Keeping Medical Liability Costs Down: How Captive Insurance and Damages Caps Could Help Control Rising Healthcare Costs.

• Author: Talmadge, Daniela

1. INTRODUCTION II. BACKGROUND A. How Captives Work 1. Popular Types of Captives 2. Benefits of Captives 3. Risks of Captives B. Considerations When Forming a Captive C. Captives and Medical Liability 1. Damages in Medical Malpractice Cases 2. Damages Caps 3. Damages Caps Nationwide 4. Challenges to Damages Caps D. Captives as the Platform for Medical Liability Reform III. ANALYSIS A. Benefits of Captives for Insuring Against Medical Liability B. How Captives Can Be Used in the Context of Medical Liability 1. Benefits of Damages Caps 2. How Captives and Damages Caps Work Together IV. RECOMMENDATION V. CONCLUSION I. INTRODUCTION

   Insurance costs continue to rise annually generally because of increased administrative costs relating to processing and paying claims, litigation costs arising from claims, and certain types of risks becoming more expensive to insure. (1) Two issues contribute to large health care costs: (1) the use of defensive medicine, and (2) the increasing costs charged to consumers to help offset the high costs of medical malpractice insurance premiums. (2) Insurance for medical liability is among the most expensive types of insurance, costing physicians anywhere from $10,000 to $100,000 a year. (3) As of 2008, medical liability costs--including medical malpractice insurance, claims, and attorney and litigation costs--totaled 2.4% of the United States' annual health care spending, or roughly $55.6 billion each year. (4) Though these high costs might seem reasonable to insure against the possible risks often encountered in the medical field, even more costs are incurred as physicians often resort to an increased practice of defensive medicine--the practice of preforming more procedures and tests than medically necessary--in an attempt to avoid litigation. (5)

   These rising costs often lead consumers, in this case physicians and medical institutions, to look outside of commercial insurance in order to affordably manage their risks. This leads consumers toward self-insurance and commercial insurance. (6) Captive insurance companies (captives) are subsidiaries created and wholly owned by noninsurance parent companies to provide insurance to the parent companies. (7) Over the last few decades, this form of self-insurance has gained a popularity that keeps growing in today's healthcare market.

   This Note will discuss the history of captive insurance, the problems with the current state of medical malpractice liability, and ways in which health care costs related to health care malpractice can be decreased. This Note will also explore using captives as an alternative to commercial insurance companies and using damages caps as a way to keep down costs associated with medical liability.

2. BACKGROUND

   Captives have existed for centuries, beginning with Frederic M. Reiss, who coined the term captive in the 1950s when he used it as a way to describe his creation of an insurance company that provided insurance only to its parent. (8) Reiss then incorporated American Risk Management in 1958. U.S. regulations at that time made it very expensive to form and operate captives within the U.S. This led him to look at offshore jurisdictions to domicile the captives. (9) He settled on Bermuda--which has since become the leading captive domicile. (10)

   Though it took some time for the captive concept to gain popularity, there are thousands of captives worldwide, with over 3,000 currently domiciled in the U.S. (11) In general, captives largely remained domicile offshore due to the unfavorable U.S. regulations that made it costly to operate a captive domestically. (12) This was the case until the 1970s when the first law was passed in the U.S. to encourage captive formation--with Colorado, Tennessee, and Vermont being the first states to adopt the captive-favorable legislation. (13)

   Though "insurance" is not defined in the Internal Revenue Code or the Treasury Regulations, it is clear through common law doctrine that "an arrangement will constitute insurance only if it incorporates requisite risk shifting and risk distribution." (14) Captive insurance is a form of insurance that has been under scrutiny by the Internal Revenue Service (IRS) for potentially failing to fall within the insurance definition. (15) In the 1970s and 1980s, the IRS believed that captives were not a legitimate form of insurance because of the lack of risk shifting, since risk was being shifted onto the captive--a subsidiary of the parent company--instead of an unconnected third party. (16) However, the role and treatment of captives has changed based on the interpretations of the courts (17) and the IRS, (18) who issued guidance in 2002 as to how to set up captives in compliance with the tax code. (19)

   1. How Captives Work

      Many companies and industries find forming captives for self-insurance purposes appealing because of the benefit of the parent company being able to profit from the captive. A parent company creates and owns a subsidiary company as the captive and pays premiums to the captives as it would to a commercial insurance company. (20) The captive then deals with any claims against the parent company. (21) The primary difference between insuring with a captive versus a commercial insurer is that if the claims paid by the captive are less than the premium, then the captive has made a profit, and thus the parent company--rather than a commercial insurer--benefits. (22) For example, if a parent company paid a premium of $100,000 to a commercial insurer and only had $50,000 in claims, the parent would lose out on the other $50,000 paid to the insurer as a premium. If the company paid the same $100,000 in premiums to a captive and there were only $50,000 in claims, the captive would retain the remaining $50,000 and the parent company would profit.

      The worry about the captive process is that the amount in claims will exceed the premium amount paid, but there are ways for the captive to deal with this. (23) For instance, if the amount in claims were to exceed the premium amount paid, the captive would need a reinsurance policy to cover the claims or would have to pay them out of its reserves. (24) However, in paying premiums to a captive instead of a traditional commercial insurer, the captive remains an asset to the parent, while still insuring against possible risks. (25) For example, if the parent company decides to dissolve and discontinue their operations, the money in the captive will not dissolve with it. Rather, the funds "continue to belong to the parent," just "as any other asset would." (26)

      1. Popular Types of Captives

         Though there are various types of captives, three types of captives would be most favorable in the medical liability setting: (1) a single parent captive; (2) a group captive; and (3) Risk Retention Groups (RRGs). The single parent captive--the most common type of captive--is where the parent company creates the captive as a subsidiary that insures only the parent. (27) An example of a group captive would be if a single hospital were to create a captive to only insure risks and pay claims against the hospital, it would be a single parent captive. "A group captive provides coverage to a group of entities that share similar risks." (28) If several similarly situated medical practices, such as hospitals of similar size and capacity, were to create a captive together to insure against risks each practice is likely to face. (29) RRGs have been recognized as a form of captives since 1986, when Congress enacted the Liability Risk Retention Act of 1986. This Act specified that an RRG must be domiciled in the United States and in a state that regulated it as a captive insurance company. (30) The RRG may then operate nationally, as long as it registers in each state it intends to operate. (31) This makes RRGs more portable than other forms of captives. However, RRGs as captives are limited to writing liability coverage, meaning RRGs are limited in use and may only be used for liability purposes. (32)

      2. Benefits of Captives

         The true motivation that has historically driven the creation of the captive insurance company are: (1) the inability to purchase insurance to insure against a particular business risk from commercial insurance companies; (2) the high prohibitive cost of insurance; and (3) premiums paid (33) to the captive are tax-deductible business expenses. (34)

         Captives provide for improved coverage availability and flexibility because they are specifically created and designed to meet the needs of the parent company and to address the risks of the parent. (35) Captive owners can write specific policies tailored to their business or industry and can go above what typical commercial insurance liability would cover. (36) This offers the parent company the opportunity to determine risks they are susceptible to based on its own experience. In doing so, parent companies are not bound by market-wide or industry-wide calculations, allowing for more flexibility. (37) It also reduces the parent's risk of being bound by the market standard or possible mismanagement by those in the industry, which leads to greater risk calculations. (38) Therefore, because the parent's own management determines the parent's risks, the parent has the possibility to enjoy lower costs associated with insuring against those risks. (39)

         Captives also eliminate the often adversarial relationship between the insurer and insured. (40) Captives create a "symbiotic relationship" between the parent and the captive because the parent owns the captive and they both have the same incentive to pay claims within the contemplated risks from the captive's reserves. (41) In contrast, commercial insurance companies may have the incentive to delay paying claims, so they can retain the insured's premiums and maximize profits by paying the fewest amounts of claims. (42)

      3. Risks of Captives

         Though there are many benefits of captives, there are also risks...