Financially Distressed Companies and Regulatory Options

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Financially Distressed Companies and Regulatory
Options
Midwestern Actuarial Forum Frederick O.
Kist March 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

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 estates 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 companys 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
  estates assets
• Final distributions from the estate will take
  many years
• Distribution of assets based on liquidation
  priorities

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Liquidation Priorities

• Receiver and guaranty fund administrative
  expenses
• Includes ULAE and ALAE claims expenses
• Perfected secured claims
• Collateralized claims
• Pre-filing employee obligations (capped)
• Known claims
• IBNR (estimated claims)
• All claims owed to the U.S.
• General creditors (assumed reinsurance)
• Surplus notes holders
• 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

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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 EO carriers dont
• 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