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Published: January 1, 2007
Author: Jonathan Schuster
Skyrocketing liability insurance costs for healthcare providers have been reaching crisis proportions. From the perspective of most providers, the most frustrating and problematic aspect of the cost increases is the fact that insurance companies are increasing premiums across the board, without regard to the loss experience associated with the widely varying levels and types of service provided by the industry. Providers of medical services and long-term care, for example, are facing availability and affordability problems with liability coverage in many parts of the country. A number of providers have elected to not maintain professional and general liability coverage. Rather than going bare or continuing to procure liability coverage from traditional insurance carriers, several alternatives exist. This article identifies and describes six such arrangements and discusses several factors and considerations to analyze before embarking on any alternative risk program.
Alternative Risk Transfer Solutions: Self-Insurance Fund. One alternative is to create a self-insurance fund. A good program includes loss projections and methods of funding those expected losses. In a self-insurance program, if unregulated, the set aside assets may not require any securitization. Under such programs, however, the healthcare provider must administer the fund and manage its own claims processing. Since such arrangements do not provide a cap on damages or defense costs, the assets of the fund and assets of the provider are at risk for any potential claim or costs of defense. To mitigate some of this risk, a provider could procure excess or stop loss coverage from a traditional insurance earner so that losses in excess of a certain threshold are covered under such policy.
Finite Risk Programs. Under a finite risk program, a healthcare provider can create a fund account with a traditional commercial insurer. The provider funds the account, either in a lump sum or by making periodic payments. The traditional commercial insurer, in exchange for a flat or percentage-based fee, then issues an insurance policy for up to the deposits made in the fund account and, based upon the insurance policy, will issue a certificate of insurance to the healthcare provider. Variations to this arrangement include obtaining financing from a third party to finance the payments into the fund account. Although an insurance policy and certificates of insurance are issued by a traditional commercial insurer, the fundamental arrangement is a self-insurance program.
Captive Insurance Company. A captive insurance company is an entity that is owned and controlled by its insureds. Essentially, there are two types of captive insurance companies. First, a single parent captive is owned and controlled by one company and insures the risks of that company and its affiliates. Second, a group captive is owned and controlled by several, unrelated businesses and insures the risks of those businesses. Captive insurance companies may be organized as either a stock, non-stock, reciprocal or mutual company.
According to the Captive Insurance Company Association, there are over 5,000 captives in existence today. As shown in Figure 1, of the total number of captives, approximately 80 percent are domiciled offshore, with Bermuda (about 1,330 captives) and the Cayman Islands (about 644 captives) leading that group. Approximately 20% of the total captives are U.S. on-shore domiciled, with Vermont (about 600 captives) continuing to lead that group.
Under this arrangement, the owners must capitalize the entity, which usually includes cash contributions and letters of credit. The captive may issue policies directly to and receive premiums from its insureds. Alternatively, the captive may act as a reinsurer. Under such arrangements, the insured obtains liability coverage from a fronting company (an insurance company admitted in the insureds jurisdiction) that in turn cedes the risks to the captive in exchange for a fee. Currently, most fronting companies are also requiring cash collateral or letters of credit to guarantee the captive's payment of claims.
Captive insurance companies can reduce or stabilize insurance costs, improve cash flow and provide continuity of insurance arrangements. In addition, a captive may write multiple lines of insurance coverage, such as professional and general liability and employee benefits insurance. As a separate legal entity, the captive is also regulated by the insurance authority of the jurisdiction in which the captive is domiciled. The captive must also engage a number of service providers, including a captive manager, risk management consultant, claims processing advisors and investment managers.
Rent-a-Captive. Another alternative risk transfer solution is a rent-a-captive, which provides companies that do not have sufficient capital and premium to take advantage of forming their own captive with the opportunity of obtaining similar benefits. Under this arrangement, the owner of the rent-a-captive provides insurance coverage and manages the captive. The insured invests capital and pays premiums. In addition, the insured also pays fees to the owner and manager of the captive. In general, a rent-a-captive is structured so that there is no sharing of risk among the various insureds and, accordingly, such arrangements are often merely another form of a self-insurance program.
Risk Retention Group. A risk retention group ("RRG") is another type of insurance company that is owned by and insures only the risks of its shareholders. RRGs are formed pursuant to the Liability Risk Retention Act ("LRRA"), a federal law that was passed by Congress in 1986 to help U.S. businesses, professionals and municipalities obtain liability insurance that had become either unaffordable or unavailable due to the liability crisis in the United States. Under the LRRA, RRGs must be domiciled in a state. Once licensed by that state, an RRG can insure members in all states. Because the LRRA is a federal law, it preempts state regulation (with certain exceptions), making it much easier for RRGs to operate nationally. Under the LRRA, RRGs may only offer liability insurance coverage and, as an insurance company, they retain risk.
According to the Risk Retention Reporter, there are approximately 173 RRGs. As shown in Figure 2, the number of RRGs has increased dramatically over the last three years. During 2003, there were 11 RRGs formed to insure long-term care providers. Prior to 2003, no RRGs were formed to provide professional and general liability coverage to this industry. Similar to captive insurance companies, RRGs often provide more stable liability coverage at reduced costs, effective loss control, risk management programs and access to reinsurance markets.
Risk Purchasing Group. In addition to creating RRGs, the LRRA also permits the formation of purchasing groups ("PGs"). A PG is comprised of insurance buyers who band together to purchase their liability insurance coverage from an insurance company, including a company operating on an admitted basis, a surplus lines basis or an RRG. The PG essentially serves as an insurance purchasing vehicle for its members. While RRGs retain risk, PGs do not. As such, PGs do not require initial capital contributions by their members.
Under the LRRA, both RRGs and PGs must be comprised of members that engaged in similar businesses or activities and that expose them to similar liabilities. PGs can negotiate tailor-made insurance coverage, broader insurance coverage terms, lower rates and provide effective loss control and risk management programs. According to the Risk Retention Reporter, there are approximately 660 purchasing groups operating today.
Factors and Considerations. As discussed, there are a number of alternative risk transfer solutions available to healthcare providers and each has its own advantages and disadvantages. The following are some of the significant factors and considerations that should be analyzed before a provider enters into any such arrangement.
Transfer and Sharing of Risk. Initially, a healthcare provider must determine whether it makes financial sense for such provider to participate in a risk-sharing arrangement, such as a group captive insurance company, RRG or PG. Inherent in such arrangements is the sharing of loss and claims history. In addition, the group must also establish underwriting criteria and agree to implement rigorous risk management procedures to which all members must adhere. Moreover, a provider should consider the governance structure of the proposed risk-sharing arrangement and analyze to what extent the provider will be able to participate in the management.
Scope of Insurance Coverage. A major factor to consider is the scope of insurance that a healthcare provider would like to obtain. RRGs and PGs, for example, are permitted to provide only liability insurance coverage under the LRRA. This includes all types of third-party liability, such as general liability, errors and omissions, medical malpractice, professional liability and product liability. The LRRA does not extend to worker's compensation, employee benefits or property insurance, all of which could be provided by another alternative risk arrangement.
Transaction and Operating Costs. One of the primary reasons to enter into an alternative risk transfer arrangement is to reduce and stabilize insurance costs. As such, transaction and operating costs are important factors when selecting a solution. Self-insurance funds are, relatively speaking, less expensive to create and operate than a captive insurance company or an RRG. In addition to out-of-pocket expenses, a provider must consider other economic costs, such as monitoring costs associated with a chief executive officer or other senior executives' involvement with the alternative risk program, which can be cumbersome for captives and RRGs. Since captive insurance companies and risk retention groups require initial capital in their formation, this additional investment should also be factored into the overall financial analysis.
Tax Implications. Tax-exempt healthcare providers should analyze the impact that an alternative risk solution will have on their Internal Revenue Code ? 501(c)(3) status. In the case of captives and RRGs, the entity should be structured to avoid unrelated business income taxes as well. For-profit providers are keenly aware of the tax implications and should probably enter into an alternative risk arrangement in which the premiums are tax deductible. There have been several IRS Revenue Rulings on these topics that provide guidance on the appropriate structure for both tax-exempt and for-profit healthcare providers, thereby eliminating some uncertainty.
Health Care Regulations. Healthcare providers must also analyze the implications of state-specific health care regulations. Effective November 1, 2003, the Texas Health and Human Services Commission, for example, adopted rules specifying the types of liability insurance coverage a nursing facility must have in order to receive the applicable professional and general liability insurance reimbursement add-on for Medicaid reimbursement. Under such rules, certain types of insurance automatically qualify for the Medicaid insurance reimbursement add-on while other types of insurance, including liability insurance coverage from an off-shore captive insurance company, do not and must be substantiated. Likewise, under Florida law, long-term care providers must maintain liability insurance coverage that is in force at all times. To comply with such statute, each provider must provide proof of liability coverage, which includes a copy of the certificate of insurance indicating the types and amounts of coverage, the name of the provider and the licensed operator covered and documentation of the insurance company's authority to provide coverage in the state of Florida. Coverage procured from an off-shore captive insurance company, absent using a fronting arrangement (which adds additional costs), may not qualify under these regulations as in-force insurance.
In addition, a number of states have enacted various forms of tort reform. To avail itself of the benefits of such tort reform under a state's statute, it is often the case that a healthcare facility must procure insurance from an entity admitted in such state and maintain certain levels of insurance coverage. Such provisions, for example, apply to certain providers operating in Pennsylvania, Texas and Wisconsin.
Insurance Regulations. Insurance is regulated on a state-by-state basis by each respective insurance department. Thus, a healthcare provider contemplating an alternative risk transfer solution should also consider its state's respective insurance regulations. As described above, RRGs and PGs may be formed pursuant to the LRRA but must also be domiciled in a state and, therefore, subject to its regulations. Off-shore captive insurance companies are generally structured to not be subject to state insurance regulations. Off-shore captives that insure the risks of healthcare providers in any particular state must be extremely cautious to make sure their business operations remain offshore to avoid running afoul of such state's insurance regulations.
Lending Covenants. Another significant factor for a healthcare provider to analyze before entering into an alternative risk transfer solution is the provider's financing documents. In genera!, most loan, bank or indenture documents and agreements often require that a provider maintain professional and general liability coverage from a rated insurance company licensed in the state where the financed property is located. Although such language is customary, lenders are becoming more familiar and comfortable with alternative risk transfer arrangements and will often renegotiate insurance provisions contained in the financing documents to recognize new market place realities. The United States Department of Housing and Urban Development ("HUD"), however, has taken a different stance. Under HUD's requirements, providers must procure professional and general liability coverage from an insurance carrier rated by A.M. Best, which usually precludes most alternative risk transfer arrangements.
Observations and Questions. As the liability crisis continues, healthcare providers will be faced with rising insurance premiums, reduced liability coverage or no affordable coverage. There are several viable alternative risk transfer solutions that can, subject to various factors and considerations, provide liability coverage, reduce or stabilize insurance costs and improve cash flow for healthcare providers. Given the numerous factors and considerations, there is not a universal solution and healthcare providers should analyze their needs on a case-by-case basis.
Should you have any questions about this Update, please contact Jonathan Schuster or the attorney at Axley with whom you maintain a client relationship.
Jonathan L. Schuster is an attorney with Axley Brynelson, LLP, focusing his legal practice on corporate finance and securities, mergers and acquisitions, private equity and corporate insurance matters. Mr. Schuster has advised numerous companies on alternative risk transfer solutions and represented healthcare companies in ike formation and operation of captive insurance companies and risk retention groups domiciled in the Cayman Islands, Vermont and South Carolina.
Mr. Schuster holds several professional credentials, including the CFA, CPA, CMA and CFM designations. He is an adjunct professor at the University of Wisconsin Law School where he teaches the course on securities regulation and he lectures on corporate law matters at the University of Wisconsin - Madison School of Business. He received a B.B.A. (with honors), an M.B.A., and a J.D., magna cum laude, from the University of Wisconsin-Madison.
Mr. Schuster may be contacted at 608.283.6769 or by email at jjschuster@axley.com.
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