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Old problem, new solution: Wisconsin's unique segregated account law for delinquent insurers saves a major player in the financial securities space.

When the subprime mortgage crisis began setting off warning sirens among regulators in 2007, none of the 2,400 residents of Darlington, Wis., had any idea that their farming community would become the setting for a multibillion-dollar insurer rehabilitation, and a new solution to an old problem in addressing the financial distress of large insurers.

The insurer at issue is Ambac Assurance Corp., one of the world's largest financial guaranty insurers. Municipal bond insurance is the backbone of Ambac 's business, but in the 1990s it began insuring other types of financial obligations that were perceived to be safe bets, namely residential mortgage-backed securities and their derivatives.

Needless to say, Ambac (like other financial guaranty insurers) miscalculated the risk posed by many of the financial instruments it insured. As those transactions began to default and insurance payouts grew with the onset of the subprime mortgage crisis, the Wisconsin commissioner of insurance intensified scrutiny of Ambac's financial condition. The commissioner ultimately commenced an insurer delinquency proceeding in Darlington, Wis. in 2010.

Two quirks of history explain how proceedings over the future of Ambac, a New York City-headquartered insurer with an international scope of business, took place in a town without a stoplight. First, Ambac's distant predecessor was incorporated in Milwaukee in 1970, and Ambac never changed its domicile. Therefore, the Wisconsin commissioner remained its primary state regulator. Second, by administrative rules dating back to the early 1990s, Wisconsin insurer delinquency proceedings have been assigned to the same (and only) judge in Darlington-originally because his county's lower caseload permitted it, and eventually because he had gained expertise through experience in these specialized proceedings.

Insurer delinquency proceedings are unique creatures. While their holding companies may file for bankruptcy, insurers themselves are statutorily ineligible for federal bankruptcy protection. When an insurer's financial condition is sufficiently hazardous to policyholders, state insurance commissioners may initiate insurer delinquency proceedings--generally akin to bankruptcy, but with fewer established procedures and far less precedent to draw upon.

The Ambac Conundrum

As insurer delinquency proceedings go, Ambac provided a familiar story. It underestimated the risks of a small subset (less than 8%) of policies, and those risks threatened to drain the claims-paying resources of the company before all outstanding policies had expired.

But Ambac presented those problems in a new context, and on a very large scale. The policy tails on Ambac's financial guaranty insurance are often decades long, particularly for municipal bond policies, which are generally its most financially sound transactions.

Had the claims against Ambac been allowed to continue unabated, it could have run out of resources long before those policies expired. That would have left the beneficiaries on Ambac policies without the insurance that is often required for their bond issuances, and without the coverage they bargained for in paying their advance premiums. Thus, the danger of not commencing an insurer delinquency proceeding to stem the tide of payouts and provide breathing room for an organized claims process was clear.

But the danger of commencing such a proceeding was equally great, due to the terms and conditions of Ambac's policies. Many of Ambac's policies were not off-the-shelf documents, but rather individually negotiated agreements that the Wisconsin judge later characterized as "some of the most complicated financial instruments ever created."

Contractual triggers lurked within many of these documents, which would authorize certain parties to those transactions to take drastic and even punitive contractual measures against Ambac (and, in some cases, its policyholders) if Ambac ever were subjected to a delinquency proceeding or transferred a significant portion of its assets. The commissioner estimated that this collateral damage of commencing a delinquency proceeding may have exceeded several billion dollars, only adding more financial strain on Ambac's claims-paying resources.

In short, the Wisconsin commissioner was stuck. Ambac needed judicial protection to preserve insurance protection for the 90%-plus of its business that was sound. But placing 100% of the insurer's business into a delinquency proceeding risked accelerating the very financial hazards the commissioner sought to alleviate.

Old Solution: Divide and Repair

Historically, insurance commissioners confronted with insurers for which a small subset of policies is causing severe financial distress have resorted to a company split, in various forms.

The U.S. Supreme Court approved the remedy of a company split in the Depression-era rehabilitation of Pacific Mutual Life Insurance Co. There, Pacific Mutual's finances were strained by a specific subset of policies. To correct the issue, the California insurance commissioner commenced a delinquency proceeding, and approved the formation of a new insurer using a significant portion of the insurer's assets as capital. He then offered policyholders a choice: continue coverage with the new company (with reduced benefits for certain policies), or remain with the old company as it was liquidated (and receive the liquidation value of their policies).

Insurance commissioners have implemented several variants of the Pacific Mutual split-company approach to financially hazardous insurers over the years, often finding a third-party insurer to assume obligations under certain policies.

From a regulator's perspective, however, many of these approaches come with practical uncertainty. Appropriate third-party suitors may be nonexistent or unwilling to assume an insurer's policy book. Policyholders may be unpredictable in exercising choices to join a new insurer, jeopardizing the feasibility of the split. Splitting a company's already strained claims-paying resources among two entities might only serve to create two financially hazardous insurers instead of one.

Even if those practical uncertainties are overcome, legal challenges remain, particularly in the area of contract law. Insurance policies are contracts, and policyholders contract for specific coverage from a specific insurer. While the full extent of coverage may be unavailable (because the insurer is in a delinquency proceeding), contract law can restrict the ability of insurance commissioners to simply rewrite those policies and/or assign them to other insurers.

The Wisconsin Solution

These more traditional solutions would not have worked for Ambac, due to contractual triggers that would be set off upon the transfer of a significant portion of its assets to another company, among other circumstances.

Fortunately, the Wisconsin commissioner had a unique tool at his disposal. In Wisconsin, by statute, the commissioner may approve the creation of a "segregated account" for "any part" of an insurer's business, and may place that segregated account into rehabilitation (a form of delinquency proceeding) while the rest of the company continues to operate outside the delinquency proceeding.

While other states authorize the creation of segregated accounts for specific purposes or lines of business, Wisconsin is the only state permitting the creation of segregated accounts for any purpose, and for any part of the insurer's business. No policyholder consent is required; the commissioner's approval is sufficient.

On its face, this statute offers exceptional flexibility in addressing insurers whose financial troubles are attributable to specific subsets of policies. A segregated account is not formally a different insurer; it is a "company within a company," according to the statutory comments. But it can be treated as separate from the main insurance company for the purposes of delinquency proceedings. Thus, the Wisconsin commissioner could obtain the same objectives as the traditional company split, but without the need to reform policies, obtain policyholder consents, deal with third parties or divide up the insurer's pool of claims-paying resources.

The formation of a segregated account appeared to be the only feasible option for addressing the urgent financial drain caused by Ambac's failing policies without setting off triggers across its vast majority of financially sound policies. After concluding that holders of healthy and loss-producing policies alike would all fare better with a segregated account approach than traditional alternatives and their accompanying collateral damage, the Wisconsin commissioner approved the creation of a segregated account for the minority of Ambac policies with large projected loss claims, to be run off in a delinquency proceeding with deferred payments over time on policy claims.

The remainder of Ambac would continue to operate, subject to strict controls to preserve assets but not formally part of the delinquency proceeding. Ambac's assets would remain entirely with Ambac--thus avoiding the contractual triggers in many policies--but the segregated account could draw upon those assets to make its deferred claim payments.

The Courts Approve

In theory, this segregated account approach would treat holders of loss-producing policies the same way they would be treated in a traditional delinquency proceeding of the entire insurer, but without unnecessarily subjecting all other policyholders to a delinquency proceeding, and without the devastating harm of contractual trigger consequences and other collateral damage to the insurer.

The question was whether the Wisconsin commissioner's segregated account approach would stand up to legal challenge. Wisconsin regulators had used segregated accounts with other, smaller insurers for similar purposes, but their use of the statute had never been tested in the courts.

After several legal battles involving lawyers from across the country, the Wisconsin appellate courts gave judicial blessing to the commissioner's segregated account approach in decisions last fall and earlier this spring.

"We acknowledge that the commissioner was creative in its approach, whereby the commissioner transferred Ambac's liabilities into a segregated account and then pursued a targeted partial rehabilitation of the segregated account," wrote the Wisconsin Court of Appeals in its decision. "The approach here differs from the approach used by insurance commissioners in other cases where the assets of the company were transferred to a new company."

But the court found that different approach permissible under Wisconsin's segregated account statute. Because a segregated account was a company within a company, rather than a wholly separate insurer, the court found that the assets of an insurer and its segregated account "need not be kept physically separate" and that contract law did not present many of the obstacles that would otherwise exist in more traditional approaches.

The court further agreed that the commissioner could approve allocations to the segregated account on a policy-by-policy basis, depending on whether a given policy was projected to give rise to material loss claims.

With judicial approval in hand, Wisconsin insurance regulators now have a powerful, flexible, and (thus far) unique tool to tailor individualized solutions for financially distressed insurers. Wisconsin remains the only state with such a statute; other state legislatures may be well-advised to follow suit.

While not necessary in every proceeding, the Ambac proceeding offers a stark example of how the added flexibility of segregated accounts can be used to provide better outcomes for policyholders. But for the historical quirk that left a multibillion dollar, Manhattan-based insurer of complex financial products subject to the regulation of the only state with that tool available, Ambac's delinquency proceeding could have taken a vastly different and more destructive course.

Key Points

* The Story: A major insurer of financial securities found itself endangered by the Great Recession.

* The Quirk: The insurer is domiciled in Wisconsin, the only state that allows regulators to segregate delinquent accounts while letting the parent continue operations unaffected.

* The Bottom Line: The added flexibility of segregated accounts can be used to provide better outcomes for policyholders.

Contributor Matthew Lynch is a litigation attorney with Foley & Lardner LLP, the firm representing the Wisconsin commissioner of insurance in the Ambac insurer delinquency proceeding. He can be reached at
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Title Annotation:Regulatory/Law
Comment:Old problem, new solution: Wisconsin's unique segregated account law for delinquent insurers saves a major player in the financial securities space.(Regulatory/Law)
Author:Lynch, Matthew
Publication:Best's Review
Geographic Code:1U3WI
Date:Jul 1, 2014
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