Insolvencies and the Current Regulatory Environment

1. Insolvenciesand the Current Regulatory Environment CAGNY June 3, 2004

2. 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”

3. InsolvenciesTrending 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 companies that have triggered regulatory action

4. InsolvencyCost - 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 • Funds have proposed increasing the assessments or expansion of the base for assessments • Alternatively, funds could restrict coverage to fewer policyholders • CA WC Fund was recently authorized to issue bonds to cover $750 million shortfall

5. InsolvencyCost - 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

6. Overviewof 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

7. ChangesAffecting 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

8. JudicialLiquidation - 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

9. JudicialLiquidation - 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

10. 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

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

12. CommercialRun-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

13. CommercialRun 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

14. IsEvery 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

15. Roleof 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

16. 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

17. 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