Laura S. Mcalister, the Inefficiencies of Exclusion: the Importance of Including Insurance Companies in the Bankruptcy Code

• Publication year: 2011

THE INEFFICIENCIES OF EXCLUSION: THE IMPORTANCE OF INCLUDING INSURANCE COMPANIES IN THE BANKRUPTCY CODE

INTRODUCTION

"I think that the most important systematic defect in the present United States bankruptcy system is that it excludes the insolvencies of insurance companies. . . ."¹These words, spoken by Judge Samuel Bufford, bankruptcy judge of the Central District of California, articulate the deficiencies in the state-by-state insolvency process for insurance companies.²Since 1898, domestic insurance companies have been excluded from federal bankruptcy law.³As a result, insurance company insolvencies take place in individual state courts under a patchwork of state laws.⁴In contrast to the state-based insurer insolvency process, insurance companies have evolved into national companies.⁵Additionally, while in the past small, regional insurance companies were at the greatest risk of insolvency, in the last two decades, insolvencies have plagued much larger companies.⁶For example, at the time of its failure in 1991, Mutual Benefit Life had policyholders in all fifty states⁷and $14 billion in assets.⁸Because insurers have become national companies with affiliates in multiple states and policyholders nationwide, the current state-by-state insolvency laws and piecemeal administration of the insolvencies have led to inefficient, duplicative proceedings that result in the inconsistent treatment of interested parties.⁹

This Comment will argue that because of the inefficiencies and inconsistencies of regulating insurance insolvencies under state law, insurance insolvencies should instead be administered by federal bankruptcy courts and according to the United States Bankruptcy Code ("Code"). Section I will describe the current state law insolvency process. Section II will examine the history of the exclusion of insurance companies from the Code and the lack of historical support for the exception. Section III will outline the problems that state-by-state insolvencies cause and how inclusion in the Code could remedy such defects. Finally, Section IV will discuss changes that should be made to the Code in order to accommodate the inclusion of insurance companies.

I. THE STATE INSOLVENCY PROCESS

In order to examine the benefits gained from regulating insurer insolvency under the Code and how to accomplish the incorporation into the Code, it is important to understand how state insurance laws currently operate.¹⁰All insurance companies are regulated under state law.¹¹Each state has its own insurance regulator¹²whose role is to monitor the life of an insurance company from beginning to end.¹³Regulators supervise the financial health of a company and require chief executive officers of insurance companies to "notify the state's insurance regulator if the insurer is 'impaired.'"¹⁴CEOs who do not alert their regulator of impairment face criminal charges.¹⁵

If a regulator finds that an insurance company is impaired, the regulator will petition the state court to place the company in receivership.¹⁶Only the insurance regulator in the state where the insurance company is domiciled can petition the court for receivership.¹⁷Thus, the regulator, not the company's management or its creditors, initiates receivership proceedings.¹⁸

Each state has its own insurer insolvency statutes that govern the insolvency proceedings for insurance companies.¹⁹Most state insolvency statutes are based upon two model acts: the Uniform Insurers Liquidation Act ("UILA"), created by the National Conference of Commissioners, or the

Rehabilitation and Liquidation Model Act ("Model Act"), created by the National Association of Insurance Commissioners.²⁰Although the goal of the model acts was to encourage uniformity among the states, the existence of two different acts has impeded this goal.²¹Furthermore, states modify the model acts before adopting them as state law.²²As a result, even if two states borrow

Insurance Regulation] (statement of Richard L. Fogel, Assistant Comptroller General, General Government from the same model act, their modifications of the act could result in two very different statutes.²³However, despite the differences between the various state insolvency statutes, the basic structure of the state insolvency process remains the same.²⁴

When a company is placed in receivership, the regulator must determine whether rehabilitation²⁵or liquidation is more appropriate and then petition the court accordingly.²⁶An insurance company does not need to be insolvent for it to be liquidated or rehabilitated.²⁷Most state statutes allow for many other justifications, ranging from evidence that the company "[h]as concealed or removed records or assets" to willful violation of the company's charter.²⁸As a result of such broad standards, regulators have great discretion on how to conduct insolvency proceedings.²⁹

If a state insurance regulator places a company in receivership, the presiding state court may issue injunctions to halt actions that thwart the regulator's efforts to rehabilitate or liquidate the company.³⁰However, such injunctions may prove ineffective if courts in other jurisdictions refuse to acknowledge the injunction.³¹

Once the court orders a company to be either liquidated or rehabilitated, the regulator takes title over the company's "property, contracts . . . rights of action and all . . . books and records."³²During the insolvency process, the regulator may take whatever steps deemed necessary to effectuate liquidation or rehabilitation.³³Although the regulator's actions are subject to court approval, the court "must affirm the actions of the [regulator] . . . unless they constitute an abuse of discretion," thereby giving the regulator wide discretion.³⁴Throughout the entire insolvency proceeding, the regulator's primary goal is to protect policyholders and maximize their distribution.³⁵

A. The Process of Rehabilitation

Upon an order of rehabilitation, the regulator "assumes all of the powers of the directors, officers, and managers of the insurer, whose authority is suspended."³⁶The regulator's discretion over the company's rehabilitation is subject only to the approval of the court.³⁷Within a year of the rehabilitation order, the rehabilitator must file an "equitable" plan, such that every claim receives treatment that is the same or better than it would receive in liquidation.³⁸Most rehabilitations ultimately lead to liquidations, and as a practical matter, "a regulator will [often] invoke rehabilitation in order to gain control of an insurer and prepare for the orderly transition to [liquidation]."³⁹

Thus, much like in federal bankruptcy, rehabilitation is often a stop on the way to liquidation.⁴⁰

B. The Process of Liquidation

If the regulator determines that rehabilitation will not be successful, the company will be liquidated.⁴¹Upon the date of the liquidation order, the rights and liabilities of the insurer, its creditors, and its policyholders become fixed, and all policies are terminated within thirty days.⁴²Once liquidation is ordered, a claimant has ninety days to file a claim.⁴³Because an insured may need more than ninety days to file a claim, policyholders can also file an omnibus claim that reserves the right to make a claim in the future.⁴⁴

Each state's guaranty fund plays an important role in the liquidation of an insurance company. Guaranty funds operate by paying the outstanding claims of an insolvent insurer's policyholders.⁴⁵Policyholders are then "deemed to have assigned [their] rights of recovery against the insolvent insurer's estate to the guaranty fund."⁴⁶As a result, guaranty funds are typically "the largest policyholder-level creditors of the insolvent insurer."⁴⁷Because guaranty funds limit the amount of a claim they will cover, any policyholder with a claim in excess of that amount becomes a general creditor of the insurance company's estate.⁴⁸All states have adopted some form of guaranty fund,⁴⁹and "[e]ach state's guaranty fund is responsible for the policyholders" in that state, regardless of the domicile of the policyholder's insurer.⁵⁰State guaranty funds are funded through contributions from solvent insurers licensed to do business in that state. In addition, they are not governed by state regulators⁵¹but are instead controlled by a board of directors comprised mostly of representatives from licensed insurance companies in that state.⁵²

Although each state has its own priority statutes, many of them follow a similar order.⁵³Most statutes give administrative claims top priority.⁵⁴Claims for wages and claims for taxes and debts due to the government receive second and third priority respectively.⁵⁵Fourth priority is usually assigned to policyholders' claims and guaranty associations' claims.⁵⁶All other claims fall under the fifth priority.⁵⁷The state priority statutes begin to diverge following the first five classes as they designate priorities for late filed claims, premium refunds, and shareholders.⁵⁸

II. THE LACK OF HISTORICAL SUPPORT FOR EXCLUDING INSURANCE

COMPANIES FROM THE CODE

Two statutes are responsible for the exclusion of insurance companies from the United States Bankruptcy Code: Sec. 109 of the Code⁵⁹and the McCarran- Ferguson Act.⁶⁰However, an examination of the history surrounding these statutes reveals very few practical or policy reasons for the exclusion.

Sections 109(b) and 109(d) of the Code currently exclude domestic insurance companies from qualifying as debtors under chapter 7 and chapter

11.⁶¹

However, insurance companies have not always been excluded from federal bankruptcy law. The Bankruptcy Act of 1867, which was "applicable to moneyed business and commercial corporations," was interpreted to apply to insurance companies.⁶²However, the inclusion of insurance companies changed in 1898 when the Bankruptcy Act limited the application of federal bankruptcy law to corporations "engaged principally in manufacturing, trading, printing, publishing, mining, or mercantile...