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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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.

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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

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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.

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Key

Red - NAIC Model Act/similar law

Blue - Uniform Act/similar law

White - NAIC Revised Model Act (IRMA)

Map of Jurisdictions

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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.

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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)

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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).

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

A contingent claim generally refers to a claim that

(1) is uncertain as to whether there ever will be a claim;

(2) uncertain as to the value of the claim; or

(3) 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.

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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:

(1) it becomes absolute against the insurer on or before the last day fixed for filing of proofs of claim, or

(2) 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)

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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)

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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.

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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)

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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.

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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.”

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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 DefenseIn 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.

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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.

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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.

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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.

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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 (cont’d)

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.

We’d be pleased to assist you on particular issues involving your company.