CRITICAL ISSUE REPORT
As in the movie, are conditions right for
state guaranty funds to be horrendously hit?
By Phil Zinkewicz
One of the things that separate insurance company insolvencies from insolvencies in other industries is the state insurance guaranty fund concept. It is a concept in which industry participants themselves provide the wherewithal to make good a defunct insurance company's promises to policyholders and creditors.
There is no concept to protect the employees or shareholders of Enron and ImClone or any of the other companies involved in recent corporate scandals. In these cases, injured parties can resort only to the court system. In contrast, for all practical purposes, the state insurance guaranty fund system has performed well since its inception in the 1970s.
However, the Alliance of American Insurers (AAI) recently published a report warning that the guaranty fund system may be in for some serious difficulties. The problem, according to the AAI, is that state guaranty funds may soon find themselves facing capacity problems.
Titled "A Perfect Storm for Guaranty Funds," the Alliance report refers to the novel and movie The Perfect Storm, which told of three major storms converging off the northeast coast of the United States to wreak havoc that had never been seen before. The Alliance report refers to the October 2001, insolvency of Reliance Insurance Co. as "the first storm" to endanger the state guaranty fund system.
"By statute, every state has a guaranty fund that pays policy claims of insolvent insurance companies," says the Alliance report. "Each state's guaranty fund gets the money to pay claims by assessments on all the other solvent insurers doing business in that particular state. Seldom are the guaranty funds ever 100% reimbursed. Since the inception of the guaranty funds, the industry has been assessed roughly $9 billion to pay the claims of insolvent insurers; and when recoveries from the estates of those involved insurers are considered, the industry's net payment has been just over $5.5 billion," says the Alliance.
The report goes on to say that, when guaranty funds were first designed, their structure and assessment capability were aimed at the "middle"--in other words, small to medium-sized insurance companies. State laws cap insurers' assessments at 1% to 2% of their premium volume in each state. In 2001, the capacity of the guaranty funds to assess insurers in all 50 states for an insolvency was more than $4.8 billion.
Guaranty funds usually are structured to single out certain categories for particular attention, meaning that workers compensation insurers are assessed to pay for a workers comp insurer insolvency, auto insurers are assessed to pay for an insolvent auto insurer, and then all other lines are grouped as one.
The Alliance points out that insolvency has never been a major problem in the insurance industry. Citing A.M. Best figures, the Alliance says that between 1992 through 2001, 243 property/casualty insurers became insolvent--a failure rate of .74%. Even in its peak year after Hurricane Andrew in 1992, the industry's failure rate was only 1.62%.
While those figures seem encouraging, the Alliance report then addresses the Reliance situation, the largest property and casualty insurance insolvency ever to hit the United States. "In its last published financial statements, the company reported $8.8 billion in assets and $9.9 billion in liabilities for a deficit of $1.1 billion," says the Alliance report. "The Reliance receiver estimates that the company will ultimately have $7 billion in direct policyholder claims. About 40% of the company's reserves is workers compensation, another 20% is auto insurance and the remaining 40% is a blend of general liability, directors and officers, errors and omissions, professional malpractice and other national and commercial lines specialty accounts.
"The guaranty funds estimate that roughly $6.5 billion in claims will flow through the guaranty fund system before the Reliance insolvency is over," continues the report. "The ultimate cost to the industry through the guaranty funds depends on many factors, not the least of which are the accuracy of Reliance's reserves, and how much of Reliance's reinsurance is collected. Whatever the final number, the Reliance insolvency will be bigger than what the guaranty funds have ever been asked to cover," says the Alliance.
But that's only the first storm. The insolvency of Reliance comes on top of other insurance company insolvencies in a relatively short period of time, the Alliance points out. "Already the insolvencies of Superior National, Credit General and HIH are resulting in a large influx of claims into the guaranty fund system. A third possible 'storm' is that there are other potential insolvencies because of companies currently in runoff, which include Frontier Co. in New York, which has liabilities of roughly $1 billion. Another large insurer, Legion Insurance Co., was put into runoff March 29, 2002. It has $2.5 billion in claims exposure, according to the most recent financial statements. The guaranty funds estimate that Legion, on top of Reliance, could overwhelm the ability of the guaranty funds to respond and pay claims in several states," warns the report.
What does that mean? Well, for one thing it means that the ability of the guaranty funds to assess insurers may not generate enough funds to pay the claims the guaranty funds would face in a year. Also, says the Alliance, with the current insolvency picture, these accounts in several states could easily max out in any given year.
What is the answer? Well there are several possible ones. One would be to raise the cap, either temporarily or permanently, on assessments insurers pay into the guaranty fund system. Another would be to move to a single account system, which would mean that all insurers would be responsible via assessments for an insolvent insurer, regardless of what line that insurer was writing.
The Alliance is opposed to both approaches. The first approach, the Alliance says, would give state regulators incentive to delay decisive action with respect to a financially troubled insurer. "Why take quick action to declare an insurer insolvent and limit the fallout if the industry's assessments are subject to expansion to clean up the mess. In addition, many times 'temporary' increases in assessments become permanent."
As for the second approach, the Alliance says that it is unfair to assess insurers for insolvencies in lines they do not write.
Rather, the Alliance supports an approach already in place in Rhode Island. This approach, says the Alliance, provides that money be borrowed among the guaranty fund accounts when there are capacity problems. The money borrowed must be paid back to the accounts--with interest--within 10 years.
"If, for example," says the Alliance report, "the workers compensation account is maxed out, the auto account can be assessed; but the funds generated are considered a 'loan' to the workers compensation account. Under this system, after the 10 years, if the loan is not paid back through continual assessments on the workers compensation account, the loan is considered uncollectible; but companies may still obtain some tax benefits in terms of deductions for uncollectible debts."
Continues the report: "In recent years, the Alliance has also sought to limit guaranty fund coverage to restore it to its intended purpose, namely, protecting individuals and small businesses that would be harmed the most by the insolvency of their insurer. Over the years, it has become common for the greatest amount of the guaranty funds' capacity to be consumed by claims of large commercial insureds, even though they are in a much better position to absorb an uncovered loss and have the ability, through professional risk managers, to carefully choose a solvent insurer in the first place."
If the Alliance is correct in its assessment of the current dangers to the guaranty fund system--and the magnitude of recent insolvencies indicates that the association may well be correct--then it might be prudent for state regulators to address the problems sooner than later. *
The author
Phil Zinkewicz is an insurance journalist with some 25 years' experience covering the international insurance and reinsurance arenas. He was the insurance editor of the Journal of Commerce for a number of years, handling all their domestic and international supplements. In addition, he regularly writes for a number of London publications.