Financially Distressed Companies and Regulatory Options

Midwestern Actuarial Forum

Frederick O. KistMarch 22, 2005

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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– Entering mandatory control level the company will still have significant assets and positive surplus

• Using risk-based tools, rating agencies are less reluctant to downgrade companies to commercially unacceptable levels - sealing the fate of a commercial lines carrier

– 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– Companies with significant assets, but insufficient surplus to assure full payment of claims

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Insolvencies Trending Upward • Contributing Factors

– 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– $5.9 billion - assets– $8.7 billion – liabilities– 144,000 claims

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 10

* Includes 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

• 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

• Regulator has concluded that grounds requiring rehabilitation exist and seeks a court order

– Illinois code describes fifteen triggers• 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

• Regulator has concluded that grounds requiring liquidation exist and seeks a court order

– 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

– Distribution of assets based on liquidation priorities

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Liquidation Priorities

1. Receiver and guaranty fund administrative expenses Includes ULAE and ALAE claims expenses

2. 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

• Current assessment capacity of funds is

estimated at $4 billion, but may be

limited by caps

• In some cases funds have sought

acceleration of alternative funding

methods

– CA WC Fund was authorized to issue bonds

to cover $750 million shortfall

• Funds have proposed increasing the

assessments or expansion of the base

for assessment

• Alternatively, funds could restrict

coverage to fewer policyholders

Guaranty Fund Assessments

1995 – 2002

(in millions)

1995 94.8

1996 124.2

1997 263.7

1998 263.7

1999 201.3

2000 328.6

2001 734.7

2002 1,209.0

2003 901.6

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Insolvency Cost - Policyholder• Policyholders must meet net worth test for guaranty fund to accept claim

– Varies by state ($10 – $50 million) – Policyholder with net worth in excess are not covered by guaranty funds

• If eligible, guaranty fund will cover claim subject to fund limit– 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

– 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– 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

• 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

• 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• Difficult to out-run a B+ downgrade

– Agents may love you – their E&O carriers don’t• Cash is king

– Surplus is less meaningful• Encumbrances can threaten a successful runoff

– Collateral triggers need to be identified before event• 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 • 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.

• To run a company a CEO should have gone through a run-off experience