On the Horizon: Treasury Department Offers Blueprint for Modernization of Financial Regulation

By Ed Wallis

The U.S. Treasury Department released its own blueprint for a stronger regulatory structure for the U.S. financial system on March 29. That report is important for guaranty associations, though it might not seem to have been the case when the Treasury began its study with a request for comments by interested parties on October 11, 2007.

The Treasury blueprint discusses the entire area of financial regulation from depository institution, futures regulation, securities regulation and insurance regulation. It was the latter topic of insurance regulation which prompted the National Conference of Insurance Guaranty Funds (NCIGF) and the National Organization of Life & Health Insurance Guaranty Associations (NOLHGA) to jointly offer comments related to the state-based system of insurance guaranty associations to Treasury on November 21, 2007.

When the Blueprint was announced, the Treasury dove into the subject of insurance regulation making short-, intermediate- and long-term recommendations for an optimal regulatory structure. While most of the press headlines and attention was directed at recommendations regarding reform of mortgage origination practices and Federal Reserve regulation in the banking area, Treasury made several recommendations regarding insurance regulation.

Treasury proposed the immediate creation of the Federal Office of Insurance Oversight (OIO) in the Treasury Department for two purposes. First, to exercise newly granted statutory authority to deal with international regulatory issues, such as reinsurance collateral, and second to advise the Secretary of the Treasury on major domestic and international policy issues.

In addition to being the lead negotiator for the U.S. in the promotion of international insurance policy, – a role which the NAIC now carries out through one of its committees – Treasury envisions the OIO as developing expertise on issues such as financial guarantee insurance (i.e. bond insurers), private mortgage insurance and natural catastrophe insurance. Soon after the Treasury Blueprint was released, Congressman Paul Kanjorski (D-PA), who is Committee Chairman of the House Financial Services Subcommittee on Capital Markets and Government Sponsored Enterprises, introduced House Bill 5840 to create such an office in Treasury.

Kanjorski’s bill, the Insurance Information Act of 2008, would establish the Office of Insurance Information in the Department of Treasury. While the change from “Oversight” to “Information” in the office’s name is interesting, Kanjorski’s bill would grant some significant powers to this office, including the authority to establish federal policy on international insurance matters and ensure that state insurance laws are consistent with agreements relating to federal policy entered into by the United States. In this context, the office’s authority would extend to all lines of insurance except health insurance and it would have the power to preempt state law which is inconsistent with federal policy on international insurance matters.

Kanjorski, who as Subcommittee Chairman, may well bring this bill up for mark up and adoption by his subcommittee during this Congress before it adjourns at year’s end. More directly of interest to state guaranty associations is the Treasury position on regulation of insurance in the United States.

In its blueprint, Treasury endorsed the establishment of a federal insurance regulatory structure to provide for the creation of an optional federal charter for insurance companies in all lines of insurance. This potential has lead both NCIGF and NOLHGA to brief members of Treasury about the State Guaranty Fund system for three times during the past five years and to offer comments to Treasury last fall.

The concern shared by many in the guaranty fund system, of course, is that a regulator of federal insurance, under the new arrangement, would deliver consumer protection if a federally chartered insurer becomes insolvent.

A joint education campaign between NCIGF and NOLHGA is on the front lines of explaining why a federal guaranty system is not the ideal approach, especially given the realities that would arise if insurers are chartered by both individual states and by the federal government. The NCIGF has urged the approach of including federally chartered insurers in the state guaranty association network by requiring any federally chartered insurer to become members of each state guaranty association where a federally chartered insurer would conduct its insurance business.

Under this concept, all insurers conducting property and casualty business within a state would be required to be members of the state’s property and casualty insurance guaranty association, just as they are today. In this way, the assessment base and capacity for each guaranty association would remain intact within a state to better assure its ability to pay claims of any insurer conducting business within the state who might suffer a fatal financial failure. The sponsors of both OFC’s bills now pending in Congress, Senate Bill 40 and House Bill 3200 both agreed with the suggestion of the guaranty funds and drafted their legislation using this approach to consumer protection against the insolvency of a federally chartered insurer. So long as a state guaranty association met the qualification requirements specified in those bills, all federally chartered insurers would be required to join and maintain their membership in every state guaranty association in the states where they conducted business.

In our comments to Treasury last year, NCIGF and NOLHGA explained that the current system provides benefits to consumers in the event of insolvency in amounts equal to – and often greater than – those provided by the FDIC for bank failures. Additionally, the NCIGF and NOLHGA explained that the guaranty association protection of insurance benefits is essentially different from bank deposit insurance in the sense that the principal focus of the insurance safety net is the fulfillment of the insurance promise to the consumer, and not merely assurance of the liquidity of deposited funds.

Insurance guaranty functions require a higher level of expertise with the insurance contract and its obligations, as well as more local and direct contact with the affected insurance consumer. The NCIGF and NOLHGA explained the efficiency of the current system and its proven record of adaptability to change in the marketplace as well as future developments.

Further, the groups explained that regulatory overlap is not an issue in the current system, and would not be under their approach to the OFC concept; this is because the system provides that the guaranty association in the state where the consumer resides is exclusively for providing the specified consumer safety net protections.

The groups were heartened by the Treasury’s recommendations for solvency regulation in conjunction with Treasury’s proposal that Congress adopt an Optional Federal Charter approach to insurance regulation. Treasury said on page 130 of its report:

This approach should require federally chartered insurers to participate in qualified state guarantee funds to protect state citizens without having to create duplicative insurer-funded federally managed guarantee systems. There are benefits to retaining these funds at the state level; The state system has been tested by several previous insolvencies; reliance on the tested system eliminates the need to create an additional federal entity; and the system appears to be adaptable to companies electing a federal charter.”

Treasury’s conclusion should gratify all guaranty association members who have worked so diligently for the years performing their responsibilities. Guaranty associations’ achievements in protecting consumers in times of insurer financial failure demonstrate their value to society and to the financial system of this country.

While we do not expect any significant activity toward adoption of OFC legislation during the remainder of this Congress, new legislation will most likely be introduced in the next Congress commencing in 2009 when a new administration takes over in Washington and Congress reorganizes following the 2008 elections.

Proponents of OFC legislation will undoubtedly urge members of the 111th Congress to again offer OFC legislation. Treasury recommendations will certainly help state guaranty associations in making their case for adoption of the NCIGF and NOLHGA’s proposal for consumer insolvency-related protection of federally chartered insurers.

Capital Market Investment Opportunities in Insurance Insolvency And Their Impact on Consumers

By Mark D. Steckbeck and Roger H. Schmelzer

There is growing interest among insurance regulators in finding market driven solutions to address the problems of troubled companies. Regulators are showing less interest in placing troubled insurers into liquidation, and troubled insurance companies seem to present investment opportunities for the capital markets.

These propositions were central to an in-depth series of panel discussions on capital markets investment opportunities at “Emerging Investment Opportunities: Bridging the Gap between the Capital Markets and Troubled Companies” hosted by the International Association of Insurance Receivers (IAIR) in October 2007. The one-day program explored the potential use of funding from the capital markets to address some of the issues and potential solutions to the serious financial challenges facing troubled insurance companies.

The program included insurance commissioners, reinsurers, attorneys and investment experts from the U.S. and abroad. The panels offered insights into the possible use of investment capital to assist regulators in their efforts to rehabilitate or runoff troubled insurers; it also reviewed the restructuring mechanisms available in other countries. In addition, the program examined some of the critical considerations and impediments potentially associated with these challenging investment opportunities. This paper summarizes highlights from these discussions.

Capital Market Opportunities in Troubled Insurance Companies. The first panel of speakers (Christopher Flowers of J.C. Flowers & Company, New York Insurance Superintendent Eric Dinallo and Forrest Krutter of Berkshire Hathaway) examined some of the issues and opportunities for investing in troubled insurance companies in the segment.

Flowers observed that while there is a growing appetite for investment opportunities, special challenges face potential investors in property and casualty liabilities, chiefly the need for adequate potential returns to interest investors.

There must be reasonable predictability of the investment returns, explained Flowers, adding this is something that is difficult to achieve with property and casualty claims in general, but especially so with the involvement of asbestos and environmental claims and natural disasters. Flowers went on to explain additional uncertainty is found where key assumptions used to evaluate company liabilities can be unexpectedly changed, for example, re-opening the statute of limitations on previously expired tort claims.

Another challenge facing investors is the high cost of collateral. Collateral posted by investors to cover property and casualty liabilities must be invested safely, which may limit the investor to relatively safe but modest investments. To an institutional investor seeking returns in the range of 20 percent, a five percent return on a treasury note is significantly below his required return threshold.

Structural Impediments Facing U.S. Investors. The second panel examined some of the structural impediments facing U.S. investors that are different from those faced by investors in troubled companies in Great Britain. The panel included Paul Dassenko, of azuRe Advisors, Inc., Oliver Horbelt formerly of Centre Group of Companies, Richard Whatton of Independent Services Group and Tim Graham, LaSalle Re.

Although both systems recognized the importance of making timely payments to policyholders and claimants, the comparison generally stopped there. While the U.S. system strongly favors policyholder protection, the British system would seek ways to bring finality to a company’s affairs, including its liabilities, thereby allowing investors to salvage part of their investment, and if possible, return at least some portion of their capital to the market.

For an institutional investor seeking an investment opportunity, the U.S. system creates several barriers. First and foremost, investors want to make money. With no benchmark for success acceptable to the regulators, investors may not be interested.

Second, there is a general lack of quality information to enable investors to evaluate troubled insurance companies. Additionally, there are a number of pitfalls for investors. These include a lack of understanding of the liability side of policy risks. Investors want to be able to extract their money quickly to pursue other investment opportunities. This may not be possible where the company has long tail exposures. Investors would want to accelerate liabilities in order to outrun adverse development. However, this approach would run contrary to the U.S. system’s strong preference for placing the interests of policyholders and claimants above the interests of investors.

Evaluating the Investment. In “Straight Talk from the Street,” the third panel addressed some of the key factors used by private equity investors when evaluating private investment deals. The panel included Bart Zanelli of Guy Carpenter, David Platter of Credit Suisse, Martin Alderson Smith of The Blackstone Group and Bill Goddard of Bingham McCutchen.

Time horizon. Private investors seek investments with a three to six year exit strategy. This strategy is at odds with the long-tail nature of property and casualty liabilities.

  • Potential rate of return. Equity investors are seeking investments that offer solid returns in the range of 20 percent for investment in a healthy company. To offset the greater risks associated with investment in a troubled company, investors may require expected returns as high as 30 percent. Returns of this magnitude may not be either achievable or politically palatable where a company is in the hands of a regulator and other creditors are receiving cents on the dollar. Investors are also concerned about reputation risk when they participate in deals that might draw damaging criticism.
  • Time and money required to close a deal. The longer it takes to close a transaction and the more money that must be spent, the less attractive the deal. This might occur where regulators are required to address objections or offer public hearings before approval is granted.
  • Difficulty in quantifying the level of investment risk. As the risk becomes less quantifiable, investors require greater returns or they will look for other opportunities. Finally, investors want to maintain at least an adequate level of control over the risks affecting the return on investment. Given the unpredictable nature of asbestos and environmental claims, natural disasters, and the ever-changing legal environment, it remains a challenge to control the risk factors affecting investment returns.

The panel examined how investors and regulators could close the gap on some of these obstacles. Four key elements to success were identified: the first issue is transparency. Parties must identify all issues and problems and exchange information to permit full evaluation of the transaction. Next, parties must have an open dialogue. The parties must identify and address all transactional elements including taking care of policyholder concerns and the investor’s profit expectations. Third, the value proposition for the transaction must be identified: all reasons for the company’s distress must be disclosed and all constituents must be represented at the bargaining table. Fourth, individual egos and private agendas must take a back seat to the transaction’s success.

Additional challenges facing potential investors include a poor institutional memory of the target company. By the time the trouble company is entertaining potential investors, many of its more experienced and knowledgeable employees have already departed. Another challenge is the inability to quickly access good quality information regarding the company’s operations and financial condition. There are also fragmented demands being made upon the company or the regulator from multiple constituents. Managing and reconciling these demands with regulatory imperatives while attempting to structure an investment deal adds another layer of complexity and cost. Moreover, there is no organized secondary market for the sale of troubled insurance companies. Without an established market, the transaction costs are higher. Finally, parties to the transaction must deal with fragmented claims. Stakeholders with competing interests each seek individual relief. Parties must find fair and effective ways to address these interests in order for the deal to proceed.

Regulatory Issues. The regulatory panel included Commissioner Al Gross of Virginia, Commissioner Thomas E. Hampton of D.C., Director Michael McRaith of Illinois, Deputy Commissioner Michael L. Vild of Delaware and Peter Gallanis, President of the National Association of Life & Health Insurance Guaranty Associations.

Mr. Gross stated his belief that insurance company receiverships should be managed with four principles in mind. First, policyholders have the right to have their claims paid timely and in accordance with their insurance contracts. Second, policyholders have the right to be protected against market abuses, for example, they should retain the protections that were granted by the state’s unfair claims settlement practices act. Third, claimants must be treated equitably. Fourth, the receiver is responsible for maximizing the value of the estate for the benefit of policyholders and other claimants.

Director McRaith believed that states are doing a better job of monitoring the financial condition of companies. He believed that if properly supervised, runoffs can benefit customers by avoiding some of the frictional costs of liquidation.

Deputy Commissioner Vild spoke of the desirability of early intervention on the part of regulators. He believed that the desired three to six year ideal investment horizon may not always be available and stated that he would be receptive to seeing proposals that addressed the issue of the investor’s withdrawal strategy up front. He further emphasized the need for transparency and full disclosure.

What Does the Future Hold? The final panel consisted of Howard Mills, Deloitte & Touche USA (and former New York Superintendent of Insurance), Nigel Montgomery, Sidley Austin and Chris Stroup, Wilton Re. The panel was asked if members expected to see an increased level of interest in investing in troubled companies by the capital markets. After summarizing some of the comments and themes voiced by the earlier panels, the presenters stated that the primary goal must be to protect consumers while still offering opportunities for investment of capital.

There is no one-size-fits-all approach to addressing the problems with troubled companies. Each company is unique and must be evaluated on its own merits. On the balance, however, the panel members did not expect to see a high level of interest by the capital markets in making investments in insurance company rehabilitations. For the capital markets to be interested in investing in troubled insurers, the insurance industry must be able to end runoffs within a reasonable timeframe.

NCIGF Analysis. The NCIGF suggests that the primary purpose of any alternative approach to insolvency be protection of the public from financial loss.

The state-based property and casualty guaranty fund system affords covered claimants a statutory remedy in the event of insolvency – many claims of the average consumer are paid in full. Based on existing state liquidation statutes and priority distribution laws, the needs of consumers, who are generally unsophisticated in insurance matters, are placed ahead of nonpolicyholder claimants and everyone with the same level or type of claim is treated equally.

It is imperative to know how and to what extent fundamental consumer protections would be affected under any alternative to outright liquidation. Would policy claims be reduced below their contract value in certain scenarios without the consent of claimants? Would consumers still receive timely payments, the full benefit of their insurance contract, fair treatment in the claims settlement process and availability of a meaningful claims appeal process? All of these are protections afforded in a traditional liquidation administered under existing state law. If they are not maintained, exactly what is the public policy objective in support of such a change?

Property and casualty insurance is a necessary ingredient to development of a civilized society by impacting the ability of commerce to develop and flourish within a free market economy. It is a contractually specified and validated agreement to transfer risks tied to virtually all personal and business investment decisions. This in turn allows individuals and businesses to confidently manage their risk and make investments, important actions that spur economic growth.

Legislators and regulators have already established the guaranty fund system to make good on the insurance promises of failed property and casualty companies by providing at least a partial remedy for insurer insolvency. That remedy retains the sanctity of the insurance contract by affording a measure of protection to those claimants state legislatures have deemed most in need of protection. Any decision to modify the existing level of consumer protection should be undertaken with the utmost of thought and deliberation.