Insolvencies and the Current
Regulatory Environment
CAGNY
June 3, 2004
Agenda
• Upward Trend of Insolvencies
• Rising Cost of Insolvencies to Industry and
Policyholders
• Overview of an Insolvency
• Changes Affecting Insolvencies
• Judicial Liquidation - Does it Work?
• Alternatives – Commercial Run-Off
• Viable Run-off Candidates
• Role of the Regulator
• The “End Game”
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Insolvencies Trending Upward
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Contributing Factors
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Inadequate pricing combined with
attempts to build market share in
period of severe under-pricing
Acceleration of asbestos losses
since 1999
Reduced investment income –
record low rates
Inability to replace funds from capital
markets
Excessive use of reinsurance
Regulatory or rating agency action
Recent insolvencies dominated
by commercial lines carriers
Reliance largest insolvency to
date
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$5.9 billion - assets
$8.7 billion – liabilities
144,000 claims
* Includes
P/C Insolvencies 1995- 2004*
(NAIC)
1995
4
1996
6
1999
6
2000
18
2001
24
2002
21
2003
29
2004 to March
20
companies that have triggered regulatory action
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Insolvency Cost - Industry
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Inability of estate to reimburse
guaranty funds results in
assessments on industry
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Recent insolvencies have depleted
funds of the guaranty associations,
placing further strain on them if
they had to absorb another major
insolvency
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Guaranty Fund Assessments
1995 – 2002
(in millions)
1995
94.8
1996
124.2
1997
263.7
Funds have proposed increasing
the assessments or expansion of
the base for assessments
1998
263.7
1999
201.3
Alternatively, funds could restrict
coverage to fewer policyholders
2000
328.6
2001
734.7
CA WC Fund was recently
authorized to issue bonds to cover
$750 million shortfall
2002
1,209.0
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Insolvency Cost - Policyholder
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Policyholders must meet net worth test for guaranty fund to accept claim
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If eligible, guaranty fund will cover claim subject to fund limit
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Varies by state $100,000 – $500,000
Defense cost is included in limit if claim covered by the guaranty fund
Judgments/settlements in excess of guaranty fund cap are the
responsibility of the policyholder
Guaranty funds do not cover surety, assumed reinsurance, surplus lines
policies, financial reinsurance, etc.
Policyholder can make claim on receiver, but amount and timing of
recovery uncertain
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Varies by state ($10 – $50 million)
Policyholder with net worth in excess are not covered by guaranty funds
Subject to liquidation priorities
Reimbursement subject to funds remaining in the estate
A separate and significant issue relates to the treatment of collateral and
asset balances held by the company for the benefit of the policyholder
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Receiver and guaranty funds have fought for control of collateral assets resulting in a
lost benefit to the estate in receivership but enhances the ability of guaranty funds to
pay out allowed funds
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Overview of an Insolvency
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Surplus/Risk-based capital ratios continually decline over time
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Company may attempt optic solutions = financial reinsurance
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Rating agencies express concern – place company on watch for downgrade
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Company seeks capital in capital markets
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Decisive event occurs if
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Regulator must decide level of supervision
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Rating agency reduces the company to a commercially unacceptable rating and/or
RBC ratio falls below commercially acceptable levels
If surplus is positive the regulator may choose to place the company in conservatorship or
allow it to operate as a non-judicial commercial run off
If surplus falls below $0, regulator must place the company into rehabilitation or liquidation
In liquidation
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Assets become the responsibility of the receiver
Claim liabilities become the responsibility of the guaranty fund if eligible
Receiver will convert non-liquid assets, collect reinsurance and pay claims made on the
estate based on liquidation priorities of the state of domicile
Transactions and cash disbursements must be approved by judge
Judicial process introduces significant expense component
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Changes Affecting Insolvencies
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Prior to RBC, regulators had limited tools to achieve control of the company
before it fell below minimum capital and surplus requirements, resulting in
insolvencies with fewer assets
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Rating agencies were reluctant to downgrade companies to levels resulting in
their collapse prior to any regulatory intervention
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Introduction of RBC has focused regulatory oversight earlier on troubled
companies
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Using risk-based tools. rating agencies are less reluctant to downgrade
companies to commercially unacceptable levels - sealing the fate of a
commercial lines carrier
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Entering mandatory control level the company will still have significant assets
In prior periods the company might have remained at a commercially acceptable level and
over time resurrected itself
Results of these changes have produced a new group of troubled companies
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Companies with significant assets, but little or no surplus
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Judicial Liquidation - Does it Work?
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The current regulatory environment is suited to handle personal
lines companies
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The expense of the current system is excessive due to high legal
and consultant costs associated with documentation requirements
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High expenses contribute to exhaustion of the estate and result in
increased losses for policyholders and assessments on the
industry
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Current legislation requires regulators to place a company in a
judicial proceeding when it reports a negative surplus even if it
could discharge a significant amount of its liabilities if allowed to
continue as a non-judicial commercial run off
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Highly liquid but surplus-challenged companies represent cash
cow for receivers and law firm/consultants supporting liquidations
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Judicial Liquidation - Does it Work? (cont.)
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Commercial policyholders are significant losers in current system
– Potentially excluded from recovery through guaranty funds due to eligibility
restrictions
– Bifurcation of assets and liabilities under receivership eliminates the direct
connection between claim payment and recovery from supporting asset
(captive, collateral, specific program reinsurance)
– Collateral pledged to cover their losses put to other use by receivers
– Insurance companies ceding to an insolvent carrier will likely recover cents
on the dollar due to their low priority
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Liquidating commercial carriers is far more complex
– Reinsurance collections represent a major issue
– Collateral associated with various program structures will become trapped
in the estate
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The current system is inefficient and results in a high cost to
policyholders and the industry as a result of high receiver
expenses, unsatisfied claims settlements, collateral losses and
sub-optimal reinsurance collections
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Alternative – Commercial Run Off
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Once under state supervision, insolvency should be redefined as
the event when the company becomes illiquid rather than reports
a negative surplus position
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The company can operate to discharge claims and more
efficiently collect reinsurance recoverables
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This will substantially reduce the outstanding liabilities and
adverse impact to policyholders that would not have had claims
covered by the guaranty funds
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A commercial, non-judicial run off represents a cost saving
alternative that results in an increased benefit to policyholders
and claimants
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Types of Commercial Run offs
• Commercial run off (Traditional)
• Nonjudicial liquidation
• Liquidation priorities
• Other non-insurance creditors
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Commercial Run-Off Advantages
• Preserves greater estate value for the satisfaction of
insurance liabilities
• Continues to provide defense for policyholders
• Faster and more effective claim resolution
• Avoids protracted delays in the collection of reinsurance
recoverables
• Quicker resolution of the estate obligations
• Lower administrative cost during the pendency of the run off
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Commercial Run Off Disadvantages
• Regulators are not yet comfortable with non-judicial runoff
• Regulators perceive greater risks in supporting a
commercial run off vs. a proceeding
• Many states require entering into a judicial proceeding when
surplus falls below zero, even though estate may still be
able to handle claims more efficiently than judicial process
• To keep a company from entering a judicial process
permitted practices may be needed to sustain accounting
solvency
• Ultimately a proceeding may not be avoidable
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Is Every Financially Distressed Insurance
Company a Viable Run-Off Candidate?
• Accounting vs. economics
• Cash is king and queen
• Operation must be cash flow neutral or better
• Level of discount embedded in loss reserves
• Investment income and operating expenses
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Role of the Regulator
• Complicated by political issues
• Second guessing by non-domiciliary regulators
• Cooperation with regulators in domicilary state is imperative
• Permitted accounting practices or allowances may be
necessary
• Large, complex insolvencies require collective agreement
among multiple state regulators
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The “End Game”
• Payment of dividends during the run off
• Challenges of extracting excess value
• Winding up under a formal proceeding
• Creation of a liquidating trust outside of a proceeding
• The new Rhode Island statute
• Conversion of an insurance company to a “C” corporation
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Benefits of commercial run-off
• Provides for a normalized process for settling valid claims
• Avoids delay in payment of valid claims
• Maintains “duty to defend”
• Prevents substantial shrinkage of reinsurance
recoverables
• Avoids additional friction costs of a judicial receivership
• Provides the state guaranty funds with a much-needed
reprieve
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