The RRG, which filed its registration with the insurance department in accordance with the Liability Risk Retention Act and California law, began writing business on July 1, 2007.

California denied the RRG's registration by letter, dated Oct. 18, 2007. The letter, and more recently, the legal documents filed by California, states several reasons for the denial, including:

o The RRG "had not established that it is licensed exclusively as a liability insurance company in a state in the U.S."

o Stop-loss coverage is "first-party coverage, not third-party coverage," as required by the LRRA.

o Stop-loss "is a layer of insurance coverage subject to state insurance laws and not preempted by ERISA."

o Labeling the coverage as "contractual liability is a misnomer, as liability insurance has its genesis in tort, not contract [law]."

The LRRA requires that prior to operating in a state, an RRG register with every state in which it intends to operate. AD-RRG complied with this requirement, as well as California's 60-day waiting period.

One of the key issues that will be tested by the litigation is whether a nondomiciliary state has the authority to deny the registration of an RRG licensed by another state.

In its complaint filed with the District Court on Dec. 10, 2007, against California, AD-RRG asserted that the provisions of the LRRA are "preemptive and exclusive," and that California "lacks the authority and jurisdiction...to examine or verify AD-RRG's qualifications as a risk retention group, or to purport to deny AD-RRG's registration or to stop it from conducting business in the state of California."

Another key issue raised in the lawsuit is whether the LRRA's definition of liability includes contractual liability--such as a legal liability for damages arising from a contractual transaction, as contrasted with a legal liability for damages arising from a tortious act.

The LRRA defines "liability" as "legal liability for damages (including costs of defense, legal costs and fees, and other claims expenses) because of injuries to other persons, damage to their property, or other damage or loss to such other persons resulting from or arising out of any business...trade, product, service (including professional services), premises, or operations...and does not include personal risk liability and an employer's liability with respect to its employees other than legal liability under the Federal Employers' Liability Act..."

In its response to AD-RRG's legal motions, California asserted that AD-RRG "is not a risk retention group" because an RRG "consists of member businesses which engage in similar types of business and which face tort liability risks arising from those similar types of business."

California argued that "the type of liability covered by the LRRA is tort liability, not 'contractual liability,'" and that AD-RRG's "contention" that it is contractual liability "should be rejected."

California also said that "the insurance offered by plaintiff is coverage pertaining to health benefits for its member's employees, and is not the type of liability contemplated by the law."

In its legal pleading, AD-RRG cited several RRGs that currently provide contractual liability for auto extended warranties and homeowner warranties.

In responding to the issue of whether the LRRA definition of "liability" includes "contractual liability," AD-RRG stated:

"Under the controlling federal law of the LRRA, liability insurance encompasses most types of commercial liability coverage...include[ing] what is known as 'contractual liability,' meaning the legal liability of covered persons arising under contract with another."

California rejects AD-RRG's contention that these RRGs provide contractual liability, distinguishing the coverage as "warranties," which relate to products, such as "the house, in the case of home warranties--and how well it has been built--or a 'defective automobile' in the case of the extended auto warranties, citing Home Warranty Corp. vs. Caldwell, 777 F2d 1457, in which the court noted that "product liability is a branch of tort law."

By contrast, California contended, "the coverage involved in the instant case pertains to something entirely different...It relates to coverage pertaining to health, not to possible defective products."

California also said that "stop-loss" insurance is a first-party and not a third-party coverage, and thus not included in the LRRA's "liability" definition.

AD-RRG explained that "the employer's contractual liability runs to the plan. The plan is a separate entity from both the employer and the employees. The plan has the obligation to pay the benefits to the employees. The employer has the obligation to fund the plan."

AD-RRG's insurance, the group said, "covers the employer from its potential liability to the plan. AD-RRG is not covering the financial liabilities running directly from the employer to the employee...The contractual liability coverage purchased by the employer protects it from its financial liability to a third party, namely the plan itself."

The debate as to whether the LRRA definition of "liability" applies only to actions arising in tort, or whether the definition includes contractual liability goes back to the beginnings of the LRRA, with some regulators taking the position that since the LRRA passed during the "liability crisis," it should be limited to the types of liabilities that were unavailable and unaffordable at that time.

In a classic exchange in the pages of the Risk Retention Reporter of December 1993 and January 1994, between regulators and the then chairman of governmental relations for the National Risk Retention Association, New York regulators argued in their article (headlined, "The Risk Retention Liability Trap") that the LRRA definition of "liability" applied only to tort actions.

But Jon Harkavy, who then chaired the NRRA's governmental affairs committee, argued in his counterpoint article, "How to Escape the Liability Trap? Read the Statute," that the plain meaning of the law itself showed clearly that the definition includes "contractual liability."

Due to the complexity of the issues, the case is likely to generate multiple appeals by one side or the other. Stay tuned!