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 insurer’s 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 insurer’s 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 (cont’d) 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 regulator’s petition, but very rarely do insurers oppose.

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

11. Rehabilitation (cont’d) 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 (cont’d) 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 insurer’s finances.

13. Rehabilitation (cont’d) 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 regulator’s plan.

14. Rehabilitation (cont’d) Unlike federal bankruptcy, no “cram down” procedure allowing creditors to control insurer’s 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 (cont’d) 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 state’s court for a liquidation order.

18. Liquidation (cont’d) 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 (cont’d) 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 (cont’d) All policyholders must be paid in full before any creditor gets anything.

21. Liquidation (cont’d) 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 (cont’d) 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 (cont’d) 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 York’s, 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 Act’s 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 (cont’d) The Model Act’s 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. § 17:30C:28 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 “[a]ny 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 receiver’s 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 “[i]n disregard of Frontier’s 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 (cont’d) 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 Commc’n, 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 York’s 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.