How to Get Paid when There is No Money:

Loss-Sensitive Coverages, Collateral and Bankruptcy in Recessionary Times†

John B. Lennes, Jr.

Introduction

No one wants to see a customer go bankrupt. This is especially true when that customer owes you money.

Insurers can face this situation when they issue “loss-sensitive” policies. Under such an arrangement, for example, the customer could be responsible for a certain dollar amount of a claim, with the insurer’s obligation limited to covering what remains to be paid after that. As a practical matter, the insurer typically would make all the payments that are called for under such a claim, and then be reimbursed an amount equal to the “retention” by the customer. There could also be some variation on this general theme. For different types of coverages, the final claims cost of a policy and, therefore, the “bottom line” for the money to be paid by the customer to the carrier may not be clear until long after the close of the policy period. There are many circumstances for which loss-sensitive coverage may make good sense. However, these do not include situations in which the customer has no money to repay the carrier. When bankruptcy strikes a policyholder who has not paid the entire premium on a loss-sensitive policy in advance, the insurer may be forced to provide coverage and pay claims for which it has not collected and may never be able to collect a premium. This can mean serious trouble, unless the carrier has taken timely steps to protect itself by obtaining adequate and suitable “collateral.”

Loss-sensitive programs or risk-sharing mechanisms constitute a high proportion of the total dollar value of coverages issued to larger policyholders. When, at the outset, not all premium and loss-payment dollars required to service the program are turned over to the insurer, this means that the carrier either trusts the policyholder to make the necessary payments when due, or in the alternative, some security mechanism must be agreed to and put in place.

Loss-sensitive programs provide the policyholder with cash flow benefits. In addition to the basic obligation to pay the claims due under the coverage, the carrier assumes the risk of recovering the amounts that are paid under that coverage from the policyholder. This means that insurers evaluating the suitability and pricing of loss-sensitive programs must not only underwrite the insurance risk, but also take into account all elements that relate to prospects for non-collection or under-collection from the inured, and respond to them effectively.

A variety of loss-sensitive programs exist in today’s marketplace, and there are different types of collateral instruments that can be put in place to service them. The key is how these instruments work when things go wrong and bankruptcy looms. The balance of this article will present an overview of the bankruptcy process generally and as it affects loss-sensitive coverages, types and character of loss-sensitive insurance in this context, and suggestions for what the parties to the coverages should do to minimize the risks of an unsatisfactory outcome.

II.

Bankruptcy Primer

When a debtor files for bankruptcy, that means, for the period preceding the filing of the petition, there are not and will not be enough assets to pay all the that person’s creditors. How and whether they are paid depends on where they stand in the hierarchy of debtors established by bankruptcy law; the assets are used to pay off the debtors according to strict statutory priorities.[1] The further down the list you are, the less likely you are to be paid in full, if at all.

The basic idea is to be a secured creditor; failing that, one would want to get as high a priority as possible.

For the period after the filing of the petition, if the debtor is operating at or above a break-even basis, a strong attempt is usually made to do what is necessary to help the debtor emerge from financial straits. If no current profitability and little prospect for future profitability exists after filing, there will be a race among the creditors to try to cash out the largest possible portions of the debts owed.

Once into bankruptcy, there is significantly decreased ability for creditors to make the moves that might optimize their chances for recovery. One thing that often is attempted is to attempt to have the post-petition debtor “assume” the contracts from the pre-petition period, thus making the costs of these agreements “administrative expenses” of the post petition era. This would give any amounts still due and owing under the contracts a much higher status and, therefore, a better chance of being paid, vaulting over a number of unsecured creditors in the process, although not those who are secured.

The bankruptcy case is commenced by the filing of a bankruptcy petition by or against the debtor. The petition filing date is the turning point. It divides everything relating to the insured between “pre-petition” (not as protected), and “post-petition (better protected) periods. The filing of a petition automatically halts certain actions against the debtor.[2] It gives the debtor time for negotiation while free from harassment, as well as time for all involved to sort out who should be entitled to what assets and to avert piecemeal dismemberment of those assets. The automatic stay prevents pressing of and payment of most claims against the debtor, and it prohibits cancellation of policies entered into pre-petition, and possibly even post-petition.[3]

Under Chapter 11, the most common bankruptcy form relevant here, the priorities are:

1. Secured creditors are first paid and must receive collateral or cash payments when the net present value is equal to the amount secured;[4] then if money remains,

2. Administrative claims are to be fully paid;[5] then if there is still money remaining,

3. Priority claims receive the net present value of the claims;[6] finally if there is any money still left,

4. Unsecured claims are paid.[7]

· Insurers may be secured creditors when they have collateral or setoff rights.

· Insurers may have administrative claims for standard premium that accrues post-petition, or for retrospective premium or reimbursement of deductibles that relate to accidents that occurred post-petition.

· Insurers may have priority claims for employee benefits claims and workers’ compensation claims that accrue in the six months prior to the filing of the petition.

· Insurers may have general unsecured claims.

It must be realized that if there are sufficient assets to pay all the unsecured claims, the debtor probably did not belong in bankruptcy in the first place. Thus unsecured creditors, who are last in line to collect from a source of funds that is by definition inadequate to pay all those who should be paid, are in great jeopardy.

Debtors can assume, reject or assign “executory” contracts, which include many insurance contracts.[8] These are agreements where the failure by one side to perform excuses the other party from performing. If the contract is rejected, this is a prepetition breach, giving rise to a prepetition claim, that might well be worthless. To “assume,” the debtor must cure any defaults, or provide adequate assurance that defaults will be promptly cured, compensate the other party for pecuniary loss resulting from default, and provide adequate assurance of future performance.[9] If the contract is assumed and later breached or rejected, the creditor then has an administrative claim, second highest priority, for damages.

If the term of an insurance contract has expired, the policy is not executory, and the insurer must pay covered claims even if the debtor does not pay the premium.[10] If the contract term is still pending, the policy is an executory contract, and the debtor’s failure to pay would allow the insurer to cancel coverage, had there not been an automatic stay. A motion to assume must be filed and pressed before the policy term expires. The goal of this effort is to try to have the obligations of the insured to the insurer treated as priority administrative claims, and thus more likely to be paid. This is more likely to occur if the existing insurance package is retained as an essential tool that the bankrupt enterprise must have available as it attempts to continue in business and eventually emerge from bankruptcy. Most struggling enterprises must have insurance to continue to function, either de facto or de jure, and it is generally best if the overall insuring package remains intact into the future. Even if the contract is not assumed, a motion to assume may cause a court to recognize that the insurer’s postpetition claims are entitled to administrative priority.

The filing of a bankruptcy petition triggers an immediate, broad and automatic stay that bars all creditors from attempting to collect pre-petition debts or to obtain possession of property.[11] The two main types of bankruptcy encountered in business contexts are Chapter 7, a straight liquidation where a trustee is winding up the operation, and Chapter 11, where the entity stays in operation, usually under mostly existing management with a view toward trying to keep afloat. Unsuccessful Chapter 11 efforts can become Chapter 7’s.

The automatic stay prohibits insurance companies from canceling insurance contracts.[12] If an insurance contract expires by its own terms, the automatic stay does not obviate that expiration. If an insurer attempts to cancel an insurance policy while the automatic stay is in place, the insurer will probably violate section 362(a)(3) of the federal bankruptcy law. That prohibits “any act to obtain possession of property of the estate . . . or to exercise control over the property of the estate” during the applicability of the stay.[13] Because insurance policies embody contract rights, they are property of the estate. If the insurance carrier knows of the bankruptcy filing, cancellation is a violation of the automatic stay, and should not be attempted.[14]

The principal issue that arises in complex insurance/bankruptcy proceedings is whether the insurer has a good claim for unpaid premiums. This can be complicated by the fact that insurers who try to recover premiums frequently fail to file timely proofs of claims, and may lose rights to subsequent filings that might otherwise have been exercisable.

Under bankruptcy, the simplified notion is that for the period up to the filing there is more debt than there are resources to pay that debt, and therefore there must be an ordering or apportionment of the obligations. Some creditors may not be paid, or many may be asked or forced to accept a reduced payment. Therefore, the objective is to get as close to the front of the line as possible.

Secured creditors are paid ahead of non-secured creditors. Non-secured creditors are paid in accordance with priorities in the Federal Bankruptcy Code, with first priority given to administrative expenses, which are the actual and necessary expenses and costs of preserving the bankruptcy estate going forward. If a carrier has unsecured debts due to the failure to collect sufficient collateral from the debtor for payment of the retention/deductible on an insurance policy, then its goal should be to have its claims afforded administrative expense status in order to maximize chances of recovery.

An insurer may, at its option, terminate financing arrangements under a policy upon default or bankruptcy. This accelerates the debtor’s obligation to pay all of its financial obligations to the insurer; the “real world” value of exercising this option against an entity that, after all, is bankrupt can be questionable.

Generally, it is in the insurer’s best interests that an executory contract is assumed by the debtor/estate, because then the insurer will receive payment of existing defaults and be assured that all claims arising under the policy get priority treatment. An early motion in the bankruptcy proceedings to compel the debtor to either accept or reject the policy is recommended.

The debtor or trustee can assume, reject or assign executory contracts. In certain circumstances, when an insured has a continuing duty to pay for insurance stretching into the future, the insurance policy is an executory contract, even if the policyholder is actually obligated to fund a self-insured retention program, or has agreed to pay retrospective premiums. If the insured breaches these obligations, that would not excuse the insurer from performance. It comes down to this:

[a]n insurance contract is considered to be an executory contract if the contract imposes upon both the debtor and the insurance company continuing duties to perform. On the other hand, if an insurance contract is expired at the time of the filing of the debtor’s petition in bankruptcy, and the debtor has only the duty to pay for retrospective premiums, the contract is not executory.[15]

· Rejection is treated as a breach of contract that immediately precedes the filing of the bankruptcy petition, which creates a pre-petition claim.[16] It is generally less likely to be paid than are post-petition claims, other things being equal.

· Assumption is accomplished when the debtor cures all defaults, or provides adequate assurance that defaults will be promptly cured, and the other party is compensated for any pecuniary loss resulting from the default, and adequate assurance of future performance is provided.[17] From the insurer’s perspective assumption is to be desired, but this almost certainly will not occur. If the contract is assumed and later breached or rejected, the creditor has an administrative claim for damages.

· Assignment requires assumption in the first instance, and the provision of adequate assurance of future performance.[18] No consent is necessary.

If a debtor assumes a contract that is executory and money is owed by the debtor for services received post-petition, then the amounts to be paid are an administrative expense and are entitled to payment after the secured creditors have been paid. This applies to insurance contracts making payments for post-petition, but generally not pre-petition losses. If an insurance contract expires under its own terms for nonpayment of premiums during the pendency of a bankrupt proceeding, and the insurer does not wish to continue, then there is nothing for the trustee to either accept or reject, because there is no contract.

Often the debtor will do nothing at all, and take none of the foregoing steps.

Insurance companies must be cautious about dealing with policies owned by insureds in bankruptcy. Carriers may not cancel a prepaid policy without running afoul of the automatic stay of section 362(a)(3). But cancellation is not the same as expiration. If a policy expires under its own terms, the automatic stay does not extend the life of the policy beyond its internally prescribed expiration.[19] It is not uncommon for various parties to seek relief from automatic stays. Insurance companies sometimes seek relief so they can cancel policies or change premium assessment procedures.

Holders of perfected security interests have a better claim to the assets of the debtor than do unsecured creditors. Perhaps that is why they are called “perfect.”

Unless the debtor can force the insurer to renew coverage under some sort of contractual agreement, a bankruptcy court cannot make the insurer renew for extended periods. Sometimes a court may force a short-term renewal under exceptional circumstances, for example, where notice requirements were not met or were inadequate, but the bankruptcy court cannot create additional contractual rights. Generally, the economics of the decision about renewal or nonrenewal are not subject to bankruptcy court second-guessing, particularly with respect to price, collateral, and the like.

If the insurer renews, does it thereby limit its chances to collect for earlier nonpayment? The debtor would have to assume the existing contract and promise to pay, and get the bankruptcy court’s approval of the renewal. Once assumed, it is treated as a post-petition agreement. In a case where the debtor’s counsel agrees to assume the contract, there could be an issue if it turns out that the debtor still owes the insurer money. The practical question becomes whether the debtor can find replacement insurance for less than it would cost to assume and renew the original coverage with the original insurer. Generally, the insurer should not renew unless the debtor assumes the obligations.

If a policy is pre-petition, and if the losses accrued before the petition, they are pre-petition unsecured claims, and thus very low on the payment priority list. When, and if, the policy is assumed, it becomes post-petition. This can be contingent upon the bankruptcy court approving the assumption, because it moves the insurer ahead of other creditors in the chain of potential payees who may object. As a post-petition administrative expense, that expense payment has particular priority and is senior to pre-petition unsecured debts. Therefore, the insurer is paid before the unsecured parties receives anything. “Confirmation” can be important. If a debtor wants to confirm a Chapter 11 plan, administrative expenses must be paid on the effective date of the plan unless the administrative expense creditor agrees to go unpaid or partly paid.[20]

The bankruptcy code requires the debtor to cure all existing defaults or to give adequate assurance of a prompt cure or the ability to perform.[21] The burden is on the debtor. In a negotiated situation, the creditor holds significant advantages. The issue is essentially more economic than legal. Can you get enough collateral to justify the risk?

The rule of thumb is that if you can keep the overall risk level at or below the current level through a negotiated deal for continued coverage, then that should be done. If not, there is probably not much sense in going forward.

One may ask for court permission to use cash collateral. But if the cash comes from assets wherein other secured creditors might claim an interest, these secured creditors will likely oppose this, probably unsuccessfully. Ultimately, the creditor likely will be able to enter into a cash collateral agreement, with conditions fully negotiated; that is a budget, time periods for performance, and the like.

The debtor may ask to have the “exclusive period” extended, the time period during which only the debtor is allowed to propose a plan. This may be opposed by the banks, which in such a case would suggest that the banks may have questions about the creditor’s viability as a going concern, at least under its current management.

A key underwriting question involves whether the insured can pay the insurer, and whether it is sufficiently stable so as to withstand any surge in claims. Workers’ compensation claims can climb rapidly for a company in financial difficulty.

III.

Risk Sharing Mechanisms

Risk sharing mechanisms in use today are only limited by the imagination of clients, brokers and underwriters, or by the ability or inclination of insurance regulators and tax codes to keep up with or permit the use of new ideas. The discussion below is limited to more typical approaches.

A. Large Deductibles

Large deductibles are a frequently utilized risk-sharing device for major construction risks. In this type of arrangement, the insured assumes a capped amount of risk above which the insurer assumes the obligation subject to the policy limit. The insurer maintains control of and services claims.

Because most construction insurance is written to include several lines of coverage, deductibles may also apply to multiple lines. These may be separate or combined. Further, the deductible may be written to apply to each claim or occurrence, or to apply to all loss arising from any one event. The latter requires analysis of the potential for any significant multi-claimant exposure, and it may or may not be limited to claims at one particular location. A maximum aggregate deductible may also be applied, either to any one coverage, or to the policy period. Deductible amounts may be written inclusive of both indemnity and allocated claims expense or to apply to indemnity only; this gives both parties a common motivation for controlling claims expense.

In large deductible programs, credit risk is substantial. The insurer is contractually obligated to handle claims, typically making expense and indemnity payments up front and being reimbursed by the insured. Most often, the insured is billed for deductible amounts due on a periodic basis. Bankruptcy considerations arise in the event of the insolvency of the insured, because the insurer is not relieved of its responsibility of continuing claim and expense payments. Further, once the insured is in formal bankruptcy, the insurer is prohibited from terminating its contractual obligations, absent a court order, until the end of the policy period.[22] The insurer normally will try to characterize claims for the continuing service of such obligations as “administrative claims” under bankruptcy. At best, this means impaired cash flow and high legal expenses, with the more likely outcome involving “cents on the dollar” of the insolvent insured’s obligations. This occurs by operation of law despite policy wording that might suggest contractual terms to the contrary.

B. Retentions

The insured in a retention program assumes a capped amount of risk, above which the insurer assumes the obligation. Unlike deductibles, the retention is usually separate from the policy limit. The policy itself is an excess contract, in that it assumes no obligation to defend, at least up to a certain specified level of loss. The insured has control of the defense rather than the insurer.

Retentions often apply to multiple lines of insurance. They may also be made to apply to each claim or occurrence, or to apply to all loss arising from any one event. Retention amounts may also be written to apply to both indemnity and allocated claims expense, or to indemnity only. Also, a maximum annual or policy aggregate retention may be specified, and after it is reached the insurer handles all claims and assumes a duty to defend.

The insurer does not assume the obligation of the insured to pay the retention. Still, challenges may arise in adverse situations, which could result in complications for ongoing excess claims obligations in the event of default.

When the client has not established an adequately funded program to meet expected loss development as it is incurred, or to adequately fund the expense of claims handling, the result can be as adverse to the excess insurer from indirect causes as it is from the more direct credit risk. Although not necessarily obligated to do so, an insurer directly excess of a financially troubled self-insurer might be forced to assume some, most or all of the retention obligations in order to protect its own interests for those excess obligations. An analogy might be that a defective foundation jeopardizes the viability of any structure erected atop it; the builder must repair or do whatever is necessary to rectify the problems with the foundation in order to safeguard the overall project.

For this reason, the underlying self-insured retention (SIR) funding mechanism must be sound. Substantial retentions funded solely from current cash flow present substantial financial risk. The insured should establish a specific means of funding all of its expected obligations, including expenses as they are incurred.

C. Captives

Captives are closely held entities whose insurance business is supplied and controlled by its owners, and in which the original insureds are the principal beneficiaries. Captives are typically formed as a vehicle for a company or through trade associations of companies with homogeneous characteristics, to assume and finance risk. In contrast to other mechanisms of risk retention, captives are often formed to take advantage of favorable tax laws for this type of risk assumption. Captives were initially based outside the United States or “offshore.” But in recent years, “onshore” captives, domiciled in the United States and known as Risk Retention Groups, have grown in popularity in states such as Vermont, Hawaii and Colorado that have set up regulations under the federal Risk Retention Group Act.[23]

Some captive insurance companies are formed to fund the risk of a single entity, or some portion of a single entity; these are called “Single Parent Captives.” Multiple owners who wish to pool their risks also form captives. Usually, these “Group Captives” share a common risk characteristic, although in some instances, group captives can pool risk from heterogeneous types of exposure.

The most common insuring mechanism used in captives involves the use of a retention type policy that establishes the coverage, terms and obligations within the insurance policy itself. The risks presented to the insurer are very similar to those described for large retention programs above.

Although many captives are “self-insured,” they may seek to share risk through other arrangements; the most common is “fronting.” Under a fronting arrangement, an insurance company issues a primary policy and “insures” risk ground up and, in turn, is reinsured or reimbursed by the captive. Such arrangements may be used to meet certain statutory, regulatory or customer requirements that an insurance “policy” per se must be in place from an established carrier to meet the financial obligations covered in the contract. Fronting may also provide a vehicle for the captive to “farm out” certain traditional insurance services, including claims handling, it would otherwise have had to provide for itself. While the insurer often handles claims, other arrangements may be made wherein the insurer agrees to use the services of a third party or client-owned administrator, or even the staff of the captive or client itself to perform a range and variety of duties.

“Fronting” is often thought of as riskless for the fronting insurance company because the client still holds the insurance risk. But the “front” arrangement essentially provides a guarantee from the insurance company that obligations will be met, and it is the insurer that is ultimately responsible for that in the event of default or sometimes even in the case of a disagreement with the client. When unauthorized reinsurance is a part of such arrangement, in the even of failure by the captive client to maintain acceptable collateral, questions about the carrier’s surplus adequacy could arise.

D. Retrospective Rating

In a retrospective rating plan, a client agrees to participate in and fund a portion of its own experience as losses develop. Although other combinations, including deductibles, may be employed in this case the insurer typically issues a “ground up” contract and handles claims directly. The client pays a basic premium to handle expenses determined by formula, including acquisition (commission), insurer overhead and other operating expenses. An insurer profit is typically built into the basic premium. A separate premium tax level is calculated, and a loss conversion factor is applied to losses to cover unallocated loss expense. Subject to an advance payment for some expected level of loss, the loss and loss expense is then adjusted periodically with the insurer either returning excess amounts or billing the client for shortfalls. Plans may be written to include case reserves, or they may be adjusted on a paid loss and expense basis only. Typically, plans are written with a minimum amount of loss and loss expense premium retained by the insurer, but they may also be written subject to a maximum, beyond which the insurer assumes all risk. While this benefits the client by freeing up current cash, it leads to a very substantial credit risk to the insurer as development continues. Adjustments continue periodically until all claims close, or until the date of some pre-agreed adjustment or “settling of accounts” has been reached.

IV.

Recommended Steps

Even in uncertain times loss-sensitive policies can perform extremely well. The key to making that happen is two-fold:

1. Underwrite for Collection Risk; and

2. Put in place Collateral that works.

A. Underwrite for Collection Risk

It is important to be as certain as possible that the policyholder can and will honor its commitments. A careful analysis of background information is crucial to making that determination accurately.

Sources for Background information include:

1. Financial Statements and Reports

2. Management Performance

3. Potential Increased Liabilities

4. Outside Sources

5. External Factors

· Financial Statements

Late financial reporting

History of significant prior adjustments

Revenues significantly decreasing (possibly also increasing)

Continuing losses

Loan covenant defaults

Decreasing current ratios

Borrowing long term to pay short term obligations

Payables stretching

Increase in age or concentration of receivables

Not paying taxes or withheld employee benefits

· Management Performance

Lack of depth or breadth/single-talent entrepreneur

Lack of succession or transition planning for closely held business

Management turnover

Management unwilling to hear and deal with bad news or changing circumstances

Lack of long term business plan

Self-dealing

· Potential Increase in Liabilities

Litigation

Employee benefits

Labor contracts expiring

Coverage disputes with insurers

· Outside Sources

Search pending litigation and tax liens

Qualified audit opinions

Accountant’s management letters

Defaults under loan agreements or significant contracts

Lenders refusing to renew or extend credit

Adverse reports from stock market analysts

Dunn & Bradstreet reports

Decreased ratings by rating agencies

· External Factors

Maturing industry

Faltering economy

Increasing interest rates

Changes in government policy

Taxes

Monetary policy

Import/export regulations affecting supplier or competitors

Technological changes

Increased pricing for supplies, raw material

Decreased demand

The best action is that taken before a dispute arises and, in any event, before a policyholder files for bankruptcy. That involves careful underwriting and securing sufficient collateral in the optimal form for the circumstances.

B. Use Collateral That Works --An Overview

What is collateral: Money or a financial instrument guaranteeing that customers who do not pay the entire cost of their insurance coverage at the outset will ultimately make payment in full.

When is it needed: Within a reasonable amount of time after an account is bound, usually thirty or sixty days, depending on the form of the collateral.

What types of risk financing call for collateral: Incurred Loss Retro’s with deferrals, Paid Loss Retro’s, Deductibles and Captives. Not needed for Guaranteed Cost or Self-Insured Retention Programs.

Why is it needed: Because the customer may not be willing to or able to pay “down the road;” because insurance regulators require it in particular instances and impose surplus penalties when requirements are not met; because good collateral keeps carriers out of bankruptcy fights they are unlikely to enjoy or win.

How much is needed: for Retro plans, ultimate needed premium minus collections; for Deductibles, indemnification of unrecovered loss payments; and for Captives, indemnification of ceded reinsurance.

What forms of collateral are acceptable, in order of preference: Letters of Credit are much preferred; Assets in Trust, Premium Collateral Insurance Policies, and Cash can be used for some applications; for some limited purposes, Surety Bonds may be used.

Is collateral an absolute requirement: Collateral sometimes is waived by carriers under limited circumstances, but not many.

Letters of Credit (LOC) are the best collateral, with the maximum protection as well as the maximum convenience. LOC’s authorize insurers to draw money from a bank in accordance with the terms of the instrument. LOC’s do not depend on the customer having funds in the bank or being willing to pay its bills when the time comes. The carrier may draw on it for the purposes stated in its terms when the need arises. The LOC must be with a bank authorized by the National Association of Insurance Commissioners (NAIC).[24] Specific form and substance requirements are laid out by regulators. The cost of an LOC to a given business customer can vary significantly based upon its creditworthiness, its relationship with the issuing bank, and so forth. Typically, the purchase price will run from a fraction of one percent of the stated value of the LOC to two or three percent; and it may not be available at all for some customers. High price or unavailability of an LOC for a particular policyholder should be cause for an insurer to reexamine the viability of a premium-financing scheme for that particular customer.

Assets-in-Trust: This mechanism is more cumbersome than an LOC, but quite secure. The customer establishes an account with an approved bank for the carrier’s benefit. The customer retains the right to the income generated by the deposited assets, while the insurer has the ability to withdraw these assets to satisfy obligations as they come due. Acceptable assets, forms and conditions are specified by New York state law.

Premium Collateral Insurance Policy: This device is issued to the insurer to guarantee payments by customers or to maintain collateral security levels. The fee is paid by the carrier and charged back to the customer, or the customer can directly pay it. This alternative generally is limited to extremely solid customers, and at least partly because it is cumbersome to administer, it is rarely employed. The New York Insurance Department approves it, but not the National Association of Insurance Commissioners.

Cash Collateral: To be of value, the carrier must maintain control and have immediate access to the cash both before and after filing of a bankruptcy petition, which can prove tricky. Under a pure cash collateral arrangement, investment income is given back to the customer or applied to the cash collateral fund. A modified compensating balance approach involves a dormant deposit account maintained at the customer’s bank but controlled by the carrier, with credit being directly earned by the customer.

Surety Bonds: These are to be used for deductible programs only. There are a number of limitations on other uses of this mechanism imposed by regulators, and other concerns exist as well. Frequently the only really usable bond forms amount to pay-on-demand notes, so one of the foregoing approaches is usually preferable. Surety Bonds are to be used sparingly.

Captives have their own special circumstances, which are discussed below.

C. Collateral Discussion

Adequate and acceptable collateral is required for programs where the credit risk assumed by the insurer is substantial in dollars, danger, or both. These programs include large deductible programs, matching deductibles, and “captive” arrangements where the insurer is reinsured by the captive. Retrospective rating arrangements, where additional premium may be required because of adverse loss development, call for collateralization as well.

The long-term relationship with customers created by deductible plans, indemnity/claims handling arrangements (fronts), or reinsurance arrangements result in credit risk to the carrier because the customer might not be able or willing to meet its future obligations under these arrangements. Such risk arises from the indemnification of loss and loss expense payments as yet unrecovered from insureds (under deductible plans), the indemnification of ceded reinsurance from unauthorized reinsurers (under captive reinsurance plans) and the difference between the ultimate needed premium and amounts collected from the insured (under retrospective rating plans). Credit risk applies even to currently financially sound clients in the case of “long tail” claims, because unforeseen and unforeseeable financial deterioration could occur while their obligations remain open.

In many instances, acceptable forms of collateral are required to meet insurance department regulations. Uncollaterized risks or as to which collateral does not meet the requirements under New York State Insurance Regulations[25] stemming from unauthorized reinsurance or retrospective rating programs may subject an insurer to “charges” against its surplus. New York law is generally the basis for most other states’ regulatory approaches to complex issues such as adequate collateralization, so it is of particular importance. The penalty to an insurer’s surplus stemming from such inadequately collateralized programs is 100 percent of the statutorily required collateral amount for unauthorized reinsurance arrangements, and ten percent for retrospective rating programs.[26] Additionally, monies due from but unpaid by customers with known financial problems can result in partial or full write-downs, and thus accounting losses.

The amount of collateral required should be determined by the calculated amount of expected loss and allocated loss expense, where this is included in a deductible program. An additional allowance should be included, particularly for new business where business relationships and prior loss experience are less certain.

Collateral should be sufficient to meet the expected value of the client’s “going forward” obligation, and also the expected value of prior policy period obligations, if any, not as yet incurred or collected. For these reasons, the amount of collateral required over time may grow or change in successive policy periods and should be reviewed and perhaps reset annually.

D. Collateral for Loss-Sensitive Programs

The most important characteristics of acceptable collateral are that it be liquid and that it be unconditional. There are four types of acceptable collateral under deductible programs. In order of general preference these are: Letters of Credit (LOC); Assets-in-Trust (Trust Accounts); Premium Collateral Insurance Policies and Cash; and, in very limited circumstances, Surety Bonds.

1. Letters of Credit (LOC)

Letters of Credit (LOC) are the preferred means of collateralization. They are relatively standardized. They are simple to administer and offer the best level of protection by guaranteeing payment from an approved financial institution. Once a Letter of Credit is given, the future economic fortunes of the insured, at least in the context of its ability to meet the obligations created by its risk-financed insurance, is of no concern to the insurer; the bank has assumed that risk.

A Letter of Credit is a letter addressed by a bank, at the request of the buyer (the insured), to a beneficiary (the insuring company), authorizing that beneficiary to draw drafts for certain amounts under certain specified terms. The buyer (the insured) agrees to provide payment to the issuer for the drafts drawn. If the buyer fails to do so, the issuing bank is at risk rather than the beneficiary/insurer.

An LOC is issued by a NAIC approved commercial bank and paid for by the buyer. As credit instruments, LOCs are relatively inexpensive, with fees generally ranging from one half percent to two and one half percent of the face value of the LOC. While the relative expense of such instruments is low, an LOC must be accounted for as a debt obligation and may thus otherwise reduce the amount of available credit to that customer.

Insurance regulations assure that the beneficiary insurer has the requisite ability to draw on the obligation to cover the responsibilities of the insured. In order for a Letter of Credit to be acceptable as collateral, the issuer must draft the document in the New York Compromise Format, which prescribes the format and wording for this instrument as well as the required conditions. The NAIC maintains a list of acceptable domestic and foreign banks from which LOC’s may be taken as collateral.

Specifically, the LOC must be “clean,” “irrevocable and unconditional,” and “evergreen.”

· Clean - the LOC must authorize the unconditional drawing of drafts;

· Irrevocable and Unconditional - the bank must waive all rights to cancel or in any way amend the LOC without the consent of the insurer;

· Evergreen - the letter must automatically renew unless the insurer is given thirty days notice in advance.

Letters of Credit may also be “standby” or “direct.” A direct Letter of Credit is used as the normal payment mechanism between the buyer and beneficiary, with the beneficiary drawing upon the LOC for reimbursement of current obligations, typically to satisfy deductibles as claims are paid. A “standby” Letter of Credit is a safety net to assure that future obligations are met. When the purpose of the collateral requirement is to mitigate credit risk for the long-tail development of losses, a “standby” arrangement is appropriate. If there is a need to address cash flow issues, other means, such as a loss or deductible fund, can be employed.

2. Assets-in-Trust

This mechanism is also appropriate under certain circumstances. This form of collateral satisfies statutory requirements, and although untested, it probably affords a high degree of protection in bankruptcy proceedings because of its similarity to the Letters of Credit format.

Under an assets-in-trust arrangement, a grantor (insured) establishes an account with a trustee, usually through the trust division of a commercial bank, for the benefit of a beneficiary (the insurer). It is then funded with cash or other acceptable assets. Income generated by the assets accrues to the benefit of the grantor, not the beneficiary, but is typically used as part of the funding mechanism for the obligation to be met. The beneficiary is allowed to withdraw assets of the trust to satisfy amounts due but unpaid.

Some trust arrangements are drawn as so-called working trusts. That is, they are used as a vehicle for the payment of current obligations. Such trusts generally are established for long-term obligations from loss development. It may be appropriate to adjust funding by offsetting payment for development periodically.

New York Insurance Regulation 114, which also references trust arrangements for non-admitted reinsurance, prescribes the conditions that must be met by the trust agreement and for acceptable assets.[27]

Key requirements include the following:

· The agreement must create a trust account into which assets are deposited.

· Assets must be valued at fair market value and be in cash, United States certificates of deposit, or investments of the type specified in New York Insurance Law.

· The trust agreement must be “clean” and “unconditional” in that:

- The beneficiary can withdraw assets at any time without approval from the grantor by written notice to the trustee;

- No document is required of the beneficiary to withdraw, other than written acknowledgement of receipt; and

- The agreement indicates it is not subject to conditions outside of the trust agreement.

· The trust agreement must be established for the sole use and benefit of the beneficiary.

· The agreement must allow no substitutions or withdrawals of assets from the trust except upon written instruction from the beneficiary.

· The agreement must provide that at least thirty days written notice will be given to the beneficiary prior to the termination of the trust agreement.

3. Premium Collateral Insurance Policy

This financial guarantee insurance policy is issued for the benefit of the carrier, to guarantee insured obligations under several types of insurance policies or for maintaining collateral security levels in accordance with agreement terms. Policy wording is similar to an LOC, with payment made on unconditional demand within a specified period. This mechanism has the advantage to the insured of not depleting the insured’s credit facility, as is the case with an LOC. Although approved by New York, this mechanism has not been approved by the NAIC, Illinois or California, and generally is not suitable for reinsurance transactions. Administrative work can also substantial. For these reasons this format is not commonly used, although it probably does provide a high degree of safety in bankruptcy proceedings due to its conceptual similarity to Letters of Credit.

4. Cash

This form of collateral includes cash funds over which the carrier maintains control, to which it has immediate access, and which can be used to offset an uncollectable recovery from a client. In retrospectively rated programs, it is treated as a prepayment of premium; for deductible programs, it is a non-working escrow fund; and for reinsurance programs, it is treated as funds withheld.

Such funds can be either pure cash collateral taken in lieu of a Letter of Credit, or a “modified compensating balance” which is an inactive deposit account maintained at the customer’s bank, but controlled by the insurer. While this sounds good as collateral, it does require a substantial amount of administrative and accounting expense on the part of the carrier.

The utility of cash for making necessary payments as they arise is excellent, but its very accessibility poses potential problems in bankruptcy proceedings. Cash held in excess of amounts payable at the time of the filing of a bankruptcy petition may be considered to be “preference” by a bankruptcy court.[28] This means that it could be characterized as a payment made by the debtor to one of its creditors (the insurance company) that involves an impermissible accelerated or early payment to that creditor. That creditor otherwise would not be entitled to such a payment due to the bankruptcy filing, regardless of whether the payment was made before or after the filing. Payments in the ordinary course of business are generally not considered to be a “preference.” The preference potential makes cash a dubious choice for collateral when bankruptcy factors are taken into consideration.

5. Surety Bond

In some instances, a surety bond may be acceptable as collateral, but solely for deductible programs because it does not meet the criteria for collateral under regulations for accepting unauthorized reinsurance. Use in that case would expose the insurer to a 100 percent surplus penalty. Also, it is unacceptable under retrospective arrangements, which would expose the carrier to a ten percent surplus penalty. Surety bonds typically offer good protection in bankruptcy, but their conditional nature can delay the recovery process.

Suretyship involves the assumption of liability by one party for the obligations of another party. The surety agrees to protect the obligee (beneficiary/insurer) against the default of the principal (obligor/insured). The surety operates like a banker and must underwrite both the principal and the obligee because the obligee can influence the possibility of loss. Although the principal pays the premium and the bond benefits the obligee, suretyship is a three-party contract wherein the surety will be responsible to the obligee for the contract of the principal.

A good surety bond guarantees the financial ability of the obligor. It does not, however, guarantee payment. Unlike an LOC, or most trust arrangements, the beneficiary cannot simply draw upon a bond when it feels the need to do so. Rather, the surety stands in the shoes of the obligor; it may, and likely will, assert any defenses to payment that the obligor would have available.

Surety bonds are also typically more expensive to purchase than are Letters of Credit. A potential advantage to a customer is that the purchase of a surety bond does not directly reduce the amount of available credit to the customer by adding a liability to its balance sheet. Because of this, any insistence on the use of a surety bond as collateral by a client might constitute a “red flag” in underwriting financial risk, perhaps evidencing an excessive debt/equity load.

Insurers’ recent experience in converting bonds into cash occasionally has been unfavorable, in part due to archaic bond forms, in part due to defective wording in agreements, but sometimes due to some sureties’ response of “defend rather than pay,” which forces judicial resolution. Also, the creditworthiness of many potential customers may have decreased recently, which makes the availability of bonds questionable.

For these reasons, a surety bond is not a preferred mechanism for providing collateral. For most carriers, surety is used as collateral only for deductible programs.

E. Collateral for Reinsurance Agreements

There are only two types of collateral acceptable under ceded reinsurance programs: Letters of Credit and Reinsurance Trust Agreements. Surety Bonds do not qualify under regulatory requirements because they expose the carrier to a 100 percent penalty against statutory surplus.

1. Letters of Credit (Captive Reinsurance)

The earlier discussion on Letters of Credit applies to LOC’s guaranteeing captive reinsurance arrangements as well, with one exception. In this situation, the applicant for the LOC must be the reinsurer/captive, not the “insured.” Again, because of the relative ease of administration, this is generally the preferred approach to collateral under a captive reinsurance arrangement, and is acceptable under regulatory requirements.

2. Reinsurance Trusts

The general description of the assets-in-trust method of collateral also applies to reinsurance trusts. Here, however, the grantor of the trust must be the reinsurer/captive, not the “insured”. As discussed, this means of collateral is somewhat less desirable because of the complexity of administration.

F. Unacceptable Collateral

Collateral that is not liquid and unconditional is usually not accepted. Some assets offered as collateral carry potential unquantifiable liabilities, such as real estate with potential lien or title issues, or possibly environmental liabilities and declining real values; royalties, where collection can be a problem; situations where it may be necessary to liquefy an entire asset in order to pay a smaller obligation; or arrangements which call for the exercise by the insurer of control or activity that it is not qualified to perform or interested in performing, such as property management. In these instances, the assets have sharply limited value as collateral.

· Surety Bonds – Reinsurance Ceded and Retrospective Programs. Surety Bonds are not acceptable to regulators as a collateral alternative for either retro programs or unauthorized reinsurance transactions because they do not allow unconditional access to funds by the insurer.

· Promissory Note. A promissory note is a formal written promise to pay that generally requires the maker of the note to repay an amount plus interest at some future date. This is a legal contract and an obligation, but it is only as good as the financial condition of the insured, which, after all, is the main reason for collateral in the first place. So this is not really a form of collateral, and, as such, has little utility. It is really no more than another promise to pay something that the customer has already promised to pay.

· Negotiable Certificates of Deposit (C.D.). A negotiable CD is a money market instrument issued by a bank, foreign or domestic, or by a non-bank depository institution such as a thrift. A certificate of deposit has a specific maturity, as well as penalties and conditions that may apply to early access of funds. These aspects make them inappropriate vehicles for collateral; you cannot get the money you need, when you need it.

· Compensating Balances. A compensating balance arrangement is one where the client agrees to keep an average deposit balance on hand over a specified period of time. It is designed for insureds who are required to maintain deposits to support lines of credit. An insurer may have access to such deposits as a form of collateral. However, the deposit is only an average; the actual daily amount is subject to the customer’s cash management practices and cash flow cycles. At any given time, then, the level of funds may not be sufficient to meet the necessary guarantee.

Conclusion

Loss-sensitive coverages make good sense in many instances, and are often the optimum method of coverage. In troubled economic times the outcome for all concerned will be optimized if reasonable precautions are taken to obtain adequate and suitable collateral for these programs. This is best done through a Letter of Credit.

Appendix A

Glossary

Administrative Expenses are expenses of the bankruptcy Debtor that are given the highest priority for payment because these payments generally benefit the Debtor’s Estate by allowing the Debtor to continue its business after filing of the bankruptcy petition. Examples of Administrative Expenses include Post-Petition legal fees, insurance premiums and business payables.

Admitted Insurer/Reinsurer is one licensed to do business in the state or country in which the exposure is located.

Aggregate Deductible is the greatest amount of paid losses within the insured’s retention and, if applicable, paid allocated loss adjustment expense (ALAE), that the insured must pay under the policy for the program term.

Allocated Loss Adjustment Expense (ALAE) is an expense directly allocable to a specific claim. It includes but is not limited to all supplementary payments as defined under the policy; all court costs, fees and expenses; costs for all attorneys, witnesses, experts, depositions, reported or recorded statements, summonses, service of process, legal transcripts or testimony, and copies of any public records; alternative dispute resolution; interest; investigative services, non-employee adjusters, medical examinations, autopsies, and medical cost containment; declaratory judgment, subrogation and any other fees, costs or expenses reasonably chargeable to the investigation, negotiation, settlement or defense of a claim or a loss under the policy.

Assumption is an agreement by or on behalf of a bankruptcy Debtor, subject to approval by the bankruptcy court, to perform all of the Debtor’s obligations to another party under an Executory Contract. The Debtor is then said to assume the contract.

Authorized Reinsurance is that written by an admitted insurer/reinsurer allowing the ceding company to take credit on its annual statement for the reinsurance ceded.

Automatic Stay means that upon filing the bankruptcy Petition, all claims against the Debtor are “stayed,” meaning that the claimants’ lawsuits and other proceedings can no longer be pursued against the Debtor unless the stay is lifted by the court.

Bar Date is the date by which all existing claims against the Debtor must be filed with the bankruptcy court.

Beneficiary is the entity (insurer) in whose favor a collateral instrument is issued.

Cede is to transfer to a reinsurer all or part of the insurance or reinsurance written by a ceding company.

Chapter 7/Chapter 11 are the two portions of the federal bankruptcy law most applicable to commercial bankruptcies. Chapter 7 involves a Trustee appointed to oversee liquidation and distribution of the Debtor’s Estate (the Debtor is “going under”); Chapter 11 involves a debtor-in-possession that plans to reorganize and hopes to emerge from bankruptcy as an ongoing business.

Claims Handling Expense is an Unallocated Loss Adjustment Expense (ULAE) that includes expenses that are not directly allocated to a specific claim. The ULAE may be charged to an insured either by applying a loss conversion factor (LCF) to the loss plus the ALAE, or by applying a Claim Handling Fee (CHF) that is a dollar amount charged per reported claim.

Collateral is a financial instrument or cash provided by an insured to secure the deferral of its financial obligations under an insurance program.

Confirmation is the process by which the bankruptcy judge approves the Plan or Reorganization of the Debtor.

Creditor Committee is a committee generally consisting of representatives of the Debtor’s largest unsecured creditors that speaks for all unsecured creditors and has standing to challenge any actions proposed to be taken by or on behalf of the Debtor or otherwise affecting the Debtor’s Estate.

Debtor is the bankrupt entity.

Debtor-in-Possession (DIP) is a Debtor that continues to conduct its business, whether with a view to emerging from bankruptcy or to liquidating its remaining assets.

Debtor’s Estate includes the assets and liabilities of the Debtor, including off-balance-sheet items such as contingent rights and obligations.

Default takes place when an insured:

1. Fails to pay any amount when it is due under an insurance program, including but not limited to the initial escrow funds amount and any subsequent adjustments; or

2. Files a petition in bankruptcy, or a declaration of insolvency, or an action or proceeding for dissolution is filed by or against the insured; a receiver or trustee is appointed for the insured; the insured executes a workout agreement; the insured makes an assignment for the benefit of creditors; or any other proceeding or arrangement of a similar nature is instituted by or against the insured; or

3. Fails to provide the initial, adjusted or replacement collateral as required under the insurance program

Disclosure Statement is the formal document sent to creditors and to other parties interested in the bankruptcy proceeding that describes the Debtor’s Plan of Reorganization.

Earned Retrospective Premium is the premium that is calculated at a retrospective premium adjustment that is subject to the minimum retrospective premium and the maximum retrospective premium.

Executory Contract is a contract that has not been fully performed, in that the term has not expired and some or all of the parties to the contract still have additional duties left to perform during the contract’s period. Unexpired insurance policies are executory contracts.

Exit Date is the date on which a Debtor emerges from bankruptcy pursuant to a plan of reorganization.

Facultative Reinsurance is a form of reinsurance where the ceding company offers individual risks for review and acceptance to the reinsurer.

Group Captive, or Association Captive, is an entity formed to cover the exposures of multiple organizations. A group captive generally refers to something insuring the exposure of nonrelated organizations, while an association captive insures the exposures of similar industries.

Guaranteed Cost is an underwriting plan whereby a premium is calculated on a prospective basis without adjustment for loss experience during the policy term. A rate is applied to the exposure base and, if auditable, the exposure base and the premium will be adjusted at the end of the policy term.

Incurred But Not Reported (IBNR) is a reserve that has been established to provide for future obligations under an insurance program that arise from either: claims and related ALAE that have already occurred but have not as yet been reported to the insured or the insurer; or anticipated changes in incurred loss and incurred ALAE for claims that have been previously reported to the insured or to the insurer.

Lifting of the Stay is an order of the court permitting a particular action, such as a legal proceeding against the Debtor, which otherwise would not be permitted due to the automatic stay.

Liquidation involves the sale or other distribution of the assets comprising the Debtor’s Estate in payment of its creditors.

Maximum Retrospective Premium is the greatest amount the insured must pay for its obligations under the program in accordance with the retrospective rating formula.

Minimum Retrospective Premium is the least amount that the insured must pay for its obligations under the program in accordance with the retrospective rating formula.

New York Compromise refers to the only acceptable format for letters of credit.

Non-Admitted Insurer/Reinsurer is one not licensed to do business in the state or the country in which the exposure is located.

Petition is the formal bankruptcy filing by the Debtor.

Plan of Reorganization is the description of the Debtor’s proposal for exiting bankruptcy that includes information regarding the Debtor’s business operations, payment of creditors and related matters ultimately submitted to the bankruptcy court for approval.

Post-Petition is the period from after the date of filing of the bankruptcy Petition until the Exit Date.

Preference is an improper payment made by a debtor to one of its creditors, typically involving an accelerated or early payment to a creditor who would otherwise not be entitles to such a payment due to the bankruptcy filing. The accelerated or early payment could have been made either prior to or after the bankruptcy filing. Payments in the ordinary course of business generally are not considered Preference.

Prepackaged Bankruptcy is a bankruptcy filing by the Debtor, often after consultation with its creditors, designed to expedite and clarify the process of resolving the Debtor’s financial situation so that the Debtor can exit bankruptcy with the greatest expediency and resume business.

Pre-Petition is the period prior to the date of filing of the bankruptcy Petition. Unsecured Claims arising during this period generally have the lowest priority and therefore the lowest likelihood of payment from the Debtor’s Estate.

Priority is the relative right of a particular claim or class of claims to payment from the Debtor’s Estate.

Proof of Claim is the form used to assert a contingent or Unsecured Claim against the Debtor’s Estate that must be filed before the Bar Date.

Qualified Bank is a bank or trust company determined by the Securities Valuation Office of the National Association of Insurance Commissioners as being qualified to issue certain instruments.

Reinsurance is a transaction that involves acceptance by a reinsurer of all or part of a risk covered by another insurance company, the ceding company. The two main types of reinsurance are Treaty and Facultative.

Reinsurer is an insurance or reinsurance company that assumes all or part of the insurance or reinsurance written by another insurance company.

Retrospective Premium is the premium developed by applying the retrospective rating formula, subject to a Minimum Retrospective Premium and a Maximum Retrospective Premium.

Secured Claim is the claim of a creditor that holds collateral to ensure payment of that claim.

Standard Premium is calculated in accordance with state rules using manual rates times the exposure times the experience modification, and (if applicable) times the deviations.

Self-Insured Retention (SIR) is an amount of liability assumed by an insured that the insured pays directly to the claimant. There is no policy issued by an insurance company, and therefore there is no obligation to pay losses within this layer. Depending upon the line of business of the self-insured, an insured may contract with a third party administrator to handles the claims within the self-insured retention.

Single Parent Captive is a captive owned and organized by one company, usually to cover only the exposures of that parent company, its subsidiaries and its affiliated companies. It may also offer coverage to unaffiliated third parties, in quest of a profit.

Surplus Penalty is a statutory accounting requirement that surplus be reduced by ten percent of the amount of the uncollateralized deferred receivable and by 100 percent of any uncollateralized amount of reinsurance ceded to an unauthorized reinsurer.

Treaty Reinsurance is a form of reinsurance in which the ceding company enters into an agreement to cede certain classes of business to a reinsurer and the reinsurer agrees to accept all business qualifying under the agreement.

Trustee is the person appointed by the bankruptcy court in some situations to manage the Debtor’s Estate for the benefit of the Debtor and its creditors.

Ultimate Retrospective Premium is the premium that is calculated at program inception and at each retrospective premium adjustment that represents the insurer’s estimate of the retrospective premium based on a current loss valuation plus IBNR.

Unauthorized Reinsurance is that written by a non-admitted insurer/reinsurer whereby the ceding company must secure collateral in order to take the credit on its annual statement for the reinsurance ceded.

Unsecured Claim is the claim of a creditor that does not hold collateral to ensure payment of that claim.

Waiver is an agreement between the insured and the insurer whereby the insurer agrees not to secure the required collateral amount.[29]