Critical Issue Report

State guaranty funds…what will their future role be?

The current financial crisis and the specter of federal regulation spawn questions

By Phil Zinkewicz

Last September, when the Federal Reserve Bank of New York agreed to provide a two-year, $85 billion government bridge loan to American International Group (AIG), many industry observers were looking to state insurance guaranty funds to determine what role, if any, they would play in dealing with the company’s financial woes.

After all, AIG is a monolith in the insurance industry—worldwide. State guaranty funds are vehicles that act as safety nets for policyholders when an insurance company becomes insolvent. They ease the burden on policyholders and claimants of the insolvent company by assuming the responsibility for most policy claims immediately following the liquidation.

New York is the only state that has a pre-assessed guaranty fund, meaning that insurance companies domiciled in New York have already been assessed for their share of the guaranty fund money, based on the company’s premium income in New York, and the money is already there in the event of an insolvency. All other states that have guaranty fund laws have post-assessment vehicles. That is to say that if a company in a state other than New York goes insolvent, insurance companies domiciled in those states would then be assessed after the insolvency is declared.

State guaranty funds also differ in some of the coverages that come under their protection. While all state guaranty funds cover auto and homeowners insurance claims, some other types of insurance may not be covered. In some states, annuities, life, disability, accident and health, surety, ocean marine, mortgage guaranty and title insurance may not be covered.

The impairment rate of insurance companies in the United States has been declining, according to A.M. Best, but the Insurance Information Institute (I.I.I.) says that the trend may not last in the current economic downturn and soft market. So, once again, in the case of the current situation involving AIG, which has myriad insurance company subsidiaries domiciled in various venues across the country, what will the role of state guaranty funds be?

“None,” says Pat Borowski, senior vice president for the National Association of Professional Insurance Agents (PIA National). “The problems AIG faces have to do with its portfolio of securities operations. It is the holding company that has run into difficulty. Despite all the misinformation that has been put forth in the media, the AIG crisis has nothing to do with insurance.”

Other industry solons agree with Borowski’s contention. “The insurance ratings of AIG insurance subsidiaries remain good,” says Dave Evans, senior vice president of the Independent Insurance Agents and Brokers of America (IIABA). “The insurance operations of AIG are not in difficulty at all.”

“The loan was needed to give the holding company time to overcome serious liquidity problems,” according to the I.I.I. “The National Association of Insurance Commissioners (NAIC) has stressed that AIG’s insurance subsidiaries are solvent and able to pay claims. It is the non-insurance parent, which is a federally regulated entity, that is financially distressed.”

Moreover, the NAIC emphasized that the insurance subsidiaries are governed by state law designed to protect the interests of policyholders. Therefore, state regulators will work closely with AIG management and other regulators to ensure that decisions made to resolve the liquidity issues at the holding company level fairly compensate its insurance company subsidiaries, said the NAIC.

Nevertheless, according to Kenneth R. Auerbach, Esq., PIA National president, those who favor federal regulation of insurance are using the AIG situation to further their cause. America’s insurance consumers have been well protected, and insurance companies remain stable and sound in the current financial turmoil thanks to fiscally prudent regulatory oversight by state insurance regulators, Auerbach said.

“State regulation is a success story in the current financial crisis,” explains Auerbach. “Our state insurance regulators got it right at the same time that federal regulators’ experiments with ‘self regulation’ failed to supervise the most fundamental activities of banks and securities firms. Regrettably, Treasury Secretary Henry Paulson and others have used the AIG rescue to argue for federal regulation of insurance. Doing so fosters an incorrect perception that the insurance operations of AIG had failed when, in fact, they have not. To use AIG as an example to argue that federal officials should be granted regulatory authority over the insurance sector is to twist the facts.”

Auerbach referred to comments made by New York Insurance Superintendent Eric R. Dinallo, who helped broker the FRB-backed $85 billion rescue of AIG: “AIG is Exhibit A for how well the state system worked, not how poorly it worked,” adding that the rescue of AIG presents a case against an optional federal charter for insurance regulation.”

AIG and its insurance subsidiaries aside, how are state guaranty funds doing in today’s insurance industry environment? Fairly well.

Actually, in recent years, there have been relatively few insolvencies that have had an effect on state insurance guaranty funds. According to A.M. Best, there were four property/casualty insolvencies in 2007. Two of the companies wrote private passenger nonstandard auto insurance in New York State. They were both affiliated with a New Jersey company that became impaired in 2001.

The third company was a South Carolina risk retention group, which provided extended vehicle service warranty contracts; and the fourth was a Florida company, Vanguard Fire and Casualty Company. Vanguard entered receivership, a form of reorganization, in January 2007, but its assets—cash and reserves—were insufficient to pay claims. The company’s 57,000 homeowners policies were assumed by other insurers, under an agreement worked out by the court. Vanguard started out in 1997 by assuming 13,000 residential policies from the forerunner of the Florida Citizens Property Insurance Corp.

However, just because state guaranty funds have not taken large hits recently does not mean that there will not be problems in the future. In 1987, a General Accounting Office (GAO) report on insolvencies noted that insolvencies generally follow the property/casualty insurance company profitability cycle. The GAO report also pointed out that the profile of insolvent insurance companies has changed over the years. In the late 1960s and 1970s, insolvencies occurred mainly among small auto insurers with a limited geographic span. Since that period, the characteristics of insolvent insurers have become more diverse and have included some large multistate companies. The incidence of large company insolvencies has raised concerns over the ability of the guaranty fund system to pay all covered claims.

But the real threat to state guaranty funds is coming from the possible regulation of insurance at the federal level, according to many insurance industry experts. Many insurers support an optional federal charter as opposed to the current system of state regulation. Where the state guaranty funds fit into that scenario is open to question.

According to a backgrounder available from the National Conference of Insurance Guaranty Funds (NCIGF): “The concern shared by many in the guaranty fund system, of course, is that a regulator of federal insurance would deliver consumer protection if a federally chartered insurer becomes insolvent. 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 insurance 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,” says the NCIGF report. “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 author
Phil Zinkewicz is an insurance journalist with more than 30 years’ experience covering the international insurance and reinsurance arenas. He was the insurance editor of the Journal of Commerce for a number of years, handling all their domestic and international supplements. In addition, he regularly writes for a number of London publications.