Insolvencies and the Current Regulatory Environment CAGNY June

Insolvencies and the Current Regulatory Environment CAGNY June 3, 2004

Agenda • Upward Trend of Insolvencies • Rising Cost of Insolvencies to Industry and Policyholders • Overview of an Insolvency • Changes Affecting Insolvencies • Judicial Liquidation - Does it Work? • Alternatives – Commercial Run-Off • Viable Run-off Candidates • Role of the Regulator • The “End Game” 2

Insolvencies Trending Upward • Contributing Factors – Inadequate pricing combined with attempts to build market share in period of severe under-pricing – Acceleration of asbestos losses since 1999 – Reduced investment income – record low rates – Inability to replace funds from capital markets – Excessive use of reinsurance – Regulatory or rating agency action • • Recent insolvencies dominated by commercial lines carriers Reliance largest insolvency to date – $5. 9 billion - assets – $8. 7 billion – liabilities – 144, 000 claims * Includes P/C Insolvencies 1995 - 2004* (NAIC) 1995 4 1996 6 1999 6 2000 18 2001 24 2002 21 2003 29 2004 to March 20 companies that have triggered regulatory action 3

Insolvency Cost - Industry • Inability of estate to reimburse guaranty funds results in assessments on industry • Recent insolvencies have depleted funds of the guaranty associations, placing further strain on them if they had to absorb another major insolvency • • • Guaranty Fund Assessments 1995 – 2002 (in millions) 1995 94. 8 1996 124. 2 1997 263. 7 Funds have proposed increasing the assessments or expansion of the base for assessments 1998 263. 7 1999 201. 3 Alternatively, funds could restrict coverage to fewer policyholders 2000 328. 6 2001 734. 7 CA WC Fund was recently authorized to issue bonds to cover $750 million shortfall 2002 1, 209. 0 4

Insolvency Cost - Policyholder • Policyholders must meet net worth test for guaranty fund to accept claim – Varies by state ($10 – $50 million) – Policyholder with net worth in excess are not covered by guaranty funds • If eligible, guaranty fund will cover claim subject to fund limit – Varies by state $100, 000 – $500, 000 • • Defense cost is included in limit if claim covered by the guaranty fund Judgments/settlements in excess of guaranty fund cap are the responsibility of the policyholder Guaranty funds do not cover surety, assumed reinsurance, surplus lines policies, financial reinsurance, etc. Policyholder can make claim on receiver, but amount and timing of recovery uncertain – Subject to liquidation priorities • • Reimbursement subject to funds remaining in the estate A separate and significant issue relates to the treatment of collateral and asset balances held by the company for the benefit of the policyholder – Receiver and guaranty funds have fought for control of collateral assets resulting in a lost benefit to the estate in receivership but enhances the ability of guaranty funds to pay out allowed funds 5

Overview of an Insolvency • Surplus/Risk-based capital ratios continually decline over time • Company may attempt optic solutions = financial reinsurance • Rating agencies express concern – place company on watch for downgrade • Company seeks capital in capital markets • Decisive event occurs if – Rating agency reduces the company to a commercially unacceptable rating and/or – RBC ratio falls below commercially acceptable levels • Regulator must decide level of supervision – If surplus is positive the regulator may choose to place the company in conservatorship or allow it to operate as a non-judicial commercial run off – If surplus falls below $0, regulator must place the company into rehabilitation or liquidation • In liquidation – Assets become the responsibility of the receiver – Claim liabilities become the responsibility of the guaranty fund if eligible – Receiver will convert non-liquid assets, collect reinsurance and pay claims made on the estate based on liquidation priorities of the state of domicile – Transactions and cash disbursements must be approved by judge – Judicial process introduces significant expense component 6

Changes Affecting Insolvencies • Prior to RBC, regulators had limited tools to achieve control of the company before it fell below minimum capital and surplus requirements, resulting in insolvencies with fewer assets • Rating agencies were reluctant to downgrade companies to levels resulting in their collapse prior to any regulatory intervention • Introduction of RBC has focused regulatory oversight earlier on troubled companies – Entering mandatory control level the company will still have significant assets • Using risk-based tools. rating agencies are less reluctant to downgrade companies to commercially unacceptable levels - sealing the fate of a commercial lines carrier – In prior periods the company might have remained at a commercially acceptable level and over time resurrected itself • Results of these changes have produced a new group of troubled companies – Companies with significant assets, but little or no surplus 7

Judicial Liquidation - Does it Work? • The current regulatory environment is suited to handle personal lines companies • The expense of the current system is excessive due to high legal and consultant costs associated with documentation requirements • High expenses contribute to exhaustion of the estate and result in increased losses for policyholders and assessments on the industry • Current legislation requires regulators to place a company in a judicial proceeding when it reports a negative surplus even if it could discharge a significant amount of its liabilities if allowed to continue as a non-judicial commercial run off • Highly liquid but surplus-challenged companies represent cash cow for receivers and law firm/consultants supporting liquidations 8

Judicial Liquidation - Does it Work? (cont. ) • Commercial policyholders are significant losers in current system – Potentially excluded from recovery through guaranty funds due to eligibility restrictions – Bifurcation of assets and liabilities under receivership eliminates the direct connection between claim payment and recovery from supporting asset (captive, collateral, specific program reinsurance) – Collateral pledged to cover their losses put to other use by receivers – Insurance companies ceding to an insolvent carrier will likely recover cents on the dollar due to their low priority • Liquidating commercial carriers is far more complex – Reinsurance collections represent a major issue – Collateral associated with various program structures will become trapped in the estate • The current system is inefficient and results in a high cost to policyholders and the industry as a result of high receiver expenses, unsatisfied claims settlements, collateral losses and sub-optimal reinsurance collections 9

Alternative – Commercial Run Off • Once under state supervision, insolvency should be redefined as the event when the company becomes illiquid rather than reports a negative surplus position • The company can operate to discharge claims and more efficiently collect reinsurance recoverables • This will substantially reduce the outstanding liabilities and adverse impact to policyholders that would not have had claims covered by the guaranty funds • A commercial, non-judicial run off represents a cost saving alternative that results in an increased benefit to policyholders and claimants 10

Types of Commercial Run offs • Commercial run off (Traditional) • Nonjudicial liquidation • Liquidation priorities • Other non-insurance creditors 11

Commercial Run-Off Advantages • Preserves greater estate value for the satisfaction of insurance liabilities • Continues to provide defense for policyholders • Faster and more effective claim resolution • Avoids protracted delays in the collection of reinsurance recoverables • Quicker resolution of the estate obligations • Lower administrative cost during the pendency of the run off 12

Commercial Run Off Disadvantages • Regulators are not yet comfortable with non-judicial runoff • Regulators perceive greater risks in supporting a commercial run off vs. a proceeding • Many states require entering into a judicial proceeding when surplus falls below zero, even though estate may still be able to handle claims more efficiently than judicial process • To keep a company from entering a judicial process permitted practices may be needed to sustain accounting solvency • Ultimately a proceeding may not be avoidable 13

Is Every Financially Distressed Insurance Company a Viable Run-Off Candidate? • Accounting vs. economics • Cash is king and queen • Operation must be cash flow neutral or better • Level of discount embedded in loss reserves • Investment income and operating expenses 14

Role of the Regulator • Complicated by political issues • Second guessing by non-domiciliary regulators • Cooperation with regulators in domicilary state is imperative • Permitted accounting practices or allowances may be necessary • Large, complex insolvencies require collective agreement among multiple state regulators 15

The “End Game” • Payment of dividends during the run off • Challenges of extracting excess value • Winding up under a formal proceeding • Creation of a liquidating trust outside of a proceeding • The new Rhode Island statute • Conversion of an insurance company to a “C” corporation 16

Benefits of commercial run-off • Provides for a normalized process for settling valid claims • Avoids delay in payment of valid claims • Maintains “duty to defend” • Prevents substantial shrinkage of reinsurance recoverables • Avoids additional friction costs of a judicial receivership • Provides the state guaranty funds with a much-needed reprieve 17