Rocketing insurance costs for hospitals, physicians and healthcare providers has sparked growing interest in alternative solutions to traditional medical malpractice insurance, writes Scott W. Wright. He highlights the key issues involved in using a Vermont captive-insurance company as a solution to the current problem.

Today’s headlines scream about the increased cost of insurance for hospitals, physicians and healthcare providers alike. This has been particularly true on the eastern seaboard, where New Jersey, Pennsylvania and West Virginia have all faced physician strikes in the past few months. These strikes directly impact on hospital systems, as physicians threaten to move their practices out of perceived high-cost states to lower-cost states. Perhaps predictably, alternative solutions to traditional medical malpractice insurance similarly have been in the headlines.

Reed Smith has been working with its healthcare clients over the past year to help them address these issues on a strategic basis. The issues involved can be complex and specific advice needs to be attained. However, this article will attempt to highlight a few principal considerations involved in using a Vermont captive-insurance company as an ART solution to the current medical malpractice insurance problem. It focuses primarily on Vermont as a domicile, but most of the strategic issues exist regardless of the domicile.

Vermont is important because it has a well-developed captive-insurance infrastructure of regulatory support and service providers. This makes forming a captive in Vermont a highly practical and desirable prospect. An invaluable initial resource is the Vermont Captive Insurance Association, which can be accessed on the web at www.vcia.com.

A question of cost

The main consideration for anyone contemplating setting up a captive is cost. If the numbers do not make sense, there is little point in pursuing the idea. As an initial matter, it is important to understand that a healthcare provider establishing the captive will be the owner of the captive and a policyholder. This means that the provider will need to supply the initial capital required to create and pay insurance premiums for the malpractice coverage.

Cost is, however, not a simple matter of determining how much premium can be saved. As Patrick Theriault of Strategic Risk Solutions, a captive manager in Burlington, Vermont, explains:

"While cost is definitely an important piece of the puzzle, we usually prefer to approach it from the point of view of finding the best way to manage someone’s risk exposure. This is often looked at by doing both a qualitative and quantitative analysis (feasibility study). We often evaluate cost by doing a net present value cash flow analysis."

Minimum capitalisation costs vary depending on the type of captive. A pure captive is one that has its policyholder as owner. This type of captive can make sense for a single hospital system. The statutory minimum capital in Vermont for a pure captive is US$250,000. On the other hand, a number of hospital systems can come together to form what is generally referred to as a Risk Retention Group (RRG). A group or groups of physicians can also form an RRG. The minimum capital for an RRG is US$500,000. As a practical matter though, in Vermont, the minimum capital required typically is one-third of the amount of premium written by the captive. This means that the actual capital required by Vermont regulators is likely to be greater than the minimum.

The value of insurance premiums is based upon the value of projected losses, which will be determined by an actuarial study. The study would be based upon a five-year loss history, assume a certain return on investment (often 5%) and project, over time, the amount of money needed to fund expected losses. The amount needed is the insurance premium to be paid by the captive owner/policyholder. The amount of money needed to fund the captive would need to be equal to the projected-loss cost plus 33% for statutory capital.

To mitigate this cost, Vermont permits a portion of the statutory surplus to be in the form of a letter of credit. The real cost then becomes collateralising the letter of credit. It is important to note, though, that Vermont regulators typically require paid-in capital and are reluctant to approve a captive capitalised solely by a letter of credit. In addition to that amount, start-up funding can be in the US$75,000 to US$100,000 range and ongoing expenses need to be considered.

The captive formation process

From a purely technical perspective, the steps for forming a captive are fairly straightforward. Patrick Theriault advises that the following steps are generally needed and can be accomplished in a matter of a few months.

Tasks/time frame for captive formation

1. Complete the business plan/feasibility study (including actuarial projections);
2. Present at meeting(s) with prospective insureds;
3. Visit Vermont regulators if required;
4. Complete application, file with State of Vermont;
5. Incorporate, appoint officers, open bank accounts;
6. Capitalise the company – issue shares (if stock company);
7. Receive licence;
8. Sign insurance and reinsurance agreements;
9. Collect premium, bind cover.

While the foregoing are the steps for forming a captive insurer in Vermont rather than an RRG specifically, the process is, in practice, the same. In addition to a general application form, other forms in the packet that require completing include:

• A table of coverage/limits/reinsurance;
• A biographical affidavit from every officer and director of the proposed captive;
• An application for authorisation to certify loss reserves and loss-expense reserves for captives;
• An application for authorisation as an independent certified public accountant for captive-insurance business, if not already approved;
• A State of Vermont captive-insurance company irrevocable letter of credit.

A summary of the basic rules for Vermont and other jurisdictions can be found at www.captiveguru.com.

As a practical matter, perhaps the most important consideration is the selection of a good captive manager. In addition, a captive owner will need to have a banker, an accountant, an actuary and a lawyer to prepare the formation, corporation and tax documentation.

Captive versus RRG

As noted above, in Vermont, a pure captive has less of a minimal capital requirement than an RRG. But, as a practical matter, Vermont regulators will require all captive entities to be capitalised adequately – and the capital minimum is just that, a minimum. The premium to surplus ratio noted above is a more accurate reflection of cost. When considered in that light, an RRG is not necessarily a more costly alternative.

Perhaps a more important factor is the ability to issue insurance policies on a direct basis in multiple jurisdictions, without the need for "fronting" insurance. Many hospital systems have facilities in different states. In addition, the corporate structure of many systems contains various entities, including employed physicians and healthcare providers. An RRG structure is ideal in this context. Once an RRG is established in Vermont, it can be registered to write insurance in various states without the need for becoming a fully licensed insurer in each of those states. This creates cost and time savings. So, for example, a hospital system in New Jersey, which must obtain certain levels of insurance from admitted insurers, can often do so via the RRG route. Pennsylvania’s insurance department has been willing to expedite this process recently to address the current crises.

One potential downside for an RRG is that each RRG member must be an owner as well. In that sense, each member becomes an insurer of the other member’s insurance risks. Legally, all share the liabilities. This means that there is a risk that the largest member of the RRG could become liable for the entire group’s losses. There are ways to structure the RRG so that this risk is minimised, but it is a noteworthy risk nonetheless. This is an area where experienced legal counsel is needed and invaluable.

Another area where experienced legal counsel is needed is in the area of not-for-profit taxation. Since many hospital systems are not-for-profit, the ability to maintain that tax treatment in the captive structure is imperative. In Vermont, it is possible to create tax-exempt entities in either the pure-captive or RRG structure.

It is worth noting that a special type of entity in Vermont is called a "reciprocal", which is a statutory form of organisation operating in Vermont via an attorney-in-fact. Because of its special nature and structure, it is possible that federal or state governments would not tax the reciprocal.

Offshore versus onshore

Finally, it is important to mention offshore jurisdictions. Often, an offshore jurisdiction has a lower capital-threshold requirement than Vermont. However, there are costs that must be paid by the captive-insurance company in order to do business in the onshore jurisdiction in which the owner is located. The "fronting" takes the form of fees paid to another insurance company that is authorised to write insurance in the desired jurisdiction. These costs can raise the amount of premium that must be paid for the coverage.

But a careful feasibility study will take into account the most desirable jurisdiction for the captive owner. Ultimately, by working with legal counsel and a good captive manager, a healthcare provider or hospital system can determine whether an alternative insurance solution is appropriate.

Pull quotes

1. The main consideration for anyone contemplating setting up a captive is cost. If the numbers do not make sense, there is little point in pursuing the idea.
2. Many hospital systems have facilities in different states. In addition, the corporate structure of many systems contains various entities, including employed physicians and healthcare providers. An RRG structure is ideal in this context.
3. One potential downside for an RRG is that each RRG member must be an owner as well. In that sense, each member becomes an insurer of the other member’s insurance risks. Legally, all share the liabilities.

First published in Risk Transfer, Volume 1 Issue 4