The treatment of derivatives, or “qualified financial contracts”, under state insurance insolvency laws has received increased attention since the financial crisis. Four states passed laws in 2010 that allow for the exercise of certain netting collateral and termination provisions in an insurance insolvency without regard to the automatic stay mechanism and similar laws are anticipated in other states in 2011. Federal laws provide a level of certainty with respect to the treatment of certain swap agreement provisions in a general corporate bankruptcy. The U.S. Bankruptcy Code provides an exception from the automatic stay mechanism for specific provisions of swap agreements. These provisions include netting provisions, certain collateral provisions and termination provisions. A counterparty to a swap agreement with the insolvent financial institution may exercise its rights under these provisions of the agreement, unaffected by the automatic stay. This allows parties to enter into derivatives contracts knowing their rights in the event of a bankruptcy proceeding with a degree of certainty. This certainty has generally not been available with respect to swap agreements to which an insurance company is a party. The U.S. Bankruptcy Code does not apply to insurance companies. The insolvency of insurance companies is governed under state laws. State laws do not generally provide the exception to the automatic stay mechanism with respect to swap agreements available under federal laws and, thus, do not provide the aforementioned level of certainty for counterparties to derivatives contracts with insurance companies. This lack of certainty has resulted in a degree of reluctance on the part of banks and other financial institutions to enter into swap agreements with insurance companies out of concern that they may be unable to exercise termination, netting and collateral realization rights under the agreements if the insurer becomes insolvent.
A number of states have addressed the concerns of potential swap counterparties to insurance companies by reconsidering state insurance insolvency laws with respect to “qualified financial contracts” and “netting agreements”. Numerous states have enacted specific laws that allow for the exercise of certain provisions of qualified financial contracts or netting agreements in an insurance insolvency without regard to the automatic stay mechanism. There appears to be growing momentum towards adopting laws with similar provisions in response to the recent financial crisis. Illinois, Massachusetts, Minnesota, and Missouri added this type of language in the last year, and New York had such a bill under consideration that is likely to be proposed again in 2011. The provisions of these agreements that are exempt from the automatic stay provisions of the state insurance insolvency laws are generally the same as those provisions that are excepted under the U.S, Bankruptcy Code: netting provisions, collateral realization provisions and termination provisions. Connecticut, Illinois, Iowa, Maryland, Massachusetts, Michigan, Minnesota, Missouri, Texas, and Utah are examples of states that have enacted laws with exceptions for qualified financial contracts or netting agreements from the automatic stay mechanism. These types of laws should provide banks and other financial institutions with more certainty with respect their rights when entering into swap agreements with insurers and could lead to an expansion of this market.