By Ed Wallis
The U.S. Treasury Department released its own blueprint for a stronger regulatory structure for the U.S. financial system on March 29. That report is important for guaranty associations, though it might not seem to have been the case when the Treasury began its study with a request for comments by interested parties on October 11, 2007.
The Treasury blueprint discusses the entire area of financial regulation from depository institution, futures regulation, securities regulation and insurance regulation. It was the latter topic of insurance regulation which prompted the National Conference of Insurance Guaranty Funds (NCIGF) and the National Organization of Life & Health Insurance Guaranty Associations (NOLHGA) to jointly offer comments related to the state-based system of insurance guaranty associations to Treasury on November 21, 2007.
When the Blueprint was announced, the Treasury dove into the subject of insurance regulation making short-, intermediate- and long-term recommendations for an optimal regulatory structure. While most of the press headlines and attention was directed at recommendations regarding reform of mortgage origination practices and Federal Reserve regulation in the banking area, Treasury made several recommendations regarding insurance regulation.
Treasury proposed the immediate creation of the Federal Office of Insurance Oversight (OIO) in the Treasury Department for two purposes. First, to exercise newly granted statutory authority to deal with international regulatory issues, such as reinsurance collateral, and second to advise the Secretary of the Treasury on major domestic and international policy issues.
In addition to being the lead negotiator for the U.S. in the promotion of international insurance policy, – a role which the NAIC now carries out through one of its committees – Treasury envisions the OIO as developing expertise on issues such as financial guarantee insurance (i.e. bond insurers), private mortgage insurance and natural catastrophe insurance. Soon after the Treasury Blueprint was released, Congressman Paul Kanjorski (D-PA), who is Committee Chairman of the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises, introduced House Bill 5840 to create such an office in Treasury.
Kanjorski’s bill, the Insurance Information Act of 2008, would establish the Office of Insurance Information in the Department of Treasury. While the change from “Oversight” to “Information” in the office’s name is interesting, Kanjorski’s bill would grant some significant powers to this office, including the authority to establish federal policy on international insurance matters and ensure that state insurance laws are consistent with agreements relating to federal policy entered into by the United States. In this context, the office’s authority would extend to all lines of insurance except health insurance and it would have the power to preempt state law which is inconsistent with federal policy on international insurance matters.
Kanjorski, who as Subcommittee Chairman, may well bring this bill up for mark up and adoption by his subcommittee during this Congress before it adjourns at year’s end. More directly of interest to state guaranty associations is the Treasury position on regulation of insurance in the United States.
In its blueprint, Treasury endorsed the establishment of a federal insurance regulatory structure to provide for the creation of an optional federal charter for insurance companies in all lines of insurance. This potential has lead both NCIGF and NOLHGA to brief members of Treasury about the State Guaranty Fund system for three times during the past five years and to offer comments to Treasury last fall.
The concern shared by many in the guaranty fund system, of course, is that a regulator of federal insurance, under the new arrangement, would deliver consumer protection if a federally chartered insurer becomes insolvent.
A joint education campaign between NCIGF and NOLHGA is on the front lines of explaining why a federal guaranty system is not the ideal approach, especially given the realities that would arise if insurers are chartered by both individual states and by the federal government. The NCIGF has urged the approach of including federally chartered insurers in the state guaranty association network by requiring any federally chartered insurer to become members of each state guaranty association where a federally chartered insurer would conduct its insurance business.
Under this concept, all insurers conducting property and casualty business within a state would be required to be members of the state’s property and casualty insurance guaranty association, just as they are today. In this way, the assessment base and capacity for each guaranty association would remain intact within a state to better assure its ability to pay claims of any insurer conducting business within the state who might suffer a fatal financial failure. The sponsors of both OFC’s bills now pending in Congress, Senate Bill 40 and House Bill 3200 both agreed with the suggestion of the guaranty funds and drafted their legislation using this approach to consumer protection against the insolvency of a federally chartered insurer. So long as a state guaranty association met the qualification requirements specified in those bills, all federally chartered insurers would be required to join and maintain their membership in every state guaranty association in the states where they conducted business.
In our comments to Treasury last year, NCIGF and NOLHGA explained that the current system provides benefits to consumers in the event of insolvency in amounts equal to – and often greater than – those provided by the FDIC for bank failures. Additionally, the NCIGF and NOLHGA explained that the guaranty association protection of insurance benefits is essentially different from bank deposit insurance in the sense that the principal focus of the insurance safety net is the fulfillment of the insurance promise to the consumer, and not merely assurance of the liquidity of deposited funds.
Insurance guaranty functions require a higher level of expertise with the insurance contract and its obligations, as well as more local and direct contact with the affected insurance consumer. The NCIGF and NOLHGA explained the efficiency of the current system and its proven record of adaptability to change in the marketplace as well as future developments.
Further, the groups explained that regulatory overlap is not an issue in the current system, and would not be under their approach to the OFC concept; this is because the system provides that the guaranty association in the state where the consumer resides is exclusively for providing the specified consumer safety net protections.
The groups were heartened by the Treasury’s recommendations for solvency regulation in conjunction with Treasury’s proposal that Congress adopt an Optional Federal Charter approach to insurance regulation. Treasury said on page 130 of its report:
This approach should require federally chartered insurers to participate in qualified state guarantee funds to protect state citizens without having to create duplicative insurer-funded federally managed guarantee systems. There are benefits to retaining these funds at the state level; The state system has been tested by several previous insolvencies; reliance on the tested system eliminates the need to create an additional federal entity; and the system appears to be adaptable to companies electing a federal charter.”
Treasury’s conclusion should gratify all guaranty association members who have worked so diligently for the years performing their responsibilities. Guaranty associations’ achievements in protecting consumers in times of insurer financial failure demonstrate their value to society and to the financial system of this country.
While we do not expect any significant activity toward adoption of OFC legislation during the remainder of this Congress, new legislation will most likely be introduced in the next Congress commencing in 2009 when a new administration takes over in Washington and Congress reorganizes following the 2008 elections.
Proponents of OFC legislation will undoubtedly urge members of the 111th Congress to again offer OFC legislation. Treasury recommendations will certainly help state guaranty associations in making their case for adoption of the NCIGF and NOLHGA’s proposal for consumer insolvency-related protection of federally chartered insurers.
By Mark D. Steckbeck and Roger H. Schmelzer
There is growing interest among insurance regulators in finding market driven solutions to address the problems of troubled companies. Regulators are showing less interest in placing troubled insurers into liquidation, and troubled insurance companies seem to present investment opportunities for the capital markets.
These propositions were central to an in-depth series of panel discussions on capital markets investment opportunities at “Emerging Investment Opportunities: Bridging the Gap between the Capital Markets and Troubled Companies” hosted by the International Association of Insurance Receivers (IAIR) in October 2007. The one-day program explored the potential use of funding from the capital markets to address some of the issues and potential solutions to the serious financial challenges facing troubled insurance companies.
The program included insurance commissioners, reinsurers, attorneys and investment experts from the U.S. and abroad. The panels offered insights into the possible use of investment capital to assist regulators in their efforts to rehabilitate or runoff troubled insurers; it also reviewed the restructuring mechanisms available in other countries. In addition, the program examined some of the critical considerations and impediments potentially associated with these challenging investment opportunities. This paper summarizes highlights from these discussions.
Capital Market Opportunities in Troubled Insurance Companies. The first panel of speakers (Christopher Flowers of J.C. Flowers & Company, New York Insurance Superintendent Eric Dinallo and Forrest Krutter of Berkshire Hathaway) examined some of the issues and opportunities for investing in troubled insurance companies in the segment.
Flowers observed that while there is a growing appetite for investment opportunities, special challenges face potential investors in property and casualty liabilities, chiefly the need for adequate potential returns to interest investors.
There must be reasonable predictability of the investment returns, explained Flowers, adding this is something that is difficult to achieve with property and casualty claims in general, but especially so with the involvement of asbestos and environmental claims and natural disasters. Flowers went on to explain additional uncertainty is found where key assumptions used to evaluate company liabilities can be unexpectedly changed, for example, re-opening the statute of limitations on previously expired tort claims.
Another challenge facing investors is the high cost of collateral. Collateral posted by investors to cover property and casualty liabilities must be invested safely, which may limit the investor to relatively safe but modest investments. To an institutional investor seeking returns in the range of 20 percent, a five percent return on a treasury note is significantly below his required return threshold.
Structural Impediments Facing U.S. Investors. The second panel examined some of the structural impediments facing U.S. investors that are different from those faced by investors in troubled companies in Great Britain. The panel included Paul Dassenko, of azuRe Advisors, Inc., Oliver Horbelt formerly of Centre Group of Companies, Richard Whatton of Independent Services Group and Tim Graham, LaSalle Re.
Although both systems recognized the importance of making timely payments to policyholders and claimants, the comparison generally stopped there. While the U.S. system strongly favors policyholder protection, the British system would seek ways to bring finality to a company’s affairs, including its liabilities, thereby allowing investors to salvage part of their investment, and if possible, return at least some portion of their capital to the market.
For an institutional investor seeking an investment opportunity, the U.S. system creates several barriers. First and foremost, investors want to make money. With no benchmark for success acceptable to the regulators, investors may not be interested.
Second, there is a general lack of quality information to enable investors to evaluate troubled insurance companies. Additionally, there are a number of pitfalls for investors. These include a lack of understanding of the liability side of policy risks. Investors want to be able to extract their money quickly to pursue other investment opportunities. This may not be possible where the company has long tail exposures. Investors would want to accelerate liabilities in order to outrun adverse development. However, this approach would run contrary to the U.S. system’s strong preference for placing the interests of policyholders and claimants above the interests of investors.
Evaluating the Investment. In “Straight Talk from the Street,” the third panel addressed some of the key factors used by private equity investors when evaluating private investment deals. The panel included Bart Zanelli of Guy Carpenter, David Platter of Credit Suisse, Martin Alderson Smith of The Blackstone Group and Bill Goddard of Bingham McCutchen.
Time horizon. Private investors seek investments with a three to six year exit strategy. This strategy is at odds with the long-tail nature of property and casualty liabilities.
- Potential rate of return. Equity investors are seeking investments that offer solid returns in the range of 20 percent for investment in a healthy company. To offset the greater risks associated with investment in a troubled company, investors may require expected returns as high as 30 percent. Returns of this magnitude may not be either achievable or politically palatable where a company is in the hands of a regulator and other creditors are receiving cents on the dollar. Investors are also concerned about reputation risk when they participate in deals that might draw damaging criticism.
- Time and money required to close a deal. The longer it takes to close a transaction and the more money that must be spent, the less attractive the deal. This might occur where regulators are required to address objections or offer public hearings before approval is granted.
- Difficulty in quantifying the level of investment risk. As the risk becomes less quantifiable, investors require greater returns or they will look for other opportunities. Finally, investors want to maintain at least an adequate level of control over the risks affecting the return on investment. Given the unpredictable nature of asbestos and environmental claims, natural disasters, and the ever-changing legal environment, it remains a challenge to control the risk factors affecting investment returns.
The panel examined how investors and regulators could close the gap on some of these obstacles. Four key elements to success were identified: the first issue is transparency. Parties must identify all issues and problems and exchange information to permit full evaluation of the transaction. Next, parties must have an open dialogue. The parties must identify and address all transactional elements including taking care of policyholder concerns and the investor’s profit expectations. Third, the value proposition for the transaction must be identified: all reasons for the company’s distress must be disclosed and all constituents must be represented at the bargaining table. Fourth, individual egos and private agendas must take a back seat to the transaction’s success.
Additional challenges facing potential investors include a poor institutional memory of the target company. By the time the trouble company is entertaining potential investors, many of its more experienced and knowledgeable employees have already departed. Another challenge is the inability to quickly access good quality information regarding the company’s operations and financial condition. There are also fragmented demands being made upon the company or the regulator from multiple constituents. Managing and reconciling these demands with regulatory imperatives while attempting to structure an investment deal adds another layer of complexity and cost. Moreover, there is no organized secondary market for the sale of troubled insurance companies. Without an established market, the transaction costs are higher. Finally, parties to the transaction must deal with fragmented claims. Stakeholders with competing interests each seek individual relief. Parties must find fair and effective ways to address these interests in order for the deal to proceed.
Regulatory Issues. The regulatory panel included Commissioner Al Gross of Virginia, Commissioner Thomas E. Hampton of D.C., Director Michael McRaith of Illinois, Deputy Commissioner Michael L. Vild of Delaware and Peter Gallanis, President of the National Association of Life & Health Insurance Guaranty Associations.
Mr. Gross stated his belief that insurance company receiverships should be managed with four principles in mind. First, policyholders have the right to have their claims paid timely and in accordance with their insurance contracts. Second, policyholders have the right to be protected against market abuses, for example, they should retain the protections that were granted by the state’s unfair claims settlement practices act. Third, claimants must be treated equitably. Fourth, the receiver is responsible for maximizing the value of the estate for the benefit of policyholders and other claimants.
Director McRaith believed that states are doing a better job of monitoring the financial condition of companies. He believed that if properly supervised, runoffs can benefit customers by avoiding some of the frictional costs of liquidation.
Deputy Commissioner Vild spoke of the desirability of early intervention on the part of regulators. He believed that the desired three to six year ideal investment horizon may not always be available and stated that he would be receptive to seeing proposals that addressed the issue of the investor’s withdrawal strategy up front. He further emphasized the need for transparency and full disclosure.
What Does the Future Hold? The final panel consisted of Howard Mills, Deloitte & Touche USA (and former New York Superintendent of Insurance), Nigel Montgomery, Sidley Austin and Chris Stroup, Wilton Re. The panel was asked if members expected to see an increased level of interest in investing in troubled companies by the capital markets. After summarizing some of the comments and themes voiced by the earlier panels, the presenters stated that the primary goal must be to protect consumers while still offering opportunities for investment of capital.
There is no one-size-fits-all approach to addressing the problems with troubled companies. Each company is unique and must be evaluated on its own merits. On the balance, however, the panel members did not expect to see a high level of interest by the capital markets in making investments in insurance company rehabilitations. For the capital markets to be interested in investing in troubled insurers, the insurance industry must be able to end runoffs within a reasonable timeframe.
NCIGF Analysis. The NCIGF suggests that the primary purpose of any alternative approach to insolvency be protection of the public from financial loss.
The state-based property and casualty guaranty fund system affords covered claimants a statutory remedy in the event of insolvency – many claims of the average consumer are paid in full. Based on existing state liquidation statutes and priority distribution laws, the needs of consumers, who are generally unsophisticated in insurance matters, are placed ahead of nonpolicyholder claimants and everyone with the same level or type of claim is treated equally.
It is imperative to know how and to what extent fundamental consumer protections would be affected under any alternative to outright liquidation. Would policy claims be reduced below their contract value in certain scenarios without the consent of claimants? Would consumers still receive timely payments, the full benefit of their insurance contract, fair treatment in the claims settlement process and availability of a meaningful claims appeal process? All of these are protections afforded in a traditional liquidation administered under existing state law. If they are not maintained, exactly what is the public policy objective in support of such a change?
Property and casualty insurance is a necessary ingredient to development of a civilized society by impacting the ability of commerce to develop and flourish within a free market economy. It is a contractually specified and validated agreement to transfer risks tied to virtually all personal and business investment decisions. This in turn allows individuals and businesses to confidently manage their risk and make investments, important actions that spur economic growth.
Legislators and regulators have already established the guaranty fund system to make good on the insurance promises of failed property and casualty companies by providing at least a partial remedy for insurer insolvency. That remedy retains the sanctity of the insurance contract by affording a measure of protection to those claimants state legislatures have deemed most in need of protection. Any decision to modify the existing level of consumer protection should be undertaken with the utmost of thought and deliberation.
By Jim Hamilton
Vice President of Claims Systems, Home Insurance Co in Liquidation and member of the NAIC UDS Technical Support Group and the NAIC UDS Financial Technical Support Group
Vice President of Internal Operations, Ohio and West Virginia Insurance Guaranty Funds, and Chairman of the NAIC UDS Technical Support Group and the NAIC UDS Financial Technical Support Group
Sometimes it seems that a world of difference divides the receivership and guaranty fund communities. Look a little closer, though, and you’ll see these two groups often share a common cause.
Understandably, there can be great disparity of opinion between the “two houses” of the insolvency structure. But it is also true the groups share a spirit of cooperation that often brings measurable benefits to the system.
The fruits of this cooperation are evident in the National Association of Insurance Commissioners’ (NAIC) adoption last year of a new version of the Uniform Data Standards (UDS) D-record. The adoption capped years of diligent and dedicated work by the members of the NAIC UDS Technical Support Group (UDS TSG) and the NAIC UDS Financial Technical Support Group (UDS FTSG). The members of these groups included claims, IT and financial professionals from the receiver and guaranty fund communities.
Upon implementation on January 1, 2009, the revised D-record will provide a uniform method of presenting quarterly guaranty funds’ financial data to receivers. It will contain information on losses, loss adjustment expenses, other administrative expenses and revenue amounts received from an inception to date, year-to-date and quarter-to-date perspective. Also included is a feature to address large deductible data as well as other enhancements.
The D-record will bring to insolvency-related financial reporting greater uniformity and standardization, better efficiency and related cost-savings, and will help strengthen and streamline the insolvency system that has protected tens-of-thousands of policyholders and claimants over the years.
Prior to any uniform data standards, processing claims for both guaranty funds and receivers was cumbersome and labor intensive. It required manual input of information from original claim files, had no standardization of forms; also there was no specified reporting timeframe. For receivers, the lack of a standard format meant that processing claims information from the more
than 50 property and casualty guaranty funds was often a heavy-lift exercise in shifting mountains of paper and key stroking claims data into a database. Every receiver was left to negotiate the best they could with guaranty funds about what to report and reporting frequency. For guaranty funds, the lack of a standard format brought other challenges: they had to report payment and reserve data in as many different formats (mostly hard copy) as there were estates.
Members of the UDS TSG originally tried to promote UDS as the format of choice in the early 1990s. The initial intent was to use the protocol to efficiently transfer claims data only. The volume of data generated by the spate of large, multi-state insolvencies a few years later showed receivers and guaranty funds the value of finding ways to efficiently gather data receivers needed to bill and collect from reinsurers. The claims protocol, the C-record, was successful, and prompted a growing consensus that it was time also to standardize financial reports; this in turn led the UDS TSG and UDS FTSG to take up development of the D-record.
The NAIC’s adoption of the D-record is an important success; it underscores the fact that guaranty funds and receivers can and often do work together to develop solutions that enable the system to better and more efficiently serve policyholders and other receivership creditors. For receivers, the D-record facilitates compilation of financial data from the various guaranty funds. The receiver uses the D-record as a control mechanism and reconciliation point with the claims detail in the C-record, plus it is the only method for reporting guaranty fund administration expenses and other revenues not included in the C-record. It also speeds up reconciliation with the claims detail in the C-record. In addition, the D-record facilitates the review and analysis of individual guaranty funds Proofs of Claims and claim servicing expenses. The upgrades also reduce expenses of guaranty funds and receivers by automating what had been a costly and tedious manual process of transmitting financial information between funds and receivers.
The revised D-record brings added efficiency and uniformity to insolvency financial reporting by replacing the various forms of hard copy reporting receivers used in the past, including financial information questionnaires (FIQs), with a uniform financial report that can be filed via hard copy or electronically. This creates a standardized system of reporting with which receiver and funds are familiar. It is an important step in the ultimate goal of users migrating to full electronic filing capability.
For guaranty funds, the D-record standardizes reports, eliminating the past situation where they might be asked to complete different reports to provide the same information to various estates. It also leverages the speed and cost advantages of automation; it speeds up the preparation and issuance of financial reports, and it reduces manpower needed to compile reports while increasing accuracy.
As the D-record came to fruition, the National Conference of Insurance Guaranty Funds (NCIGF) created Secure UDS (SUDS), a secure electronic clearinghouse for UDS data exchange between receivers and guaranty funds. Prior to SUDS, many organizations transferred their UDS files in unencrypted and unsecure methods such as email, postal mail, and FTP (File Transfer Protocol). While these methods have been reliable in the past, the recent changes in security and compliance laws led the NCIGF to reevaluate how its members send sensitive, non-public personal information such as names, addresses, and social security numbers. 1
SUDS delivers a range of benefits. It provides a secure means by which guaranty funds and receivers transfer claims data in a manner that protects sensitive personal information from interception, theft, and unauthorized access. It also offers a single standardized point of data exchange between receivers and guaranty funds. The NCIGF makes SUDS available to receivers and guaranty funds at no cost.
Coinciding with the rollout of the D-record, the UDS TSG and UDS FTSG is undertaking a new UDS training program for the guaranty fund and receivership communities. The goal is to increase the general understanding of the D-record and UDS overall through a new generation of on-line, modular and interactive UDS and SUDS training materials.
In addition to the obvious educational benefits these materials will bring to UDS users, the materials will help promote uniform UDS reporting practices and help users gain maximum benefit from the tools. Development of the training materials, which is being overseen by the UDS TSG and UDS FTSG, draws on the expertise of UDS experts from the guaranty fund and receivership communities. Target completion of the D-record portion of training is August; the remainder of the project will be completed in 2009.
At the end of the day, a key part of the D-record success lay in the fact that the UDS TSG and UDS FTSG was made up of receiver and guaranty fund representatives. These professionals know first-hand the mutual advantages that arise from taking a joint, solutions-based approach to addressing issues.
Indeed, the effort is something of a casebook example of the benefits that come when the receivership and guaranty fund communities work together. The UDS TSG and UDS FTSG knew early on that if the D-record was to succeed, the effort had to be spearheaded by receiver and guaranty fund representatives. It is the front-line claims, IT and financial professionals from receiverships and guaranty funds on the UDS TSG and UDS FTSG who are best-placed to recognize the benefits of uniformity and standardization the D-record and UDS overall.
If the D-record’s adoption has accomplished nothing else, it has shown the value of good communication between the receivership and guaranty fund communities. Those of us who have served on the UDS TSG and UDS FTSG committees have seen first-hand the mutual benefits that arise when a spirit of unity and cooperation guides an effort and issues are resolved openly through good communication.
In the final analysis, electronic systems such as UDS allow guaranty funds and receivers to save time, effort and resources while allowing us to bring new levels of uniformity and accuracy in reporting. For some there are initial “birthing pains” associated with adapting to these changes. However, the overall capabilities and mutual benefit brought to receivers and guaranty funds alike make it well worth the investment of time and resources.
Admittedly there are – and always will be – differences of opinion between guaranty funds and receivers. But the successful adoption of the D-record clearly shows what can happen when differences are set aside in favor of exploring what will work best for all.
1Portions the foregoing text is drawn from “UDS Overview” prepared by Dale Stephenson. The authors thank Dale for contributing this material.
The authors would also like to thank the members to the UDS Technical Support Group and the UDS Financial Technical Support Group whose talents and dedication have done so much to improve insolvency reporting.
Members of the UDS TSG and UDS FTSG groups are available to answer questions about UDS, the D-record and related issues. The group invites readers to e-mail questions to the UDS Help Desk at email@example.com.
By Kevin Harris
The property and casualty guaranty funds know better than anyone that the increased insolvency activity that occurred starting in the late 1990s resulted in a record payout for the guaranty funds. The vast majority of this work for the guaranty funds arose from the insolvency of insurers that wrote primarily commercial lines business such as workers’ compensation, liability and commercial auto. An analysis of the data for this recent period provides a good opportunity to address some lingering questions concerning the property and casualty guaranty funds, and the extent of coverage they provide on these commercial lines claims.
This paper explores and explains some rather surprising conclusions suggested by a review of this data: first, the recent high level of claims activity further establishes that the guaranty funds, in fact, do provide extensive coverage on commercial lines claims, second, guaranty fund claims comprise the vast majority of policyholder class claims even in insolvencies involving commercial lines carriers, and finally the recent high payout indicates that a significant portion of related costs may be borne by personal lines insureds.
The latest batch of insolvencies caused the busiest period ever for the guaranty funds. This recent period was somewhat unique in that the vast majority of the payout was driven by a small number of large commercial insurers that for the most part wrote workers’ compensation insurance. Exhibit A lists the 10 largest 2000-05 insolvencies along with their respective payouts. (While only 10 insolvencies in total are listed here, a number of these insolvencies actually involved groups of affiliated insurers. The 10 items listed here actually involved the insolvencies of almost two dozen individual insurers.) Seven of these insolvencies wrote workers’ compensation as a major or exclusive line of business. Two wrote personal lines in Florida, and one wrote medical malpractice coverage.
Things got rolling with the insolvency of the Superior National companies in 2000. A total of five different workers’ compensation insurers were a part of this group, for which most of the responsibility came to rest with the California Insurance Guarantee Association. Reliance Insurance Company, the largest property and casualty insolvency to date, followed in 2001. The total payout to date through 2005 for these 10 insolvencies represents 84 percent of the total net payout that occurred during this period, and already comprises 35 percent of the total net payout on an inception-to-date basis. If payout for the personal lines insolvencies is excluded, the remaining eight commercial lines insurers still accounted for 79 percent of the total net payout for 2000-05. What is somewhat surprising is that these recent insolvencies already by themselves comprise a significant component of guaranty fund payout even though the data represents only the first few years of activity.
This recent period in which commercial lines claims dominated payout provides some interesting and rather surprising new information concerning the guaranty funds’ extent of coverage and level of protection provided to commercial insureds.
Guaranty Funds’ Coverage of Commercial Lines Claims
The guaranty funds published late last year the first-ever comprehensive review of guaranty fund expenses. The review, which compared guaranty fund and industry expenses, provides extensive information on guaranty fund and insurance industry claims activity by line of business, albeit for a smaller four year slice of the recent busy period – 2001-2004. The review nonetheless proved to be quite informative and relevant.
The data developed in connection with the review indicates heavy payout on commercial lines claims. The study reported that guaranty funds paid in total for 2001-04 claims of $6.1 billion and LAE of $1.1 billion, for a total of $7.2 billion. A total of $6.8 billion, or 94 percent of the total payout was on claims involving commercial lines. Two thirds of total payments related to workers’ compensation claims.
The latter is significant if for no other reason because it indicates a very significant flow of policy benefits to commercial insureds. This is true despite the fact that the guaranty fund laws of well over a majority of the states (in number) limit coverage of commercial lines claims through some combination of provisions that establish independent filing deadlines for claims (“bar dates”) or limitations based upon the net worth of the insured.
Admittedly, one challenge that almost always exists in analyzing insolvency data is that we only have part of the picture. We have data on the claims the guaranty funds actually cover, but we don’t really know much about claims they don’t cover. Not surprisingly, guaranty funds do not maintain data on claims they don’t pay. Most receivers, while responsible for evaluating all policyholder claims, don’t publish any such data. Many receivers would likely say that they don’t know the extent of non-covered claims because claims have not adequately developed. The obvious question is: how can we actually know how much guaranty funds actually cover if we don’t have any data on what they don’t cover? This practical difficulty has in the past usually frustrated any kind of meaningful analysis in this area.
hings may be changing. The Reliance liquidation, discussed below, may prove to be an important exception to the above rule.
Interestingly, the “line of business mix” of guaranty fund payments differs dramatically from the industry, as indicated by the expense review data, and tends to further establish that guaranty funds do in fact protect commercial insureds. For the insurance industry, according to the expense review data, commercial lines claims comprised only 52 percent of total payments (personal lines account for the remaining 48 percent), in contrast to the guaranty funds’ 94 percent. Again according to data from the expense review, workers’ compensation only represented 9 percent of total payout, in contrast to guaranty funds’ two thirds of total payout.
Does a 6 percent payout on personal lines mean something is wrong? Probably not. Statutory limitations that require all other applicable coverage by solvent insurers to first be exhausted likely significantly reduced guaranty fund payout on at least personal auto claims. Further, the nature of the business written by insolvent insurers themselves would tend to result in relatively low payout on personal lines claims.
There may be some good reasons for the significant differences in guaranty fund and industry claims profiles when viewed in the aggregate that would make it difficult to draw any conclusions from the above. Although Reliance, Aries and American Superior each presented personal lines exposure, these insolvencies together with the others probably don’t present a mix of business that is representative of the industry’s mix when taken as a whole, so overall comparisons may have limited value.
However, Reliance when viewed on its own does provide some interesting information concerning the guaranty funds’ coverage of commercial lines claims.
Reliance Data Provides Further Evidence of Guaranty Funds’ Extensive Coverage of Commercial Lines Claims
The liquidator of the Reliance estate has done a very commendable job of publishing financial data that in many respects is quite extensive. Quarterly financial reports are filed with the receivership court, and can be found at www.reliancedocuments.com. This, together with the availability of pre-liquidation loss reserves for Reliance, permits a new kind of analysis to be done with respect to the extent to which policyholder claims are covered by guaranty funds.
The last year in which Reliance filed annual statements was 1999. The annual statement data for that year indicated that on a consolidated basis, total loss reserves including IBNR on direct business gross of reinsurance and excluding surplus lines totaled $4.7 billion. This amount represents the closest proxy for overall guaranty fund exposure that can be found in an annual statement.
According to the Reliance liquidator’s most recent status report, the guaranty funds in total have paid out through June 30, 2007 a total of $2.4 billion in losses and LAE, with $1.8 billion in Loss/LAE reserves for total of $4.2 B in paid/incurred. The liquidator so far has allowed $391 million in other (non-covered) policyholder level claims. This means that in terms of pre-liquidation reserves, guaranty fund paid claims and reserves comprise 89 percent of the total. When guaranty fund paid/incurred is combined with non-covered claims so far allowed by the liquidator, the resulting total of $4.6 billion comes surprisingly close to total pre-liquidation reserves. This tends to indicate that guaranty funds have paid or will pay an amount equating to roughly 90 percent of the company’s pre-liquidation reserves for its entire book of direct, admitted business. This provides some support to indicate that guaranty funds are covering the vast majority of policyholder claims.
Granted, there are limitations in this comparison. Troubled companies are notoriously under-reserved, and Reliance was probably no exception. Further, the comparison does not consider that bar dates vary from jurisdiction to jurisdiction. Some guaranty associations are required to continue to honor certain new claims that may be reported. Therefore, guaranty fund incurred claims will continue to grow. However, and conveniently, each of these factors would tend to cancel the other out.
Also, the liquidator has only evaluated 36 percent of policyholder proof of claim filings. This would tend to drive up the non-covered portion. However, even if the non-covered portion were “grossed up” to estimate fully developed non-covered claims ($391 million divided by 36 percent), the resulting non-covered component would represent only 20 percent of total policyholder claims, meaning that guaranty funds would cover the remaining 80 percent.
While the above could not be considered a definitive analysis, it does shed some light on the extent of coverage actually provided by the guaranty funds for all admitted business of a commercial lines insurer. It would be interesting to expand the analysis to some of the other insolvencies, to the extent such data could be made available, to see if they provide the same result. Significantly, the above comparison uses a very simple, objective approach and hard data from at least the post-liquidation side.
It is important to note that the three largest states in terms of gross guaranty fund payout, California, New York and Florida, do not have one or both of a net worth or bar date provision. The three states together made 62 percent of the total 2000- 05 net guaranty fund payments nationwide. While it may be likely that this alone had a significant impact on the overall extent to which guaranty funds covered policyholder claims, it would not change the bottom-line result that significant coverage, in fact, existed.
Despite various statutory limitations on coverage, it appears that, based upon recent data, guaranty funds are providing quite extensive coverage on commercial lines claims. Yet the guaranty funds’ statutorily prescribed method of passing on costs for paying these claims places a heavy burden on personal lines insureds.
Over 50 percent of inception-to-date guaranty fund costs are recouped by means of the inclusion of a factor in premium rates. In most of these states for assessment and recoupment purposes, three accounts are used. The workers’ compensation line has its own separate account. Personal auto premiums are mixed with commercial auto premiums in the auto account, and homeowner premiums are mixed with non-auto/non-workers’ compensation commercial lines premiums in the “All Other” account. In a small number of these states, there are no separate accounts, meaning that all premiums are mixed together for assessment and recoupment purposes. The effect in either case is that non-workers’ compensation commercial lines claims costs from these recent insolvencies were passed on to both commercial lines insureds and personal lines insureds. Given that personal lines premiums would have represented over half of total non-workers’ compensation premiums written, and that $2.4 billion in non-workers’ compensation commercial lines claims costs were involved, the likely result is that a substantial portion of the cost associated with the significant non-workers’ compensation commercial lines claims payout was borne by personal lines insureds.
It may be worthwhile to consider a more in-depth study concerning the extent of the guaranty funds’ coverage of commercial claims. If receivers from some of the recent large insolvencies would be able to provide the same kind of data that the Reliance liquidator has seen fit to regularly make public, it would enable us to develop a broader-based analysis. If in fact guaranty funds are paying most commercial lines claims, as the above tends to suggest, this is a matter that should be communicated to policymakers and other interested parties.
By Barb Cox and Nick Crews
National Conference of Insurance Guaranty Funds
If the high insolvency activity of the early 2000s 1 confirmed anything, it showed a need for a prepared guaranty association system. For a state guaranty fund—just as it is for the local firehouse—future effectiveness exists in direct proportion to the degree of preparedness it maintains. Standing ready to deal with the next insolvency, or series of insolvencies, is basic to the property and casualty guaranty fund system’s continued ability to deliver on its statutory charge of paying the covered claims of policyholders and claimants quickly and efficiently, thereby preserving the sanctity of the insurance contract.
Preparing for future insolvencies: the guaranty association rapid response. After a company is declared insolvent, state guaranty funds step into the shoes of the failed insurer and immediately begin paying covered claims.
But the ability of the guaranty fund system to perform its statutory mandate to pay claims promptly requires that guaranty associations be prepared to respond quickly when new insolvencies – expected or not – occur. Moreover, the state guaranty fund system must work within the confines of the structure and business practices of the insolvent company to ensure a smooth transition to the state funds of their claims handling function.
The liquidation of the Reliance Insurance Company in October of 2001 illustrates just how suddenly insolvency can hit. It also provides a compelling “case study” of how preparation can ready guaranty associations to manage the challenges of a major insolvency.
Prior to the Reliance liquidation, the guaranty associations and the Pennsylvania regulator had worked together to closely monitor the situation and prepare for a possible liquidation. However, among the fallouts of September 11, 2001 was a disruption of ongoing reinsurance collections by Reliance that were critically important to its cash flow.2 The disruption was the death knell for the company; within weeks, the Pennsylvania Court ordered its liquidation. Fortunately for policyholders who awaited payment of outstanding claims against the company the property and casualty guaranty funds had invested both their professional talents, skills and coordinated efforts to prepare for this sudden and unpredictable event.
Groundwork performed by the guaranty fund system prior to the Reliance insolvency did much to help the system respond quickly in the weeks following the failure. Experienced professional guaranty association staffs provided a depth of institutional knowledge for the intense work of the insolvency. Also enabling the system to bear up under the taxing demands of Reliance was Uniform Data Standards (UDS), an electronic communication protocol with defined computer file formats allowing a fast and efficient reporting of policy and claim information. The standardized reporting that UDS provided was developed in 1995 and allowed the funds to “hit the ground running” in a period of unprecedented claims volume. In addition, state statutes had been updated in key areas – specifically regarding net worth and bar dates.
The demands of the Reliance insolvency were daunting: the liquidation required that more than 80,000 claim files be moved to the guaranty funds. The guaranty funds were ready, due in large part to pre-Reliance investment in facilities, information technology resources and its proactive efforts to develop and maintain core professional staffs of claims adjustors, coupled with uniform standards for communicating claim and policy information.
The scope and magnitude of the Reliance insolvency and its sudden liquidation is not typical. However, Reliance clearly showed that effective preparation for unknown “short-fused” insolvencies is essential. It also showed this level of preparedness is only possible when the guaranty fund system strategically works to maintain a state of readiness.
“Working to remain ready” with a core professional guaranty association staff. Guaranty fund staffing generally contracts and expands depending upon the number of claim files a particular fund has under review. However, even in times of relatively light insolvency activity, state funds must maintain core professional staffs; there is a certain staffing level under which it would be unwise to fall. By maintaining adequate staffing, funds ensure continuity of practice and institutional knowledge of systems, laws and policies and the ability to train newly hired staff when activity increases. Standing professional staffs serve as repositories of important guaranty fundrelated information, and encourage positive working relationships with receivers. It is the foundation on which the work of a state guaranty fund rests.
A standing, professional guaranty fund staff is also essential because often, the last few, usually older, claims are the most complex and offer the highest potential for litigation. In addition to supporting ongoing claim activity, staff must pursue and report subrogation recoveries, and prepare and file claims and other reports with the estate’s liquidator, necessary actions to marshal the reinsurance recoveries that reduce company assessments. These and other tasks exist over the life of an insolvency – a period that can extend 20 years or more.
Preparing for the next insolvency in the constantly evolving insurance environment. While the insurance industry is dynamic and ever-changing, the central charge of the guaranty fund system is not; covered claims must be paid efficiently notwithstanding insolvency’s challenges or complexities.
State guaranty associations were formed in the late 1960s around the principal that the insurance contract into which a consumer enters should be honored within defined limits as a matter of public policy. Relief was intended for insolvencies of companies that, at that time, wrote mostly personal line policies in single states. Insolvencies of these companies tended to be generally smaller and simpler, and were easier to administer. The most common claims were those related to substandard auto and house fires. 3 Much has evolved in the insurance marketplace and the realm of insurance insolvencies since the 1960s.
The 1980s witnessed a growing number of large insolvencies among insurers writing significant amounts of commercial insurance. Recent insolvencies occurring mostly in the early 2000s have involved complex commercial insurance products, such as large deductible policies and policyholders doing business (and consequently presenting claims with the funds) in several states. In addition, many of these insolvencies, such as Reliance, Fremont Indemnity Company and Legion Insurance Company, were larger than any the system had before absorbed.
The insolvency of a large commercial insurer then was viewed as almost impossible to occur. There was certainly no “track record” available at the time to inform the decision to extend coverage to the commercial market segment, with policyholders as varied as main street storefronts to Fortune 500 conglomerates. Additionally, subsequent developments in commercial lines products were difficult, if not impossible, to foresee at that time, and the state guaranty fund laws were never expected to cover such products. The report on the hearing of the U.S. Senate Subcommittee held on June 25, 1968 discussing the need for a safety net to cover insurer insolvencies suggests that such a safety net was intended to protect individual policyholders and claimants rather than large commercial insureds. For example, in that hearing, Senator Dodd advocated the need for the safety net by stating that individuals who are driven by the unstable market force to high risk insurers “must face the fact that their families can never be secure by their fireside knowing that the insurance company standing between any judgment and their home may become insolvent.” See Hearings on S. Res. 233, Part 13, Automobile Liability Insurance before the Subcommittee on Antitrust and Monopoly of the Committee on the Judiciary United States Senate, 90th Cong. (1968). These factors have significantly changed the landscape for guaranty funds, requiring that they adapt to this new world. Recently, the guaranty funds have been faced with:
- High volume of claims resulting from large, multi-state, multi-line insolvencies;
- Claims operations that have been delegated to various third party administrators;
- Paperless record-keeping by companies that become insolvent;
- Pockets of capacity strains that resulted from insolvencies of significant size – either as large, multi state companies or as companies with significant presence in discrete states.
These challenges have brought renewed focus on the need for policymakers to examine guaranty fund operational practices and statutes with an eye toward strengthening their protections for those whom they were originally intended – the average citizen and small business policyholders and claimants.
Guaranty funds continue to develop the electronic systems and legal and operational structures to enable them to deliver protections in a changing insurance world. Human and financial investment greatly enhances the ability of the guaranty fund system to address the changing industry.
Many recent enhancements to the functionality of the guaranty fund system and its statutory underpinnings have their origins in “lessons learned” from periods of heavy activity dealing with complex multi- line, multi-state insolvencies. Today, Reliance and other insolvencies are seen as the catalyst for many of the statutory and operational developments which are viewed as “cutting edge” in insolvency practice.
Currently, the funds are proposing solutions to such matters as privacy protection for claims data, and dealing with imaged files. At the end of the day. Common wisdom suggests that good preparation today ensures success tomorrow. The truth of this axiom is borne out by the statebased guaranty funds.
Like a local firehouse, the occupants of which stand ready to rush to the assistance of a property owner, the guaranty fund system is prepared to step into the shoes of an insolvent insurer and protect policyholders by paying outstanding covered claims, the role policymakers and industry envisioned for the system nearly 40 years ago.
The strength of the guaranty fund system – today and tomorrow – rests on preparedness. Because of the funding mechanism that shifts the costs of insurance insolvencies to policyholders, and in some states taxpayers, it is critical that the guaranty fund system works efficiently and cost-effectively.
With insolvency activity at a relatively low ebb, state guaranty funds are refining and streamlining their systems, adding tools and working to strengthen their readiness for tomorrow while protecting policyholders today. By doing so, the state property and casualty guaranty fund system is undertaking the important ongoing work necessary to meet its statutory duties to policyholders and claimants while ensuring that the sanctity of the insurance contract will be preserved.
1Between 1999 and 2005 the guaranty funds paid out about $10 billion as a result of such mega insolvencies as Reliance, Legion, PHICO and Fremont in the early 2000s – almost half of the $21 billion paid by the system since its inception in the late 1960s.
2In a press release dated October 3, 2001, then Commissioner Diane Koken states “[t]he ongoing shortfall of cash receipts — especially those of reinsurance — needed to pay policyholder claims and administrative expenses has been exacerbated significantly by the terrorist attack on the World Trade Center. Recent output from the financial model shows that Reliance will be unable to pay policyholder claims as early as the fourth quarter of 2001.”
The NCIGF is a nonprofit association incorporated in December 1989 and designed to provide national assistance and support to the property and casualty guaranty funds located in each of the fifty states, Puerto Rico and the District of Columbia.