When insurers go belly up: implications for insurers, policyholders and guaranty funds: it's not only the insured who suffers when there is an insurer insolvency; the ripples may cause damage to several other parties as well.

• Author: Aylward, Michael F.

RELIANCE, Frontier, Legion, Phico and now Home.

Not since the late 1980s has the insurance industry seen such a dramatic series of financial calamities.

The recent insolvencies of major commercial insurance companies such as Home and Reliance have created a significant problem for other liability insurers, as both were significant players in many mass tort and environmental liability claims. State guaranty funds also are increasingly seeking to shift their obligations to other parties. Indeed, the collapse of these insurers has created a hole that no one seems anxious to fill. One or more of the following four candidates ultimately will be forced to bear responsibility:

* Excess Carriers. In the absence of available underlying insurance, will the umbrella or excess coverage in that year "drop down"?

* Other Primary Insurance. To the extent that primary insurers are deemed to have joint and several obligations for a shared loss, will the orphan shares be absorbed by the remaining solvent insurers?

* State Guaranty Funds. State insurance insolvency funds were established more than 20 years ago to take responsibility for losses that would otherwise have been covered by insolvent insurers. Are there circumstances in which they can avoid that responsibility and shift the burden to other parties?

* Policyholders. Insofar as the insolvency of a primary insurer results in a loss for which coverage is otherwise unavailable, will responsibility default to the policyholder?

There are no clear answers to this conundrum. The resolution of the issue depends on state law, the wording of state insolvency statutes and, most importantly, the wordings of the insurance policies at issue. Nevertheless, it is possible to illustrate the likely outcome of these disputes depending on the particular configurations of wordings, statutes and case law.

REGULATORY FRAMEWORK

1. Why Do Insurers Fail?

   Insurers become insolvent for many reasons. An April 1989 analysis by the U.S. General Accounting Office concluded that Midland and Transit had failed because of a combination of over-aggressive growth strategies, particularly the use of managing general agents who aggressively promoted business in areas outside the insurer's traditional areas of expertise; unsecure reinsurance; inadequate state oversight and inconsistent auditing practices.

   An investigation by the U.S. House of Representatives Commerce Committee in 1990 also found disturbing parallels between recent insurer insolvencies and the collapse of many savings and loans companies. The Dingell Committee's report, Failed Promises: Insurance Company Insolvencies, concluded that insurers such as Anglo-American, Integrity, Mission and Transit had failed owing to a combination of rapid expansion; unsupervised delegation of authority; extensive and complex reinsurance arrangements; underpricing, reserve problems; false reports; reckles management; incompetence; fraud, greed and self-dealing.

   In June 1991, the A.M. Best Co. released a special report analyzing property and casualty insolvencies from 1969 through 1990. The Best report observed that of 3,200 property and casualty carriers in the United States, 372 were declared insolvent during this period. The failure rate was highest in California and Illinois. The report concluded that insolvencies were most likely to occur in companies that had deficient loss reserves and rapid growth, although internal fraud, changes in business models, and reinsurance failures also might contribute to insurer failures.

   Whatever their causes, insurer insolvencies are expensive and getting more so year by year. Data released by the National Conference of Insurance Guaranty Funds stated that in 1998, state guaranty funds assessed insurers $264 million to pay for insolvencies, an increase of 13.9 percent over 1997 and more than double the $95 million assessed in 1996.

2. State Regulation

   Proceedings involving insolvent or financially troubled insurers in the United States are governed by state law, generally the law of the state where the insurer is domiciled. While each state's laws are somewhat different, most follow a common model. Because insurers are specifically exempted from the federal Bankruptcy Code, the liquidation of an insolvent insurance company, like most other issues involving insurance regulation, is subject to state law and varies somewhat from state to state.

   Most states, as well as the National Association of Insurance Commissioners (NAIC) Model Act, distinguish between rehabilitation, from which an insurer may emerge after successfully reorganizing its t affairs, and liquidation, in which the insurer is liquidated, on the completion of which the insurer ceases to exist. (1)

   Liquidation is a last step that state regulators employ after initial efforts to correct financial problems at an insurer have failed. State insurance regulators monitor the financial condition of all insurance companies. If a company appears to be in r poor financial health, regulators are empowered to take certain steps to strengthen the insurer's position and, if all else fails, to liquidate it.

   The first indication of trouble for an insurer is often its failure to pass four or more of the 11 financial tests that regulators administer as part of the normal monitoring process. Failure may trigger special audits or a requirement that the company begin to report its financial data on a quarterly basis instead of annually. These initial steps are precautionary in nature and serve as a warning to the company to put its financial affairs in order.

   If there is no improvement, the state insurance department may place an insurer under supervision and take a more hands-on role in the day-to-day operations of the r troubled company. During supervision, the insurer may be ordered to increase premiums, restructure its investment portfolio and debts, or take other measures to improve its prospects.

   If the deterioration continues, the state insurance commissioner in the insurer's t home state may apply for a court order to place the insurer in rehabilitation, an intermediate phase in which the state insurance department essentially takes over the operation of the insurer. Rehabilitation of a domestic insurer involves taking possession of the insurer's property, conducting t its business and taking steps to remedy the insurer's financial problems. If the rehabilitation is successful, state regulators will withdraw, allowing the insurer to resume doing business under its own management. If the rehabilitation efforts prove futile, the state regulators may apply for a court order of liquidation, to wind up the insolvent insurer's affairs by selling its assets and settling claims on those assets.

   The process for placing a company into rehabilitation or liquidation is similar in most states. Generally, once the state insurance department in the relevant state (usually the state of domicile) concludes that an insurer or reinsurer is so financially weak that action is required for the protection of policyholders, the state insurance commissioner will petition for a court order of liquidation or rehabilitation. Although these orders are often consensual, a company or its shareholders may contest them if they believe the commissioner's actions are not warranted.

   Liquidation of a domestic insurer involves taking possession of the property of an insurer, being vested by operation of law with title to all property, contracts and rights of action of the insurer, and giving notice to all creditors to present their claims. All of the insurer's policies and insuring obligations are cancelled, and insurance premiums are returned to the former insureds. The insurer's assets are marshaled, claims against the insurer are identified and quantified, and an equitable distribution of the insurer's assets is made to its creditors.

   Liquidation proceedings are conducted under court supervision. They typically take many years and usually will result in only partial payment to claimants. On entry of an order of rehabilitation or liquidation, the insurance department's authority generally is to:

   * Hire and fire employees, counsel and agents, and fix their compensation;

   * Collect all debts and money due;

   * Manage, deposit and invest assets;

   * Sell, transfer or otherwise encumber corporate assets;

   * Contract and either affirm or disavow existing contracts; and

   * Pursue and defend against claims or suits--standing in the shoes of the company

   State insolvency statutes generally establish priorities for recoveries from the assets of insolvent insurers. Claims under policies issued by the insolvent insurer have the highest priority after administrative expense claims. Section 46 of the NAIC Model Act excludes from this category "obligations of the insolvent insurer arising out of reinsurance contracts." All claims within a class are paid in full before payment is made to the next lower class. Within a class, all claims are paid pro rata if there are insufficient funds to pay the class in full.

   In the event of liquidation, policyholders of an insolvent insurance company may present certain claims to the guaranty funds of the states in which they reside. Typically, these funds, which are financed by surcharges on all solvent insurers doing business in the state, will pay claims up to their statutory limit of liability, which often is $300. Policyholders with claims in excess of the statutory limit of liability will receive payment from the guaranty fund up to the limit of liability and then will have a claim in the liquidation for any excess amount over the guaranty fund limit. Policyholders whose claims are either not covered by the guaranty fund or whose claims exceed the limits of the guaranty fund may submit a claim in the liquidation but will be paid only on approval of a final plan of liquidation.

   REINSURANCE IMPLICATIONS

1. Direct Liability to Policyholders?

   Because of the substantial delay in the...