Phil Zinkewicz assesses the need for change in the US state guaranty fund system.

The state guaranty fund system in the US is being looked upon these days as being in need of serious changes. Simply stated, state guaranty funds were originally set up as protection vehicles for the public in the event of insurer insolvency. In the past, they performed well, but today, insolvencies are on the rise compared to the relatively calm days of the 1990s. In addition, the severity of insurance company insolvencies has also increased, the most notable example being the Reliance debacle, which by itself has state guaranty funds in various parts of the country caught up in a sea of confusion.

Task force report

In a report by a special task force of the American Bar Association (ABA) on insurer insolvency, the importance of guaranty funds was stressed thus: "The insolvency of an insurance company can cause disruption in the lives of individuals and in the operations of businesses. An insurer insolvency can disrupt the flow of periodic payments, such as annuities, pensions and workers compensation benefits, that individuals depend on for financial support. It can delay personal injury and other civil litigation involving the insolvent insurer or its insureds. The insolvency of an insurer can delay claims payments. Businesses can find that they are suddenly responsible for losses that they had previously insured with a now insolvent insurer. An insurer insolvency causes unemployment, which is significant to individual employees and sometimes to the community in which the insolvent insurer was based. The consequences of an insurer insolvency are many and varied. The insolvency can have a devastating impact on those affected, and can erode the public's confidence in the insurance industry and in government's ability to regulate the insurance industry."

The ABA task force described guaranty funds as "involuntary, statutorily mandated, not-for-profit entities composed of all the solvent insurers licensed to transact business in a state for the lines of coverage protected by the guaranty fund." They exist to pay the covered claims as defined in each state statute for most insolvent insurers. Many guaranty funds hire a full-time fund manager and staff to take care of their day-to-day operations.

Rapid payment intention

The original intention of guaranty funds was to provide rapid payment to individuals, small business policyholders and third party claimants, who were usually unsophisticated in insurance matters and most likely to need protection in case of an insurer insolvency. However, according to the ABA task force, as matters have evolved, many large corporate insureds are now able to avail themselves of guaranty fund coverage, putting even greater pressure on the system.

In most states, after an insolvency, insurers which are members of the guaranty fund are assessed based on their premium volume in the state, to pay the covered claims of the insolvent insurer in the state. New York is the only state that has a pre-assessed guaranty fund.

From 1969, when guaranty funds first came into existence, to 2001, property and casualty insurers have been assessed at $7.6bn for insurance company insolvencies, according to a special report, Guaranty Funds: 2001 Assessments, by Roger K Kenney, associate vice president - research for the Alliance of American Insurers (AAI). Insurer assessments amounted to $31m in 1983, according to the report. In 1984, the assessments more than tripled to $97m and then doubled every year in each of the next three years. Rapid growth in the assessments to insurers occurred between 1983 and 1987. From 1988 to 1994, assessments ranged from $360m to $545m, except for 1989 when assessments exceeded $700m. In 1995, assessments declined to $94m, the lowest since 1983. After reaching a plateau of $200m to $300m from 1997 to 2000, assessments more than doubled to $734m in 2001, the second highest ever. The reason for this surge is that four large insurers were declared insolvent in late 2000 and early 2001, according to Kenney's report.

Initial resistance

Interestingly, when guaranty funds were first proposed, large multinational insurers resisted, saying that they shouldn't have to be forced money into a fund because their size and scope precluded the possibility of an insolvency. The large multinationals believed that they would be subsidising the smaller insurers. However, a look at Kenny's statistics on company assessments shows that the higher charges occurred in years when large insurers went under. Companies that spring to mind include Mission, Legion, Transit Casualty and, of course, Reliance.

Substantial similarity

The individual state property/casualty guaranty fund laws are substantially similar to each other, according to the ABA task force, as they are based on the National Association of Insurance Commissioners' Model Property/Casualty Guaranty Fund Act. In order for a claim to be covered by a guaranty fund, it must usually arise under a policy issued by an insurer that was licensed to transact business in the state. The claim must also be covered under the terms and conditions of the insurance policy issued to the insured by the now insolvent insurer. Most property/casualty guaranty funds exclude coverage for losses arising under life, accident and health insurance, annuities, fidelity and surety bonds, credit insurance, mortgage guaranty insurance, title insurance, investment-type products, ocean marine insurance and insurance provided by or guaranteed by the government.

Guaranty funds also pay only certain types of claims made by certain types of claimants, according to the task force, and their liability is further limited by maximum dollar amounts (caps) with respect to each covered claim, ranging from $50,000 to $1m. Should a covered claim exceed the guaranty fund's statutory cap, the claimant retains a claim for the excess directly against the estate of the insolvent insurer.

Sometimes, claimants have to deal with `ancillary receivers' when seeking a payment for injuries. In fact, that is the situation in New York with the current Reliance insolvency. The Pennsylvania Insurance Department is the liquidator of Reliance, but in New York the insurance department has been named ancillary receiver. According to the ABA task force, an ancillary receiver may be appointed by a court in a non-domiciliary state in which the insolvent insurer maintains assets, which may include general and special deposits. The ancillary receiver's primary responsibility is to marshal the local assets of the insolvent insurer. These funds may be used to pay certain claims against special deposits and to reimburse the costs of administering the ancillary receivership. Excess funds are transferred to the domiciliary receiver and become part of the general assets of the state.

Depending on statutory provisions, claimants in an ancillary state may exercise the option of having the ancillary receiver adjudicate their claims against the insolvent insurer, as long as the domiciliary receiver is provided with notice and an opportunity to contest the claim. The option is designed to afford greater convenience to the out-of-state claimant so that, at least for purposes of allowance or disallowance of a claim against the insolvent insurer, the claimant need not travel to or retain counsel in the state in which the insolvent insurer was domiciled. Assuming appropriate notice has been provided to the domiciliary receiver, coverage determinations made by the ancillary receiver will receive full faith and credit in the domiciliary receivership proceeding, and there is no discrimination between ancillary and domiciliary claimants with respect to the adjudication of coverage or the distribution of the state's assets. Although the ancillary claimants must still seek distributions from the domiciliary receiver, they may come to the ancillary forum with claims that have already been liquidated, says the AMA task force.

The fact that New York's guaranty fund is a pre-assessed fund has caused some problems in the past and its function has apparently come into question regarding the Reliance insolvency. Some years ago, the New York State Property and Casualty Insurance Guaranty Fund was the subject of considerable controversy in the insurance industry, centring on the fact that, although the fund was a pre-assessment fund (i.e. a fund set up from the assessments of solvent insurance companies prior to any insurance company insolvency), there was no money in it. The money that had gone into the fund, obtained by assessing insurance companies in the state, had been diverted by legislators to satisfy the needs of the state's general coffers. In short, the guaranty fund contained nothing more than one great big IOU from state lawmakers.

What that meant was that if there had been a major insolvency, the state legislature would have had to go into an emergency session to reallocate the funds that had been diverted, or insurance companies would have had to be re-assessed. The insurance industry went to court over the issue and won. The state had to return the money to the fund, and the law now stipulates that the fund can never be allowed to fall below $150m.

Questions raised

Recently, however, questions have been raised about exactly how the New York state fund and other state insurance funds operate - or should operate in the event of an insolvency. These questions have been raised surrounding a case involving a man who was injured on a bus - the insurer of which was insolvent. That insurer was Reliance.

Carmine Montemarano and his wife Rosalie were riding a New York bus owned by the Atlantic Express Transportation Co when Carmine needed to use the bathroom facilities. He was holding on to a rail in the rest room when the rail broke causing him injuries. Carmine put in a claim with Atlantic Express, but the bus company was insured by the insolvent Reliance. During this time, the bus company itself ceased operations.

Carmine's only recourse was to turn to New York's regulators. New York differs from other states in that it has several guaranty funds, among which are the Property and Casualty Guaranty Fund, the Workers' Compensation Guaranty Fund and the Public Motor Vehicle Liability Security Fund (PMV fund). As the ABA task force stated, insurers that write particular lines of business are pre-assessed by each fund accordingly. Since this was a transportation occurrence, Carmine sought to be compensated by the PMV.

That was the place to go, but for one little problem. The PMV, a pre-assessment fund, did not have the money to pay the claim. Carmine then turned to the property and casualty guaranty fund, but was rejected. He then sued the New York Insurance Department, saying that the fund was set up for the protection of claimants in the event of an insolvency. The New York Insurance Department counterargued, on the other hand, that the lawsuit violated the Ancillary Receivership Order, which it said "enjoins commencement or maintenance of any lawsuits that related to the management of the Reliance insolvency or defence and/or indemnification of claims of risks insured by the company." The Superintendent of Insurance also said that any claims made should be considered only by the court supervising the liquidation.

The judge agreed with the Superintendent, asserting that the objections derived from the principles of receivership law that a corporation in receivership "is the ward of the supervising court, and no action against or involving rights or obligations of the ward may be maintained without the court's permission."

So, the Montemaranos are out in the cold, unless they want to go to the additional time and expense of going to Pennsylvania and retaining counsel there against the primary receiver.

All this raises several serious questions. The first is: why was there not enough money in the PMV fund to pay the claim initially? After all, insurers had been pre-assessed for a possible insolvency. Peter Molinaro, a spokesman for the New York Insurance Department, said that no monies have been diverted from the PMV fund for any other state purposes. Rather, he said, the fund is "temporarily depleted," until further assessments can be levied against insurance companies that write transportation insurance. Most of the money that had been in the fund, he said, had gone to pay Reliance claims, adding that the lion's share of the transportation-related business that Reliance wrote was in New York, and New York, as an ancillary receiver, has had to pay those claims. "We are almost current with transportation-related claims payments," Molinaro said, "and we will be current when the next quarterly assessments come around."

Does that mean, when the PMV fund is replenished, that Carmine will get his claim paid? "It's possible," Molinaro said, but he didn't sound very convincing.

Another question that must be answered is: what is the role of an "ancillary receiver?" If the ancillary receiver's job is to pay valid claims with local assets of a defunct company domiciled elsewhere and with insurer assessments, then where is Carmine's money? Similar situations have occurred with claims against Reliance in New York.

But New York's guaranty fund system is not the only one where there should be questions asked. According to the Alliance of American Insurers, the assessment systems of workers' compensation funds in many states are woefully inadequate.

Judge Michael D Stallman, in the case between the Montemaranos and the New York Insurance Department cited above, made the following observation: "The Reliance receivership, the insolvency of other insurers and the questionable viability of state-mandated security funds in New York and other states, undoubtedly burdens interstate and foreign commerce. Such impact suggests the need for a comprehensive federal solution - one that would assure all policyholders, beneficiaries and claimants the financial security and peace of mind, which insurance intends to provide. If the existing system of state regulated private insurance and security funds is inadequate to meet the public's needs, an alternative must be devised."

The implication here, of course, is that a federal approach to protecting against insurer insolvency might be preferable, but whether a federal solution is the answer is open to debate, of course. However, one thing is certain. The state system of guaranty funds, created in 1969, never anticipated the level to which insolvencies would grow or the financial impact they would have on the Montemaranos of the world and the economy in general.

On a state-by-state basis, the Alliance of American Insurers (AAI) has worked in recent years to effect major reforms in the guaranty fund system. The AAI's major legislative objective in this area has been to enact several key reforms, based on model legislation of the National Conference of Insurance Guaranty Funds (NCIGF), including bar dates, net worth exclusions and aggregate caps. Bar dates refers to the amount of time claimants have to file their claims, usually 18 months. The AAI would like to see every state implement such a bar date. Net worth exclusions refer to the amount of money that can be assessed from an insurer in the event of an insolvency. Caps put a dollar amount on how much a claimant can receive from the guaranty fund after which the claimant must go to the original estate and its liquidator. These things are intended to preserve the financial viability of guaranty funds at a time when they are being severely pressured.

The AAI also seeks to change the trigger for guaranty fund coverage to require a final order of liquidation in the remaining states that could result in guaranty fund coverage on a mere finding of insolvency, which could be in a rehabilitation proceeding long before liquidation. The AAI says it seeks these key amendments to the guaranty fund laws as the opportunities arise, state by state.

Phil Zinkewicz is a re/insurance journalist based in New York.