised by an RRG's governing body,
such as its board of directors. However, regulators from the District of
Columbia asserted that they permit RRGs to issue nonvoting shares to their
insureds because some members are capable of making a greater financial
contribution than others and, in exchange for their investment, will seek
greater control over the RRG. The regulators noted that allowing such
arrangements increases the availability of insurance and has no adverse
effect on the financial solvency of the RRG. Further, the District of
Columbia permits nonmembers (that is, noninsureds) to appoint or vote for
directors. In addition, we found that even regulators who expect all RRG
members to have voting rights (that is, at a minimum a vote for directors)
sometimes make exceptions. For example, an RRG domiciled in Vermont was
permitted to issue shares that did not allow insureds to vote for members
of the RRG's governing body. The Vermont regulators reported that the
attorney forming the RRG believed issuing the shares was consistent with
the department's position that RRG members should have "voting rights"
because under Vermont law all shareholders are guaranteed other minimal
voting rights.84

83For example, hospitals and doctors, respectively, may be assigned class
A and class B shares, with each classification of shareholder entitled to
vote for a different number of directors; additionally, a shareholder
could be issued nonvoting shares.

84Five of the leading domiciliary states-Arizona, the District of
Columbia, Hawaii, Nevada, and Vermont-allowed us to review the bylaws and
articles of incorporation of their three most recently domiciled RRGs,
providing us an opportunity to review a sampling of their chartering
practices.

While most regulators affirmed that they expect RRG members to own and
control their RRGs, how these expectations are fulfilled is less clear
when an organization, such as an association, owns an RRG. Four states-
Arizona, District of Columbia, South Carolina, and Vermont-reported that
they have chartered RRGs that are owned by a single or multiple
organizations, rather than individual persons or businesses.85 One of
these states-the District of Columbia-permits noninsureds to own the
organizations that formed the RRG. However, the District regulator said
that while the noninsureds may own the voting or preferred stock of the
association, they do not necessarily have an interest in controlling the
affairs of the RRG. In addition, Arizona has permitted three risk
purchasing groups (RPGs) to own one RRG.86 While the three RPGs, organized
as domestic corporations in another state, collectively have almost 8,000
policyholders, four individuals, all of whom are reported to be RRG
insureds by the Arizona regulator, are the sole owners of all three
RPGs.87

85Nevada regulators did not respond to our question on whether they had
chartered RRGs owned by an organization.

86RPGs are businesses with similar risk exposures that join to purchase
liability insurance as a single entity.

87This structure illustrates the ambiguity surrounding LRRA's ownership
requirement as contained in 15 U.S.C. S: 3902(a)(4)(E). This provision has
been interpreted by both the U.S. Department of Commerce and NAIC to
require that all insureds have an ownership interest in the RRG. See, U.S.
Department of Commerce, Liability Risk Retention Act of 1986:
Implementation Report (Washington, D.C.: 1987), at 64; and NAIC Model Risk
Retention Act (June 1999), S: 2.K Drafter's Note. However, LRRA does not
explicitly state that all insureds must own the RRG, and the matter
remains open to interpretation. See, e.g., Attorneys' Liability Assurance
Society v. Fitzgerald, 174 F.Supp.2d 619, 632-34 (W.D. Mich. 2001) noting
the ambiguity surrounding the definition of "member" as it relates to
LRRA's ownership requirement. According to the Arizona regulator, the
three RPGs are the policyholders and owners of the RRG, but the members of
the RPGs who are insured by the RRG do not have an ownership interest in
the RRG. Therefore, to the extent this Arizona RRG has insureds that do
not have an ownership interest in either the RRG or any of the RPGs that
own the RRG, this would seem to depart from an interpretation of LRRA's
ownership requirement that all insureds must own the RRG. The domiciliary
state of the three RPGs identified the number of entities that purchased
insurance policies through the three RPGs. However, we do not know if each
policyholder obtained their insurance from the Arizona-domiciled RRG or
from another insurance company used by the RPG.

Regulators Expressed Concerns That Some RRGs Might Be Operated to Make
Money for an Entrepreneur, Rather Than to Provide Self-Insurance

The chartering of an "entrepreneurial" RRG-which regulators generally
define as formed by an individual member or a service provider, such as a
management company, for the primary purpose of making profits for
themselves-has been controversial. According to several regulators,
entrepreneurial RRGs are started with a few members and need additional
members to remain viable. The leading domiciliary regulators have taken
very different positions on entrepreneurial RRGs, based on whether they
thought the advantages entrepreneurs could offer (obtaining funding and
members) outweighed the potential adverse influence the entrepreneur could
have on the RRG. We interviewed regulators from the six leading
domiciliary states to obtain their views on entrepreneurial RRGs. In 2004,
South Carolina regulators reported they firmly endorsed chartering
entrepreneurial RRGs because they believed that already chartered RRGs
stand a better chance of attracting members than those in the planning
stages.88 They cited cases of entrepreneurial RRGs they believe have met
the insurance needs of nursing homes and taxicab drivers. However,
regulators from Vermont and Hawaii had strong reservations about this
practice because they believe the goal of entrepreneurs is to make money
for themselves-and that the pursuit of this goal could undermine the
financial integrity of the RRG because of the adverse incentives that it
creates. Vermont will not charter entrepreneurial RRGs and has discouraged
them from obtaining a charter in Vermont by requiring RRGs (before
obtaining their charter) to have a critical mass of members capable of
financing their own RRG. In addition, the Vermont regulators said they
would not permit an entrepreneur, if just a single owner, to form an RRG
as a means of using LRRA's regulatory preemption to bypass the licensing
requirements of the other states in which it planned to operate. Two of
the other leading domiciliary states-Arizona and Nevada-were willing to
charter entrepreneurial RRGs, providing they believed that the business
plans of the RRGs were sound.89

Finally, some of the leading state regulators that have experience with
chartering entrepreneurial RRGs told us that they recognized that the

88In July 2005, South Carolina officials further commented that the state
does not oppose licensing entrepreneurial RRGs provided the group has a
sound business plan and satisfies other department requirements. The
officials noted that they require entrepreneurial RRGs to meet more
stringent initial capital and surplus requirements than other RRGs
chartered by their state and that they have conducted "target
examinations" on several entrepreneurial RRGs to ensure their compliance
with the state's statutes.

89According to District regulators, they were not familiar with the term
entrepreneurial RRG.

LRRA Lacks Governance Standards to Protect RRG Insureds from Management
Companies with Potential Conflicts of Interest

interests of the RRG insureds have to be protected and that they took
measures to do so. For example, the regulators from South Carolina said
that even if one member largely formed and financed an RRG, they would try
to ensure that the member would not dominate the operations. However, they
admitted that the member could do so because of his or her significant
investment in the RRG. Alternatively, the regulator from Hawaii reported
that the state's insurance division, while reluctant to charter
entrepreneurial RRGs, would do so if the RRG agreed to submit to the
division's oversight conditions. For example, to make sure service
providers are not misdirecting money, the division requires
entrepreneurial RRGs to submit copies of all vendor contracts. The Hawaii
regulator also told us that the insurance division requires all captives
to obtain the insurance commissioner's approval prior to making any
distributions of principal or interest to holders of surplus notes.
However, he concluded that successful oversight ultimately depended on the
vigilance of the regulator and the willingness of the RRG to share
documentation and submit to close supervision.

LRRA imposes no governance requirements that could help mitigate the risk
to RRG insureds from potential abuses by other interests, such as their
management companies, should they choose to maximize their profits at the
expense of the best interests of the RRG insureds. Governance rules
enhance the independence and effectiveness of governing bodies, such as
boards of directors, and improve their ability to protect the interests of
the company and insureds they serve. Unlike a typical company where the
firm's employees operate and manage the firm, an RRG usually is operated
by a management company and may have no employees of its own. However,
while management companies and other service providers generally provide
valuable services to RRGs, the potential for abuse arises if the interests
of a management company are not aligned with the interests of the RRG
insureds to consistently obtain self-insurance at the most affordable
price consistent with long-term solvency.

These inherent conflicts of interest are exemplified in the circumstances
surrounding 10 of 16 RRG failures that we examined.90 For example, members
of the companies that provided management services to Charter

90Since 1990, 22 RRGs have failed using NAIC's definition of failure. We
examined 16 of the 22 failures. See appendix I for additional information
on how we selected RRGs to examine and appendix IV for a list of the
failures.

Page 54 GAO-05-536 Risk Retention Groups

Risk Retention Group Insurance Company (Charter) and Professional Mutual
Insurance Company Risk Retention Group (PMIC) also served as officers of
the RRGs' boards of directors, which enabled them to make decisions that
did not promote the welfare of the RRG insureds. In other instances, such
as the failure of Nonprofits Mutual Risk Retention Group, Inc.
(Nonprofits), the management company negotiated terms that made it
difficult for the RRG to terminate its management contract and place its
business elsewhere. Regulators knowledgeable about these and other
failures commented that the members, while presumably self-insuring their
risks, were probably more interested in satisfying their need for
insurance than actually running their own insurance company.

The 2003 failure of three RRGs domiciled in Tennessee-American National
Lawyers Insurance Reciprocal Risk Retention Group (ANLIR), Doctors
Insurance Reciprocal Risk Retention Group (DIR), and The Reciprocal
Alliance Risk Retention Group (TRA)-further illustrates the potential
risks and conflicts of interest associated with a management company
operating an RRG.91 In pending litigation, the State of Tennessee's
Commissioner of Commerce and Insurance, as receiver for the RRGs, has
alleged that the three RRGs had common characteristics, such as (1) being
formed by Reciprocal of America (ROA), a Virginia reciprocal insurer,
which also served as the RRGs' reinsurance company; (2) having a
management company, The Reciprocal Group (TRG), which also served as the
management company and attorney-in-fact for ROA; (3) receiving loans from
ROA, TRG, and their affiliates; and (4) having officers and directors in
common with ROA and TRG.92 The receiver has alleged that through the terms
of RRGs' governing instruments, such as its bylaws, management agreements
with TRG (which prohibited the RRGs from replacing TRG as

91The failures of the Tennessee RRGs are at the center of pending lawsuits
filed by both the Tennessee and Virginia regulators, as receivers, and
class action lawsuits filed by insureds of the Tennessee RRGs. See Flowers
v. General Reinsurance Corporation et al., No. 04-CV-2078 (W.D. Tenn.
filed Feb. 9, 2004); Gross v. General Reinsurance Corporation et al., No.
03-CV-955 (E.D. Va. filed Nov. 12, 2003); Michael A. Jaynes, P.C. et al.
v. General Reinsurance Corporation et al. No. 04-2479 (W.D. Tenn. filed
July 13, 2004); Fullen et al. v. General Reinsurance Corporation et al.,
No. 03-2195B (W.D. Tenn. filed Apr. 3, 2003); Herrick et al. v. General
Reinsurance Corporation et al., No. 03-W-329-N (M.D. Ala. filed Mar. 26,
2003); and Crenshaw Community Hospital et al. v. General Reinsurance
Corporation et al., No. 03-M-338-N (M.D. Ala. filed Mar. 28, 2003).

92The Circuit Court for the City of Richmond determined that "ROA and TRG,
as attorney-in-fact for ROA, operate as, and comprise a single insurance
business enterprise." Commonwealth of Virginia v. Reciprocal of America,
et al., No. CH03000135-00 (Final Order Appointing Receiver, Jan. 29,
2003).

their exclusive management company for as long as the loans were
outstanding), and the common network of interlocking directors among the
companies, TRG effectively controlled the boards of directors of the RRGs
in a manner inconsistent with the best interests of the RRGs and their
insureds.93 As alleged in the complaint filed by the Tennessee regulator,
one such decision involved a reinsurance agreement, in which the RRGs
ceded 90-100 percent of their risk to ROA with a commensurate amount of
premiums-conditions that according to the regulator effectively prevented
the RRGs from ever operating independently or retaining sufficient revenue
to pay off their loans with ROA and TRG and thus remove TRG as their
management company.94 Within days after the Commonwealth of Virginia
appointed a receiver for the rehabilitation or liquidation of ROA and TRG,
the State of Tennessee took similar actions for the three RRGs domiciled
in Tennessee.95

The following failures of other RRGs also illustrate behavior suggesting
that management companies and affiliated service providers have promoted
their own interests at the expense of the RRG insureds:

o  According to the Nebraska regulators, Charter failed in 1992 because
its managers, driven to achieve goals to maximize their profits,
undercharged on insurance rates in an effort to sell more policies. One
board officer and a company manager also held controlling interests in
third-party service providers, including the one that determined if claims

93In the complaint filed by Tennessee, the regulator alleged that the
loans were unsecured, no payments were anticipated, and due dates for the
payments were routinely continued. The Tennessee regulator has charged
that "despite their independent fiduciary duties to the RRGs and the
inherent conflicts of interest presented, TRG management executed
agreements between and among ROA and the RRGs without commercially
reasonable terms and arms-length negotiation." Flowers v. General
Reinsurance Corporation, et al., No. 04-CV-2078 (W.D. Tenn. filed Feb. 9,
2004), P: 44.

94Flowers v. General Reinsurance Corporation, et al., No. 04-CV-2078 (W.D.
Tenn. filed Feb. 9, 2004), P:46.

95ROA and TRG were placed into receivership on January 29, 2003, when the
Circuit Court of the City of Richmond, Virginia, issued its "Final Order
Appointing Receiver for Rehabilitation or Liquidation." The court
determined that the receivership was necessary because any further
transaction of business would be hazardous to their policyholders and
other affected parties; for example, their creditors and the public. The
Chancery Court of the State of Tennessee placed the three RRGs-ANLIR, DIR,
and TRA-into receivership on January 31, 2003, due to the hazardous
financial condition and receivership of ROA, with which the RRGs reinsured
substantially all of their business. In June 2003, the Court issued a
Final Order of Liquidation for each of the three RRGs.

should be paid. Further, the board officer and a company manager, as well
as the RRG, held controlling interests in the RRG's reinsurance company. A
Nebraska regulator noted that when a reinsurance company is affiliated
with the insurer it is reinsuring: (1) the reinsurer's incentive to
encourage the insurer to adequately reserve and underwrite is reduced and
(2) the insurer also will be adversely affected by any unprofitable risk
it passes to the reinsurer.

     o PMIC, which was domiciled in Missouri and formed to provide medical
       malpractice insurance coverage for its member physicians, was declared
       insolvent in 1994. The RRG's relationship with the companies that
       provided its management services undermined the RRG in several ways.
       The president of PMIC was also the sole owner of Corporate Insurance
       Consultants (CIC), a company with which PMIC had a marketing service
       and agency agreement. As described in the RRG's examination reports,
       the RRG paid CIC exorbitant commissions for services that CIC failed
       to provide, but allowed CIC to finance collateral loans made by the
       reinsurance company to CIC. In turn, CIC had a significant ownership
       stake in the RRG's reinsurance company, which also provided PMIC with
       all of its personnel. The reinsurer's own hazardous financial
       condition resulted in the failure of PMIC.
     o In the case of Nonprofits, Vermont regulators indicated that
       essentially the excessive costs of its outsourced management company
       and outsourced underwriting and claims operations essentially
       contributed to its 2000 failure. The regulators said that the
       management company was in a position to exert undue influence over the
       RRG's operations because the principals of the management company
       loaned the RRG its start-up capital in the form of irrevocable LOCs.
       In addition to charging excessive fees, the management company also
       locked the RRG into a management contract that only allowed the RRG to
       cancel the contract 1 year before its expiration. If the RRG did not,
       the contract would automatically renew for another 5 years, a
       requirement of which the RRG insureds said they were unaware.

Although LRRA has no provisions that address governance controls, Congress
has acted to provide such controls in similar circumstances in another
industry. In response to conditions in the mutual fund industry, Congress
passed the Investment Company Act of 1940 (1940 Act). The 1940 Act, as
implemented by the Securities and Exchange Commission (SEC), establishes a
system of checks and balances that includes participation of independent
directors on mutual fund boards, which oversee transactions between the
mutual fund and its investment adviser.96 A mutual fund's structure and
operation, like that of an RRG, differs from that of a traditional
corporation. In a typical corporation, the firm's employees operate and
manage the firm; the corporation's board of directors, elected by the
corporation's stockholders, oversees its operation. Unlike a typical
corporation, but similar to many RRGs, a typical mutual fund has no
employees and contracts with another party, the investment adviser, to
administer the mutual fund's operations.

Recognizing that the "external management" of most mutual funds presents
inherent conflicts between the interests of the fund shareholders and
those of the fund's investment adviser, as well as potential for abuses of
fund shareholders, Congress included several safeguards in the 1940 Act.
For example, with some exceptions, the act requires that at least 40
percent of the board of directors of a mutual fund be disinterested (that
is, that directors be independent of the fund's investment adviser as well
as certain other persons having significant or professional relationships
with the fund) to help ensure that the fund is managed in the best
interest of its shareholders.97 The 1940 Act also regulates the terms of
contracts with investment advisers by imposing a maximum contract term and
by guaranteeing the board's and the shareholders' ability to terminate an
investment adviser contract.98 The act also requires that the terms of any

96For purposes of this report, the term "mutual fund" refers generally to
open-end investment companies required to register with SEC under the 1940
Act.

9715 U.S.C. S: 80a-10(a). Persons who are not "interested persons" of the
fund are referred to as "independent" or "disinterested directors."
Section 2(a)(19) of the 1940 Act [codified at 15

U.S.C. S: 80a-2(a)(19)] defines an "interested person" of a mutual fund to
include any person, partner, or employee of the mutual fund's investment
adviser. SEC has authority under the 1940 Act to promulgate rules to
address a constantly changing financial services industry environment in
which mutual funds and other investment companies operate. While the 1940
Act requires that 40 percent of a fund's directors be independent, SEC has
adopted several exemptive rules that permit mutual fund companies to
engage in certain transactions that present conflicts of interests and
would otherwise be prohibited or restricted under the 1940 Act, if at
least 75 percent of the members of the fund's board of directors and the
board chair are disinterested persons.

98After an initial term of up to 2 years, the investment adviser contract
may be renewed "annually" upon the approval of a majority of the mutual
fund's independent directors or a majority of the shareholders. 15 U.S.C.
S: 80a-15(a). The mutual fund's board of directors or its shareholders
have the right to terminate the investment adviser contract at any time
after providing adequate advance notice (60 days or less) as specified in
the contract. 15 U.S.C. S: 80a-15(c).

RRG Members May Not Realize They Lack Guaranty Fund Protection

contract with the investment adviser and the renewal of such contract be
approved by a majority of directors who are not parties to the contract or
otherwise interested persons of the investment adviser. Further, the 1940
Act imposes a fiduciary duty upon the adviser in relation to its level of
compensation and provides the fund and its shareholders with the right to
sue the adviser should the fees be excessive.99 The management controls
imposed on mutual fund boards do not supplant state law on duties of "care
and loyalty" that oblige directors to act in the best interests of the
mutual fund, but enhance a board's ability to perform its responsibilities
consistent with the protection of investors and the purposes of the 1940
Act.

In addition to lacking comprehensive provisions for ownership, control,
and governance of RRGs, LRRA does not mandate that RRGs disclose to their
insureds that they lack state insurance insolvency guaranty fund
protection. LRRA's legislative history indicates that the prohibition on
RRGs participating in state guaranty funds (operated to protect insureds
when traditional insurers fail) stemmed, in part, from a belief that the
lack of protection would help motivate RRG members to manage the RRG
prudently. LRRA does provide nondomiciliary state regulators the authority
to mandate the inclusion of a specific disclosure, which informs RRG
insureds that they lack guaranty fund coverage, on insurance policies
issued to residents of their state (see fig. 8).100 However, LRRA does not
provide nondomiciliary states with the authority to require the inclusion
of this disclaimer in policy applications or marketing materials. For
example, of 40 RRGs whose Web sites we were able to identify, only 11
disclosed in their marketing material that RRGs lack guaranty fund
protection. In

99Section 36(b) of the Investment Company Act [codified at 15 U.S.C. S:
80a-35(b)] authorizes excessive fee claims against officers, directors,
members of an advisory board, investment advisers, depositors, and
principal underwriters if such persons received compensation from the
fund. In addition, pursuant to Section 206 of the Investment Advisers Act
of 1940, an investment adviser has a fiduciary duty to act in the best
interests of a fund it advises. Act of August 22, 1940, c. 686, 54 Stat.
852, S: 206 (codified as amended at 15 U.S.C. S: 80b-6). Typically, under
state common law a fiduciary must act with the same degree of care and
skill that a reasonably prudent person would use in connection with his or
her affairs. See also GAO/GGD-00-126.

10015 U.S.C. S: 3902(a)(1)(I). In addition to the six domiciliary states,
we conducted further research in eight additional states-California,
Florida, Illinois, New York, Ohio, Pennsylvania, Tennessee, and Texas-to
obtain the perspectives of other states that had domiciled few or no RRGs.
These states all required that RRGs operating in their state include the
lack of guaranty fund disclosure on their policies.

addition, 11 of the RRGs omitted the words "Risk Retention Group" from
their names.101

        Figure 8: Permitted Wording of Guaranty Fund Disclosure in LRRA

NOTICE

This policy is issued by your risk retention group. Your risk retention
group may not be subject to all of the insurance laws and regulations of
your State. State insurance insolvency guaranty funds are not available
for your risk retention group.

Source: LRRA.

All of the six leading domiciliary states have adopted varying statutory
requirements that RRGs domiciled in their states include the disclosure in
their policies, regardless of where they operate. The statutes of Hawaii,
South Carolina, and the District of Columbia require that the disclosure
be printed on applications for insurance, as well as on the front and
declaration page of each policy. By requiring that the disclosure be
printed on insurance applications, prospective RRG insureds have a better
chance of understanding that they lack guaranty fund protection.
Regulators in South Carolina, based on their experience with the failure
of Commercial Truckers RRG in 2001, also reported that they require
insureds, such as those of transportation and trucking RRGs, to place
their signature beneath the disclosure. The regulators imposed this
additional requirement because they did not believe that some insureds
would be as likely to understand the implications of not having guaranty
fund coverage as well as other insureds (for example, hospital
conglomerates). In contrast, the statutes of Arizona and Vermont require
only that the disclosure be printed on the insurance policies. The six
leading domiciliary state regulators had mixed views on whether the
contents of the disclosure should be enhanced, but none recommended that
LRRA be changed to permit RRGs to have guaranty fund protection.

101LRRA requires that the name of any RRG should include the phrase "Risk
Retention Group." 15 U.S.C. S: 3901(a)(4)(H). We performed our initial
search of RRG Web sites in August 2004, based on a listing of 160 RRGs
NAIC identified active as of the beginning of June 2004. We updated the
results of the initial search in May 2005, for the same group of RRGs.

Page 60 GAO-05-536 Risk Retention Groups

It is unclear whether RRG insureds who obtain insurance through
organizations that own RRGs understand that they will not have guaranty
fund coverage. Four states-Arizona, the District of Columbia, South
Carolina, and Vermont-indicated that they have chartered RRGs owned by
single organizations. When an organization is the insured of the RRG, the
organization receives the insurance policy with the disclosure about lack
of guaranty fund protection. Whether the organization's members, who are
insured by the RRG, understand that they lack guaranty fund coverage is
less clear. The Vermont regulators indicated that members typically are
not advised that they lack guaranty fund coverage before they receive the
policy. Thus, the regulators recommended that applications for insurance
should contain the disclosure as well. The Arizona regulator reported that
the insurance applications signed by the insureds of the Arizona-domiciled
RRG owned by three RPGs did not contain a disclosure on the lack of
guaranty fund coverage, although the policy certificates did. Further, he
reported that the practices of RPGs were beyond his department's
jurisdiction and that he does not review them.

Not understanding that RRG insureds are not protected by guaranty funds
has serious implications for RRG members and their claimants, who have
lost coverage as a result of RRG failures. For example, of the 21 RRGs
that have been placed involuntarily in liquidation, 14 either have or had
policyholders whose claims remain or are likely to remain partially unpaid
(see app. IV).102 Member reaction to the failure of the three RRGs
domiciled in Tennessee further illustrates that the wording and the
placement of the disclosure may be inadequate.103 In 2003, an insurance
regulator from Virginia, a state where many of the RRG insureds resided,
reported that he received about 150-200 telephone calls from the insureds
of these RRGs and the insureds did not realize they lacked "guaranty fund"
coverage, asking instead why they didn't have "back-up" insurance when
their insurance company failed. He explained that the insureds were
"shocked" to discover they were members of an RRG, rather than a
traditional insurance company and that they had no guaranty fund coverage.

102One of the 22 RRGs that "failed" using NAIC's definition of failure,
which includes companies placed into rehabilitation, was not liquidated.

103In 1987, the U.S. Department of Commerce concluded that LRRA's
provision for the guaranty fund notice was insufficient. The department
concluded that greater disclosure would be provided if the guaranty fund
disclosure would be required on application forms.

U.S. Department of Commerce, Liability Risk Retention Act of 1986:
Implementation Report (Washington, D.C.: 1987).

Lack of Guaranty Fund Protection Also Has Consequences for Consumers Who
Purchase Extended Service Contracts

According to the regulator, they commented, "Who reads their insurance
policies?" Regulators in Tennessee also noted that insureds of the RRGs,
including attorneys, hospitals, and physicians did not appear to
understand the implications of self-insuring their risks and the lack of
guaranty fund coverage. In 2004, the State of Tennessee estimated that the
potential financial losses from these failures to the 50,000 or so
hospitals, doctors, and attorneys that were members of the Tennessee RRGs
could exceed $200 million, once the amount of unpaid claims were fully
known.104

Other regulators, including those in Missouri, in response to our survey,
and New York, in an interview, also expressed concern that some RRG
members might not fully understand the implications of a lack of guaranty
fund protection and were not the "sophisticated" consumers that they
believe may have been presumed by LRRA. In addition, in response to our
survey, regulators from other states including New Mexico and Florida
expressed specific concerns about third-party claimants whose claims could
go unpaid when an RRG failed and the insured refused or was unable to pay
claims. The Florida regulator noted that the promoters of the RRG could
accentuate the "cost savings" aspect of the RRG at the expense of
explaining the insured's potential future liability in the form of unpaid
claims due to the absence of guaranty funds should the RRG fail. In
addition, regulators who thought that protections in LRRA were inadequate,
such as those in Wyoming, Virginia, and Wisconsin, tended to view lack of
guaranty fund protection as a primary reason for developing and
implementing more uniform regulatory standards or providing nondomiciliary
states greater regulatory authority over RRGs.

Lack of guaranty fund protection also can have unique consequences for
consumers who purchase extended service contracts from service contract
providers. Service contract providers form RRGs to insure their ability to
pay claims on extended service contracts-a form of insurance also known as
contractual liability insurance-and sell these contracts to consumers.105
In exchange for the payment (sometimes substantial) made by the consumer,
the service contract provider commits to performing services-

104Tennessee Department of Commerce and Insurance media release, dated
February 9, 2004. In addition, see appendix IV for more recent information
on expected losses.

105Contractual liability insurance is liability assumed under any contract
or agreement. Extended service contracts are also known as "extended
warranties."

Page 62 GAO-05-536 Risk Retention Groups

for example, paying for repairs to an automobile. Service contract
providers may be required to set aside some portion of the money paid by
consumers in a funded "reserve account" to pay resulting claims and may
have to buy insurance (for example, from the RRG they have joined) to
guarantee their ability to pay claims.106 However, potential problems
result from the perception of consumers that what they have purchased is
insurance, since the service contract provider pays for repairs or other
service, when in fact it is not.107 Only the service contract provider
purchases insurance, the consumer signs a contract for services.

The failure of several RRGs, including HOW Insurance Company RRG (HOW) in
1994 and National Warranty RRG in 2003, underscores the consequences that
failures of RRGs that insure service contract providers can have on
consumers:

o  In 1994, the Commonwealth of Virginia liquidated HOW and placed its
assets in receivership. This RRG insured the ability of home builders to
fulfill contractual obligations incurred by selling extended service
contracts to home buyers. While settled out of court, the Commonwealth of
Virginia asserted that the homeowners who purchased the contracts against
defects in their homes had been misled into believing that they were
entitled to first-party insurance benefits- that is, payment of claims.108
A Virginia regulator said that while his department received few calls
from the actual insureds (that is, the home builders) at the time of
failure, they received many calls from home owners who had obtained
extended service contracts when they purchased their home and thought they
were insured directly by the RRG.

106The amount placed in the account by the service contract provider may
or may not be based on actuarial standards that provide some assurance
that the account would be sufficient.

107Responses to our survey indicated that only eight states regulate
vehicle service contracts as insurance in their states although others
reported that they did so under certain conditions. However, we did not
perform any additional audit work to compare how the regulation of vehicle
service contracts as an insurance product could differ from the regulation
of other insurance products in these states. Moreover, our survey only
addressed the regulation of vehicle service contracts, not other types of
service contracts.

108See Foster v. Spies et al., No. 3:95-CV-832 (E.D. Va. filed Oct. 10,
1995).

o  In 2003, National Warranty Insurance RRG failed, leaving behind
thousands of customers with largely worthless vehicle service contracts
(VSCs). This RRG, domiciled in the Cayman Islands, insured the ability of
service contract providers to honor contractual liabilities for automobile
repairs. Before its failure, National Warranty insured at least 600,000
VSCs worth tens of millions of dollars. In 2003, the liquidators of
National Warranty estimated that losses could range from $58 to $74
million.109 National Warranty's failure also raised the question of
whether RRGs were insuring consumers directly, which LRRA prohibits-for
example, because the laws of many states, including Texas, require that
the insurance company become directly responsible for unpaid claims in the
event a service contract provider failed to honor its contract.110

The failure of National Warranty also raised the question of whether RRGs
should insure service contract providers at all because of the potential
direct damage to consumers. Several regulators, including those in
California, Wisconsin, and Washington, went even further. In response to
our survey, they opined that LRRA should be amended to preclude RRGs from
offering "contractual liability" insurance because such policies cover a
vehicle service contract provider's financial obligations to consumers.111
At a minimum, regulators from New York and California, in separate
interviews, recommended that consumers who purchase extended service
contracts insured by RRGs at least be notified in writing that the
contracts they purchase were not insurance and would not qualify for state
guaranty fund coverage.

109The loss estimates, from June 2003, and the number of contracts
insured, from March 2004, are based on the most recent loss estimates made
available by the liquidators of National Warranty.

110In response to our survey, 17 states reported that in the event a
service contract provider fails to pay or provide service on a vehicle
service contract claim within a certain number of days after proof of loss
has been filed, the contract holder is entitled to make a claim directly
against the insurance company. For example, the Texas code provides that
if a service covered under a service contract is not provided to a service
contract holder not later than the sixtieth day after the date of proof of
loss, the insurer shall pay the covered amount directly to the service
contract holder or provide the required service. Tx. Occ. Code S:
304.152(a)(2).

111The regulators provided these opinions in response to our question on
whether LRRA should be amended or clarified. In addition, one other
state-Texas-recommended that Congress clarify whether RRGs should be
permitted to offer contractual liability insurance.

  Conclusions

In establishing RRGs, Congress intended to alleviate a shortage of
affordable commercial liability insurance by enabling commercial entities
to create their own insurance companies to self-insure their risks on a
group basis. RRGs, as an industry, according to most state insurance
regulators, have fulfilled this vision-and the intent of LRRA-by
increasing the availability and affordability of insurance for members
that experienced difficulty in obtaining coverage. While constituting only
a small portion of the total liability insurance market, RRGs have had a
consistent presence in this market over the years. However, the number of
RRGs has increased dramatically in recent years in response to recent
shortages of liability insurance. While we were unable to evaluate the
merits of individual RRGs, both state regulators and advocates of the RRG
industry provided specific examples of how they believe RRGs have
addressed shortages of insurance in the marketplace. This ability is best
illustrated by the high number of RRGs chartered over the past 3 years to
provide medical malpractice insurance, a product which for traditional
insurers historically has been subject to high or unpredictable losses
with resulting failures.

However, the regulation of RRGs by a single state, in combination with the
recent increase in the number of states new to domiciling RRGs, the
increase in the number of RRGs offering medical malpractice insurance, and
a wide variance in regulatory practices, has increased the potential for
future solvency risks. As a result, RRG members and their claimants could
benefit from greater regulatory consistency. Insurance regulators have
recognized the value of having a consistent set of regulatory laws,
regulations, practices, and expertise through the successful
implementation of NAIC's accreditation program for state regulators of
multistate insurance companies. Vermont and NAIC negotiated the relaxation
of significant parts of the accreditation standards for RRGs because it
was unclear how the standards, designed for traditional companies, applied
to RRGs. However, this agreement allowed states chartering RRGs as
captives considerable latitude in their regulatory practices, even though
most RRGs were multistate insurers, raising the concerns of nondomiciliary
states. With more RRGs than ever before and with a larger number of states
competing to charter them, regulators, working through NAIC, could develop
a set of comprehensive, uniform, baseline standards for RRGs that would
provide a level of consistency that would strengthen RRGs and their
ability to meet the intent of LRRA. While the regulatory structure
applicable to RRGs need not be identical to that used for traditional
insurance companies, uniform, baseline regulatory standards could create a
more transparent and protective regulatory environment, enhancing the
financial strength of RRGs and increasing the trust and confidence of
nondomiciliary state regulators. These standards could include such
elements as the use of a consistent accounting method, disclosing
relationships with affiliated businesses as specified by NAIC's Model
Insurance Holding Company System Regulatory Act, and the qualifications
and number of staff that insurance departments must have available to
charter RRGs. These standards could reflect the regulatory best practices
of the more experienced RRG regulators and address the concerns of the
states where RRGs conduct the majority of their business. Further, such
standards could reduce the likelihood that RRGs would practice regulatory
arbitrage, seeking departments with the most relaxed standards. While it
may not be essential for RRGs to follow all the same rules that
traditional insurers follow, it is difficult to understand why all RRGs
and their regulators, irrespective of where they are domiciled, should not
conform to a core set of regulatory requirements. Developing and
implementing such standards would strengthen the foundation of LRRA's
flexible framework for the formation of RRGs.

LRRA's provisions for the ownership, control, and governance of RRGs may
not be sufficient to protect the best interests of the insureds. While
acknowledging that LRRA has worked well to promote the formation of RRGs
in the absence of uniform, baseline standards, this same flexibility has
left some RRG insureds vulnerable to misgovernance. In particular, how
RRGs are capitalized is central to concerns of experienced regulators
about the chartering of entrepreneurial RRGs because a few insureds or
service providers, such as management companies, that provide the initial
capital also may retain control over the RRG to benefit their personal
interests. Further, RRGs, like mutual fund companies, depend on management
companies to manage their affairs, but RRGs lack the federal protections
Congress and SEC have afforded mutual fund companies. As evidenced by the
circumstances surrounding many RRG failures, the interests of management
companies inherently may conflict with the fundamental interests of
RRGs-that is, obtaining stable and affordable insurance. Moreover, these
management companies may have the means to promote their own interests if
they exercise effective control over an RRG's board of directors. While
RRGs may need to hire a management company to handle their day-to-day
operations, principles drawn from legislation such as the Investment
Company Act of 1940 would strongly suggest that an RRG's board of
directors would have a substantial number of independent directors to
control policy decisions. In addition, these standards would strongly
suggest that RRGs retain certain rights when negotiating the terms of a
management contract. Yet, LRRA has no provisions that establish the
insureds' authority over management. Without these protections, RRG
insureds and their third-party claimants are uniquely vulnerable to abuse
because they are not afforded the oversight of a multistate regulatory
environment or the benefits of guaranty fund coverage. Nevertheless, we do
not believe that RRGs should be afforded the protection of guaranty funds.
Providing such coverage could further reduce any incentives insureds might
have to participate in the governance of their RRG and at the same time
allow them access to funds supplied by insurance companies that do not
benefit from the regulatory preemption. On the other hand, RRG insureds
have a right to be adequately informed about the risks they could incur
before they purchase an insurance policy. Further, consumers who purchase
extended service contracts (which take on the appearance of insurance)
from RRG insureds likewise have a right to be informed about these risks.
The numerous comments that regulators received from consumers affected by
RRG failures illustrate how profoundly uninformed the consumers were.

Finally, while opportunities exist to enhance the safeguards in LRRA, we
note again the affirmation provided by most regulators responding to our
survey-that RRGs have increased the availability and affordability of
insurance. That these assertions often came from regulators who also had
concerns about the adequacy of LRRA's regulatory safeguards underscores
the successful track record of RRGs as a self-insurance mechanism for
niche groups. However, as the RRG industry has matured, and recently
expanded, so have questions from regulators about the ability of RRGs to
safely insure the risks of their members. These questions emerge,
especially in light of recent failures, because RRGs can have thousands of
members and operations in multiple states. Thus, in some cases, RRGs can
take on the appearance of a traditional insurance company-however, without
the back-up oversight provided traditional insurers by other state
regulators or the protection of guaranty funds. This is especially
problematic because RRGs chartered under captive regulations differ from
other captives-RRGs benefit from the regulatory preemption that allows
multistate operation with single-state regulation. Further, we find it
difficult to believe that members of RRGs with thousands of members view
themselves as "owners" prepared to undertake the due diligence presumed by
Congress when establishing RRGs as a self-insurance mechanism. Because
there is no federal regulator for this federally created entity, all
regulators, in both domiciliary and nondomiciliary states, must look to
whatever language LRRA provides when seeking additional guidance on
protecting the residents of their state. Thus, the mandated development

  Recommendations for Executive Action

and implementation of uniform, baseline standards for the regulation of
RRGs, and the establishment of governance protections, could make the
success of RRGs more likely.

In the absence of a federal regulator to ensure that members of RRGs,
which are federally established but state-regulated insurance companies,
and their claimants are afforded the benefits of a more consistent
regulatory environment, we recommend that the states, acting through NAIC,
develop and implement broad-based, uniform, baseline standards for the
regulation of RRGs. These standards should include, but not be limited to,
filing financial reports on a regular basis using a uniform accounting
method, meeting NAIC's risk-based capital standards, and complying with
the Model Insurance Holding Company System Regulatory Act as adopted by
the domiciliary state. The states should also consider standards for laws,
regulatory processes and procedures, and personnel that are similar in
scope to the accreditation standards for traditional insurers.

  Matters for Congressional Consideration

To assist NAIC and the states in developing and implementing uniform,
baseline standards for the regulation of RRGs, Congress may wish to
consider the following two actions:

     o Setting a date by which NAIC and the state insurance commissioners
       must develop an initial set of uniform, baseline standards for the
       regulation of RRGs.
          * After that date, making LRRA's regulatory preemption applicable
            only to those RRGs domiciled in states that have adopted NAIC's
            baseline standards for the regulation of RRGs.
          * To strengthen the single-state regulatory framework for RRGs and
            better protect RRG members and their claimants, while at the same
            time continuing to facilitate the formation and efficient
            operation of RRGs, Congress also may wish to consider
            strengthening LRRA in the following three ways:
     o Requiring that insureds of the RRG qualify as owners of the RRG by
       making a financial contribution to the capital and surplus of the RRG,
       above and beyond their premium.
     o Requiring that all of the insureds, and only the insureds, have the
       right to nominate and elect members of the RRG's governing body.
          * Establishing minimum governance requirements to better secure the
            operation of RRGs for the benefit of their insureds and safeguard
            assets for the ultimate purpose of paying claims. These
            requirements should be similar in objective to those provided by
            the Investment Company Act of 1940, as implemented by SEC; that
            is, to manage conflicts of interest that are likely to arise when
            RRGs are managed by or obtain services from a management company,
            or its affiliates, to protect the interests of the insureds.
            Amendments to LRRA could
               o require that a majority of an RRG's board of directors
                 consist of "independent" directors (that is, not be
                 associated with the management company or its affiliates)
                 and require that certain decisions presenting the most
                 serious potential conflicts, such as approving the
                 management contract, be approved by a majority of the
                 independent directors;
               o provide safeguards for negotiating the terms of the
                 management contract- for example, by requiring periodic
                 renewal of management contracts by a majority of the RRG's
                 independent directors, or a majority of the RRG's insureds,
                 and guaranteeing the right of a majority of the independent
                 directors or a majority of the insureds to unilaterally
                 terminate management contracts upon reasonable notice; and
               o impose a fiduciary duty upon the management company to act
                 in the best interests of the insureds, especially with
                 respect to compensation for its services.

To better educate RRG members, including the insureds of organizations
that are sole owners of an RRG, about the potential consequences of
self-insuring their risks, and to extend the benefits of this information
to consumers who purchase extended service contracts from RRG members,
Congress may wish to consider the following two actions:

o  Expand the wording of the current disclosure to more explicitly
describe the consequences of not having state guaranty fund protection
should an RRG fail, and requiring that RRGs print the disclosure
prominently on policy applications, the policy itself, and marketing
materials, including those posted on the Internet. These requirements

  Agency Comments and Our Evaluation

also would apply to insureds who obtain their insurance through
organizations that may own an RRG; and

o  Develop a modified version of the disclosure for consumers who purchase
extended service contracts from providers that form RRGs to insure their
ability to meet these contractual obligations. The disclosure would be
printed prominently on the extended service contract application, as well
as on the contract itself.

We requested comments on a draft of this report from the President of the
National Association of Insurance Commissioners or her designee. The
Executive Vice President and CEO of NAIC said that the report was "...well
thought out and well documented," and provided "...a clear picture of how
states are undertaking their responsibilities with regard to regulation of
risk retention groups." She further stated that our report "...explored
the issues that are pertinent to the protection of risk retention group
members and the third-party claimants that are affected by the coverage
provided by the risk retention groups." NAIC expressed agreement with our
conclusions and recommendations. NAIC also provided technical comments on
the report that were incorporated as appropriate.

As agreed with your office, unless you publicly announce the contents of
this report earlier, we plan no further distribution until 30 days from
the report date. At that time, we will send copies to other interested
Members of Congress, congressional committees, and the Executive Vice
President of NAIC and the 56 state and other governmental entities that
are members of NAIC. We also will make copies available to others upon
request. In addition, this report will be available at no charge on GAO's
Web site at h ttp://www.gao.gov.

If you or your staff have any questions on this report, please contact me
at (202) 512-8678 or [email protected]. Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last page
of this report. GAO staff who made major contributions to this report are
listed in appendix VI.

Sincerely yours,

Richard J. Hillman

Managing Director, Financial Markets and Community Investment

Appendix I

                       Objectives, Scope, and Methodology

Effects on Availability and Affordability of Commercial Liability
Insurance

Our objectives were to (1) examine the effect risk retention groups (RRG)
have had on the availability and affordability of commercial liability
insurance; (2) assess whether any significant regulatory problems have
resulted from the Liability Risk Retention Act's (LRRA) partial preemption
of state insurance laws; and (3) evaluate the sufficiency of LRRA's
ownership, control, and governance provisions in protecting the interests
of RRG insureds. We conducted our review from November 2003 through July
2005 in accordance with generally accepted government auditing standards.

Overall, we used surveys, interviews, and other methods to determine if
RRGs have increased the availability and affordability of commercial
liability insurance. First, we surveyed regulators in all 50 states and
the District of Columbia. The survey asked regulators to respond to
questions about regulatory requirements for RRGs domiciled in their state,
their experiences with RRGs operating in their state, and their opinions
about the impact of LRRA. We pretested this survey with five state
regulators, made minor modifications, and conducted data collection during
July 2004. We e-mailed the survey as a Microsoft Word attachment and
received completed surveys from the District of Columbia and all the
states except Maryland. Then, to obtain more specific information about
how regulators viewed the usefulness of RRGs, we interviewed insurance
regulators from 14 different states that we selected based on several
characteristics that would capture the range of experiences regulators
have had with RRGs. In addition, we interviewed representatives from eight
RRGs serving different business areas and reviewed documentation they
provided describing their operations and how they served their members.1
Second, we asked the National Association of Insurance Commissioners
(NAIC) to calculate the overall market share of RRGs in the commercial
liability insurance market as of the end of 2003. We used 2003 data for
all financial analyses because it constituted the most complete data set
available at the time of our analysis. Using its Financial Data
Repository, a database containing annual and quarterly financial reports
and data submitted by most U.S. domestic insurers, NAIC compared the total
amount of gross premiums written by RRGs with the total amount of gross
premiums generated by the sale of

1The business areas were environmental, government and institutions,
healthcare, manufacturing and commerce, professional services, and
property development.

Page 72 GAO-05-536 Risk Retention Groups

                                Failure Analysis

                 Appendix I Objectives, Scope, and Methodology

commercial liability insurance by all insurers.2 For the market share
analysis, as well as for our analysis of gross premiums written by RRGs,
we only included the 115 RRGs that wrote premiums during 2003. NAIC
officials reported that while they perform their own consistency checks on
this data, state regulators were responsible for validating the accuracy
and reliability of the data for insurance companies domiciled in their
state. We conducted tests for missing data, outliers, and consistency of
trends in reporting and we found these data to be sufficiently reliable
for the purposes of this report. Third, to determine the number of RRGs
that states have chartered since 1981, we obtained data from NAIC that
documented the incorporation and commencement of business dates for each
RRG and identified the operating status of each RRG-for example, whether
it was actively selling insurance or had voluntarily dissolved. Finally,
to determine which business sectors RRGs were serving and the total amount
of gross premiums written in each sector, we obtained information from a
trade journal-the Risk Retention Reporter-because NAIC does not collect
this information by business sector.

We also requested that NAIC analyze their annual reporting data to
calculate the "failure" rate for RRGs and compare it with that of
traditional property and casualty insurance companies from 1987 through
2003. In response, NAIC calculated annual "failure" rates for each type of
insurer, comparing the number of insurers that "failed" each year with the
total number of active insurers that year. The analysis began with
calendar year 1987 because it was the first full year following the
passage of LRRA. NAIC classified an insurance company as having failed if
a state regulator reported to NAIC that the state had placed the insurer
in a receivership for the purpose of conserving, rehabilitating, or
liquidating the insurance

2Gross premiums are the total direct premiums written by the insurer and
assumed by other carriers.

Page 73 GAO-05-536 Risk Retention Groups Appendix I Objectives, Scope, and
Methodology

company.3 Since NAIC officials classified an insurance company subject to
any one of these actions as having failed, the failure date for each
insurance company reflects the date on which a state first took regulatory
action. We independently verified the status of each RRG that NAIC
classified as failed by cross-checking the current status of each RRG with
information from two additional sources- state insurance departments'
responses to our survey, with follow-up interviews as necessary, and the
Risk Retention Group Directory and Guide.4 To determine if the differences
in annual failure rates of the RRGs and traditional companies were
statistically significant, NAIC performed a paired T-test. They concluded
that the average annual RRG failure rates were higher than those for
traditional property and casualty insurers.5 We also obtained a similar
statistically significant result when testing for the difference across
the 18-year period for RRGs and traditional insurers active in a given
year. We recognize that, although these tests indicated statistically
significantly different failure rates, the comparison between these
insurer groups is less than optimal because the comparison group included
all property and casualty insurers, which do not constitute a true "peer
group" for RRGs. First, RRGs are only permitted to write commercial
liability insurance, but NAIC estimated that

3Conservation, rehabilitation, and liquidation are regulatory actions a
state insurance commissioner can take in response to concerns about the
condition of an insurance company. A state places an insurance company in
conservation when the management is deemed unable to administer the
company in a proper fashion, usually because of concerns about insolvency.
The scope of conservation under current state law can vary from seizure of
certain assets to the supervision of an insurer's operations, with or
without a court order, and could include an order of rehabilitation.
Rehabilitation generally involves the transfer of all operational
authority from an insurer's management to a receiver with the objective of
initiating a rehabilitation plan to return the company to sound financial
and operational condition. An insurance company not deemed susceptible to
a successful conservation or rehabilitation may be placed in liquidation.
The liquidation process ordinarily would include the seizure, marshalling,
and liquidation of the company's assets, a determination of the company's
liabilities, and the distribution of the assets of the insurance company
to claimants with approved claims. Each time states take one of these, or
other, regulatory actions, they are supposed to notify NAIC of these
actions so NAIC can store this information in its Financial Data
Repository.

4Risk Retention Group Directory and Guide, ed. Karen Cutts, J.D.
(Insurance Communications, Pasadena Calif.: 2004).

5A paired T-test is used to make multiple paired comparisons (in the same
or many subjects), over a number of years, to determine if the average
difference between these paired comparisons is larger than would be
expected by chance.

                 Appendix I Objectives, Scope, and Methodology

Selection of Regulators for Interviews

only 34 percent of insurers exclusively wrote liability insurance.6
Further, NAIC's peer group included traditional insurers writing both
commercial and personal insurance. Second, we noted that the paired T-test
comparison is more sensitive to any single RRG failing than any failure of
a traditional insurer because of the relatively small number of RRGs.
Finally, most RRGs are substantially smaller in size (that is, in terms of
premiums written) than many insurance companies and may have different
characteristics than larger insurance companies. Given the data available
to NAIC, it would have been a difficult and time-consuming task to
individually identify and separate those property and casualty insurers
with similar profiles for comparison with RRGs.

In choosing which regulators to interview, we first selected regulators
from the six states that had domiciled the highest number of active RRGs
as of June 30, 2004, including two with extensive regulatory experience
and four new to chartering RRGs. The six leading domiciliary states were
Arizona, the District of Columbia, Hawaii, Nevada, South Carolina, and
Vermont. Second, we selected regulators from eight additional states,
including four that had domiciled just a few RRGs and four that had
domiciled no RRGs. For states that had domiciled just a few or no RRGs, we
identified and selected those where RRGs, as of the end of 2003, were
selling some of the highest amounts of insurance. Finally, we also
considered geographic dispersion in selecting states across the United
States. In total, we selected 14 regulators (see table 1 for additional
information).

6According to NAIC, estimates based on its analysis of 2004 filings
indicate that 9 percent of insurers wrote only property lines of
insurance, 34 percent wrote only liability lines of insurance, 9 percent
wrote neither property or liability insurance, and 48 percent wrote either
property or liability insurance combined with another line of insurance
(for example, property and liability). NAIC explained that its conducting
such an analysis for each year included in the failure analysis would be
both time-intensive and complex-for example, because companies sometimes
changes the lines of business they write from year to year.

                 Appendix I Objectives, Scope, and Methodology

Table 1: Characteristics of States We Interviewed, Based on Years of Regulatory
                    Experience and Number of RRGs Domiciled

                                   Number of active             Amount of     
                                                                insurance     
                              domiciled RRGs, as of Year first  written by    
                                                    RRG was     RRGs in the   
Characteristics of      State           June 30, formed      state, as of  
states                                      2004             Dec. 31, 2003 
High number of RRGs and Vermont               63 1987        N/Aa          
years of experience     Hawaii                17 1988        N/A           
domiciling RRGs                                              
High number of RRGs and South Carolina        36 2001        N/A           
new to domiciling RRGs  District of           12 2003        N/A           
                           Columbia                             
                           Nevada                 8 2001        N/A           
                           Arizona                6 2003 (for   N/A           
                                                    RRGs formed 
                                                    under       
                                                    captive     
                                                    law)b       
Limited number of       Florida                1 1987        $46 million   
domiciled RRGsc         Illinois               1 1980        $74 million   
                           Texas                  1 1984        $87 million   
                           Tennessee              1 1987        $38 million   
No RRGs domiciled       California             0 N/Aa        $156 million  
                           New York               0 N/A         $206 million  
                           Ohio                   0 N/A         $45 million   
                           Pennsylvania           0 N/A         $238 million  

Effects of Partial Preemption of State Insurance Laws

Source: NAIC.

aIn the "Amount of Insurance Written" column, we use N/A to mean "not
applicable" because we did not use "amount of insurance written in each
state" as a criterion for selecting states that had domiciled the highest
amount of RRGs. "Amount of insurance written" is based on direct written
premiums as of December 31, 2003, the most recent annual data available at
the time we selected states for interview. In the "Year First RRG Was
Formed" column, we used N/A to mean "not applicable" because the four
states had not domiciled any RRGs.

bArizona chartered three RRGs between 1987 and 1989, but they dissolved by
1995. Arizona began chartering RRGs under its captive law in 2003.

cFlorida, Illinois, Texas, and Tennessee had chartered other RRGs in the
past, although each state had only one active as of mid-2004. According to
NAIC's data, California, New York, and Ohio never chartered an RRG.

To determine if any significant regulatory problems have resulted from
LRRA's partial preemption of state insurance laws, as part of our survey
we asked regulators to evaluate the adequacy of LRRA's protections,
describe how they reviewed RRG financial reports, and report whether their
state had ever asked a domciliary state to conduct an examination. To
obtain an in-depth understanding of how state regulators viewed the
adequacy of LRRA's regulatory protections and identify specific problems,
if any, we interviewed regulators from each of our selected 14 states. We
made visits

Appendix I Objectives, Scope, and Methodology

to the insurance departments of five of the six leading domiciliary
states- Arizona, the District of Columbia, Hawaii, South Carolina, and
Vermont- and five additional states-Nebraska, New York, Tennessee, Texas,
and Virginia. To assess the regulatory framework for regulating RRGs in
the six leading domiciliary states (the five we visited plus Nevada), we
also reviewed state statutes and obtained from regulators detailed
descriptions of their departments' practices for chartering and regulating
RRGs. To determine how the RRG regulatory framework created in these
states compared with that of traditional insurers, we identified key
components of NAIC's accreditation program for traditional insurance
companies, based on documentation provided by NAIC and our past reports.
Finally, our survey also included questions about RRGs consisting of
businesses that issued vehicle service contracts (VSC) to consumers
because this type of arrangement is associated with two failed RRGs.

In reviewing how RRGs file financial reports, we assessed how the use or
modification of two sets of accounting standards, generally accepted
accounting principles (GAAP) and statutory accounting principles (SAP),
could affect the ability of NAIC and regulators to analyze the reports.
For the year 2003, we also obtained from NAIC the names of RRGs that used
GAAP to file their financial reports and those that used SAP. To obtain an
understanding of differences between these accounting principles, we
obtained documentation from NAIC that identified key differences and
specific examples of how each could affect an RRG's balance sheet. We
relied on NAIC for explanations of SAP because NAIC sets standards for the
use of this accounting method as part of its accreditation program. The
purpose of the accreditation program is to make monitoring and regulating
the solvency of multistate insurance companies more effective by ensuring
that states adhere to basic recommended practices for an effective state
regulatory department. Specifically, NAIC developed the Accounting
Practices and Procedures Manual, a comprehensive guide on SAP, for
insurance departments, insurers, and auditors to use. To better understand
GAAP and its requirements, we reviewed concept statements from the
Financial Accounting Standards Board (FASB), which is the designated
private-sector organization that establishes standards for financial
accounting and reporting. We also consulted with our accounting experts to
better understand how GAAP affected the presentation of financial results.

                 Appendix I Objectives, Scope, and Methodology

Sufficiency of LRRA Provisions in Protecting RRG Insureds

To determine if LRRA's ownership, control, and governance requirements
adequately protect the interests of RRG insureds, we analyzed the statute
to identify provisions relevant to these issues. In addition, we reviewed
the insurance statutes of the six leading domiciliary states-Arizona, the
District of Columbia, Hawaii, Nevada, South Carolina, and Vermont- related
to the chartering of RRGs to determine if those states imposed any
statutory requirements on RRGs with respect to ownership, control, or
governance of RRGs. To identify additional expectations that state
insurance departments might have set for the ownership, control, or
governance of RRGs, we interviewed regulators from the six leading
domiciliary states and reviewed the chartering documents, such as articles
of incorporation and bylaws, of RRGs recently chartered in five of those
states. One state insurance department, South Carolina, would not provide
us access to these documents although we were able to obtain articles of
incorporation from the Office of the South Carolina Secretary of State. In
addition, we looked at past failures (and the public documentation that
accompanies failures) to assess whether factors related to the ownership,
control, and governance of RRGs played a role, or were alleged to have
played a role, in the failures, particularly with respect to inherent
conflicts of interest between the RRG and its management company or
managers. To identify these factors, we first selected 16 of the 22
failures to review, choosing the more recent failures from a variety of
states. As available for each failure, we reviewed relevant documentation,
such as examination reports, liquidation petitions and orders, court
filings (for example, judgments, if relevant), and interviewed
knowledgeable state officials. Because some of the failures were more than
5 years old, the amount of information we could collect about a few of the
failures was more limited than for others. In the case of National
Warranty RRG, we reviewed publicly available information as supplied by
the liquidator of National Warranty on its Web site; we also interviewed
insurance regulators in Nebraska where National Warranty's offices were
located and reviewed court documents. We used these alternative methods of
obtaining information because National Warranty RRG's liquidators would
not supply us any additional information. To determine how frequently RRGs
include the lack of guaranty fund disclosure on their Web sites and if
they use the words "risk retention group" in their name, we searched the
Internet to identify how many RRGs had Web sites as of August 2004, based
on a listing of 160 RRGs NAIC identified as active as of the beginning of
June 2004. When we identified Web sites, we noted whether the words "risk
retention group" or the acronym "RRG" appeared in the RRG's name and
reviewed the entire site for the lack of guaranty fund disclosure. We
updated the results of our initial search in May 2005, using the original
group of RRGs.

Appendix II

Survey of State Regulators on Risk Retention Groups

Appendix II Survey of State Regulators on Risk Retention Groups

  Definitions of acronyms and terms used in this questionnaire

Risk Retention Group (RRG): An RRG is a group of members with similar
risks that

                           join to create an insurance company to self-insure
                        their risks. The Liability Risk Retention Act permits
                           RRGs to provide commercial liability insurance and
                         largely exempts them from regulatory oversight other
                               than that performed by their chartering state.
                             The state that charters an RRG and is            
State of Domicile:        responsible for                                  
                             performing regulatory oversight, including       
                             examinations. ("State" includes the District of  
                             Columbia, and for RRGs chartered before 1985,    
                             Bermuda and the Cayman Islands.)                 
Host state:               Any state in which an RRG operates but is not    
                             chartered.                                       
                             A vehicle service contract, purchased by         
Vehicle Service Contract: consumers                                        
                             when they buy cars, is for maintaining and       
                             repairing an automobile beyond its               
                             manufacturer's                                   
                             warranty coverage.                               

  INSTRUCTIONS:

1. Please use your mouse to navigate throughout the survey by clicking on
the field or check box

you wish to answer or filling in the requested field [ ].

 E-Mail: [ ]

                                       2

Appendix II Survey of State Regulators on Risk Retention Groups Appendix
II Survey of State Regulators on Risk Retention Groups

s/regulations that are applicable?
                    
b. Captive Insurance Laws/Regs           21                   $[ ]         
c. Other (Specify): [ ]                  19                   $[ ]         

                                       Not Applicable (RRGs Cannot Be         
         Type of Law/Regulation        Chartered Under These Statutes  Yes No
                                       or Regulations in this State)       
a. Traditional Insurance Laws/Regs                3                 44  2  
b. Captive Insurance Laws/Regs                    19                 7  12 
c. Other (Specify): [ ]                           19                 3  2  

                                      Not Applicable (RRGs Cannot Be          
         Type of Law/Regulation       Chartered Under These Statutes  Yes No*
                                       or Regulations in this State)      
a. Traditional Insurance Laws/Regs                3                45   0  
b. Captive Insurance Laws/Regs                   20                14   4  
c. Other (Specify): [ ]                          20                 4   0  

*If you indicated that your state does not require RRGs to file financial
information with NAIC, please explain: [ ]

4

Appendix II Survey of State Regulators on Risk Retention Groups Appendix
II Survey of State Regulators on Risk Retention Groups Appendix II Survey
of State Regulators on Risk Retention Groups Appendix II Survey of State
Regulators on Risk Retention Groups Appendix II Survey of State Regulators
on Risk Retention Groups Appendix II Survey of State Regulators on Risk
Retention Groups

f request, the domiciliary state to which you
       made the request, and a brief explanation of the circumstances.
Retention Act should be expanded to permit RRGs to provide property
insurance?

31

No, the Act should not be expanded

8

Yes, the Act should be expanded

10

No opinion

Please offer any comments on your response: [ ]

                                       10

Appendix II Survey of State Regulators on Risk Retention Groups

 your opinion, how adequate or inadequate are the regulatory
       protections or safeguards built into the Risk Retention Act? (Check
       one.)
Retention Groups

     apply.)

    25    No                           
    21    Yes                          
          Name of the state agency: [  ]                                    

28

Insure VSCs under a reimbursement or other insurance policy

13

Maintain a funded reserve account for its obligations

16

Place in trust with the commissioner a financial security deposit (e.g., a
surety bond)

13

Maintain a net worth of $100 million or another amount: (If checked,
identify amount: [ ])

18

Other, please describe []

44. If obligors in your state purchase insurance for their VSCs, does your
state require that in the event the obligor fails to perform, the insurer
issuing the policy must either pay on behalf of the obligor any sums the
obligor is legally obligated to pay, or provide any service which the
obligor is legally obligated to provide?

19

No (Skip to Question 46)

23

Yes

4

Yes, but under certain conditions Citation for statute/regulation: [ ]

45. If you answered "yes" to question 44, does that mean that the insurer
is required to pay 100 percent of the loss (i.e., first dollar coverage)
or does the insurer's risk not attach until some deductible amount is met,
such as a loss in excess of the obligor's reserves?

2

No

18

Yes

4

Yes, but under certain conditions Please explain: [ ]

13

Appendix II Survey of State Regulators on Risk Retention Groups

n email and
                        send it to [email protected])

                         Thank you for your assistance.

                                       14

Appendix II Survey of State Regulators on Risk Retention Groups

    Appendix A: Identification of RRGs Domiciled in Your State

For each RRG that your state has chartered since 1981, please provide the
following information:

(Duplicate the table as many times as needed to complete for all RRG
domiciled in your state.) Note: You may also choose to send this
information as a separate attachment.

Name of RRG Date of  Date      Type of Insured NAIC      If INACTIVE, Date 
               Charter  Started   Business        Status    Stopped Business  
                        Business                  Code (See 
                                                  below)    
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       
[ ]                            [ ]             [ ]       

NAIC Status codes: 1-Active-No regulatory action in process 2Not Used
3-Inactive-Merged or combined into another company 4-In rehabilitation,
permanent or temporary receivership 5-Voluntarily out of business 6-Being
liquidated or has been liquidated 7-Inactive-Estate has closed
8-Inactive-Charter is inactive

                                       15

Appendix III

    Selected Differences between Statutory and Generally Accepted Accounting
           Principles as They Relate to Financial Reporting for RRGs

On an annual basis, traditional insurance companies, as well as risk
retention groups (RRG), file various financial data, such as financial
statements and actuarial opinions, with their respective state regulatory
agencies and the National Association of Insurance Commissioners (NAIC).
More specifically, RRGs-although subject to the regulation of one state
(their domiciliary state)-can and do sell insurance in multiple states and
are required to provide their financial statements to each state in which
they sell insurance. Unless exempted by the state of domicile, RRGs
generally file their financial statements with NAIC as well. Additionally,
although insurance companies generally are required to file their
financial statements based on statutory accounting principles (SAP),
captive insurance companies (a category that in many states includes RRGs)
are generally permitted, and in some cases required, to use generally
accepted accounting principles (GAAP), the accounting and reporting
principles generally used by private-sector (nongovernmental) entities.1
Thus, while some RRGs report their financial information using SAP, others
report using GAAP or variations of GAAP and SAP.

However, the use or modification of two different sets of accounting
principles can lead to different interpretations of an RRG's financial
condition. For example, differences in the GAAP or SAP treatment of assets
and acquisition costs can significantly change the reported levels of
total assets, capital, and surplus. Because regulators, particularly those
in nondomiciliary states, predicate their review and analysis of insurance
companies' financial statements on SAP reporting, the differing accounting
methods that RRGs may use could complicate analyses of their financial
condition. For instance, based on whatever accounting basis is filed with
them, the different levels of surplus reported under GAAP, or SAP, or
modifications of each, can change radically the ratios NAIC uses to
analyze the financial condition of insurers-undercutting the usefulness of
the analyses. Similarly, the accounting differences also affect
calculations for NAIC's risk-based capital standards and may produce
significantly different results. For example, an RRG could appear to have
maintained capital adequacy under GAAP but would require regulatory action
or control if the calculations were based on SAP.

1Captive insurance companies are companies that are formed and owned by a
single company or association to self-insure the risks of the parent
organization. According to NAIC, 79 of the 115 RRGs active as of the end
of 2003 filed financial statements using GAAP while the others filed using
SAP.

Page 94 GAO-05-536 Risk Retention Groups

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

Differences in Accounting Principles Produce Different Financial
Statements

Differences in the two sets of accounting principles reflect the different
purposes for which each was developed and may produce different financial
pictures of the same entity. GAAP (for nongovernmental entities) provides
guidance that businesses follow in preparing their general purpose
financial statements, which provide users such as investors and creditors
with a variety of useful information for assessing a business's financial
performance. GAAP stresses measurement of a business's earnings from
period to period and the matching of revenue and expenses to the periods
in which they are incurred. In addition, these financial statements
provide information to help investors, creditors, and others to assess the
amounts, timing, and uncertainty of future earnings from the business. SAP
is designed to meet the needs of insurance regulators, who are the primary
users of insurers' financial statements, and stresses the measurement of
an insurer's ability to pay claims-to protect policyholders from an
insurer becoming insolvent (that is, not having sufficient financial
resources to pay claims).2

Additionally, while RRGs may be permitted to report their financial
condition using either GAAP or SAP, some regulators permit RRGs to report
using nonstandard variants of both sets of accounting principles-to which
we refer as modified GAAP and modified SAP. The use of variants further
constrains the ability of NAIC and nondomiciliary state analysts to

(1) understand the financial condition of the RRGs selling insurance to
citizens of their state and (2) compare the financial condition of RRGs
with that of traditional insurers writing similar lines of insurance. In
some cases, RRGs are permitted to count letters of credit (LOC) as assets
as a matter of permitted practice under modified versions of GAAP and SAP,

2Each state conducts financial oversight of the companies operating in its
jurisdictions to help ensure that policyholders and claimants receive the
requisite benefits from the policies sold. In recognition of these special
concerns and responsibilities, statutes, regulations, and practices
combine to establish statutory accounting principles. Statutory accounting
principles have historically been those practices or procedures prescribed
or permitted by an insurer's domiciliary state. NAIC has standardized and
incorporated these principles in its Accounting Practices and Procedures
manuals (which provide a comprehensive guide of statutory principles),
Annual Statement Instructions, and Financial Condition Examiners Handbook.

                               Acquisition Costs

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

although neither accounting method traditionally permits this practice.3
Further, regulators in some states have allowed RRGs filing under GAAP to
modify their financial statements and count surplus notes as assets and
add to surplus, another practice which GAAP typically does not allow.4

According to NAIC, the key differences between GAAP and SAP as they relate
to financial reporting of RRGs are the treatment of acquisition costs and
assets, differences that affect the total amount of surplus an RRG reports
on the balance sheet. This is important because surplus represents the
amount of assets over and above liabilities available for an insurer to
meet future obligations to its policyholders. Consequently, the
interpretation of an RRG's financial condition can vary based on the set
of accounting principles used to produce the RRG's balance sheet.

According to NAIC, GAAP and SAP differ most in their treatment of
acquisition costs, which represent expenditures associated with selling
insurance such as the commissions, state premium taxes, underwriting, and
issuance costs that an insurer pays to acquire business. Under GAAP, firms
defer and capitalize these costs as an asset on the balance sheet, then
report them as expenses over the life of the insurance policies. This
accounting treatment seeks to match the expenses incurred with the related
income from policy premiums that will be received over time. Under SAP,
firms "expense" all acquisition costs in the year they are incurred
because these expenses do not represent assets that are available to pay
future policyholder obligations. As illustrated in figure 9, the different
accounting treatments of acquisition costs have a direct impact on the
firm's balance sheet. Under GAAP, a firm would defer acquisition costs and
have a higher level of assets, capital, and surplus than that same firm
would have if reporting under SAP. Under SAP, these acquisition costs
would be fully charged in the period in which they are incurred, thereby
reducing assets, capital, and surplus.

3A letter of credit is a financial guaranty issued by a bank or financial
institution that permits the party to which it is issued to draw funds
from the bank if necessary. In the case of RRGs, LOCs generally are drawn
if a commissioner of insurance needs to take over the RRG and use the LOC
to pay all outstanding claims.

4A surplus note is debt that an insurance company owes and that the lender
has agreed cannot be repaid without regulatory approval.

Page 96 GAO-05-536 Risk Retention Groups

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

Figure 9: The Effect of Differences in Accounting for Acquisition Costs on
Assets, Capital, and Surplus, GAAP Compared with SAP

Source: NAIC.

aAn aggregate write-in is an item that is included in the balance sheet
but for which there is no preprinted or established line item.

bDeferred acquisition costs are a balance sheet item only under GAAP or
modified versions of GAAP. SAP does not allow for the deferral of
acquisition costs.

cPrepaid expenses are payments made for goods and services in advance of
the date they will be received.

Assets GAAP and SAP also treat some assets differently. Under GAAP, assets
are generally a firm's property, both tangible and intangible, and claims
against others that may be applied to cover the firm's liabilities. SAP
uses a more restrictive definition of assets, focusing only on assets that
are available to pay current and future policyholder obligations-key
information for regulators. As a result, some assets that are included on
a GAAP balance sheet are excluded or "nonadmitted" under SAP. Examples of
nonadmitted assets include equipment, furniture, supplies, prepaid
expenses (such as prepayments on maintenance agreements), and trade names
or other intangibles.

Appendix III Selected Differences between Statutory and Generally Accepted
Accounting Principles as They Relate to Financial Reporting for RRGs

Some RRGs also modify GAAP to count undrawn LOCs as assets. More
specifically, the six leading domiciliary states for RRGs-Arizona, the
District of Columbia, Hawaii, Nevada, South Carolina, and Vermont-allow
RRGs to count undrawn LOCs as assets, thus increasing their reported
assets, capital, and surplus, even though undrawn LOCs are not recognized
as an asset under GAAP or SAP. For example, in 2002-2003, state regulators
permitted about one-third of RRGs actively writing insurance to count
undrawn LOCs as assets and supplement their reported capital.5

Figure 10 illustrates the impact of different asset treatments for undrawn
LOCs. In this example, the RRG had a $1.5 million LOC that was counted as
an asset under a modified version of GAAP but was not counted as an asset
under a traditional use of SAP.6 In addition, the RRG treated $363,750 in
prepaid expenses as an asset, which it would not be able to do under SAP.
Under a modified version of GAAP, the RRG's total assets would be
$17,914,359 instead of $16,050,609 under a traditional use of SAP, a
difference of $1,863,750.

5According to NAIC data, 37 of 115 RRGs were allowed to admit an LOC as an
asset during either 2002 or 2003.

6However, had the RRG used a modified version of SAP, the $1.5 million
could have been counted as an asset as well.

Page 98 GAO-05-536 Risk Retention Groups Appendix III Selected Differences
between Statutory and Generally Accepted Accounting Principles as They
Relate to Financial Reporting for RRGs

Source: NAIC.

aIn some states, RRGs file under SAP, but can admit an LOC as an asset as
a matter of permitted practice. This example assumes that such permitted
practices are not present.

bAn aggregate write-in is an item that is included in the balance sheet
but for which there is no preprinted or established line item.

cDeferred acquisition costs are a balance sheet item only under GAAP or
modified versions of GAAP. SAP does not allow for the deferral of
acquisition costs.

dPrepaid expenses are payments made for goods and services in advance of
the date they will be received.

Figure 11 illustrates different treatments of acquisition costs and
assets, using a modified version of GAAP and a traditional version of SAP.
In this example, under a modified version of GAAP, undrawn LOCs ($2.2
million), acquisition costs ($361,238), and prepaid expenses ($15,724) are
valued as an additional $2,576,962 in assets with a corresponding increase
in capital and surplus. The overall impact of treating each of these items
as assets under a modified version of GAAP is significant because the RRG
reported a total of $2,603,656 in capital and surplus, whereas it would
report only $26,694 under a traditional use of SAP. Under traditional
GAAP, capital and

Appendix III Selected Differences between Statutory and Generally Accepted
Accounting Principles as They Relate to Financial Reporting for RRGs

surplus would be reported as $403,656 ($2,603,656 minus the $2,200,000
undrawn LOC).

Source: NAIC.

aIn some states, RRGs file under SAP, but can admit an LOC as an asset as
a matter of permitted practice. This example assumes that such permitted
practices are not present.

bAn aggregate write-in is an item that is included in the balance sheet
but for which there is no preprinted or established line item.

cDeferred acquisition costs are a balance sheet item only under GAAP or
modified versions of GAAP. SAP does not allow for the deferral of
acquisition costs.

dPrepaid expenses are payments made for goods and services in advance of
the date they will be received.

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

Additionally, the two accounting principles treat surplus notes
differently. Although SAP restricts certain assets, it permits (with
regulatory approval) the admission of surplus notes as a separate
component of statutory surplus, which GAAP does not. When an insurance
company issues a surplus note, it is in effect making a promise to repay a
loan, but one that the lender has agreed cannot be repaid without
regulatory approval. Both SAP and GAAP recognize the proceeds of the loan
as an asset to the extent they have been borrowed but not expended (are
still available). However, since the insurer cannot repay the debt without
approval, the regulator knows that the proceeds of the loan are available
to pay claims, if necessary. Thus, under SAP, with its emphasis on the
ability of an insurer to pay claims, the proceeds are added to capital and
surplus rather than recognizing a corresponding liability to repay the
debt. GAAP, on the other hand, requires companies issuing surplus notes to
recognize a liability for the proceeds of the loan, rather than adding to
capital and surplus since the insurer still has to repay the debt.
However, according to NAIC data, four state regulators have allowed RRGs
to modify GAAP and report surplus notes as part of capital and surplus
during either 2002 or 2003. A total of 10 RRGs between the four states
modified GAAP in this manner and were able to increase their reported
level of capital and surplus.7

Finally, in addition to the differences between GAAP and SAP already
discussed, and as they have been modified by RRGs, other differences
between the two accounting methods include the treatment of investments,
goodwill (for example, an intangible asset such as a company's
reputation), and deferred income taxes. According to NAIC, while these
differences may affect a company's financial statement, they generally do
not have as great an impact as the differences in the treatment of
acquisition costs and assets.

                               Other Differences

The Different Results under Each Permitted Accounting Method Can Affect
Analysis of an RRG's Financial Condition

Use or modification of GAAP and the modification of SAP can also affect
the ability of NAIC and regulators to evaluate the financial condition of
some RRGs. Although subject to the regulation of one state (their
domiciliary state), RRGs can and do sell insurance in multiple states and
are required to provide financial statements to each state in which they
sell insurance. In almost all cases, RRGs also provide financial
statements to NAIC for analysis and review.

7The value of the surplus notes for the 10 RRGs ranged from $25,000 to $3
million.

Appendix III Selected Differences between Statutory and Generally Accepted
Accounting Principles as They Relate to Financial Reporting for RRGs

NAIC uses financial ratios and risk-based capital standards to evaluate
the financial condition of insurance companies and provides this
information to state regulators in an effort to help them better target
their regulatory efforts.8 NAIC calculates the ratios using the data from
the financial statements as they are filed by the companies. However,
since both the formulas and the benchmarks for the financial ratios are
based on SAP, the ratio information may not be meaningful to NAIC or the
state regulators if the benchmarks are compared with the ratios derived
from financial information based on a standard or modified version of
GAAP, or a modified version of SAP. Further, the use of GAAP, modified
GAAP, or modified SAP could make risk-based capital standards less
meaningful because these standards also are based on SAP. (We discuss
accounting differences in relation to risk-based capital standards in more
detail at the end of this appendix.)

To illustrate how the use of two different accounting methods can impede
an assessment of an RRG's financial condition, we selected two financial
ratios that NAIC commonly uses to analyze the financial condition of
insurers-net premiums written to policyholders' surplus (NPW:PS) and
reserves to policyholders' surplus. Using SAP, NAIC has established a
"usual range" or benchmark for these financial indicators from studies of
the ratios for companies that became insolvent or experienced financial
difficulties in recent years. As part of its review process, NAIC compares
insurers' ratios with these benchmarks. We selected these two ratios
because of the emphasis regulators place on insurance companies having an
adequate amount of surplus to meet claims and because policyholders'
surplus is affected by the different accounting treatments used by RRGs.9

8NAIC collects information on insurance companies through the annual and
quarterly financial reports that insurance companies file and conducts
analyses using financial ratios to identify companies that are likely to
have financial difficulties. An NAIC database generates key ratio results,
which cover indicators of financial condition such as profitability and
liquidity, and serve as tools to determine the level of regulatory
attention required for a particular insurer.

9While the different accounting treatments affect these two ratios, they
would not necessarily affect all of the analyses performed by NAIC.

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

Net Premiums Written to Policyholders' Surplus Ratio

The NPW:PS ratio is one of the 12 ratios in NAIC's Insurance Regulatory
Information System (IRIS) and measures the adequacy of a company's ability
to pay unanticipated future claims on that portion of its risk that it has
not reinsured.10 The higher the NPW:PS ratio, which is typically expressed
as a percentage, the more risk a company bears in relation to the
policyholders' surplus available to absorb unanticipated claims. In other
words, the higher the NPW:PS, the more likely an insurance company could
experience difficulty paying unanticipated claims. Since surplus, as
reflected by the availability of assets to pay claims, is a key component
of the ratio, the use of GAAP, modified GAAP, or modified SAP instead of
SAP may affect the results substantially.

As shown in figure 12, each of the three RRGs has a lower NPW:PS ratio
when the ratio is calculated using balance sheet information based on a
modified version of GAAP than when the same ratio is based on SAP. In
other words, under modified GAAP, each of these three RRGs would appear to
have a greater capability to pay unanticipated claims than under SAP.
However, one RRG (RRG from figure 9) is below the NAIC benchmark
regardless of which accounting method is used.

10IRIS is part of NAIC's Financial Analysis Solvency Tools (FAST), a collection
    of analytical tools designed to provide state insurance departments with
 information to better screen and analyze the financial condition of insurance
                companies operating in their respective states.

  Page 103 GAO-05-536 Risk Retention Groups Appendix III Selected Differences
between Statutory and Generally Accepted Accounting Principles as They Relate to
                          Financial Reporting for RRGs

  NPW:PS Ratio

Modified GAAP

SAP

NAIC (benchmark)

Source: NAIC.

Note: In some states, RRGs file under SAP, but can admit an LOC as an
asset as a matter of permitted practice. This example assumes that such
permitted practices are not present.

Some of the higher NPW:PS ratios under SAP could provide a basis for
regulatory concern. NAIC considers NPW:PS ratios of 300 percent or less as
"acceptable" or "usual." However, according to NAIC staff, companies that
primarily provide liability insurance generally should maintain lower
NPW:PS ratios than insurers with other lines of business because
estimating potential losses for liability insurance is more difficult than
estimating potential losses for other types of insurance. Since RRGs only
can provide liability insurance, NAIC staff believe a value above 200
percent (in conjunction with other factors) could warrant further
regulatory attention. Using this lower benchmark, two RRGs (from figures

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

Reserves to Policyholders' Surplus Ratio

9 and 11) meet the benchmark criteria under modified GAAP, but all three
RRGs fail to meet the benchmark under SAP. Thus, an analysis of an RRG's
financial condition as reported under modified GAAP could be misleading,
particularly when compared with other insurers that report under SAP.

The reserves to policyholders' surplus ratio is one of NAIC's Financial
Analysis Solvency Tools ratios and represents a company's loss and loss
adjustment expense reserves in relation to policyholders' surplus.11 This
ratio, which is typically expressed as a percentage, provides a measure of
how much risk each dollar of surplus supports and an insurer's ability to
pay claims, because if reserves were inadequate, the insurer would have to
pay claims from surplus. The higher the ratio, the more an insurer's
ability to pay claims is dependent upon having and maintaining reserve
adequacy. Again, surplus is a key component of the ratio and the use of
GAAP, modified GAAP, or modified SAP rather than SAP could affect the
ratio.

As shown in figure 13, each of the three RRGs has higher reserves to
policyholders' surplus ratios when the calculations are derived from
balance sheet numbers based on SAP rather than modified GAAP. Under the
modified version of GAAP, each of the three RRGs reports higher levels of
surplus and consequently less risk being supported by each dollar of
surplus (a lower ratio) compared with SAP.

11A company's loss reserves represent the estimated liability for
outstanding insurance claims or losses that have occurred but have not
been reported as of a given evaluation date. Loss adjustment expenses are
the expenses incurred in investigating and settling such claims or losses
and insurers also establish reserves for these expenses. The sum of the
two reserves represents the total reserves for unpaid losses and the
expenses incurred in investigating and settling them.

Page 105 GAO-05-536 Risk Retention Groups

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

  R:PS Ratio

Modified GAAP

SAP

NAIC (benchmark)

Source: NAIC.

Note: In some states, RRGs file under SAP, but can count an LOC as an
asset as a matter of permitted practice. This example assumes that such
permitted practices are not present.

Higher reserves to policyholders' surplus ratios could provide a basis for
regulatory concerns. According to NAIC, ratios of 200 percent or less are
considered "acceptable" or "usual" for RRGs. However, although the RRG
from figure 11 meets NAIC's benchmark under modified GAAP, it
significantly exceeds NAIC's benchmark when the ratio is calculated based
on SAP-a condition that could warrant further regulatory attention.

Risk-Based Capital NAIC applies risk-based capital standards to insurers
in order to measure their capital adequacy relative to their risks.
Monitoring capital levels with other financial analyses helps regulators
identify financial weaknesses. However, since risk-based capital standards
are based on SAP, numbers used to calculate capital adequacy that are
derived from any other

Appendix III Selected Differences between Statutory and Generally Accepted
Accounting Principles as They Relate to Financial Reporting for RRGs

accounting basis (GAAP, modified GAAP, or modified SAP) could distort the
application of the standards and make resulting assessments less
meaningful.

NAIC uses a formula that incorporates various risks to calculate an
"authorized control level" of capital, which is used as a point of
reference. The authorized control level is essentially the point at which
a state insurance commissioner has legal grounds to rehabilitate (that is,
assume control of the company and its assets and administer it with the
goal of reforming and revitalizing it) or liquidate the company to avoid
insolvency. NAIC establishes four levels of company and regulatory action
that depend on a company's total adjusted capital (TAC) in relation to its
authorized control level, with more severe action required as TAC
decreases. They are

     o Company action level. If an insurer's TAC falls below the company
       action level, which is 200 percent of the authorized control level,
       the insurer must file a plan with the insurance commissioner that
       explains its financial condition and how it proposes to correct the
       capital deficiency.
     o Regulatory action level. If an insurer's TAC falls below the
       regulatory action level, which is 150 percent of its authorized
       control level, the insurance commissioner must examine the insurer
       and, if necessary, institute corrective action.
     o Authorized control level. If an insurer's TAC falls below its
       authorized control level, the insurance commissioner has the legal
       grounds to rehabilitate or liquidate the company.
     o Mandatory control level. If an insurer's TAC falls below the mandatory
       control level, which is 70 percent of its authorized control level,
       the insurance commissioner must seize the company.

Because the differences between GAAP and SAP, as well as the modification
of both accounting bases, affect an RRG's capital, the differences also
affect the TAC calculation for an RRG, and when compared to the control
levels, could lead an analyst to draw different conclusions about the
level of regulatory intervention needed. For example, in table 2, we place
the three RRGs that we have been using as examples in the action
categories that would result from calculating each TAC under the two
accounting methods or their variants. The accounting methods used have no
effect in terms of regulator action for the first RRG

Appendix III Selected Differences between Statutory and Generally Accepted
      Accounting Principles as They Relate to Financial Reporting for RRGs

(because the RRG maintained a TAC level of more than 200 percent of the
authorized control level). The other two RRGs change to categories that
require more severe actions.

Table 2: Differences in Regulatory Actions When Calculating Risk-Based
Capital for Three RRGs, Modified GAAP Compared with SAP

           Current financials (modified GAAP)  With adjustments converting to 
                                                                          SAP 
RRG from figure 9    No action required    No action required              
RRG from figure 10 Regulatory action level Mandatory control level         
RRG from figure 11   No action required    Mandatory control level         

Source: GAO analysis of NAIC data.

Note: In some states, RRGs file under SAP, but can admit an LOC as an
asset as a matter of permitted practice. This example assumes that such
permitted practices are not present.

Appendix IV

Liquidated Risk Retention Groups (RRG), from 1990 through 2003

                   Page 109 GAO-05-536 Risk Retention Groups

                                      Amount of claims paid on each dollar of
                                        loss and overall loss, as measured in
                                Liquidation status          dollarsb
                    Date business                  
                      commenced                    
Name of RRG     and type of              Open/     Closed        Open      
                   coverage                                     liquidations  
and state of    provideda       Start    closed liquidations (estimates)   
domicile                        date                         
National        1984            2003     Open                 As of 2003,  
Warranty                                                          the      
Insurance RRG   Contractual     August                        liquidators  
                   liability                                      reported    
(Cayman         insurance                                     that losses  
Islands)        arising from                                     could     
                   extended                                      reach about  
                   service                                           $74      
                   contracts                                     million. The 
                                                                  liquidators 
                                                       have not updated their
                                                          loss estimate since
                                                             2003.
Doctors         1990            2003     Open       As of May 2005, timely
Insurance                                       
Reciprocal, RRG Medical         June                    claims against the
(DIR)           malpractice                     
(Tenn.)         for physicians                          RRG numbered 1,990
                                                          but it is not known
                                                           what percentage of
                                                         approved claims will
                                                                   be paid. c
American        1993            2003     Open       As of May 2005, timely
National                                        
Lawyers         Malpractice for June                    claims against the
Insurance                                       
Reciprocal RRG  lawyers                                 RRG numbered 2,420
(ANLIR) (Tenn.)                                        but it is not known
                                                           what percentage of
                                                         approved claims will
                                                                   be paid. d
The Reciprocal  1995            2003     Open       As of May 2005, timely
Alliance,                                       
RRG (TRA)       Malpractice for June                    claims against the
(Tenn.)         healthcare                             RRG numbered 2,150,
                   liability                       
                   providers,                             but it is not known
                   including                       
                   institutions,                           what percentage of
                   such as                         
                   hospitals, and                        approved claims will
                   individuals,                                    be paid. e
                   such as                         
                   doctors                         
Heritage        1999            2002       Open       As of July 2005, the
Warranty                                        
Mutual          Contractual     September                  liquidation was
Insurance, RRG, liability                       
Inc.            insurance                            expected to be closed
                   arising from                    
(Hawaii)        extended                              within a few months.
                   service                         
                   contracts for                          No claims have been
                   the cost                        
                   of automobile                             paid yet for the
                   repairs                         
                                                                 unauthorized
                                                                   insurance.

Appendix IV Liquidated Risk Retention Groups (RRG), from 1990 through 2003

                   Page 110 GAO-05-536 Risk Retention Groups

(Continued From Previous Page)
                                      Amount of claims paid on each dollar of
                                        loss and overall loss, as measured in
                                Liquidation status          dollarsb
                    Date business                  
                      commenced                    
Name of RRG     and type of              Open/  Closed           Open      
                   coverage                                     liquidations  
and state of    provideda     Start date closed liquidations (estimates)   
domicile                                                     
Commercial      2001          2001       Open                    As of May 
Truckers                                                         2005, the 
RRG Captive     February      September                       receivership 
Insurance                                                        estimated 
Company         Commercial                                   that the RRG  
                   truckers                                          had      
(S.C.)          liability                                        about 350 
                                                                  outstanding 
                                                            claims, valued at
                                                        about $6 million. The
                                                         receiver expected to
                                                       pay claims at 50 cents
                                                               on the dollar.
Nonprofits      1991          2000      Open          As of July 2005, the
Mutual RRG,                                     
Inc. (Vt.)      Liability     June                  overall estimated loss
                   insurance for                   
                   nonprofit                                was undetermined.
                   service                         
                   providers                            Claims are being paid
                                                           at 86 cents on the
                                                            dollar.
Osteopathic  1986             1996      1998    The RRG's business
Mutual                                          
Insurance    Medical          December  March   was assumed by
Company      malpractice                        
RRG, Inc.    for osteopathic                    another insurance
(Tenn.)      physicians                         company, pursuant to
                                                   an approved plan of
                                                   rehabilitation.
Beverage     1988             1995      Open          As of July 2005, the
Retailers                                       
Insurance     Liability for   July                   overall loss estimate
Company          licensed                       
RRG (Vt.)       alcoholic                          was about $1.5 million.
                    beverage                       
                retailers                               Claims have been paid
                                                         at 82.5 cents on the
                                                            dollar.
North         1989            1995    Open           As of April 2005, the
American                                        
Physicians    Medical         January                     overall loss was
Insurance     malpractice                       
RRG (Ariz.)   for cosmetic,                              estimated at $4.2
                 plastic,                          
                 and                                   million with about 260
                 reconstructive                    
                 surgeons                                       claims filed.
                                                      Distribution to date is
                                                       32 cents on the dollar
                                                          and may increase to
                                                      42 cents on the dollar.
U.S.        1989              1994       Open             As of June 2005,
Physicians                               (but   
Mutual RRG       Medical      February expected       claims were expected
                  malpractice                to    
(Mo.)        for orthopedic             close       to be paid at 63 cents
                                           soon)   
               surgeons                                      on the dollar. f

Appendix IV Liquidated Risk Retention Groups (RRG), from 1990 through 2003

                   Page 111 GAO-05-536 Risk Retention Groups

(Continued From Previous Page)
                                      Amount of claims paid on each dollar of
                                        loss and overall loss, as measured in
                                 Liquidation status         dollarsb
                    Date business                   
                      commenced                     
Name of RRG      and type of            Open/    Closed           Open     
                    coverage                                     liquidations 
and state of     provideda     Start    closed   liquidations (estimates)  
domicile                       date                           
Professional     1987          1994     Open but              Claims paid  
Mutual                                                          in full.   
Insurance        Medical       April    expected              
Company          malpractice               to                 
RRG              to physicians           close                
                                             soon                
(Mo.)                                            
National Dental   1987         1997      Open         As of June 2005, the
Mutual Insurance  Malpractice  April                  claims were expected
Co., a            insurance                      
RRG               for dentists                         to be paid in full.
(Colo.)                                          
HOW          1981              1994    Open           The claims have been
Insurance                                        
Company, A      Contractual    October               paid in full, and the
RRG              liability                       
(Va.)        insurance arising                             receivership is
                             from                   
                extended service                       expected to close in a
                contracts for the                                  few years.
                cost                                
                  of home repairs                   
Transportation  1992           1994     Closed   Claims paid in full.
American Group, Commercial     July      2000    
Inc.,                                            
an Insurance    automobile             February  
RRG             liability                        
(Hawaii)        insurance for                    
                   taxicab                          
              drivers                               
Charter RRG       1987         1992     Closed   The overall loss was
Insurance                                        
Company (Neb.)    Automobile   December 1997     about $6 million, and
                     and                            
                     garage                December claims were paid at
                     liability                      
                     insurance to                   75 cents on the
                     persons                        
                     engaged in                     dollar.      
                     the                            
                automobile rental                   
              industry                              
United Physicians 1989         1992     Closed   The loss was 
Insurance, RRG    Medical      July      2005    estimated at $5
(Tenn.)           malpractice                    
                     insurance              July    million, and claims
                     for                            
                     physicians                     were paid at 65 cents
                                                    on the dollar.
Physicians     1987            1991     Open              As of July 2005,
National                                         
RRG (La.)          Medical     November             claims were being paid
                    malpractice                     
                                                           at 50 cents on the
                                                       dollar and will pay an
                                                       estimated additional 7
                                                        cents at closing. The
                                                       overall estimated loss
                                                        is about $27 million.

Appendix IV Liquidated Risk Retention Groups (RRG), from 1990 through 2003

(Continued From Previous Page)
                                      Amount of claims paid on each dollar of
                                        loss and overall loss, as measured in
                             Liquidation status           dollarsb
                  Date business                 
                    commenced                   
Name of RRG    and type of            Open/      Closed          Open
                  coverage                                      liquidations
and state of   provideda      Start   closed  liquidations   (estimates)
domicile                      date                           
National Auto  1989           1991    Open                   Payments have
Mutual                                                                been
Insurance Co., Commercial     August                            made at 60
a RRG          auto                                               cents on
(N. Mex.)      liability                                      the dollar,
                  insurance                                        with a
                                                               possible final
                                                      distribution of 4 cents
                                                               on the dollar.
Petroleum   1988              1990    Open          Liquidated claims have
Marketers                                    
Mutual      Liability         May                   been paid in full, and
Insurance   insurance for                    
Company, A  the environmental                               money has been
RRG                                          
(Tenn.)     clean-up of                                reserved to pay the
               underground                                estimated amount of
               storage                          
               tanks                                      unliquidated claims
                                                              (as they become
                                                                   payable).  
Rent Rite    1987             1990   Closed   The overall loss  
Advantage                                                       
Services,    Commercial       March                 estimate is 
Inc., a RRG  vehicle                                  $945,000, 
(N. Mex.)    liability                          and claims were 
                insurance for                                 paid 
                rental cars                     at 61 cents on the 
                                                dollar.         

Sources: NAIC, state regulators, liquidators, and public documents.

Note: This table provides information about the 21 RRGs that have been
liquidated. RRGs that have been liquidated meet NAIC's definition of
"failure." Using NAIC's definition of failure, one other RRG can be
categorized as failed because it was placed into receivership. However,
because this RRG was not liquidated, we have not included it in our table.

aFor the date on which each RRG commenced business we obtained data for
most RRGs from NAIC.

bThe information contained in this table is based on information we
obtained from state regulators or liquidators. However, these sources were
not always able to provide us the same types of information.

cAccording to a Tennessee official, as of December 31, 2004, DIR had
approximately $5 million in assets and $115 million in liabilities in
expected losses for policy claims.

dAccording to a Tennessee official, as of December 31, 2004, ANLIR had
approximately $6 million in assets and $91 million in liabilities in
expected losses for policy claims.

eAccording to a Tennessee official, as of December 31, 2004, TRA had
approximately $17 million in assets and $61 million in liabilities in
expected losses for policy claims.

fAs of July 2005, no estimate of the overall losses was available.

Appendix V

Comments from the National Association of Insurance Commissioners

  EXECUTIVE HEADQUARTERS

     2301 MCGEE STREET SUITE 800 KANSAS CITY MO 64108-2662 VOICE 816-842-3600
                                                             FAX 816-783-8175

  GOVERNMENT RELATIONS

            HALL OF THE STATES 444 NORTH CAPITOL STNW SUITE 701 WASHINGTON DC
                               20001-1509 VOICE 202-624-7790 FAX 202-624-8579

                                                   SECURITIES VALUATION OFFICE

    48 WALL STREET

                                       TH

             FLOOR NEW YORK NY 10005-2906 VOICE 212-398-9000 FAX 212-382-4207

  WORLD WIDE WEB NATIONAL ASSOCIATION OF INSURANCE COMMISSIONERS

July 21, 2005

Richard J. Hillman, Director Financial Markets and Community Investment
Government Accountability Office 441 G. Street N.W. Washington, DC 20548

RE: GAO Report on Risk Retention Groups

Dear Mr. Hillman:

The National Association of Insurance Commissioners (NAIC) appreciates
this opportunity to review the GAO draft report on Risk Retention Groups.
As you know, the NAIC is a voluntary organization of the chief insurance
regulatory officials of the 50 states, the District of Columbia and five
U.S. territories. The association's overriding objective is to assist
state insurance regulators in protecting consumers and helping maintain
the financial stability of the insurance industry by offering financial,
actuarial, legal, computer, research, market conduct and economic
expertise. Formed in 1871, it is the oldest association of state
officials.

Several members of the NAIC staff and Director L. Tim Wagner in his
capacity as chair of the NAIC's Property and Casualty Insurance Committee
reviewed the draft report and a consensus opinion among them was that the
report was well thought out and well documented. The research methods
employed were solid and the results obtained were carefully interpreted to
obtain a clear picture of how states are undertaking their
responsibilities with regard to regulation of risk retention groups. It
explored the issues that are pertinent to the protection of risk retention
group members and the third party claimants that are affected by the
coverage provided by the risk retention groups.

Overall, the reviewers believed that the report was materially accurate.
The reviewers agree with the recommendations contained in the report for
Congress and for insurance regulators. Attached to this letter are several
editorial suggestions and clarifications that we believe would improve the
final document.

Thanks again for all your hard work in making government accountable to
the public that it serves.

Appendix VI

                     GAO Contact and Staff Acknowledgments

Richard J. Hillman (202) 512-8678

  GAO Contact

Lawrence D. Cluff was the Assistant Director for this report. In addition,

  Staff

Sonja J. Bensen, James R. Black, William R. Chatlos, Tarek O. Mahmassani,
Omyra M. Ramsingh, and Barbara M. Roesmann made key contributions to this
report.

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