Following the crash of the traditional medical malpractice insurance market at the turn of the last century, the alternative risk market - in particular a model referred to as a risk retention group ("RRG") - has enjoyed unprecedented popularity. Now that the traditional market has rebounded, the value of many RRGs has been called into question. Promises ranging from ownership or control convince some physicians and administrators to entertain RRGs, but since so few have strong financial backing, they should first understand the full scope of potential risk factors before signing on.

The Federal Risk Retention Act of 1986 gave individuals the ability to pool among themselves certain risks, such as the risk of medical malpractice. As such, RRGs gave individuals and companies with difficulty finding insurance in the traditional market a new option. Today, according to www.RRR.com, there are 153 risk retention groups insuring healthcare professional liability, 64 of which are listed as specific to physicians.

These numbers should not necessarily be confused with success. Historically, start-up companies formed to insure against medical malpractice collect hefty premium and capital dollars from new members. Since medical malpractice lawsuits are generally not resolved for years after an incident occurs, these start-ups initially pay out very little for claims. Only after a company and its claims mature can the financial viability of that company be reliably assessed. Similar to a portfolio of adjustable rate mortgages, only time will tell whether each selected risk was prudent. And like investors in the subprime mortgage market, prospective members of an RRG would be well-served by first examining its underlying structure to determine weaknesses and strengths.

Most RRGs contract with a management company to run their day-to-day operations. Management companies may charge as much as twenty-five cents of every premium dollar in fees, but since they are not "members" of the RRG, they often do not assume any of the financial risks. Reinsurance, which can protect a company against catastrophic claims (commonly above $250,000), may cost the RRG another 25% of collected premiums, depending upon ultimate losses.

Reinsurance can be one of the most misleading aspects of an RRG. RRGs frequently tout that they secure reinsurance from "AM Best, A-Rated" carriers. Yet, too often, the financial strength of the reinsurer has little to do with the financial strength of the RRG.

Depending upon the structure of a reinsurance deal, an RRG may be required to renegotiate reinsurance contracts annually and the costs of present, future and even past contracts can be contingent upon losses. If an RRG is not performing well, the reinsurance companies (absent a "cut-through" endorsement) may quickly terminate their relationship, leaving only the RRG, and its members, to deal with losses.

In one 2006 case involving the insolvency of a medical liability RRG, the Judge, in dismissing a claim brought by the insolvent company against its reinsurance company noted, "...the appearance of financial stability could be created without amassing the necessary capital and surplus, a daunting and very lengthy process. Instead, they could arrange for a well-respected and well-heeled reinsurer to at least appear to stand behind its obligations through reinsurance."

After paying for reinsurance costs and management company costs, the remaining (approximately) 50% of premiums should go to defending and paying claims. And since this 50% is rarely needed for claims in early years, it can be prudently invested and added to the surplus or reserves of a company and can produce critical returns to offset future losses. However, many RRGs, eager to flaunt their early "successes," have been known to return unused capital in the form of dividends, reduced premiums, or even executive payouts.

Separating out the strong RRGs can be challenging. In rare cases, RRGs are well-rated by AM Best, and one has even earned its highest "A++ Superior" mark. In the absence of an AM Best or similar rating though, practices should retain specialized, independent consultants to analyze financial statements, reinsurance treaties, and overall risk. Unfortunately, many RRG representatives discourage the use of consultants, and some even require prospective members to sign non-disclosure agreements - a good sign that the deal has terms that would be questioned either by insurance experts, attorneys, accountants, or even regulators.

So far, state regulators have been reticent to pass comprehensive legislation to regulate RRGs. Since most RRGs tend to be relatively small in scope, and many are in there infancy stages, there is little public interest in them. More importantly, the Federal Act makes state regulation difficult. For example, RRGs are exempt from certain state laws, such as those that "discriminate" against them, making lawmakers reluctant to pass legislation or regulation that could be construed as targeting RRGs in favor of state-approved insurers.

The Act also exempts RRGs from being forced "to participate in any insurance insolvency guaranty association which an insurer licensed in the State is required to belong." These "associations", commonly referred to as "guaranty funds" have been created to replace participating insolvent carriers. For example, New Jersey's guaranty fund provides $300,000 of indemnity coverage per claim, and New York provides $1,000,000. By not participating in these funds, RRGs cannot offer this protection to their members, leaving them personally liable for claims in the event the RRG does not have the resources to respond to a claim.

In the event a policy is assessable, members may be obligated to fund not only their own claims, but the claims of all the other members in the RRG, until the very last one is resolved. Notwithstanding a policy's assessability, years of poor performance would logically lead to increased premiums for all members. Those with a claim history that would allow them to find cheaper insurance in the traditional market are likely to jump ship, leaving the others to sink.

Most RRGs claim that their policies are "non-assessable," which means that members are not subject to additional payments, even if the company's liabilities exceed its assets. While this may benefit members without any pending or future claims, it could force other members into personally funding their own lawsuits, and possibly even into bankruptcy.
As long as the traditional medical malpractice insurance market is stable, and until the alternative market sufficiently matures, with some exception, physicians may want to invest their assets elsewhere.

Brian S. Kern, JD is a co-founder and principal with Argent Professional Insurance Agency, LLC . He can be reached at bsk@insuranceagent.com