Solving problems and herding cats: a struggling risk retention group

I have had over 30 years of experience in the insurance industry, and since 1992 this has been with troubled, distressed or even insolvent insurance entities and the many and varied potential solutions. There has rarely been a dull moment, and in the first of what I hope may become a series, here is the story of a struggling risk retention group (RRG).

The RRG, domiciled in Montana, had come to the end of its natural life. We see a number of reasons that insurance companies, captives and RRGs go into run-off and often, to find the best solution, it is important to understand why the entity is in the mess that it is.

This particular RRG provided professional indemnity insurance to a group of financial services small businesses and one-man bands. It had been formed in the 1990s when rates in the commercial market were high and there was significant logic in forming a RRG and providing their own coverage.

It was a fronted programme; it operated throughout the US and fundamentally there was little wrong with the results, or the underlying claims—the RRG performed well for a number of years. However, as the market softened, starting around 2010, members of the RRG found that they could buy coverage in the open market more cheaply than the RRG would provide.

(There is a separate question here as to why those insurers were providing coverage at rates that were not deemed sustainable by a successful RRG that fully understood the underlying business—but that is a thought for another day.)

The inevitable happened: members started to leave the RRG, and there was unlimited liability associated with the members themselves, which began to fall on the shoulders of the fewer and fewer remaining members. Coupled with this, there was a significant drop in premium volume, so that the fixed costs of running the RRG became a much larger percentage of premium and the loss ratios therefore started to deteriorate.

On the back of the deteriorating loss ratios and the reducing premium, the front company demanded more collateral to the point where the RRG became illiquid.

Case study

We became involved at this point and worked with the RRG and the Montana Insurance Department (MID) to provide a solution. In this particular example, a lot of the credit for the solution we ultimately reached was down to the thought, flexibility and innovative approach of the MID, and for that we remain extremely grateful.

SOBC Sandell wanted to buy the RRG—it’s what we do—but we had three main problems:

The answer required all three parties, the owners, the buyer (us) and the regulator to work together and compromise a little so that we could get to the desired result. In the end we agreed:

The meaning of unlimited liability

How did we deal with this and why did all parties agree to all of these changes?

MID agreed the conversion from an RRG to a captive, as this was the only logical way that SOBC Sandell could purchase the company. This meant trading theoretical unlimited liability for limited liability.

What does ‘unlimited liability’ really mean? Those of us old enough to have been in the Lloyd’s market pre- and post-Equitas possibly have a unique insight into this.

Lloyd’s Names had unlimited liability: they signed up to their last cufflink. Then came those syndicate names that can still send a shiver of fear down the spine of a few of us: Outhwaite, Cuthbert Heath, and Merrett to name a few. These losses were so large that those Names, even with every cufflink piled up, could not possibly make the payments.

It was at NewCo, where we had to work out how to get enough money in to pay future losses and the theoretical unlimited liability of the Names did not help us, that I first came across the myth of unlimited liability. The lesson perhaps is that unlimited liability sounds great, but doesn’t necessarily help.

Back to Montana and the unlimited liability of the members of the RRG. Montana was swapping a theoretical unlimited liability in exchange for two things from SOBC Sandell:

Essentially Montana got cash now vs potential future cash that it might never get and would probably have to go to court for.

The seller sold at a discount to net assets to SOBC Sandell as it did not have the skills, or the desire to manage the run-off itself. As the membership reduced, and the concurrent premium reduced, the situation became more acute for those remaining members, all with unlimited liability.

Further it did not have the financial resources to put up the LOC or any other form of cash and make the company liquid once more. Finally it did remove the spectre of unlimited liability.

Why did SOBC Sandell buy the company? We had looked in details at the claims and the remaining live policies on the book, and looked at the reserves, the claims handling opportunities and the potential return and decided it was an economically sound case, although with significant potential downside risk, for us.

Bluntly, the discount to net assets that the seller accepted, combined with our ability to manage run-off successfully, was our opportunity for a profit.

At this point, I should also be fair to the fronting company who worked with us—its agreement was integral to this process. Its view, a little like Montana’s, was that they wanted a professional run-off company managing the business to closure.

The elephant in the room

What about the fact that the company was now a captive, not an RRG, and it did not have the licences to do business in any of the 52 states other than Montana?

The answer to this was a pragmatic approach by MID. The company did have live policies when we purchased it, but was not, obviously, writing new business. Montana looked closely at the risk retention legislation which essentially stated “doing insurance business” in the 52 states.

MID took the view that “doing insurance business” meant underwriting but not paying claims or managing the run-off. Their view, on balance, was that they were prepared to have the argument with states that took a different view on the definition of doing insurance business. For Montana this was a practical approach that enabled a successful transfer.

Again, taking a simplistic view, and thinking about state regulators—are they really going to stop a captive from another state, when it is trying to pay promptly the valid claims in the home state, from paying those claims, just because it might not be licensed there?

This solution was the product of several parties working together—the seller, the buyer, the front company and the regulator—to get to the conclusion everyone wanted. It involved a lot of time, cajoling, consulting and persuading and I give credit to cleverer people than me in this process.

I do believe that with an unerringly positive approach—‘we can solve this’, rather than ‘you can’t do that’—to what was essentially a big cat-herding exercise led to a great outcome for all concerned.

Stephanie Mocatta can be contacted at:  stephanie.mocatta@sobccorp.com