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A risk manager's guide to insurer insolvency.

INSURERS ARE BEING DECLARED insolvent with an increasing frequency. Between 1969 and 1989 there were 150 property/casualty company insolvencies, with nearly half of them occurring since 1985. What's more startling is the cost of such insolvencies to guaranty funds and consumers. Between 1969 and 1987, insurer insolvencies generated $2.2 billion in assessments from state guaranty funds. Shockingly, $900 million of that amount was assessed in 1987 alone.

The "typical" insolvency has not increased much in real dollar costs over the last two decades (the median deficit of property/casualty companies is roughly $2 million). However, the cost of "jumbo" insolvencies has soared. The number one all-time insolvency deficit will likely be that of Executive Life from 1991 (perhaps $1.5 to $2.0 billion), following closely on the heels of the number two all-time deficit of the Mission companies from 1989 ($1.6 billion).

By taking care in selecting a carrier, buyers play a key role in disciplining the insurance market. However, predicting the financial condition of an insurer is difficult. Auditors, raters, investors and regulators often have a poor track record for anticipating financial problems before they become serious. Thus, there is always the possibility that a risk manager can be confronted with an unwelcome notice stating that an insurer has become insolvent.

Given the frequency and costs associated with insurer insolvency, risk managers, brokers and agents should understand the complex conditions under which regulatory authorities can take control of the affairs of an insurer. They should also be aware of agent responsibility in the event of liquidation, the protections afforded by insurance guaranty funds, and the inconsistencies in guaranty fund laws. The mechanics of claims handling is also an important aspect of coming to an understanding of insurer insolvency.

TRIGGERING INTERVENTION

Regulatory intervention is triggered by a combination of unacceptable surplus level coupled with a pattern of conduct that clearly indicates the financial condition of the insurer will deteriorate. Often, regulators may choose to intervene quietly so that the public's fears of insolvency are not needlessly inflamed.

Formally taking over the affairs of an insurer - called conservatorship, rehabilitation, or receivership - is done to protect the company from its management or to allow suspension of certain policyholder rights. The latter was the case in the New Jersey Insurance Department's seizure of Mutual Benefit Life. Receivership is sometimes the prelude to the most severe form of regulatory intervention - liquidation. The final dissolution of an insolvent insurer is governed by state liquidation laws, not federal bankruptcy law. Once a company is in liquidation, the law requires that the assets of the insurer be reduced to cash and liabilities fixed as quickly as possible.

Timing is critical in "going public" with the problems of a troubled insurer. No regulator wants to destroy an insurer that has a reasonable potential to overcome financial problems. Several companies rated A today were at or near statutory insolvency in the mid-1980s. On the other hand, if the size of the deficit is substantial and no turnaround is in sight, delay increases the size of the eventual deficit that must be shared by guaranty funds and establishes preferences for current claimants (who will be paid in entirety) against future claimants (who will have an even larger shortfall in payment).

The timing of regulatory intervention is complicated by tests that must be met to prove to a court that the insurer is subject to the liquidation statutes of that state. In the case of First Transcontinental Life Insurance, the authority of the Wisconsin commissioner of insurance to take control of the company was relatively easy to prove. The company's surplus had fallen below its compulsory level. Impairment of compulsory surplus is a clearcut test that will allow the commissioner in some states to seize control of an insurer.

Other commissioners are not so fortunate to have clear and enforceable standards for liquidation. In the case of George Washington Life, a number of regulators were concerned about the condition of the company. Yet, the West Virginia commissioner delayed taking control of the company for lack of clear authority. New Jersey Life Insurance was able to engage in a protracted court dispute over the New Jersey Insurance Department's declaration of impairment, contending that New Jersey Life was neither insolvent nor impaired. Differences across states in legal authority, staff competence, or regulatory fortitude by the commissioner allow troubled companies to continue to limp along for months or even years after clear warnings of impending ruin have been sounded.

TAKING ACTION

Once the supervisory authority has received a court order to take control, a chain of events is triggered that requires prompt action on the part of agents. Ideally, notice of liquidation should immediately be sent by the authorities to: regulators in other states who change the status of a company from "good standing" to a rehabilitation/liquidation status; the administrators of guaranty funds that are on notice that claims will be received; and agents who should notify their insureds and seek alternative coverage, if necessary or desirable.

In actual practice, effective notice to the above parties is often delayed. At best, a week to 10 days can pass before an agent receives a letter announcing the court-ordered liquidation. Moreover, regulatory coordination sometimes breaks down to the point where the local regulatory department may still recognize a company as being in good standing even after the regulator in its state of domicile has secured an order of liquidation. In the case of First Transcontinental Life, it took weeks of repeated phone calls, faxes, and letters to convince a large insurance department that the company was in liquidation.

Adding to the confusion, insurers in the same group may have a substantially different financial condition and, hence, may receive different regulatory treatment from their domiciliary insurance department. For instance, Executive Life of New York, the New York-based subsidiary of California's First Executive may survive its parent's bankruptcy.

Agents bear a heavy responsibility to act in their principle's best interest after a liquidation. Liquidation statutes typically obligate the agent of record to notify policyholders of the liquidation and to advise them of procedures for filing claims. In some cases the agent is required to give immediate oral notice to policyholders as well as written notice. Moreover, agents often fail to understand that, absent any instructions to the contrary from the liquidator, all policy loss claims must be filed with the liquidator of the failed insurer, even claims previously 1led and being adjudicated by the insurer.

GUARANTY FUNDS

In 1969, property/casualty guaranty funds first appeared in Wisconsin, Michigan and California. They now exist in every state and protect policyholders and third-party claimants to many property/casualty contracts. Similar funds exist to cover life and health insurance policy claims. These funds are creatures of state law and can pay only those claims provided by law. They are typically administered by a board of representing insurers subject to assessment to pay for the fund.

From the time of their inception, through 1990, property/casualty guaranty funds made net assessments of $3,770,222,988 for property/casualty insurer insolvencies. In 1989 alone, net assessments were a staggering $715 million. Despite these large and growing losses, there is no reason to believe that fund protection is in jeopardy. Few funds are likely to approach their assessment ceilings (typically 2 percent of written premiums in the line being assessed), nor is there any strong legislative pressure to limit coverage or assessments.

The laws that govern the affairs of these funds are inconsistent. The first area in which these inconsistencies occur is in triggering fund coverage. A court order of liquidation by the domiciliary state is usually sufficient to trigger guaranty fund coverage in all states in which policies are in force. However, in some cases the form of the notice and the nature of the court action can make a difference.

In the past, some regulators have attempted to trigger fund coverage for companies that were still in a form of receivership - that is, a company that the regulator still hoped could be saved. Having been forced to participate in the rehabilitation of troubled companies contrary to the spirit - if not the letter - of the law, funds now require that a court has truly declared the company to be insolvent and has triggered the irrevocable liquidation of the company before the funds are activated. Thus, guaranty funds were not involved in the payment of claims during the receivership phases of Mutual Benefit Life and Executive Life.

State guaranty funds differ on what they will cover and on the amount of the benefit. The circumstances under which a given state's guarantee fund will respond are no less complex. The claimant's residency at the time of liquidation, at the time of claim, or at the time the policy was initially written may all control coverage. In one liquidation, confusion existed over the responsibility of a claim by a woman who was covered by a policy while her husband worked in Illinois, which has a fund. The couple later moved to another state with a guaranty fund just after the date of liquidation and then moved to Louisiana (which had no fund) where the wife had a baby. It took a skilled attorney hours of research to determine coverage.

Regarding the cancellation of contracts, in property/casualty, the norm is to allow a 15- to 30-day period after the order of liquidation before policies are canceled. However, in life and health, the statutory allowances for continuation of certain coverage beyond the date of liquidation can extend for years. Claims incurred after the statutory cancellation date are not allowed as claims against the estate. Some states allow appeals of enforcement of this claims cancellation date for good cause (e.g., not receiving proper notice of liquidation).

Deductibles and co-payments over those contained in the policy are sometimes applied by funds. The norm on property/casualty claims is to apply a $200 deductible over any policy deductibles. In 1989, the National Association of Insurance Commissioners (NAIC) Guaranty Fund Model Act incorporated a provision that is of special significance to corporate risk managers. Firms with more than $10 million in net worth are subject to a large deductible on property/casualty claims.

Guaranty funds were first designed to cover garden variety personal lines and business losses. The original framers of these funds probably never envisioned being asked to cover the 250,000 pensioners dependent on guaranteed investment contracts (GICs) issued by Executive Life. Products with a significant investment component, such as annuities (especially without a life contingency), variable life policies and GICs, present the most variability in coverage from state to state. Surety is seldom covered, and credit insurance is generally not covered. Common personal and commercial property/casualty losses are covered, and most states cover unearned premium. The maximum payment to any claimant is limited by all funds. Amounts vary from $100,000 to $500,000. Workers' compensation benefits are fully covered. Furthermore, most funds honor contractual rights to continuation or conversion coverage for health insurance.

None of the above issues represents critical defects to the guaranty fund mechanism. However, coordinating fund coverage for insurers with large interstate accounts can present a challenge to fund managers and liquidators. There is a movement in the NAIC to improve coverage coordination and uniformity in guaranty fund laws.

HANDLING CLAIMS

The claims handling function also differs by state. Since guaranty funds are ultimately responsible for paying policy loss claims, the law allows them to adjudicate such claims.

Most funds have established one carrier to be the designated claims agent for a particular class of insolvencies. In other states, claims are adjusted directly by employees or independent contractors of the fund.

Adjusting claims is ordinarily a standard process in most liquidations. The agent must, however, take notice of all requirements established by the liquidator to prove the claim. Some states require a sworn proof of loss to be made to the liquidator, regardless of other loss reports or proof sent to the insurer. The liquidator will be required by law to set a "bar date" for filing timely claims. This bar date is six months to one year after the notice of liquidation has been given. Claims made and filed after the bar date may be "excused" by the liquidator for good cause. Without being excused, late claims are subject to substantial reductions in payment.

Before a defunct insurer's final assets can be distributed to policyholders and other claimants, a number of thorny administrative issues involving the liquidator, fund administrators and other governmental agencies must be resolved. Among the greatest sources of delay in settling a liquidation concerns obligations to the federal government. Federal courts have ruled that any obligation to the federal government - taxes, surety payments, payroll withholding - has priority in the liquidation above all other creditors. In many cases, establishing the tax obligations of the insurer can be complex and take years to accomplish. This delay frustrates the liquidator's attempts to make, or estimate, the final payout to policyholder claimants.

Return of the insolvent insurer's security deposits is another illustration of the inconsistency of state laws. In some states, it is virtually impossible to recover a deposit until the regulator and guaranty fund administrator are convinced that all potential claimants in that state, including the guaranty fund itself, are completely paid. Thus, the liquidator has a difficult time getting all the assets in hand before paying the final dividend to claimants.

Finally, long-tail claims can block closing the books on a long defunct company. Without a firm reserve for the liquidated insurer's liabilities, it is difficult to secure court permission to make a final distribution of assets to claimants. A single open claim file often stretches out final settlement of the estate for years. In one case, a 15-year-old claim for medical malpractice blocked the final payment on a 12-year-old liquidation. Fortunately, most policyholders or third-party claimants have long since been paid by guaranty funds by the time the court decrees the final dissolution of a liquidation estate. The legal and administrative delays simply delay the distribution of assets to guaranty funds.

The risk manager, agent or broker has special duties to protect the claims of his or her principle. First, all policy loss claims must be filed in the form and time frame established by the liquidator. Second, doubts about coverage can usually be addressed by the guaranty fund manager in each state.

While guaranty funds offer protection to business policyholders, guaranty fund coverage poses some special problems for businesses. In some states, large, well-capitalized firms are exposed to high deductibles for property/casualty claims. Pensions funded through life insurance products are exposed to coverage gaps or denials by many guaranty funds. Funds were never designed to cover investment-oriented products, such as GICs and variable annuities. Health insurance generally poses the fewest guaranty fund coverage problems. There are seldom special filing requirements or deductibles, and fund limits are normally sufficient to cover all claims.

Insurance professionals should neither be complacent nor fearful about the potential for insurer insolvency. In the worst case - liquidation - the vast majority of policy claims will be covered by guaranty funds. The guaranty fund mechanism generally responds promptly and efficiently to claims. The assessments for funds do not appear to be placing an unmanageable burden on any segment of the industry.
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Author:Krohm, Gregory C.
Publication:Risk Management
Date:Dec 1, 1992
Words:2562
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