A second paradigm: the level of protection provided by state guaranty funds hasn't kept pace with inflation. Spreading the risk in tiers among additional insurers may restore the safety net.

Imagine that you are a physician with insurance problems. The medical malpractice insurance industry has been experiencing convulsions, your premiums have been skyrocketing, and you have just received news that your carrier has been declared insolvent. The year is 1976.

Imagine now that you are a homeowner, and your possessions--the $25,000 collection of vintage Cadillacs, and $85,000 seaside mansion--were severely damaged by Hurricane Camille two months ago, but the bad news hasn't stopped. You've just learned that your insurer has become insolvent. You wonder whether you will receive the indemnification that you contracted with your insurer to receive. It is late in 1969.

Fortunately, in both cases, your state government has recently joined the ranks of states creating a State Property & Casualty Insurance Guaranty Fund that will indemnify you--up to $300,000 per claim. This limit of protection in most policyholder's cases will provide thorough indemnification.

As the National Conference of Insurance Guaranty Funds explains on hits Web site www.ncigf.org, "Guaranty associations are nonprofit organizations created by statute for the purpose of protecting policyholders from severe financial losses and delays in claim payment to insolvency of an insurance carrier. They do this by assuming responsibility for the payment of claims that would otherwise have been paid by the insurance carrier, had it not become insolvent." The aim of guaranty fund legislation enacted 35 years ago was for "protecting policyholders."

Fast forward to 2005. A physician's daughter, who is also a physician, in similar straits to her father's situation 30 years ago, recently has received notice that her carrier, which is managing two of her current professional liability claims, has been placed into receivership. At the same time, our homeowner's son, who inherited the family seaside mansion and auto collection now valued at $3 million lost the home to Hurricane Ivan in September of 2004. Unfortunately, his insurer also has lost its financial house in the wake of 2004's natural disasters.

These modern day policyholders find, unfortunately, that the safety net of the state insurance guaranty fund has shrunk in the dryer of inflation, providing far less value at the same $300,000 of indemnification that was provided to their parents 35 years ago. The purchasing power of $300,000 in 1970 dollars is roughly equivalent to $2.5 million in purchasing power today--the level that the rinds needed to reach in order to provide similar protection to policyholders as that which was provided to policyholders in 1970.

What to Do

One possible solution would be to simply raise the state guaranty fired limits of protection to resemble the value proposition offered in 1970. In other words, have state guaranty funds offer a safety net that is indexed to inflation, and grows with the times. This solution will not be well received by the insurance industry, as it will place more burden on the backs of solvent insurers and their policyholders through premium increases required to fund the state guaranty associations.

The Funds generally receive their capital from two sources: the assets of failed insurers including reinsurance recoverables (See "Resolving Insolvencies," Best's Review, February 2005), and from assessments of solvent property/casualty insurers admitted to do business in the particular fund's state. Any increase in limits of protection offered by Funds most certainly will result in state funds "passing the hat" to the solvent insurers for greater contributions. The maximum contribution in most states is currently between 1.5% and 2% of an insurers' net direct-written premiums in that state. In a study published by the National Conference of Insurance Guaranty Funds in February 2005, property/casualty guaranty fund payments have grown from just trader $500 million in 1997 to just over $2.5 billion in 2003.

The second solution, or "second paradigm" will require regulatory cooperation, diligence in structuring, and care in implementation, but may benefit all parties involved--admitted primary insurance companies, legislators, receivers, regulators, injured parties where applicable, and most important--the policyholder. The conceptual solution is simply this: to place one's insurance eggs into more than one insurance basket, in increments up to the limits of coverage provided by the state guaranty funds. In most cases, this is $300,000.

Fast Forward

Our physician in the previous modern day example would not purchase the typical $1 million/$3 million policy as most do today, but rather she would purchase several layers of policies in increments of coverage limits up to the amount of protection offered by their state's guaranty fund. The separate policies would be coordinated in order to keep costs streamlined. Underwriting would be coordinated through a lead carrier or managing general underwriter; claims management, through a lead carrier, or a third-party administrator.

In a simple example of this proposed transaction, our physician might purchase a primary policy with $300,000/$900,000 limits, and an excess policy with $700,000/$2.1 million limits of coverage from admitted carriers. In the event that one of the insurers in the structure were to be liquidated, the state guaranty fund should "step into the shoes" of the failed insurer to cover the specific "layer" of protection that was to be afforded by the failed insurer. If the primary insurer were to fail, the state guaranty fund would be liable to step in and cover the first $300,000 of any claim, and the excess carrier would continue to indemnify losses in excess of $300,000. In the event that the excess carrier were to become insolvent, the fund would provide $300,000 in protection for that layer, and the primary insurer would continue to cover the first $300,000 of each claim. The net result in this example would yield only $600,000 in total indemnity (only $300,000 from the fund), but twice what would be covered under insurance failures today. The more insurers in the mix, the greater the overall protection, however, the management of the structure becomes more complicated.

The principle at work is "spread of risk," in the same way that a depositor may strategically place a maximum of $100,000 in any given bank account, and may layer multiple different accounts in order to maintain full protection for their total deposits from the Federal Deposit Insurance Corp. in the event that their bank(s) were to become insolvent. There are many hybrid variations of layering that could occur. Examples include a primary carrier covering the first $300,000 of any loss, with the excess being covered by the insured's captive. This structure would afford a measure of protection from the fired where it currently does not typically exist for captive structures. A similar structure could be put into place through a primary carrier on the first layer, and an excess and surplus carrier on the second layer--wherein a failure of either company would net the same amount of coverage afforded to any insured currently--$300,000.

In this model, it would be necessary for claims to be managed by someone other than the state guaranty fund, as the excess layer admitted insurers would not be comfortable with the state guaranty fund managing the claims. It would be necessary to have well-written "anti-drop-down" provisions in the excess policies to protect the writers from dropping into the primary layer of exposure in the event of the primary insurer's insolvency.

Fund Liability

Remember the goal: to keep the state guaranty fired liable for only $300,000 in any given claim, while increasing the protection afforded to policyholders, and minimizing the exposure of admitted property/casualty carriers in funding the state guaranty fund. Caps for overall losses on a given occurrence should be put into place in order to keep the fund's overall liability in check, however in the second paradigm, it would be extremely rare for more than one carrier to fail at the same time within any given coverage structure, therefore the fund's liability will generally be limited to $300,000 in any specific claim situation.

Through this second paradigm, the need for reinsurance would be diminished, the net direct-written premiums would therefore be higher, and greater revenue would be generated for the state guaranty funds. The market for admitted insurers would grow substantially as they would participate in more layers of a given risk, albeit in bite-sized chunks (normally up to $300,000 each) without having to handle on their own the shock losses associated with severe claims. State guaranty funds would be more well endowed. Legislators would face less often the complete loss of insurers in specific lines of coverage in their state. Most importantly: policyholders would be more secure.

In both paradigms the severe losses are covered: in the first paradigm by one admitted carrier in partnership with a reinsurer collaborating on the risk; in the second paradigm by several admitted carriers collaborating on the risk to cover both the burning laver, and the shock losses. In the second paradigm, the safety net of the state guaranty funds would once again be spread out to cover the losses that they originally were intended to cover.

Key Points

* Fund protection of policyholders is not keeping pace with inflation.

* A business method is discussed that will simultaneously fully indemnify policyholders against insurance company failure; stabilize guarantee funds; limit assessments of admitted insurers.

* The method will expand the market for admitted insurers.

Contributor David A. Martin is president of The Premium Group Inc., an insurance brokerage based in Cleveland.