In early 2003, Washington Managed Imaging (WMI), an independent practice association (IPA) composed of 13 radiology groups and approximately 280 radiologists, decided to investigate self-insuring its malpractice risk. Commercial malpractice insurers increased rates 30% to 50% (or more) starting in late 2001. This has caused a significant number of health care providers to consider self-insuring their malpractice risk. In many cases, this decision is being driven by the need to survive: if commercial malpractice premiums continue to increase at the pace seen over the past 3 years, many providers will be driven out of business.
According to the American Medical Association ( www.amaassn.org/ama ), only six states are not currently in crisis or showing significant signs of problems as a result of the malpractice insurance situation. In the state of Washington, lack of competition among insurers and high liability award levels have caused dramatically increased premiums and reductions in coverage. Further, radiology is looked upon as a high-risk specialty by most insurers and reinsurers because of a high number of frivolous liability cases, constant introduction of new technologies that insurers understand only marginally, and a shortage of radiologists that leads to chronic overwork (with the attendant risk of error).
COMPANY STRUCTURE
As executive director of the IPA, I was asked to lead the self-insurance investigation. There are many self-insurance models, including captive insurance companies, so-called rent-a-captive models, risk-retention groups, and risk-purchasing groups. Since I had no experience in insurance, outside experts were needed. A team of consultants was retained, including lawyers, reinsurance experts, third-party administrators with insurance-operations expertise, captive managers, investment managers, bankers, accountants, and actuaries. It was more efficient and cost-effective to retain experienced companies, regardless of location, than to rely on local companies that might have had less experience.
The first step in the investigation process is an actuarial study of the losses (indemnity, reserves, and defense costs) of the group and its physicians over the prior 5 to 7 years. Loss information was obtained from the insurance brokers who placed our commercial malpractice coverage. At a cost of approximately $25,000, the actuaries then produced a report estimating WMI’s losses for the next year, along with 50%, 70%, 75%, and 90% confidence-level estimates. Reinsurers typically insist that confidence levels be calculated.
The actuarial report also showed expected losses at various risk-retention levels (the dollar amount per claim that the self-insured group is willing to bear before ceding the remaining risk to reinsurers). The higher the retention level, the lower the reinsurance premium will be. Because the WMI physicians had no experience with retaining risk, we opted for a conservative retention figure of $250,000. The actuarial report indicated that 140 radiologists would be needed to retain that level of risk. The more risk units that potential losses can be spread among, the lower the risk for each insured unit.
Self-insurance companies next face a critical make-versus-buy decision. Will you hire enough staff and purchase enough equipment to recreate the operations of a commercial insurance company (including underwriting, policy development, claims, risk management, finance and accounting, and data processing), or will you retain an experienced third-party administrator (TPA) to perform these functions? The WMI board decided to retain a TPA under a multiyear agreement based upon a percentage of our gross premiums, with an annual cap. The TPA developed plans to visit each WMI member site and to present classes on the best ways to manage risk in radiology. We agreed with their position that most radiology malpractice cases are filed as a result of patients’ negative encounters with support staff and technologists, not radiologists. For that reason, significant risk-management focus was placed upon support staff.
Next, we needed to retain a captive manager. This is a company residing in the domicile in which the captive insurance company will be located, with popular domiciles being Vermont, South Carolina, Montana, Hawaii, the Cayman Islands, and Bermuda. Our lawyers recommended forming a risk-retention group in Hawaii because of its geographic proximity (an annual board meeting must be held in the domicile) and other advantages, so we retained a captive manager there. The captive manager, in return for fees that vary from about $25,000 to $75,000 per year, assists the captive in becoming licensed in its domicile and files the paperwork (including annual reports) required by authorities in the domicile. The captive manager works closely with the captive’s accountants, investment managers, and lawyers in the domicile. A requirement of Hawaii is that a Hawaiian resident be appointed to the captive’s board, so we appointed our Hawaiian lawyer to that position.
OBTAINING REINSURANCE
Securing reinsurance is the single most important factor for success in self-insurance. For small companies, reinsurance premiums can easily account for 50% or more of the annual premium charged to the insured physicians. Most major medical malpractice reinsurance companies are in London, elsewhere in Europe, or Bermuda, and a personal visit will be required. Before meeting with reinsurers, the self-insurance company must develop a submission. This is a lengthy document containing detailed information about the group, its physicians, and its management team; 5 or more years of malpractice losses; its most recent actuarial study; a description of the malpractice market in the group’s service areas; and a detailed business plan covering the first 10 years of the new company’s life, with details on the company’s board of directors, insurance operations, capital structure, legal and tax issues, ownership issues, governance, and pro forma financial projections. Our submission was 110 pages long.
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Major reinsurance syndicates typically control billions of dollars in capital. They choose quite carefully where they invest these funds, so unless they have a good reason to meet with a start-up captive company, they probably will not. Our reinsurance broker’s London team arranged for us to meet with 12 of the major syndicates, and four of them were willing to provide reinsurance quotes. Considering that we were a start-up company with no track record, and that radiology is in disfavor in the insurance community, this was a great accomplishment for us. Reinsurance brokers are paid roughly 2% to 5% of the reinsurance premium per year. That is a substantial sum, but their services are almost mandatory in approaching reinsurers for the first time. Reinsurance will be very expensive, but it is necessary unless the group’s physicians are prepared to assume the risk for the entirety of any losses. Since radiologists are generally unwilling to take such risks, reinsurance is basically mandatory. Although it is difficult to secure, it can be obtained if the reinsurance broker is competent and the group’s past loss experience is good.
FINANCIAL, LEGAL RELATIONSHIPS
Once reinsurance has been secured, the captive must develop banking, auditing/accounting, and investment-management relationships in its domicile (and elsewhere, as appropriate). The captive is likely to generate several million dollars per year in premiums, and this money must be carefully managed and invested in compliance with domestic and domicile-specific laws. The captive manager can help the group choose the necessary companies, and the TPA may already have relationships with them.
Most domiciles required audited financial information each year, so the captive’s financial statements will need to be audited by a major, reputable accounting firm that has at least one local office in the domicile. As an insurance company, a captive is limited in the investments that it can legally pursue. For example, most insurance companies are prohibited from buying high-risk stocks or derivatives. Instead, most invest the great majority of their available funds in high-grade bonds. Because millions of dollars flow through the company each year, even a 5% return can yield hundreds of thousands of dollars in investment income each year. These funds are vital to the success of the company, so the investment manager should definitely have experience working with captive insurance companies. WMI’s chosen accountants, banks, and investment managers required only 1-year contracts. The total cost of accounting, banking, and investment services will vary, up to about 1% of the gross premium per year.
Competent, specialized legal services are required nationally, in the domicile, and in the captive’s home state. For WMI, the total cost for legal services during the investigation stage was a little over $50,000. While this was not inexpensive, we received fair value due to the expertise displayed by each firm. They produced recommendations on the domicile (Hawaii) and captive type (risk-retention group), as well as articles of incorporation, bylaws, a prospectus, a stockholder agreement, a determination of deductibility of premiums, and applications to state and captive insurance authorities. Determining the deductibility of premiums is particularly important. If premiums will not be deductible for state and federal income-tax purposes, physicians need to know that from the beginning. If nondeductibility makes the captive idea untenable, that decision should be made quickly. In our case, the lawyers determined that our legal structure would ensure that our premiums were deductible.
Premium taxes must be paid by all US insurance companies, including captives domiciled in the United States. These taxes can be as much as 5% of gross premiums each year, so they are not inexpensive, but the actual tax rate is decided by regulators in the domicile. Our captive manager and lawyers were instrumental in getting a 2% premium tax for the group, for a potential six-figure savings in the first year.
THE CAPTIVE BOARD
WMI decided on a 10-member board composed of one physician from each of the WMI member groups buying into the new company and a senior partner from our Hawaiian law firm. Only two committees were formed: claims and finance. The claims committee was composed of five WMI physicians and a claims manager. This committee was to consider each case brought against a WMI member and decide whether to settle the case or proceed to trial. If the committee decided to settle a case, the accused physician would still be free to pursue a trial. If the verdict went against the physician, however, he or she would be liable for 50% of the indemnity over the settlement amount recommended by the committee.
 Michael S. Fenton |
The finance committee, consisting of five WMI physicians, myself, and a TPA member, was instituted to oversee the management of funds, working closely with outside bankers and investment managers. They were also to review each year’s updated business plan to determine the premiums to be charged to each participating WMI physician. Both committees were to take their decisions to the captive board for final approval.
We were ready to begin operations on January 1, 2004. All we lacked were the investments from participating physicians to fund the new company. But then the crisis in Washington state softened somewhat, and most WMI member groups accepted coverage from Physicians Insurance for 2004. A major benefit of the study is that we knew, from an actuarial point of view, exactly what our coverage should cost. So the WMI members were much more informed buyers of insurance than they had been.
CONCLUSION
WMI is now positioned to self-insure at any time, since most of the groundwork has already been done. The commercial market shows no signs of real improvement, so, should the marketplace harden again, WMI could revisit the self-insurance idea in late 2004. A new actuarial study, business plan, and reinsurance submission will be needed, but much of the latter two documents can be copied from the previous versions. Reinsurers may be cautious because of our false start, so we will ensure that we have a committed, critical mass of WMI physicians before approaching the reinsurers.
Since early 2004, at least three major medical malpractice captive insurance companies have begun operations in Washington, and more are currently being studied. This is clearly a trend that appears to be gaining traction.
In the absence of national tort reform, self-insurance is our best long-term strategic alternative. It is better to take control of our own future than to rely upon the whims of the commercial market, especially when those insurers have little understanding of our business. Practice managers should understand, however, that the captive investigation process is long and difficult, but they will learn more from it than they ever thought possible.
Michael S. Fenton is executive director, Washington Managed Imaging, Seattle. This article has been excerpted from Self-Insuring Your Malpractice Risk, which he presented at the Radiology Summit 2004 of the Radiology Business Management Association on June 7, 2004, in San Diego.
