What Happens When Your Financial Guaranty Insurer Goes Bust?

1
What Happens When Your Financial Guaranty Insurer
Goes Bust?

• A Presentation on the Insurance Insolvency of a
  Financial Guaranty Insurer
• Richard G. Liskov Donald J. Mros

2
How Regulators Identify Troubled Insurers

• Regulators use a variety of tools to measure the
  solvency of insurers, not just outside ratings
• risk-based capital reports
• independent actuarial and accounting audits
• IRIS ratios
• the insurers own plan for improving its
  finances.

3
How Regulators Deal with Troubled Insurers

• Regulators have used a variety of methods to
  improve the situation informally
• encouraging the insurer to sell books of business
• urging sales of subsidiaries
• encouraging policy buy-outs
• doing reinsurance deals that increase surplus

4
The Three Types of Proceedings for Troubled
Insurers

• Supervision
• Rehabilitation (sometimes called Conservation)
• Liquidation

5
Supervision

• Supervision regulator in insurers state of
  domicile requires insurer to obtain numerous
  specific approvals to operate, but
• management remains in place
• no court proceeding initiated
• and supervision is confidential.

6
Supervision (contd)

• Typically, an insurer under supervision is placed
  into runoff with no new policies written.
• Insurer must obtain prior approval for
• all inter-company transactions
• all reinsurance transactions
• major investments
• levels of staffing and
• changes in commission scales.

7
Rehabilitation

• If supervision is not feasible or not effective,
  the regulator will consider the next step
• seeking a state court order placing insurer into
  rehabilitation or conservation.
• Insurer must have notice and opportunity to
  oppose the regulators petition, but very rarely
  do insurers oppose.

8
Rehabilitation (contd)

• Rehabilitation (sometimes called conservation)
• state court in the home state appoints regulator
  to manage insurer until the conditions causing
  the rehabilitation are eliminated.
• Insurers are not eligible to be debtors under
  federal bankruptcy law, so only state courts deal
  with insurer rehabilitations and liquidations.

9
Rehabilitation (contd)

• Completely open-ended proceeding no time limits
• No such thing as 60-day rehabilitation
• Insurer remains in existence but management
  ousted with occasional exceptions, and regulator,
  acting as rehabilitator, appoints managers
• Insurer almost always stops writing new
  business, but continues to pay claims,
  except much, much more slowly

10
Rehabilitation (contd)

• Similar to an automatic stay in bankruptcy, a
  rehabilitation order from state court will enjoin
  policyholders and creditors from suing the
  insurer or attaching insurers assets.
• Policyholders living in other states are required
  to file their claims with the Rehabilitator in
  the insurers home state.
• For most monolines that means New York.

11
Rehabilitation (contd)

• State insurance codes give broad powers for
  courts to order rehabilitation.
• Not necessary for regulator to prove that insurer
  is actually insolvent when applying for a
  rehabilitation order.

12
Rehabilitation (contd)

• It is sufficient in New York and other states
  for regulators to allege that insurer is in
• hazardous financial condition
• This is a very nebulous concept which does not
  require detailed showing of insurers finances.

13
Rehabilitation (contd)

• Like Chapter 11, with the objective of proposing
  and implementing a plan of rehabilitation so that
  insurer can operate normally again, but
• only regulator can initiate the proceeding
• only regulator can propose plan of
  rehabilitation
• policyholders and creditors can object to plan,
  but courts typically defer to regulators plan.

14
Rehabilitation (contd)

• Unlike federal bankruptcy, no cram down
  procedure allowing creditors to control
  insurers fate.
• Rehabilitator either proposes plan for
  rehabilitating the insurer, or regulator decides
  to seek liquidation order.
• State courts usually approve the plan, unless
  they find it egregiously unfair or plainly
  inconsistent with state insurance code.

15
Rehabilitation (contd)

• In the plan of rehabilitation Rehabilitator
  may propose
• having policies assumed by stronger insurer or
  
• modifying policy terms so that insurer pays less
  or
• so that insurer pays over much longer time or
• not paying reinsurers and general
  creditors anything.

16
The Basic Rule of Rehabilitations

• Policyholders and creditors cannot object to a
  rehabilitation plan that gives them much less
  than their policy or contract promised as long
  as
• the plan gives them at least what they would
  receive if the insurer were liquidated.
• Neblett v. Carpenter, 305 U. S. 297, 305 (1938)

17
Liquidation

• Liquidation occurs when a regulator determines
  there is no realistic possibility of
  rehabilitating an insurer.
• As with rehabilitations, the home state regulator
  petitions that states court for a liquidation
  order.

18
Liquidation (contd)

• Liquidation involves marshalling all of the
  assets of the insurer, mainly reinsurance
  recoveries, and distributing them according to
  priorities enacted in the state insurance code.
• In New York, the priorities for non-life
  insurers, including New York-based financial
  guaranty insurers, are set forth in section 7434
  of the Insurance Law.

19
Liquidation (contd)

• After administrative expenses (including lawyers)
  
• then, in order of priorities
• policyholders (but no interest for delayed
  payment with certain exceptions)
• ?
• government claims
• ?
• general creditors, including ceding insurers
  and reinsurers
• ?
• shareholders

20
Liquidation (contd)

• All policyholders
• must be paid in full
• before any creditor gets anything.

21
Liquidation (contd)

• Big unknown
• whether a credit default swap (CDS) that is
  not specifically in the form of a financial
  guaranty insurance policy will be treated as a
  policy for purposes of priority.
• New York Insurance Law appears to say a credit
  default swap is not a policy, but the New York
  Insurance Department has said some CDS are
  where CDS holder has an interest in the
  referenced obligation.

22
Insurance Company Receiverships Are Governed by
State Law

• Insurance company receiverships are conducted
  under the state law of the domicile of the
  insurance company.
• Most states have enacted either a version of
  the former NAIC Insurers Rehabilitation and
  Liquidation Model Act (Model Act) or the
  Uniform Insurers Liquidation Act (Uniform Act).
  

23
Insurance Company Receiverships (contd)

• In 2005, the NAIC revised its Model Act, which it
  adopted as the Insurer Receivership Model Act
  (Revised Model Act), but only Oklahoma, Texas
  and Utah have enacted all or part of the revision
  to date.
• New York has enacted a version of the Uniform Act
  (N.Y. Ins. Law 7401-36). The receivership of a
  New York domiciled financial guaranty insurer
  would be governed by these sections.

24
Map of Jurisdictions
Key Red - NAIC Model Act/similar law Blue -
Uniform Act/similar law White - NAIC Revised
Model Act (IRMA)
25
Monolines Originally Insured Low Risk Public
Finance Business

• Financial guaranty insurers originally provided
  coverage for public finance business. This
  involved providing coverage for defaults on bonds
  issued by governmental bodies, such as municipal
  bonds.
• This business historically did not pose a lot of
  risk. Recently, however, due to the budget crisis
  in California, monolines may be faced with larger
  than expected exposures on their public
  finance business.

26
The Economic Crisis Leads To Financial Stress For
The Monolines

• Starting in the late 1980s and early 1990s, the
  monolines expanded their business to cover
  various structured finance risks, including
  credit default swaps.
• With the economic crisis, the insurers faced
  large possible losses on these risks, leading to
  financial stress and ratings downgrades for the
  monolines.

27
To Date, Monolines Have Avoided Receivership

• The monolines have avoided receivership through
  restructurings or negotiated settlements
  with creditors.
• Recently, Syncora Guarantee reported a negative
  policyholder surplus of 3.8 billion and was
  ordered to stop paying claims by the NYID.
• It has entered into a restructuring agreement
  with credit default swap counterparties that is
  subject to certain closing conditions.

28
ACA Financial Guaranty Corporation and Kemper
Insurance Companies

• ACA Financial Guaranty was the first monoline to
  restructure. Counterparty creditors received cash
  payments on their claims and were issued
  surplus notes.
• The Kemper Insurance Companies have been
  operating under a voluntary run-off plan since
  2004 subject to the supervision of the Illinois
  Insurance Department under confidential plan.
• Key component reaching agreement with large
  commercial insureds for buy backs of their
  policies.

29
Avoid A State Insurance Company Receivership If
Possible

• Counterparties usually have an interest in
  avoiding a monoline receivership due to the costs
  and delays that such proceedings generally
  entail.
• In states where contingent claims are not
  allowed, there is likely to be considerable delay
  before distributions are made to creditors since
  the maturity on public finance obligations is
  often far in the future.
• Even where contingent claims are allowed, it is
  likely that there will be considerable delay as
  the receiver will need to marshal assets and
  determine claims before making distributions.

30
Bar Date

• The bar date is the date by which a claim has to
  be filed.
• In general, if a claim is not filed by that date
  then it is barred from receiving estate
  distributions or it is placed in the lowest
  priority.

31
Bar Date In New York

• In New York, creditors are to present their
  claims within four months of the receivership
  order or such longer period as allowed by the
  receivership court.
• N.Y. Ins. Law 7432(b)
• Proofs of claims may be filed after the bar date
  but they will not share in estate distributions
  unless all timely filed claims are paid in full
  with interest.
• N.Y. Ins. Law 7432(c)

32
Bar Date In New York (contd)

• In practice, the bar date in New York is not set
  within four months of the receivership order.
• American Fidelity Fire Insurance
  Company/American Insurance Company was ordered
  into liquidation on March 26, 1986 with a bar
  date of December 31, 2001 (more than 15 years
  later).
• Ideal Mutual was ordered into liquidation on
  February 7, 1985, with a bar date of December
  31, 2003 (more than 18 years later).

33
Many State Insurance Laws Do Not Allow For The
Payment Of Contingent Claims

• A contingent claim generally refers to a claim
  that
• is uncertain as to whether there ever will be a
  claim
• uncertain as to the value of the claim or
• it is uncertain when the claim will become
  payable.
• Many state insurance laws, including New
  Yorks, do not allow for the payment of
  contingent claims.

34
New York Law Does Not Allow For Payment Of
Contingent Claims

• Under New York law, a contingent claim shall not
  share in estate distribution unless
• it becomes absolute against the insurer on or
  before the last day fixed for filing of proofs of
  claim, or
• there is a surplus and the liquidation is
  thereafter conducted upon the basis that such
  insurer is solvent.
• N.Y. Ins. Law 7433(c)

35
Definition of Absolute

• A commercial general liability IBNR claim would
  not be absolute based on case law in New Jersey,
  which has the same contingent claim provision as
  New York.
• In re Liquidation of Integrity Ins. Co., 193 N.J.
  86, 935 A.2d 1184 (2007)
• The New Jersey Supreme Court interpreted
  absolute to be synonymous with unconditional,
  non-contingent, free from conditional
  limitation, free from doubt, and final and
  not liable to modification or termination. Under
  its interpretation, an actuarial estimate, even
  by generally accepted estimating techniques, is
  not absolute.

36
Financial Guaranty Contingent Claim

• There are no cases in New York on how the
  provision on contingent claims might apply to a
  claim on a financial guaranty policy for a credit
  default swap
• but
• if there is a loss that is certain as to
  liability and amount then it should not be
  considered a contingent claim.

37
The NAIC Model Act Provision On Contingent Claims

• The 1977 Model Act provides that
• A contingent claim may receive estate
  distributions if it is filed in accordance with
  Acts claim filing requirements and does not
  prejudice the orderly administration of the
  liquidation.
• Claims that are due except for the passage of
  time shall be treated as absolute claims are
  treated, except that such claims may be
  discounted at the legal rate of interest.
• NAIC Insurers Rehabilitation and Liquidation
  Model Act 37(B),(C) (1977)

38
Model Act (contd)

• The Model Acts contingent claim provision has
  not been universally adopted in the Model Act
  states. Several states have adopted a more
  restrictive contingent claim provision, and do
  not permit contingent claims.
• Me. Rev. Stan. Ann. tit. 24 4378 Nev. Rev.
  Stat. Ann. 696B.450
• N.J. Stat. Ann. 1730C28 N.C. Gen Stat. Ann.
  58-30-195
• Alaska Stat. 21.78.280
• Many of Uniform Act states also do not allow
  contingent claims.
• Ala. Code 27-32-30 Ariz. Rev. Stat. Ann.
  20-63
• Ark. Code. Ann. 23-68-128 Del. Code. Ann.
  tit. 18 5928
• N.Y Ins. Law 7433 Wyo. Stat. Ann. 26-28-127

39
NAIC Insurers Model Receivership Act Provision

• The 2005 Revised Model Act provides that
• An unliquidated contingent claim may be allowed
  if the contingency is removed by the bar date.
• A claim that is unliquidated by the bar date can
  be valued using an accepted method of valuation
  and allowed if it will not delay administration
  or the cost of valuing the claim is not excessive
  relative to the amount available for distribution
  for the claim.
• NAIC Insurer Receivership Model Act, Art. VII,
  705(c)(2) (2005)

40
Illinois Allows Contingent Claims

• In Illinois, contingent or unliquidated claims
  that have not been made absolute and liquidated
  by the bar date may be determined and allowed by
  estimation.
• Ill. Comp. Stat. 5/209(7)
• Utah, Missouri and Connecticut also allow
  contingent claims that can be valued with
  reasonable actuarial certainty or another method
  of valuing claims with reasonable certainty.
• Utah Code Ann. 31A-27a-605(2) Mo. Rev. Stat.
  375.1220(2) Conn. Gen. Stat. 38a-945

41
Transfers Within 12 Months May Be Avoided As A
Preference In New York

• Whenever a creditor receives a payment from a
  troubled insurer, the creditor has to be
  concerned with a voidable preference claim.
  Preferences are where a creditor receives better
  treatment than similarly situated creditors.
• Voidable preferences may be recovered by the
  receiver of an insurance company, whether
  the company is in a rehabilitation or
  liquidation proceeding.

42
New York Preference Provision

• A receiver may avoid any transfer of, or lien
  created upon, the property of an insurer within
  twelve months prior to the granting of an order
  to show cause under this article with the intent
  of giving to any creditor or enabling it to
  obtain a greater percentage of its debt than
  any other creditor of the same class and which is
  accepted by such creditor having reasonable
  cause to believe that such a preference will
  occur, shall be voidable.
• N.Y. Ins. Law 7425(a)

43
Preference In New York

• It is within a New York receivers discretion to
  decide whether to seek to recover a payment on
  grounds of voidable preference.
• A payment in the preference period that is
  explicitly approved in advance by regulators is
  not an absolute defense, but reduces the risk
  that the receiver would consider it a preference.

44
The New York Case Law

• The little case law we found in New York focused
  on the intent element. In Serio v. Rhulen, 806
  N.Y.S.2d 283, 285 (N.Y. App. Div. 3d Dept. 2005)
  the court found that the defendant insiders in
  disregard of Frontiers deteriorated financial
  condition, with knowledge and intent . . . caused
  preferential payments to be made by Frontier to
  Frontier Group and other Group-controlled
  entities during the twelve-month period preceding
  the entry of the Order of Rehabilitation for
  Frontier and a finding of insolvency.

45
Preference Under the Model Acts

• Under the Model Act, a preference is any transfer
  (i) within one year before a successful
  delinquency filing (ii) that enables the creditor
  to obtain a greater percentage of its debt than
  another creditor in the same class would receive.
  NAIC Model Act 28
• Under the Revised Model Act, a preference is as
  any transfer (i) within two (2) years before a
  successful delinquency filing (ii) that enables
  the creditor to receive more than the creditor
  would have received in a liquidation of the
  insurer. NAIC Revised Model Act Art. VI 604

46
Ordinary Course Of Business Defense

• In a recent case involving Reliance Insurance
  Company (in Liquidation), the Pennsylvania
  Supreme Court ruled that an ordinary course of
  business defense protected a payment on an
  insurance policy from a preference claim,
  although there was no specific language in the
  Pennsylvania statute. Ario v. Ingram Micro, 965
  A.2d 1194 (Pa. 2009)
• The Pennsylvania court ruled that a payment on a
  policy was not on account of an antecedent debt
  based on (i) public policy grounds, (ii)
  legislative intent and (iii) on the bankruptcy
  code where payments in the ordinary course of
  business are not considered preferential. Id.
• There is no such case law in New York, and the
  Ario decision may not have great persuasive
  value in New York since the New York voidable
  transfer statute does not have an antecedent
  debt requirement, although the public policy
  arguments may be persuasive to a New York court.

47
Ordinary Course Of Business (contd)

• The purpose of the ordinary course of business
  defense is to leave undisturbed normal financing
  relations. Generally, to prove a transfer is
  non-preferential under the ordinary course of
  business defense, the creditor must prove
• (1) that the transfer was in payment of a debt
  incurred by the debtor in the ordinary course of
  business or financial affairs of the debtor and
  the transferee, (2) that the transfer was made in
  the ordinary course of business or financial
  affairs of the debtor and the transferee, and (3)
  that the transfer was made according to ordinary
  business terms.
• Ohio Rev. Code 3903.28 Covington v. HKM Direct
  Market Commcn, Inc., 03AP-52, 2003 WL 22784378
  (Ohio Ct. App. Nov. 25, 2003)

48
Protection In Illinois

• In Illinois, where the Director of the Illinois
  Insurance Department approves a pre-receivership
  transfer in writing it cannot be later set aside
  as a preference.
• 215 Ill. Comp. Stat. 5/204(m)(C)
• This does not protect against a fraudulent
  transfer.

49
Fraudulent Conveyance

• A fraudulent conveyance may also be avoided by a
  receiver under New Yorks debtor creditor law but
  this is more difficult to establish than a
  voidable preference under New York Insurance Law.

50
Are There Any Safe Harbors For Swap Claims?

• The short answer in New York is no. Other states,
  such as Maryland, have a provision protecting
  against a payment on a swap being a
  voidable preference.

51
Maryland Provision

• Section 229.1(f) of the Maryland Insurance Code
  provides that
• Notwithstanding any provision of this subtitle
  a receiver may not avoid a transfer of money or
  other property arising under or in connection
  with a netting agreement or qualified financial
  contract, or any pledge, security, collateral, or
  guarantee agreement or any other similar security
  arrangement or credit support document relating
  to a netting agreement or qualified financial
  contract, that is made before the commencement of
  a delinquency proceeding under this title.
• Md. Code Ann., Ins. 9-229.1(f)
• This protection does not apply to a transfer
  made with the actual intent to hinder, delay or
  defraud a receiver or other creditors.
• Md. Code Ann., Ins. 9-229.1(f)(2)

52
Arguably A Safe Harbor For Swap Claims

• This provision is arguably a safe harbor against
  a voidable preference claim for a payment on a
  financial guaranty policy covering a swap claim
  if the policy relates to a qualified financial
  contract. A qualified financial contract in
  Maryland is defined to include a swap agreement.

53
Definition of A Swap Agreement

• Swap agreement is defined as
• an agreement, including the terms and conditions
  incorporated by reference in the agreement, that
  is a rate swap agreement, basis swap, commodity
  swap, forward rate agreement, interest rate
  future, interest rate option, forward foreign
  exchange agreement, spot foreign exchange
  agreement, rate cap agreement, rate floor
  agreement, rate collar agreement, currency swap
  agreement, cross-currency rate swap agreement,
  currency future, currency option, or any other
  similar agreement, and includes any combination
  of agreements and an option to enter into an
  agreement.
• Md. Code Ann., Ins. 9-229.1(a)(9).

54
The Definition of Swap Agreement (contd)

• The definition of swap agreement does not
  specifically include credit default swaps. Credit
  default swaps should be considered a similar
  agreement, but we found no case law on point.

55
Further Possible Statutory Protection Under
Maryland Law

• Section 229.1(b)(2) of Maryland Insurance Code
  provides that a person may not be stayed or
  otherwise prohibited from exercising any right
  under a pledge, security, collateral, or
  guarantee agreement, or any other similar
  security arrangement or credit support document
  relating to a netting agreement or qualified
  financial contract.
• Md. Code Ann., Ins. 9-229.1(b)(2).
• Again, the definition of qualified financial
  contract is key since the protection is afforded
  if the guarantee agreement is related to a
  qualified financial contract.

56
Protection Against The Stay

• This provision should protect a counterparty from
  a claim that it violated a stay by exercising its
  CDS rights. This provision, though, is not
  included in the New York insurance laws.

57
Other States With Similar Provisions

• Several other states, including Iowa, Michigan,
  Texas, and Utah have similar provisions
  permitting the exercise of rights under a
  qualified financial contract.
• Iowa Code Ann. 507C.28A
• Mich. Comp. Laws Ann. 500.8115a
• Tex. Ins. Code Ann. 443.261
• Utah Code Ann. 31A-27a-611

58
Concluding Remarks

• In a receivership of a financial guaranty insurer
  in New York, counterparty creditors should
  anticipate
• long delays before any distributions
• possible advantages in a plan of rehabilitation
  to public finance policyholders issue sure to
  be litigated
• potential preference challenges to any payments
  made within the 12 month look back period, (but
  payments made with explicit prior regulatory
  approval may be OK) and
• potential litigation over whether a stay would
  apply to CDS remedies.

59
Conclusion

• Thanks for attending what we hope was a
  useful and informative program.
• The views we expressed are ours but not
  necessarily those of Chadbourne clients.
• Wed be pleased to assist you on particular
  issues involving your company.