• Disclosure Documents for Risk Retention Groups Under State and Federal Securities Laws: Why are They Necessary?
  • May 2, 2003 | Author: Kathleen H. Davis
  • Law Firm: Downs Rachlin Martin PLLC - Burlington Office
  • One of the advantages of forming a risk retention group under the federal Liability Risk Retention Act of 1986 ("LRRA") is that the issuance and transfer of ownership interests in an RRG are exempt from the registration and reporting requirements of the federal and state securities laws. Such ownership interests are considered exempted securities for purposes of Section 5 of the Securities Act of 1933 (the "1933 Act") and Section 12 of the Securities Exchange Act of 1934 (the "1934 Act"). As a result, ownership interests in an RRG can be issued or transferred without the substantial time and cost of a complex securities registration and without the need to comply with the restrictions of other potentially available exemptions from registration. This can facilitate the formation and capitalization of an RRG through an offering of shares or other ownership interests.

    Despite the registration exemptions it is important to disclose fully to potential investors all of the terms and conditions of their ownership, because the issuance and transfer of ownership interests in an RRG are subject to the anti-fraud provisions of the federal securities laws. Under the anti-fraud rules, virtually any person involved in the offering or sale of interests in an RRG may be liable to the Securities and Exchange Commission for fines, penalties or criminal sanctions. They also may be liable to the RRG investors themselves for damages (under the anti-fraud provisions of the securities laws and the common-law torts of fraud and deceit).

    If capital is going to be raised through an offering, whether the RRG is a stock company, mutual insurer or reciprocal insurer, the promoters of the RRG must explain the nature of the investment and associated risks. This article explores the need for adequate disclosure and outlines some of the information that should be shared with potential owner-insureds.

    Antifraud Provisions of the 1933 and 1934 Acts

    The 1933 and 1934 Acts contain similar anti-fraud rules regarding the offering or sale of securities. The 1933 Act applies to the original issuance or sale of securities by a company to investors, while the 1934 Act applies to secondary sales of securities between investors. Section 17 of the 1933 Act makes it illegal, in the offering or sale of a security to any person: (i) to "employ any device, scheme, or artifice to defraud"; (ii) to make untrue statements or fail to disclose a material fact; and (iii) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit.

    Section 10 of the 1934 Act prohibits the use of "any manipulative or deceptive device or contrivance" in connection with the purchase or sale of a security, which violates rules established by the Securities Exchange Commission. This provision has been fleshed out in SEC Rule 10b-5, which contains provisions very similar to those in Section 17 of the 1933 Act.

    The Need for Disclosure

    Organizers of an RRG may underestimate the risks of inadequate disclosure to their investor-insureds. Our research has found few published court cases involving RRGs and claims of securities fraud. In the past 15 years, however, we've seen a number of "real-world" situations that could have proven very costly had the RRG not provided investors with a written description of the nature and risks of investment in the RRG:

    • a gentleman whose dissolved company was a shareholder of an RRG was "surprised" to learn his company's RRG stock would generate no return to his company for several years after termination of his insurance. He sued claiming a right to immediate repayment for his shares of the RRG, but lost.

    • a large non-profit left an RRG program owing money under the terms of its policy. It was surprised to learn that the RRG had a contractual right to set off the amount due against the capital it otherwise would have received on surrender of its shares.

    • a trade association provided up-front capital to an RRG that went into run-off in the soft market of the mid-1990's. It was surprised to learn that the run-off liability for its occurrence-form policies will likely exceed 5 years, during which time all of its capital will remain tied up in the RRG.

    • a shareholder of an RRG failed to tell its accountant of various restrictions applicable to its RRG stock, and experienced a painful balance sheet "hit" when the stock restrictions were accounted for correctly.

    In each of these "real-world" situations, the disclosure document, including the Articles of Incorporation and By-laws of the RRG, provided the basis for resolving the issue quickly, in favor of and without loss to the RRG.

    Recommended Disclosures in the Offer or Sale of Interests in an RRG

    The reasons for a disclosure document are compelling in the case of most RRGs, due to the somewhat unusual nature of a typical RRG structure. Examples of unusual restrictions raised by many start-up RRGs' structures include an absolute restriction on transfer of the ownership interest, a minimum commitment to buy insurance for several years, a restriction on the return to the owner-insured of its capital investment after termination of insurance (perhaps an additional 5 years), and a right of setoff against capital for unpaid premiums or deductibles. If these restrictions are not carefully disclosed "up front," the consequences could range from an unhappy insured to significant liability for the RRG and its organizers.

    We recommend that the RRG provide a potential investor-insured with a written description of the insurance program and the nature of the investment in the RRG. The investor should be required to execute a participation agreement, in which the investor affirms that it has received and reviewed the written disclosure and has had an opportunity to request additional information from the RRG.

    No two RRGs are alike; the appropriate disclosures differ as well. Generally, the disclosures should cover, at a minimum:

    • that the RRG was formed under the LRRA, and as such is subject to only limited regulation other than regulation by its state of domicile;

    • that any person insured by the RRG must purchase an ownership interest in the RRG and execute a subscription/participation agreement;

    • the price per share or investment unit in the RRG, the minimum amount of investment and a statement that sales of interests in the RRG are exempt from federal and state securities registration requirements;

    • a description of the RRG's business plan, including the types of coverage provided to insureds, reinsurance arrangements, governance of the company, use of the insureds' investment to meet capital and surplus requirements, and relationships with affiliated entities and the RRG's captive management company;

    • minimum term of investment by insureds, restrictions on transfers of interests by insureds, the RRG's rights to repurchase equity interests, and any restrictions on the insured's rights to terminate the investment;

    • business risks, including such risks as lack of operating history and experience of directors and officers in the insurance business, dependence upon access to reinsurance, and risks of losses in excess of reserves leading to potential loss of investment.

    The disclosure document should also cover the following:

    • general terms for insurance, including claims-made or occurrence-based coverage, exclusions, premium payment requirements, rights to defense or indemnification, and renewal and termination terms;

    • policies with regard to payment of policyholder dividends or premium credits, and distributions of net assets on liquidation of the company;

    • claims adjustment procedures and administration of the RRG;

    • unavailability of insurance insolvency guaranty funds;

    • federal income tax treatment of the RRG as an "insurance company" taxable under subchapter L of the Internal Revenue Code of 1986, with the recommendation that investors seek qualified advice as to the income tax ramifications of their investment;

    • general investment policy to be followed.

    These disclosures should be modified as a particular program matures, and a periodic review should be conducted to be sure program changes are incorporated.


    An RRG benefits significantly from limited state regulation of its insurance program and the exemption from federal and state securities laws. These exemptions make it easier to establish an insurance program, but they will not insulate the RRG or its organizers from liability for sloppy business practices or for unexpected business events. Careful and full disclosure to potential investor-insureds up front will help assure good relations between the RRG and its insureds over the long run.