Clean-up operation: state guaranty funds are handling the messy details from a rash of insolvent property/casualty companies, but so far the funds are rising to the challenge and protecting policyholders.

State guaranty funds, the safety net designed to protect consumers when insurance companies fail, could be facing their biggest challenges to date. A spate of high-profile insolvencies has left the property/casualty state funds to clean up $1.7 billion in claims for 2002, an all-time high. Ultimately, it's consumers, policyholders and taxpayers who foot the bill for failed companies, as state guaranty funds assess insurers for money to cover claims that the defunct companies can no longer pay, and insurers, in turn, recoup the assessments through premium tax discounts, policy surcharges or rate increases. The property/casualty assessment for 2002, $1.35 billion, is the highest it's been in 10 years, and 2003's assessments could end up being even higher.

Despite the pressures placed on it, the state guaranty fund system seems to be working just fine. Even when a company becomes insolvent, its policyholders--for the most part--get paid, and paid quickly. Guaranty funds play the vital role of protecting consumers, which is necessary because some companies will always fail in a free market system driven by competition, experts said.

The Cleaners

"I don't know anybody who ever set out to be involved with insolvent insurance companies," said Dale Stephenson, executive director of the National Conference of Insurance Guaranty Funds, a trade group representing the property/casualty guaranty funds in every state.

Stephenson has been director of the organization since it was formed in 1971 to coordinate multistate issues for insolvencies. "For insolvencies like Reliance, you don't want 50 states to go through the same process 50 times," Stephenson said.

Reliance Insurance claims alone are approaching $1 billion. The failed Pennsylvania company, a large commercial writer, could be the biggest property/casualty insolvency ever. It also may top the list of insolvent accident and health companies, although its overall accident and health claims will be dwarfed by its property/casualty claims.

After several months of attempting to rehabilitate Reliance, Pennsylvania regulators placed the company in liquidation in December 2001. Regulators have filed several lawsuits in an attempt to recoup assets, including a suit filed against former Reliance Group Chairman Saul P. Steinberg and 17 other directors and officers accusing them of breach of fiduciary duty and professional negligence. Regulators alleged the directors and officers permitted $500 million to be diverted from the insurer, Reliance Insurance, to the parent company, Reliance Group Holdings, in the form of dividends, bogus tax payments and loans. The directors and officers knew or should have known the money was being used to support "the lavish lifestyles of the controlling shareholders," not the best interests of the company, regulators said in the lawsuits.

Although Stephenson did not set out to have a career cleaning up the mess left behind when an insurer goes belly up, he said he enjoys the job.

"It's fascinating. If you deal with a property/casualty company, you are probably dealing with one or two lines. In the insolvency business, you deal with everything. You have the potential to get involved in some way with virtually any property/casualty policy out there," Stephenson said.

The job also can be rewarding.

"We're helping people," said Paul

Gulko, president of Guaranty Fund Management Services in Boston, a nonprofit organization that manages the guaranty funds for eight states. "When people call up here, they really have no other place to go. When a guy hasn't received his workers' comp check, and we can say, 'yeah, it's in the mail' ... there's a certain amount of satisfaction in that."

Stephenson and Gulko are two of the hundreds of people working quietly and without fanfare to pick up the pieces of insolvent companies. And business is booming. Gulko's Guaranty Fund Management Services has grown from a single employee--Gulko, about 30 years ago--to 100 people today.

Gulko may have gotten calls from policyholders, but he's never received a negative call from a reporter. "That tells me that people are getting things done, and there's not a lot of complaints. A lot of people, even in the industry, don't know about the guaranty funds. They're starting to pay attention because the assessments have gotten up there. But the system is working. If it wasn't working, we'd have people down our throats about it."

Picking Up the Pieces

Taking over the claims for an insolvent property/casualty company isn't easy, Gulko said. "Think of it as a catastrophe. All of a sudden a hurricane goes through the area, and you have 2,000 claims develop over night. That's what we get. When a company goes down, all of a sudden, we're given all of their claims. And most companies, if there is a problem, aren't doing a great job with the claims in the first place," Gulko said.

When a company is judged to be insolvent, the guaranty fund's phones ring off the wall, Gulko said. "People have cars in garages; they can't get paid for the repair work. They can't get to work. Workers' comp recipients need money to live on. Our initial goal in the workers' comp is that people don't miss a payment so these people have money to live on," Gulko said.

Gulko got into the insolvency business by taking on a one-year assignment to run off a Massachusetts insolvency. That was 1975, and the one-year assignment has grown into a career spanning three decades.

Back in the 1970s, regulators "felt so sure that insolvencies weren't going to be around. We thought there'd be just one year of work," Gulko said.

Past generations of regulators may have been overly optimistic in that thought. In the past 20 years, about 1,100 property/casualty and life/health companies have gone insolvent, according to A.M. Best Co. That may sound like a large number, but as a percentage of all insurance companies, it's a relatively small percentage. For example, the 218 property/casualty insolvencies from 1993 to 2002 generated a 10-year average failure frequency rate for the industry of only 0.72%.

"I like to say it's the American way. Everyone has the right to fail," Gulko said.

State Guaranty Funds also can spend years paying claims for an insolvent company, especially if it wrote commercial lines, such as workers' comp.

The Pennsylvania fund still is paying claims for the Westmoreland Casualty Co., which went insolvent in 1987, and the Rockwood Insurance Co., which went insolvent in 1991. "Those companies continue in liquidation because their primary business was workers' comp," said Joe DiMemmo, director of liquidation and rehabilitation administration for Pennsylvania. "Those go on forever. The guaranty fund pays the claims and submits them to us. We submit to reinsurers, collect the reinsurance and give it back to the guaranty fund."

In addition to being the largest single insolvency, Reliance has also been one of the most complicated, DiMemmo said.

"It was a multiline writer. In terms of dollars, you're talking billions. They had thousands of reinsurance agreements, and their largest asset is reinsurance recoverables," DiMemmo said. "It's very technical, very time consuming to collect information and submit claims. A lot of reinsurance claims were distributed [to the reinsurers] and end up in arbitration. Plus we have seen claims with Reliance that we just aren't familiar with, and many policy coverages that aren't covered by guaranty associations, like surety, financial guarantees. These folks have to wait in line until there's a distribution of assets."

Cash Crunch

Led by the demise of Reliance Insurance in 2001, 17 companies with more than $8 billion in claims reserves were ordered liquidated in 2001. That was followed by 20 insolvencies in 2002 and 10 in the first seven months of 2003, according to the National Conference of Insurance Guaranty Funds.

Total payments from guaranty funds in 2001 and 2002 were $2.8 billion. Workers' comp lines have been hit the hardest. The seven largest liquidated companies have brought $10.7 billion in new claim loss reserves. Because workers' comp benefits require immediate payments of weekly indemnity benefits and medical bills, some state guaranty funds have been crunched for cash.

In 2002, guaranty associations in 19 states levied the maximum assessment possible on their workers' comp carriers, but some states found even that wasn't enough.

In California, the premium surcharge on workers' comp writers was doubled to 2% from 1% in 2001 to help beef up the guaranty fund's reserves, but that still has fallen short. The 2% surcharge brings in about $300 million annually, but the fund was expected to pay about $800 million to cover 40,000 injured workers' claims in 2003.

Faced with the possibility that the workers' comp guaranty fund might run out of cash, the California Department of Insurance approved the California Insurance Guarantee Association's request in May for an emergency $170 million loan from the guaranty funds that cover auto and homeowners claims. Later in 2003, CIGA received approval to issue $1.5 billion in 10-year bonds.

"California has always allowed additional assessments for natural disasters, but they've changed the law to allow for financial disasters as well," said Mark Sektnan, vice president for the American Insurance Association. "By creating the bonding authority, there should be enough money available to cover claims."

The AIA, which represents insurers, said the industry supported increasing the premium surcharge and the bonding effort.

"The system is designed to ensure that injured workers get their benefits paid. It's working," Sektnan said. "It's only appropriate that everyone contribute to helping ensure the system does what it is supposed to do."

He added the association believes "we've crested the wave on insolvencies. Hopefully, there aren't any huge, unexpected insolvencies out there."

How the System Works

Guaranty funds are a vital part of the safety net protecting consumers. They are nonprofit entities, established by state statute, that pay claims for companies that have been deemed insolvent. The system works like this: state insurance regulators, who oversee the health of insurance companies, do periodic financial exams on those companies. If a company is found to be on shaky financial ground, the regulators can step in and take actions to protect the policyholders of the company. While laws vary from state to state, in general, regulators have a range of options--some requiring court approval and confidentiality--including the following:

* Supervision. Requires the company to take specific corrective steps and gain regulators' approval before undertaking certain transactions.

* Suspension. Stops the company from writing new business in the state.

* Rehabilitation. The regulator is named rehabilitator of the company and has the authority to manage the company until the solvency problems are corrected.

* Liquidation. When the regulator doesn't believe the financial difficulties can be solved, the company is placed into insolvency and a receiver is appointed to manage the liquidation process. The receiver takes over the company's offices, marshals the company's assets and informs the policyholders and other creditors. The state guaranty funds are triggered, and claims are transferred to the funds to be paid. While the regulator in the state in which the company is domiciled is the primary authority responsible for the regulation and possible liquidation of a company, the claims from each insolvent company are forwarded to the guaranty funds of each state where the company did business.

States often have separate funds for life/health, property/casualty, and workers' compensation claims, and can have separate guaranty funds for other lines, as well. The National Conference of Insurance Guaranty Funds is the trade group representing the country's property/casualty associations, while the Association of Life and Health Guaranty Associations represents the country's life/health state guaranty funds.

While the state guaranty associations are responsible for paying the claims from insolvent companies, it's up to regulators and receivers to collect the available assets from the defunct company. Sometimes that involves pursuing legal action against entities or individuals who may have led to the company's demise, DiMemmo said.

"The goal would be two-fold: marshal assets to pay claims and hold responsible parties responsible for their actions," DiMemmo said.

When a state is able to recapture assets from an insolvent company--by a successful legal action or a reinsurance recovery, for example--it doles the money out to pay expenses. First on the list of creditors in many states, including Pennsylvania, is the administrative expense of handling the liquidation. Next in line are claimants, including the guaranty funds, who pay claims immediately and then seek reimbursement from the receivers. When an insolvent company doesn't have enough money to cover all of its claims, the guaranty funds can assess insurers. In some cases, only a percentage of the claims owed are paid.

Most state guaranty funds pay up to individual policy limits, except that they cap the maximum amount per claim to be paid. Although caps vary from state to state, the most common limit is $300,000. A policyholder whose claim is greater than the state guaranty fund allows could apply to the state receiver to get the rest of the claim paid, but would have to wait until the receiver distributes the insolvent company's assets.

Property/casualty state guaranty funds are also responsible for returning unearned premium to policyholders. All property/casualty policies are cancelled when the company is placed into liquidation.

Learning Curve

Regulators who oversee the insurance industry are in a somewhat difficult position. When they intervene with a troubled company, and successfully help the company to turn around, the situation is never made public. Only the failures, the companies that are deemed to be insolvent, make headlines.

"At some point, there will be an insolvency. You can't regulate to prevent every one," said Holly Bakke, New Jersey commissioner of banking and insurance, and former head of the guaranty funds in New Jersey. She attended a meeting with Alan Greenspan, chairman of the Federal Reserve System, in which Greenspan told regulators if they don't let companies fail, then they're over-regulating.

One of the things regulators struggle with is the appearance that they don't move quickly enough, Bakke said.

"Administrative supervision is confidential. People don't know we are working with a company. If it weren't confidential, it would hurt the company's ability to survive. But it's hard to convey we are acting appropriately. We can't talk about our success stories," Bakke said.

DiMemmo, of the Pennsylvania department of insurance, agreed. "Companies do not go into liquidation overnight," he said. "It's not a shock when we get to the point where it's a liquidation."

Businesses may be loathe to turn to government for management advice, but those who have made a living from cleaning up insolvent companies would love to be asked what they've learned.

Gulko, of the Guaranty Fund Management Services, said, "In my line of work, I don't know what makes a company successful, but I can tell you what makes them fail."

He said companies that chase after market share, even if it means under-pricing their policies, are often doomed. Also, companies that rely too much on third parties, such as managing general agents or third-party administrators, also can get into trouble. "Don't give away the pen. I think you'd have tighter control if you manage the claims yourself," he said.

Stephenson said as "sexy as fraud is, the biggest reason for companies to fail is not fraud, but management stupidity. Insurance is spreading of the risk, and if you don't price it right, you have a problem. Also, management ego is a problem. If you are trying to increase the size of the company by being bigger continuously, but losing money on what you are selling, you are in trouble."

Reliance and Legion Insurance, another failed insurer, competed on a lot of business. Both used TPAs often, and ironically, had offices a block apart from each other in Philadelphia, Stephenson said.

"In our experience, the number one reason companies go insolvent is because of management's inability to recognize trends, changes, and to plan for the future," said Pennsylvania Insurance Commissioner M. Diane Koken, in a speech given to the financial management group of the Pennsylvania Association of Mutual Insurance Companies.

In fact, planning is also the biggest challenge facing guaranty funds, said Stephenson. "We went through a period in the 1990s when there was very little work, few insolvencies. Most guaranty funds were downsizing; we were holding the line on costs, not upgrading computer systems. We, in fact, had a committee that was looking at how we charged the expenses of ongoing operating expenses during periods of little work, but we never finished the report because we no longer have that problem. Everything has mushroomed in the last three years."

Bakke said regulators learn lessons from every insolvency.

"Solvency regulation is not just whether the bottom line is black or red. We need to understand the company's business strategy, we need to understand the company as a whole," Bakke said. "Instead of solvency regulation being a linear process--a company is born, gets a certificate to do business, sells insurance, is monitored, goes under administration supervision, rehabilitation and then insolvent--you begin to see a loop. We need to intervene earlier, and in a more meaningful way."

Through the National Association of Insurance Commissioners, regulators are creating a Global Receivership Information Database to share information about insolvent companies, she said.

"If Reliance has taught us anything, it's that the system is capable of handling such a large insolvency," Bakke said. "Not just the magnitude of the estate, but the number of states involved underscores how important cooperation is among the states. If we are truly an effective system, we have to be like a firehouse: we always have to be ready, and you don't know what's coming ... one alarm, two alarm, an office building, a home ... the thing we are demonstrating is flexibility is key. We have an obligation to respond to different types of insolvencies."

Largest Property/Casualty Insolvencies

These insolvent companies have resulted in the largest payments from
the state property/casualty guaranty fund system from the inception of
their insolvencies to December 2003. It could take years, and billions
of dollars more, to pay all of the eventual claims arising from these
companies.

   Insolvent Company                                         Payments

 1 Reliance Insurance Co.                                $719,276,990
 2 California Compensation Insurance Co.                  565,489,087
 3 Mission Insurance Co.                                  464,572,229
 4 Midland Insurance Co.                                  453,351,190
 5 Transit Casualty Co.                                   428,049,826
 6 American Mutual Liability Insurance Co.                418,700,870
 7 PIE Mutual Insurance Co.                               384,776,381
 8 Ideal Mutual Insurance Co.                             367,142,282
 9 Integrity Insurance Co.                                338,246,722
10 Superior National Insurance Co.                        316,249,036
11 Texas Employers Insurance Association                  274,596,683
12 American Mutual Insurance Company of Boston            227,303,130
13 Champion Insurance Co.                                 224,489,318
14 PIC Insurance Group Inc.                               199,291,941
15 MCA Insurance Co.                                      196,644,424
16 Mission National Insurance Co.                         189,533,870
17 HIH American Compensation & Liability Insurance Co.    188,442,074
18 Union Indemnity Insurance Company of New York          186,233,772
19 Iowa National Mutual Insurance Co.                     181,451,347
20 Credit General Insurance Co.                           153,894,243

Source: National Conference of Insurance Guaranty Funds, as of
December 2003

Reason for insolvency--1993-2002

More than half of all companies that fail go under because
of deficient loss reserves.

I      Deficient loss reserves   51%
II     Rapid growth              10%
III    Alleged fraud              3%
IV     Overstated assets          2%
V      Discounted operations      8%
VI     Change in business         3%
VII    Reinsurer failure          0%
VIII   Catastrophe loss           3%
IX     Unidentified              17%
X      Impairment of affiliate    3%

Note: Table made from pie chart.