*As seen on Bankruptcy Law360.
The financial news coming out of the insurance industry lately has been anything but good. American International Group (AIG), the nation's largest insurer, teetered on the verge of collapse until the federal government rushed in with an $85 billion bailout package. That initial package, however, has proved insufficient to stabilize AIG, so the government has responded with a new $150 billion financial rescue package for the faltering company. Although not as dramatic as the turmoil facing AIG, other major insurers have begun reporting significant losses, in part attributable to losses in their investments as a result of the current financial crisis that has seized Wall Street. All of this dour financial news emanating from the insurance industry raises the question of what happens when an insurance company goes bust. The answer to that question lies in insurance company regulation.
Insurance companies in the United States are regulated by the states, rather than the federal government, with each state having its own insurance statutes, regulations, and rules. Although the insurance regulatory requirements of the states vary, they are more alike than they are different, particularly when it comes to insurance company insolvency. When an insurance regulator determines that an insurance company based in the state is insolvent, the state's insurance commissioner petitions the court for an order placing the company into liquidation. There are various standards for determining whether an insurance company is insolvent, but generally an insurer is considered insolvent if its liabilities exceed its assets plus capital and surplus or if it is unable to pay its debts when due. If the state court agrees with the commissioner's petition or if the board of directors of the insurer join in the petition, a liquidation order is issued appointing the insurance commissioner liquidator of the company. The liquidation proceeding then takes place, governed by the state's liquidation statute.
Most state's liquidation statutes are based on the Insurers Supervision, Rehabilitation and Liquidation Act (NAIC Model Act) promulgated by the National Association of Insurance Commissioners. Although a state proceeding, an insurance company liquidation generally is similar to a chapter 7 proceeding under the Bankruptcy Code. Insurance companies may be part of a holding company system in which the parent company and other affiliated companies are not insurance companies. Any insolvencies of the non-insurance companies would be handled in federal bankruptcy courts, while the insolvency of an insurance company in the system would be handled in a state liquidation proceeding. The federal bankruptcy of parent company would not result in the liquidation of an insurance company subsidiary unless the subsidiary itself is determined to be insolvent by the appropriate state court.
The various state liquidation statutes generally provide that all property and casualty insurance policies are cancelled thirty days from the date of issuance of the liquidation order. If the policies' normal expiration date or the date the business is transferred to a different insurance company is less than thirty days from the date of issuance of the liquidation order, the policies will end as of that lesser date. Life and health insurance policies or annuities, on the other hand, continue in force for such period and under such terms as provided for by any applicable guaranty association statute, which could be the policies' or annuities' original termination date many years after the date of the liquidation order. If policies or annuities are not covered by a guaranty association, they will terminate on the same thirty days or less time frame as property and casualty insurance policies.
Upon issuance of the liquidation order, the liquidator is vested by operation of law with the title to all the property, contracts and rights of action of the failed insurance company. The liquidator then takes possession of the company's offices, equipment, records and assets. Under the court's supervision the liquidator is charged with gathering the insurance company's assets, converting them into cash and distributing the cash to claimants of the company. The liquidation order also enjoins all persons from instituting or continuing to prosecute any civil action or claim against the insurer or the liquidator or from otherwise interfering with the liquidator's possession or control of the assets of the insurer.
Shortly after the liquidation order is issued, notice is sent to all potential claimants advising them of the liquidation and telling them the process they must follow to perfect their claim against the estate of the failed insurer. A time period is set within which claims must be filed with the liquidator together with proper proof. Any persons filing claims with the liquidator after such date may receive no distribution or a distribution less than they would have otherwise received. To be eligible to receive a disbursement from the failed insurance company's liquidation estate, a claimant must submit to the liquidator on proof of claim forms approved and provided by the liquidator all outstanding claims, including even ones presented to the insurer prior to its having been placed in liquidation.
Timely filed proofs of claim will be evaluated by the liquidator in the normal course of the liquidation proceeding and determined in accordance with the priority of claim classes established by the liquidation statute. After all claims have been evaluated and determined as to class and amount, the liquidator will seek approval from the liquidation court to make a disbursement of assets based upon the priority of claim classes. There typically are around nine classes of claims under a liquidation statute. The first class is payment of the administrative expenses of the estate, followed by payment of claims for benefits under the policies or contracts of insurance written by the insurance company. The last class is payment to the owners of the insurance company.
The amount to be paid on a claim will depend on the amount of assets collected by the liquidator and the amount of claims in each priority class. As claims are paid, the highest priority class of claims is paid first and every claim in each successive class must be paid in full before members of the next lower priority class receive any payment. If there are not sufficient assets to pay a particular class in full, the creditors of that class will share in any distribution on a pro rata basis based upon the assets available and the total amount of claims in that class. The liquidator will not know the distribution percentage that can be paid on any individual claim until all claims are evaluated and all assets are converted to cash. This process may take a number of years. Rarely do unsecured general creditors of a failed insurance company receive any payment on their claims. Most of the distributions from an insurer's liquidation estate go to pay administration costs of the liquidation and claims for policy benefits, which include claims of guaranty associations.
To provide a safety net for policyholders from the uncertainty of whether and when their claims might be paid, the states have established guaranty associations. Guaranty associations, also known as guaranty funds, are non-profit, state based entities created by individual state statute for the purpose of protecting policyholders and claimants residing in the state from financial loss and delays in payment of claims as a result of the insolvency of an insurance company. States typically have at least two guaranty associations: one for life and health insurance and one for property and casualty insurance (homeowners, automobile, commercial liability, worker's compensation, professional liability, etc.)
All insurance companies licensed by the state to sell lines of insurance covered by an association automatically are members of the association. Unlicensed insurers, such as surplus and excess lines insurers, are not covered by guaranty associations. Property and casualty guaranty associations usually exclude title, credit, mortgage, and ocean marine insurance. Life and health guaranty associations normally do not cover members of managed care plans, such as health maintenance organizations (HMOs) and preferred provider organizations (PPOs). When a guaranty association denies coverage due to its statutory provisions, the policyholder must provide their own defense and pay any losses. All such expenditures that would have been covered by the failed insurer become class two (benefits under policy) claims for the policyholder against the insurance company's estate.
Guaranty associations protect policyholders and third-party claimants from insurance company insolvency by stepping into the place of the defunct insurer and paying most claims that would have been covered under the terms of the policies written by the insurer. In the case of liability policies, the guaranty association also assumes the defense of claims against the policyholder if a duty to defend exists in the policy. Life insurance guaranty associations often fulfill their responsibilities by transferring the policy obligations to a financially stable insurer. In most states, guaranty association coverage is triggered by a court finding an insurer insolvent and placing the insurer into liquidation. Generally, guaranty associations begin paying claims within ninety days of the date a liquidation order is issued. Guaranty associations secure the monies they need to pay claims by assessing member companies.
Although most covered claims are paid in full, there are statutory limits on guaranty association payments that can vary from state to state. Most life and health guaranty associations, for instance, provide at least $300,000 in life insurance death benefits and $100,000 in health insurance benefits, although some states have maximums that are much higher. Property and casualty guaranty associations also have $100,000 to $300,000 maximum covered claims caps, except for workers' compensation, which is accorded unlimited statutory benefits. In addition, most property and casualty guaranty associations impose a $100 deductible per claim. This deductible is in addition to any deductibles in the policy. Many property and casualty guaranty associations also have special deductibles or exclusions for policyholders with a large net worth (e.g., $25 million or $50 million).
Upon payment of a claim, the guaranty association obtains a class two (benefits under policy) claim against the estate of the insolvent insurance company. The costs incurred by a guaranty association in handling policyholder claims and claims against policyholders constitute class one (administrative) claims against the insurer's liquidation estate. To the extent that deductibles, claim caps, etc. apply to a claim, the amounts that are not paid by the guaranty association but are borne by the policyholder become class two (benefits under policy) claims for the policyholder against the insolvent insurance company.
At this point, it is anyone's guess as to whether the current economic crisis will cause any insurance companies to fail. If it does, there are established state-based regulatory schemes for handling the liquidation of the insolvent insurers. These schemes, which vary somewhat from state to state, are intended to reduce financial loss to policyholders and third-party claimants. They do not, however, provide full protection to all policyholders and claimants. Some claims against a failed insurance company will likely not be covered in full because they are subject to guaranty association limits or other statutory provisions. Should the worst happen and an insurance company is placed into liquidation, it is very important for policyholders and claimants to carefully read all notices and information received from the liquidator and/or guaranty association and to follow the instructions provided so as to ensure that their claims are properly addressed. If their claims are significantly large, it probably is in the best interests of policyholders and claimants to seek advice of experienced counsel in presenting the claims.