Resolving insolvencies: reinsurers are thrust into a difficult position when a cedent becomes insolvent.

Property/casualty insurer financial impairments hit a decade high of 43 in 2002, then dropped by nearly half that in 2003, according to the 2004 Best's Insolvency Study, Property/Casualty, U.S. Insurers, 1965-2002. Throughout most of 2004, impairments were again occurring at a slower rate, according to A.M. Best Co. data.

Financial impairments follow the swings in the insurance underwriting cycle, however, so more impairments are inevitable. Accordingly, reinsurers doing business in the United States need to be aware of the potential difficulties dealing with a cedent insurer that is insolvent.

Generally, when an insurance commissioner determines that a company under that state's jurisdiction is impaired, the regulator will step in and either rehabilitate or liquidate the insurer. If the company is liquidated, the commissioner's job is to marshal all of the company's assets and pay off as many outstanding policyholder claims as possible. Typically, the largest asset of an insolvent estate is the company's reinsurance contracts. Commissioners are able to obtain these proceeds due to statutorily required clauses in reinsurance treaties, which act as a cut through, essentially requiring a reinsurer to pay the liquidator even before the liquidator has paid the policyholder. The insolvency clause is an exception to the indemnity rule, which requires an insurer to have paid a claim in full before it can cede that loss to its reinsurer for indemnification.

Conflicting Interests

Insurance commissioners and their appointed liquidators face a daunting task in winding down an insurance company. Essentially, the commissioner must step into the shoes of the insurer and protect its assets. Thus, the best interests of the company and its policyholders and creditors logically drive the regulator's decisions. At the same time, the commissioner also has a fundamental duty to police and regulate the industry against insurance fraud and other malfeasance. Conflicting interests come into play because of the commissioner's dual roles if a reinsurer claims that it is not required to make payment under a reinsurance contract as requested by the liquidator on grounds that, prior to the liquidation proceeding, the insurer acted improperly in breach of the reinsurance contract.

If an insurer cannot afford to pay its insureds, chances are that it is because of mismanagement within the company, in some form or another. In fact, as noted in the oft-cited Congressional report, "Failed Promises: Insurance Company Insolvencies," based on an extensive 1990 study of four insolvent companies--Mission Insurance Co., Transit Casualty Co., Integrity Insurance Co. and Anglo-American Insurance Co.--there are "disturbing" parallels between the fraudulent activity and mismanagement that led to the Insolvencies. Among the noted problems were rapid expansion, unsupervised delegation of authority, under-pricing, reserve' problems, false reports, reckless management, incompetence, fraud, greed and self-dealing. The 2004 Best's Insolvency Study found that 70% of the 562 property/casualty company insolvencies that occurred between 1969 and 2002 were primarily caused by deficient loss reserves or fraud.

Therefore, the commissioners must marshal assets of an insolvent insurer, including reinsurance assets, with a cautious hand. This is particularly true for the collection of reinsurance proceeds because an insurer owes a duty of utmost good faith to its reinsurer. This entails a higher duty of care than the traditional good faith and fair dealing that applies to parties in a corporate transaction. Insurers are required to make full disclosures to their reinsurers on an ongoing basis, and may not rely on a caveat emptor or "buyer beware" defense in keeping material information secret. As a result, the commissioner (who is responsible for policing the industry) cannot in good conscience ask a reinsurer to pay if the cedent insurer has defrauded the reinsurer--conduct the commissioner should have prevented.

Because of this conflict, commissioners faced with a cedent that defrauded its reinsurer typically blame the reinsurer and attempt to collect, notwithstanding the fraud the commissioner should have prevented.

Practical Considerations

There are a number of practical difficulties that reinsurers often face in dealing with an insolvent cedent. The insolvency statutes of each state were created to streamline the liquidation process. Because the commissioner of each state and insurance department officials are presumed to be experts in insurance, it is logical to believe that the insurance department is the best party to take over and wind down an insurer's operations. In a perfect world, this system would work. But, by its very nature of being a government agency, a state insurance department has limited resources to devote to a liquidation. Often, the system's infrastructure is unable to handle the enormous task of winding down insurers' operations fairly, efficiently and at as little cost as possible to the state's taxpayers. For the reinsurer that has to deal with an innately inefficient bureaucracy, this can be costly.

California is a case In point. Like many other states, California has a special department within the insurance department dedicated to handling conservations and liquidations--the Conservation and Liquidation Office. According to an audit report released in 2001 by the California Auditor's Office, the CLO is poorly managed, and has been since at least 1994. The report cites specific examples of problems rampant within the CLO. In one instance, the organization spent more than $6 million of estate money on an automated claim processing system that it could not use. It therefore had to manually process claims for reinsurance, which is inefficient and prone to error, as demonstrated by the fact that an employee retired before he billed a reinsurance company for more than $900,000 and the CLO discovered the error only when the reinsurance company itself notified it months later.

The report explained that the CLO failed to protect insurers' assets because of an absence of oversight. In fact, the CLO itself has not had a permanent chief executive since the report was issued, instead operating under a string of acting chiefs, some with little or no reinsurance experience. The report further criticized the CLO for losing track of insolvent companies' assets, such as furniture and office equipment, and failing to seek competitive bids on contracts. The CLO similarly failed to manage its contracts in an effective manner, causing it to overpay one contractor, for example, more than $43,000. The report concluded that the CLO does not maintain effective hiring practices, often hiring less than qualified employees and contractors, and without checking for possible conflicts of interest.

In light of such an inherently problematic system, reinsurers may face high hurdles in trying to exercise their rights, even to examine the insurer's files before paying any losses and expenses.

The injunction order is an example of one of these hurdles. Similar to an automatic stay in bankruptcy proceedings, once a commissioner commences a takeover action, the court system will immediately issue an injunction, under which all entities are prohibited access to any of the insurer's files, and prohibited from initiating or maintaining any legal actions against it. In other words, if a reinsurer determined that the insurer engaged in misconduct that may have led to its insolvency, absent permission from the court, which the commissioner usually opposes, that reinsurer has no recourse other than to pay claims as they are presented. As to the fraud, the commissioner typically directs the reinsurer to file a proof of claim and wait with other general creditors to see if it can collect a few cents on the dollar, years later once the liquidation is completed. The merits of the proof of claim are summarily determined by the commissioner.

For a reinsurer, this typically translates into the liquidator's demand for immediate payment of all reinsurance proceeds, without allowing the reinsurer to first investigate the claims it is being asked to pay. And in the event the reinsurer determines that the insurer in fact conducted business in breach of its reinsurance contract, the liquidator often continues to request payment and deny the reinsurer any recourse.

The reinsurer may wish to pursue a negotiated commutation of contracts for a certain amount, but this can be a frustrating process. The commissioner has limited time and resources to invest in determining a commutation amount that might reduce the state's recovery over time. Even if outside actuaries eventually are retained to help determine this amount, the liquidator may not have the incentive or resources to evaluate these actuarial numbers in order to reach a compromise.

The commissioner also has little incentive to negotiate with reinsurers because of an obligation to the state insurance guaranty fund. In 2001, state guaranty funds assessed their member insurers $735 million, according to the National Conference of Insurance Guaranty Funds. That figure jumped to $1.2 billion in 2002. Taxpayers ultimately pay for the guaranty fund because the assessment on member insurers is passed on to policyholders through premiums. Thus, the commissioner is under pressure to collect from reinsurers, regardless of the merits, to reimburse the guaranty associations.

Dispute Resolution

What happens wizen a reinsurer and the liquidator come to an impasse, with the liquidator demanding payment and the reinsurer refusing to do so? Although litigation may be an option, reinsurance treaties usually contain a provision that requires the parties to arbitrate disputes. There are several issues to be aware of when initiating formal dispute resolution.

The commissioner may argue that reinsurers are not entitled to challenge their contractual obligations at all, because the injunction order prohibits any action against the estate for rescission or breach of the contract. The commissioner typically contends that the reinsurer's fraud allegations should be addressed in the proof-of-claim process discussed above after payment is made. However, reinsurers are allowed to petition the court that issued the injunction order to make an exception and allow them to arbitrate or litigate their claims with the commissioner on behalf of the estate. While the rules applied for such petitions vary from state to state, courts may be inclined to allow arbitration because it is in the estate's best interest to have an arbitration panel quickly decide whether the reinsurance contract should be enforced, in order to collect the reinsurance proceeds as soon as possible.

Assuming that an arbitration moves forward, the parties may face a lengthy discovery process. The commissioner may not be intimately familiar with the day-to-day operations of the impaired insurance company; therefore, the commissioner may not immediately know the names of key witnesses, or the location of relevant documents. Thus, just getting the facts and witnesses lined up for the arbitration hearing is likely to be more time consuming than it normally would be in litigation between private parties.

The commissioner also may claim that the proceedings should be kept strictly confidential. The reason is obvious: it would not be in the commissioner's interest if an arbitration panel rendered an award finding that under the commissioner's watch, the insurer had engaged in some form of misconduct. Nor would it be in the commissioner's interest to have the public learn the commissioner was pursuing money not really due. Unless the reinsurance contract specifically states that the arbitration must be confidential, the parties are not legally required to agree to confidentiality. Furthermore, state laws on open proceedings when governmental entities are involved may prohibit confidential arbitration proceedings involving the state.

The conflict of interest and bureaucracy issues also may surface during formal dispute resolution. For example, during the course of an arbitration, the evidence may or may not show that the insolvent insurer acted improperly. Assume there is evidence of misconduct. The commissioner must recognize that the dual roles of liquidator and regulator continue during arbitration. This would require the commissioner to stop the arbitration proceedings and acquiesce to the reinsurer's request for relief or, in the alternative, at least come to the table and negotiate a reasonable compromise that protects both the insolvent company's policyholders as well as the industry as a whole.

Key Points

* Seventy percent of the 562 property/casualty company insolvencies that occurred between 1969 and 2002 were caused primarily by deficient loss reserves or fraud.

* If an insolvent cedent insurer has defrauded the reinsurer, the insurance commissioner has conflicting roles as liquidator and regulator.

* Because state insurance departments have limited resources to devote to a liquidation, reinsurers may have difficulties trying to exercise their rights.

Guaranty Fund Assessments *

Guaranty funds are the mechanisms established by the state legislatures to collect and redistribute funds to the claimants of insolvent insurers.

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Financial Impairments of U.S. Property/Casualty Insurers

Impairments averaged 25.6 companies annually for an average annual impairment frequency of 0.80%.

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Primary Causes of Insolvency
1969-2002

Deficient loss reserves and fraud
accounted for 70% of the insolvencies
for the 34-year period 1969-2002.

Deficient Loss Reserves (a)      54%

Other                            14%

Catastrophe Losses                7%

Reinsurance Failure               4%

Significant Change in Business    5%

Fraud (b)                        16%

(a) Deficient loss reserves were usually associated with rapid
growth and inadequate pricing.

(b) Includes companies with overstated assets.

Source: Best's Insolvency Study Property/Casualty
U.S. Insurers, 1969-2002.

Note: Table made from pie chart.

Sharon Sonnett is a senior associate in Milbank's Reinsurance practice.