A Look at Reciprocal Insurers From 30,000 Feet

For years, newly organized reciprocal insurers were few and far between and were not the preferred vehicle for new entrants to the insurance space. In fact, at one time, a prominent state insurance regulator refused to license new reciprocals, believing that the structure limited the insurer’s options to raise capital. Those views have changed with a renewed interest in reciprocals by both investor and stock insurance groups focused on gaining an ability to earn fee income through the ownership of the reciprocal’s attorney-in-fact, while avoiding the attendant underwriting risks associated with an insurer’s operations.

This article discusses the history and structure of reciprocals, as well as the pros and cons of operating under the reciprocal construct.

The History and Structure of the Reciprocal Arrangement

As Andrew Verstein noted in his 2017 law review article, reciprocals operate as “vast enterprises — with millions of customers paying trillions of dollars …without any meaningful use of … a legal entity.” In general, reciprocals provide a system under which parties (subscribers) agree to indemnify each other against specified losses by the mutual exchange of insurance contracts through a common attorney-in-fact appointed by each of the subscribers to manage the reciprocal.

That appointment is affected by means of a “subscription” agreement. Reciprocals are often referred to as an unincorporated association, a “trust for a purpose,” a quasi-corporation, and more than a partnership and something less than an insurance corporation. Somewhat circularly, one court stated: “This is what it is: It’s an interinsurance exchange defined by the Insurance Code.”

Reciprocals were first organized in 1881 by New York dry-goods merchants who were displeased with the rates offered by the insurers covering their facilities. Believing they were being over-charged, the merchants decided to self-insure to lower their insurance costs. As “subscribers,” they agreed to indemnify each other when a member suffered a loss.

Historically, therefore, each subscriber was considered to be both an insurer and an insured, which, in turn, gave rise to the term “reciprocal.” As the merchants were not in a position to manage the reciprocal’s day-to-day operations they appointed an attorney-in-fact to handle those and other functions. This essentially resulted in a tri-party arrangement consisting of the reciprocal, the attorney-in-fact and the subscribers, each addressed below.

The Reciprocal Party

The first party, the reciprocal, is an unincorporated association of individuals or legal entities (i.e., “subscribers”) who, as noted above, undertake to indemnify each other against losses through the mutual exchange of insurance contracts issued by the reciprocal. Those contracts are effected by an attorney-in-fact appointed by the subscribers pursuant to a subscription agreement. The policies are generally non-assessable, which keeps the subscriber (or policyholder) from being charged additional amounts if the reciprocal’s operating costs are higher than expected. In other words, the financial liability of subscribers is limited to the cost of the policy. Compare this to a true “inter-indemnity” structure that exists today for certain commercial liability coverages. California, for example, permits inter-indemnity arrangements for medical malpractice coverage that involves actual contract-holder (policyholder equivalent) joint and several liability for losses.

Limited oversight of the reciprocal is provided through its board of governors or directors, and oversight is generally limited to monitoring the reciprocal’s finances and the attorney-in-fact’s compliance with the Subscription Agreement entered into with subscribers.

The Attorney-In-Fact Party

The second party, the attorney-in-fact, is appointed by subscribers to operate the reciprocal’s day-to-day business. The attorney-in-fact is the agent of the subscribers to, among other things, accept or reject risks and make other underwriting decisions, effect contracts of reciprocal insurance or reinsurance, seek new subscribers, collect premiums, pay claims, invest the reciprocal’s funds, contract with third parties (e.g., insurance agents or brokers) and commence or defend legal actions. In acting in this capacity, the attorney-in-fact bears no underwriting risk.

As concerns the attorney-in-fact’s form, it could be a natural person (or persons) or a legal entity such as a corporation or limited liability company. In situations where the attorney-in-fact is an individual, all the assets required for the reciprocal’s operations are owned by and employees are employed by the reciprocal. Although a “natural person” attorney-in-fact may seem like an antiquated arrangement, it’s not — one prominent reciprocal operated with individual attorneys-in-fact into the early aughts. That, however, is not a preferred structure due to personal/employee attrition and liability issues.

Thus, maintaining the attorney-in-fact’s operations in a legal entity is a preferred and more common structure. Under this scenario, the operational assets may be held by the attorney-in-fact, which performs all of the insurer-related functions for the reciprocal resulting in the reciprocal’s having minimal direct operations. As a legal entity, the attorney-in-fact could be owned by the reciprocal, subscribers or one or more third parties independent of the subscribers or the reciprocal.

The attorney-in-fact’s compensation is dependent on the fees that it earns from managing the reciprocal. In other words, there is no mechanism for the reciprocal to pay dividends or make other distributions of profits to its attorney-in-fact. Whether the attorney-in-fact is compensated based upon the actual cost of it providing services versus a fee-based structure generally depends upon its ownership. If the attorney-in-fact is owned by the reciprocal, compensating it on anything other than a cost basis is not as prevalent because any payments made to the attorney-in-fact would remain in the holding company system due to the attorney-in-fact’s ownership structure. It’s a different story when the attorney-in-fact is owned by a third party and not by the reciprocal. Under that structure, the attorney-in-fact is typically held as a fee-generating operation, which fees (and its profits) inure to the benefit of its owners. Thus, a cost-based fee structure would not be optimal.

It is important to remember that the attorney-in-fact is generally considered as the reciprocal’s statutory “affiliate.” Insurance regulators generally require that the compensation under service agreements between insurers and their affiliates be structured on a cost-basis, which would not be a desired structure for a privately owned attorney-in-fact. Interestingly, under California law, Subscription Agreements in place before 1943 are not subject to the provisions of the Insurance Holding Company Act governing affiliate transactions (e.g., generally requiring actual cost-based compensation). In practice, however, insurance regulators do not necessarily adhere to cost-based compensation for third-party attorneys-in-fact, but it’s an issue requiring consideration during the organization and regulatory review process.

The Subscriber Parties

Finally, the third parties to the reciprocal structure are the subscribers (or policyholders). As previously discussed, these are the people or entities that associate with each other for the purpose of exchanging reciprocal contracts of insurance through a common attorney-in-fact. The rights and liabilities of the subscribers are established by the Subscriber Agreement, the insurance policies issued by the reciprocal through the attorney-in-fact and applicable law.

Capitalizing the Reciprocal

Reciprocals generally do not have access to traditional equity markets for their capital needs. They are generally capitalized through a sponsor such as an association (e.g., industry-specific groups), an existing insurance group (e.g., an established holding company with stock insurer subsidiaries) or investors (e.g., private equity). The sponsor can capitalize a reciprocal through the reciprocal’s issuance of surplus notes or through subscriber contributions. These instruments do not permit interest or principal payments or redemption without insurance regulatory approval, are treated as equity on the reciprocal’s financial statements, and are unsecured and subordinated to the reciprocal’s other liabilities. As the reciprocal becomes profitable, those instruments can be repaid allowing the sponsor to recoup its initial investment.

As Compared to Stock Insurers

There are challenges to the reciprocal structure that do not exist with stock insurers. For example: (1) The sponsor has no rights to the reciprocal’s underwriting profits, although it is possible to participate in the reciprocal’s underwriting performance via the sponsor’s organizing a reinsurer to reinsure the reciprocal’s business; (2) There is also a potential for diminished control and/or operational influence of the reciprocal as a consequence of subscriber voting, although this can be addressed in structuring the reciprocal’s governing documents and subscription agreement; and (3) Similar to the limitations that exist in initially capitalizing the reciprocal previously discussed, those issues generally remain throughout the reciprocal’s life.

The Acquisition of Control of a Reciprocal

Changes in control of a reciprocal (somewhat akin to an acquisition that occurs with stock insurers) are unique and present challenges depending upon how the reciprocal is organized — we’ll cover three scenarios.

The first involves a reciprocal and its third-party, independently owned attorney-in-fact. In this scenario (as well as the others to be discussed), the reciprocal itself cannot be acquired as there are no shares, other equity interests or, as we noted earlier, an actual entity to acquire. Thus, the change in, or acquisition of, control of the reciprocal occurs in one of two ways — either through a third-party’s acquisition of the reciprocal’s attorney-in-fact from its current owner or by replacing the attorney-in-fact with a new one. The latter approach could be more cumbersome as, in addition to obtaining regulatory approval, the need to obtain subscriber approval could be triggered — although it is not uncommon for the subscription agreement to permit the attorney-in-fact’s substitution by the reciprocal’s board or its then current attorney-in-fact.

The second scenario involves the situation where the reciprocal owns its attorney-in-fact. Like the first scenario, the change in control occurs by a third party’s acquisition of the attorney-in-fact. In this situation, being a subsidiary of the reciprocal, it is possible that the attorney-in-fact is compensated on an actual cost basis as discussed above. It is unlikely that the acquiror would want to maintain a cost-based fee structure post-acquisition. The challenge, therefore, would be to convince the regulators that a fee increase (i.e., a structure that’s not cost-based) benefits the reciprocal and its subscribers/policyholders. This is not necessarily insurmountable issue — it just requires a well-established plan.

The third and final change in control scenario involves the acquisition of one reciprocal by another by means of merger. In this case, the attorney-in-fact of the surviving reciprocal would remain the attorney-in-fact of the combined enterprise, which would then include the disappearing (or merged-out) reciprocal. Likewise, subscribers of the disappearing reciprocal would become subscribers of the surviving entity.

Benefits to Policyholders and Investors

The reciprocal structure presents an interesting insurance vehicle for both policyholders and investors. On the one hand, policyholders could, conceivably, have more influence in the insurer’s operation as compared to a stock insurer’s policyholders. On the other hand, from the investor perspective, the division of management fee income and underwriting results may present a more attractive opportunity.