Morris Manning & Martin, LLP

LETTER FROM WASHINGTON - Good Governance for RRGs

10.01.2007

The NAIC Risk Retention Group Working Group’s corporate governance standards evidence the hard work and common sense utilized in the drafting process. The result is workable standards that embody the principles of fiduciary responsibility and member/shareholder involvement and control.

The NAIC started this project in response to the criticisms of the Government Accountability Office (“GAO”) report on risk retention groups (“RRGs”) (see “NAIC To Be Tested by GAO Report,” Winter 2005 Newsletter), which, in part, criticized the regulation of RRGs due to the lack of uniformity of regulation among the RRG domiciliary states. The Liability Risk Retention Act (“LRRA”) creates a particularly important role for these states due to the preemption of many elements of regulation in the non-domiciliary states. The GAO focused on two aspects of RRG governance – control by the member insureds and disclosure to members regarding the limitations on regulation established by the Act.

The Working Group’s corporate governance standards (the “Standards”) address the core ingredients of good governance for any business corporation – prohibition against “self-dealing,” board of directors and audit committee oversight, disclosure to regulators (and the opportunity to disapprove) of “material” contracts and transactions, mandatory disclosure of governance to member insureds, mandatory ethics standards, and mandatory disclosure by “insiders” to regulators of non-compliance with the Standards. While these standards were developed to address the particular needs of RRGs, they were initially drafted on the basis of standards for public corporations and the principles resulting from the state law of fiduciary responsibility. The Working Group member regulators, with input from affected industry participants, then winnowed down the proposal so that it works for RRGs, which almost always start as very small liability insurance companies chartered under the captive insurance laws of a state.

The Standards

In response to the GAO’s criticism that some RRGs are not controlled by their member/insureds, the Standards require that the majority of the members of the board be “independent,” which is defined as not having a “material relationship” with the RRG. Examples of “material relationships” in the Standards are: the receipt of compensation from a service provider or consultant to the RRG in an amount greater than 5percent of gross written premium or 2 percent of surplus in a single year; employment or other relationship with the auditor of the RRG (either currently or during a “cooling off” period of one year); and a relationship with a related entity as a result of “overlapping boards” or employment. A determination of a director’s “independence” must be made annually by the whole board and disclosed to the domestic regulator.

The second area of focus in the Standards is service provider contracts. The GAO Report directly challenged the impartiality of the contracts provided by “entrepreneurial RRGs” to service providers such as captive managers, accountants, lawyers, agents, and others. The Standards mandate that no such contract can exceed five years in length and that any “material” contract will have to be approved by a majority of the board’s independent directors and is subject to review by the domiciliary regulator, similar to the thirty-day notice and regulatory disapproval provisions of the NAIC Model Holding Company Systems Act.

The Standards also require that the board have a written charter or policy in the Bylaws that requires the Board to perform certain governance functions, including oversight of management and service providers, disclosure of ownership interest information to members, and the establishment of written governance standards. These standards, which are required to be disclosed to all members of the RRG, include the process by which directors are elected, director qualification standards and responsibilities, director compensation and related management issues. An Audit Committee is also mandated, unless the domestic regulator decides that the RRG Board can accomplish the same objectives and waives the requirement. The Audit Committee is to be made up of at least three independent Board members. Additionally, the RRG is required to adopt a Code of Conduct and Business Ethics for all directors, officers and employees. This Code addresses the normal considerations of conflicts of interest, confidentiality, adherence to applicable laws, fair dealing and fiduciary responsibilities.

Finally, the Standards embody a key concept in captive regulation – the duty to inform the captive regulator when there is any material non-compliance. Captive managers in most domiciles already have the duty to report any financial irregularity or hazard to the domestic regulator as soon as it is discovered. The Standards further elaborate on this theme by requiring the captive manager or chief executive officer to notify the domestic regulator in writing of any material non-compliance with the RRG’s governance standards.

Conclusion

The development of governance standards for RRGs by the Working Group was a beneficial one both for the regulators and the industry. Of particular importance was the educational opportunity provided to the regulators of non-domiciliary states, who gained greater insight into the alternative form of regulation employed in the management of what is known as the Alternative Market. RRGs will benefit from the implementation of the Standards due to both the increase in good corporate governance and the acceptance of RRGs by non-domiciliary states.

Robert “Skip” Myers is a partner in the firm’s insurance group and practices in the areas of insurance regulation, antitrust, and trade association law. Skip received his bachelor’s degree from Princeton University and his law degree from the University of Virginia.