Financially Distressed Companies
and Regulatory Options
Midwestern Actuarial Forum
Frederick O. Kist
March 22, 2005
Agenda
• Changes Affecting Insolvencies
• Insolvency Trends
• Options
• Priorities
• Guaranty Funds and Their Role
• Rising Cost of Insolvencies to Industry and
Policyholders
• Observations
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Changes Affecting Insolvencies
•
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
•
Rating agencies were reluctant to downgrade companies to levels resulting in
their collapse prior to any regulatory intervention
•
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 and positive
surplus
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 insufficient surplus to assure full payment of claims
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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 leverage through 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
1997
27
1998
9
1999
6
2000
18
2001
24
2002
21
2003
32
11 Mos. 2004
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companies that have triggered regulatory action
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Options
• Commercial Run-off
– Solvent Run-off
– Commercial Run-off Leading to Judicial Proceeding
• Receivership
– Conservation
– Rehabilitation
– Liquidation
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Commercial Run-off
– Company decides to suspend underwriting and place
business/operation into run-off
– Company has the support of a parent or sufficient resources within
its balance sheet to discharge remaining liabilities
– Depending on RBC, run-off can either be:
• Free of reporting to the regulator,
• Under informal oversight of the regulator, or
• Under a formal administrative supervision
– Company continues to collect premium receivables
– Company continues to process claims for all policyholders and all
other obligations
– Company processes and recovers reinsurance
– Company is in a substantial expense reduction mode working to
eliminate costs – staff, locations, and other overhead
– Successful run-off will be able to discharge all claims at 100%
– Judicial proceeding (receivership) is unnecessary
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Run-off leading to proceeding
– Company has a high probability of entering a judicial proceeding
before completely discharging claims
– Under the supervision of the state, the company ceases writing
policies and remains an operating company outside of a judicial
proceeding
– Company must maintain a positive surplus and can demonstrate it
has liquid assets to meet obligations
• Favorable settlement of liabilities generate surplus
• Cash must be generated from the investment income, collection of
receivables and conversion of other non-liquid assets
– Minimal new cash from premiums
– Contracts and obligations of the company remain in force subject to
limits of corrective order
– Company continues to process, in normal course, claims for all
policyholders and all other obligations
– Company processes and recovers reinsurance
– Company is in a substantial expense reduction mode working to
eliminate costs – staff, locations, and other overhead
– Company transitions into receivership at time when a surplus or
liquidity event occurs
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Options
• Commercial Run-off
– Solvent Run-off
– Commercial Run-off Leading to Judicial Proceeding
• Receivership
– Conservation
– Rehabilitation
– Liquidation
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Receivership - Conservation
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Regulator has concluded that grounds requiring
rehabilitation/liquidation exist and the interest of
policyholders/creditors will be endangered by delay
Regulator seeks the protection of a judicial proceeding to
provide a legal protection in the continued operation of the
company
Contracts and obligations of the company remain in force
subject to limits of corrective order
Certain transactions may require court approval
Under state and court supervision the company continues
to operate
– Paying claims in normal course and all other obligations
– Converting receivables and non-liquid assets to cash
– Reducing expenses
•
Conservation is a protective action which may be a
precursor to rehabilitation/liquidation
– Rehabilitation/liquidation action usually initiated shortly thereafter
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Receivership - Rehabilitation
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Regulator has concluded that grounds requiring
rehabilitation exist and seeks a court order
– Illinois code describes fifteen triggers
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Regulator seeks an order of rehabilitation to provide a legal
protection during this period
Commissioner is usually appointed receiver
The receiver takes over the operation of the company
Certain transactions may require court approval
If cash flow is insufficient to meet claims the rehabilitator
will place a moratorium on claim payments
Claim payments are resumed after a plan of rehabilitation
has been put in place
Guaranty funds do not respond to claims until liquidation
and as such payments to claimants are delayed
Under rehabilitation court approval must be obtained on
transactions over a threshold resulting in increased legal
expense
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Receivership - Liquidation
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Regulator has concluded that grounds requiring liquidation exist
and seeks a court order
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Illinois code describes fifteen triggers
Under liquidation the liquidator marshals the assets and
determines the estate’s liabilities subject to judicial oversight
All contracts are terminated – any outstanding non-policy
obligations will be treated as general creditor in any future
distribution
All claim payments are halted and future payments from the estate
are based on liquidation priorities
The company’s duty to defend is terminated
Certain transactions may require court approval
An order of liquidation will generally trigger coverage by the
guaranty funds – resuming claim payments for those that are
covered by the guaranty fund
Guaranty funds may get early access to the estate’s assets
Final distributions from the estate will take many years
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Distribution of assets based on liquidation priorities
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Liquidation Priorities
1.
Receiver and guaranty fund administrative expenses
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2.
Includes ULAE and ALAE claims expenses
Perfected secured claims

Collateralized claims
3.
Pre-filing employee obligations (capped)
4.
Known claims
5.
IBNR (estimated claims)
6.
All claims owed to the U.S.
7.
General creditors (assumed reinsurance)
8.
Surplus notes holders
9.
Equity interest of shareholders, members or other owners
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Guaranty Funds and Their Role
• Over 50 state guaranty associations across
the US
• Over $9 billion paid by funds in last 25 years
• Have the capacity to assess the industry up
to $4 billion annually
• Responsible for
– Continuing timely claim payments upon triggering
event
– Allocating of the cost of insolvencies across
companies writing within the state, and
– Minimize financial loss to policyholders and claimants
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Insolvency Cost - Industry
•
Assessments result due to a delay of
recovery from estate or Inability of estate
to fully reimburse guaranty funds
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Current assessment capacity of funds is
estimated at $4 billion, but may be limited
1995
94.8
1996
124.2
acceleration of alternative funding
1997
263.7
methods
1998
263.7
1999
201.3
Funds have proposed increasing the
2000
328.6
assessments or expansion of the base
2001
734.7
2002
1,209.0
2003
901.6
by caps
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In some cases funds have sought
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CA WC Fund was authorized to issue bonds
to cover $750 million shortfall
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for assessment
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Guaranty Fund Assessments
1995 – 2002
(in millions)
Alternatively, funds could restrict
coverage to fewer policyholders
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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
IL law has clarified collateral treatment, but has allowed for a 3% fee for collateral held
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Insolvency Cost - Policyholder
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Commercial policyholders receive less protection 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
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Insurance companies ceding to an insolvent carrier are
treated as general creditors and will likely recover little due
to their low priority
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Observations
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Difficult to out-run a B+ downgrade
– Agents may love you – their E&O carriers don’t
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Cash is king
– Surplus is less meaningful
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Encumbrances can threaten a successful runoff
– Collateral triggers need to be identified before event
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Modeling becomes very important
ULAE is a significant, but should not be considered a
sufficient provision to assure a successful runoff
– ULAE is the only accrued expense of many continuing non-accrued
operating expenses
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RBC should be reviewed for
– Charge relating to run-off company expense burn or upward
modification of the mandatory control level.
– Some evaluation of encumbrances and collateral triggers should
also be incorporated.
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To run a company a CEO should have gone through a runoff experience
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