FINANCIALLY IMPAIRED INSURERS

CHAPTER THIRTY-EIGHT

FINANCIALLY IMPAIRED INSURERS

Ellen M. Dunn, Esq. Stephen W. McInerney, Esq.*

* Ellen M. Dunn is a partner and Stephen W. McInerney is an associate in the Insurance and Financial Services Group of Sidley Austin LLP.

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Under New York law, like in most states, an insurer is financially impaired if it (1) cannot pay its claims or debts; (2) has inadequate reserves; or (3) has engaged in conduct that violates the law. The New York State Legislature adopted a version of the Uniform Insurers Liquidation Act, which sets forth the salient principles regarding the administration and conduct of impaired insurers in New York. That legislation appears in article 74 of the N.Y. Insurance Law (Insurance Law).

[38.0] I. REMEDIES AVAILABLE TO IMPAIRED INSURERS

New York law provides that an impaired insurer may be placed in either rehabilitation1 or liquidation.2 The purpose of rehabilitation is to attempt to cure the insurer's financial problems under court-ordered protection from litigation. In both rehabilitation and liquidation, the New York Superintendent of Insurance (Superintendent) must obtain an order from a New York State court permitting the company to be placed under the Superintendent's care.3 The goal of rehabilitation is for the insurer to emerge as a viable company pursuant to a court-approved plan. The closest analogy in bankruptcy is a Chapter 11 reorganization.

In contrast, the purpose of liquidation is to sell the insurer's assets and collect debts to maximize value for the estate. The insurer's business affairs are to be "wound up" pursuant to a court-approved plan. The closest analogy in bankruptcy is Chapter 7 liquidation.

In both rehabilitation and liquidation the regulator runs the company. The company's management and board are stripped of their authority.4 Occasionally, the regulator will grant a role to management in rehabilitation but that is unusual. In New York, like other states, the regulator in charge of the impaired insurer is usually the Insurance Commissioner in the state where the insurer is domiciled.5 The Superintendent, as regulator-in-charge, may appoint a designee to act as rehabilitator or liquidator.6

1 N.Y. Insurance Law ? 7402 (Ins. Law). 2 Ins. Law ? 7404. 3 Ins. Law ?? 7403, 7405. 4 Ins. Law ? 7409. 5 Ins. Law ? 7409(a). 6 Ins. Law ? 7409(c).

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Unlike many other states, New York has no explicit provision for supervision. Supervision, which does not require a court order, allows the regulator to review and approve management's actions and to attempt to cure financial or other defects through that review without assuming full control over the company. Although there is no explicit provision for supervision in Insurance Law article 74, informal supervision in New York is common.

An insurer may be placed into rehabilitation or liquidation with or without the consent of management. In order to place a company into rehabilitation or liquidation, the Superintendent must obtain an order to show cause from a New York State court.7 The court has the power to place the insurer into rehabilitation or liquidation temporarily, pending a full hearing.8

Regardless of whether rehabilitation or liquidation is contested by management, the Superintendent must show, in order to place the company into rehabilitation or liquidation, that the insurer meets one of a number of criteria, including that (1) the insurer is impaired or insolvent; (2) the insurer has willfully violated the law; (3) the insurer's continued operation is hazardous to its policyholders or the public; or (4) the insurer has ceased doing business for one year or more.9 If the insurer has significant assets in other states, the insurance commissioners in those states may apply for an order directing them to conserve the insurer's assets in that state.10 These orders establish what is known as an ancillary receivership.

[38.1] II. ONCE AN INSURER IS PLACED INTO REHABILITATION OR LIQUIDATION, WHAT HAPPENS?

After an insurer is placed into rehabilitation, the Superintendent alone is charged with removing the causes that resulted in the placement of the insurer into rehabilitation.11 The Superintendent, together with his or her designees, runs the company. Often, there is no set time frame within

7 Ins. Law ? 7417.

8 Ins. Law ? 7419; see also In re Rehabilitation of Frontier Ins. Co., 6 Misc. 3d 291, 788 N.Y.S.2d 827 (Sup. Ct., N.Y. Co. 2004), rev'd on other grounds, 27 A.D.3d 274, 813 N.Y.S.2d 50 (2006).

9 Ins. Law ?? 7402, 7404.

10 Ins. Law ? 7410(a). New York adopted the Uniform Insurers Liquidation Act, which allows for the reciprocity of conserving assets located in a particular member state.

11 Ins. Law ? 7403(a).

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which the Superintendent must complete rehabilitation of the company.12 The Superintendent may sell or dispose of company assets.13 Usually, all

pending litigation against the insurer is stayed, both in and out of New York,14 and the Superintendent is given authority to pursue causes of action belonging to the company, its policyholders and creditors.15

In liquidation, the Superintendent alone is charged with marshaling or selling assets to maximize the value for the estate. The Superintendent and his or her successors in office run the company.16 As in rehabilitation, there is often no set time frame within which the liquidation must be completed. All pending litigation against the insurer may be stayed.17 The Superintendent also may pursue litigation on causes of action belonging to the insurer, its policyholders or creditors.18 Specifically, the Superintendent "stands in the shoes" of management and may take any action management was empowered to take.19

12 For example, Frontier Insurance Company entered into rehabilitation in October 2001 and remained there for 11 years, until the Court converted the company's rehabilitation proceeding into a liquidation proceeding in November 2012. See Frontier Insurance Company, New York Liquidation Board (Sept. 10, 2015), frontier.htm.

13 Ins. Law ? 7428.

14 Ins. Law ? 7419(b); see Ins. Law ? 7414. But see Pires v. Ortiz, 18 A.D.3d 263, 795 N.Y.S.2d 9 (1st Dep't 2005) (holding that a liquidation stay against all proceedings involving the insurer did not apply to an inquest after entry of default judgment against insureds, since the stay took effect after the insurer had disclaimed coverage); In re Rehabilitation of Frontier Ins. Co., 27 A.D.3d 274, 813 N.Y.S.2d 50 (1st Dep't 2006) (holding that a temporary restraining order (TRO) in a rehabilitation proceeding did not restrain surety's attorneys from submitting papers in opposition to performance bond obligee's summary judgment motion against surety in federal action, as that conduct was not expressly identified in TRO; thus surety had defaulted on that motion).

15 See Bernstein v. Centaur Ins. Co., 606 F. Supp. 98 (S.D.N.Y. 1984) (where Superintendent was substituted as plaintiff once Superintendent was appointed rehabilitator).

16 Ins. Law ? 7405.

17 Id.; Ins. Law ? 7419(b). There are, however, time frames for certain actions once the liquidator elects to take such action. See, e.g., Ins. Law ? 7405(f)(1) ("No later than one hundred eighty days after a final order of liquidation with an adjudication of insolvency . . . the liquidator may in his sole discretion make application to the court for approval of a proposal to disburse assets out of marshaled assets, from time to time as such assets become available, to any fund established by article seventy-six of this chapter, article six-A of the workers' compensation law and any foreign entity performing a similar function. . . .").

18 See Corcoran v. Hall & Co., Inc., 149 A.D.2d 165, 170?71, 545 N.Y.S.2d 278 (1st Dep't 1989).

19 See Corcoran v. Nat'l Union Fire Ins. Co. of Pittsburgh, PA, 143 A.D.2d 309, 311, 532 N.Y.S.2d 376 (1st Dep't 1988).

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[38.2] III. CLAIMS IN LIQUIDATION

When a company is placed into liquidation, notice is generally provided to its creditors that claims and proof of claims should be filed in the liquidation proceeding.20 A claim is an assertion that payment is owed by an impaired insurer. Claims may be filed for (1) specific losses or occurrences arising under the coverage of an insurance policy; (2) return of unearned insurance premium due to early cancellation of an insurance policy; (3) commissions or fees; (4) unpaid legal expenses; or (5) other unpaid invoices.21

Claimants include policyholders or insureds, agents and brokers, attorneys, litigants and general creditors. A claim is generally made by making a filing with the rehabilitator or liquidator.22 The filing must generally include, in reasonable detail:

? the claim;

? the consideration for the claim;

? any securities held for the claim;

? any payments made on the claim; and

? a statement that the claim is justly owing from the insurer.23

All claims must be accompanied by supporting documentation24 and be filed by a date specified by the liquidator and the court.25

20 Ins. Law ? 7405(a).

21 Ins. Law ? 7437 (the Derivatives Act) clarifies the ability to close out "qualified financial contracts" and "netting agreements" in the context of insurance insolvency proceedings. The Derivatives Act allows persons who entered into a "netting agreement" or a "qualified financial contract" with an insurer that becomes insolvent, or otherwise subject to a proceeding under article 74, to exercise rights under that agreement or contract they would otherwise be stayed or prohibited from exercising. For example, such a person could exercise a contractual right to cause the "termination, liquidation . . . or close out of any obligation" arising from such an agreement. The Derivatives Act does not apply to financial guaranty insurers.

22 Ins. Law ? 7432(b).

23 Ins. Law ? 7433(a)(1).

24 Id.

25 Ins. Law ? 7432(b).

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To disallow a claim, the liquidator must report the claim to the court and specify the action that he or she recommends. The court then fixes a time for a hearing, provides notice of the hearing and then allows or disallows the claim.26 The court's order allowing or disallowing the claim is an appealable order.27

Like most states, New York has a statutory priority scheme for distributing assets of the impaired insurer in order to pay claims. The priority scheme set forth in New York for all insurers, except life insurance companies, generally is as follows:28

? Class one: the Superintendent's administrative costs and expenses for

acting as liquidator or rehabilitator.

? Class two: claims under policies by any level of government for

losses incurred by third parties, and for unearned premiums; claims by a security fund, guaranty association or the equivalent, except for claims arising under reinsurance contracts.

? Class three: all other claims of the federal government.

? Class four: wages owed to the insurer's employees for services within

one year prior to the commencement of rehabilitation/liquidation proceedings (capped at $1,200/employee); claims for unemployment insurance contributions.

? Class five: all other claims of state and local governments.

? Class six: claims of general creditors, including claims under reinsur-

ance contracts.

? Class seven: claims filed late and any other claims not covered under

any other class.

? Class eight: claims for advanced or borrowed funds made pursuant to

Insurance Law ? 1307.

26 See Ins. Law ? 7417 for the procedures governing all proceedings under article 74.

27 See In re N.Y. Sur. Co., 282 A.D.2d 463, 723 N.Y.S.2d 201 (2d Dep't 2001) (where appellate court decides the outcome of appeal of Supreme Court's allowance of a claim).

28 Ins. Law ? 7434(a)(1). See Ins. Law ? 7434(e) ("The provisions of this section shall apply to distributions made after the effective date of this subsection in any proceeding under this article, regardless of the date such proceeding was commenced under this article. . . .").

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INSURANCE LAW PRACTICE, 2D. ED, 2016 REV.

? Class nine: claims of shareholders or other owners in their capacity as

shareholders.

The priority scheme for life insurance companies generally is as follows:29

? Class one: the Superintendent or guaranty association's administra-

tive costs and expenses for acting as liquidator, rehabilitator, or guaranty association.

? Class two: debts owed to the insurer's employees for services within

one year prior to the commencement of rehabilitation/liquidation proceedings (capped at $1,200/employee).

? Class three: claims for payment for goods/services rendered to the

impaired insurer in the ordinary course of business within 90 days prior to the date the insurer was determined to be impaired or insolvent.

? Class four: claims under insurance policies and annuity contracts;

claims of guaranty association other than its claims in class one.

? Class five: claims of any level of government, limited to the extent of

the pecuniary loss sustained from the insurer's act along with reasonable costs--the remainder of such claims are placed in class eight.

? Class six: claims of general creditors and any other claims not cov-

ered under any other class.

? Class seven: surplus, capital, or contribution notes or similar obliga-

tions.

? Class eight: claims of policyholders other than under class four;

claims of shareholders or other owners.

Other rules also affect claim payment. For example, the rehabilitator or liquidator is permitted to avoid fraudulent transfers or transactions. This means that every obligation incurred by the impaired insurer within one year prior to the granting of an order placing the insurer into rehabilitation or liquidation is fraudulent if (1) it is made with the intent of enabling a creditor to recover a greater percentage of his or her debt than any other creditor of the same class; and (2) the creditor has reasonable cause to believe that this preference will occur.30

29 Ins. Law ? 7435(a).

30 Ins. Law ? 7425(a).

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Similarly, New York has rules relating to payment of contingent claims. In a distribution of the assets of an insolvent insurer, a contingent claim is only allowed if (1) it becomes absolute against the insurer on or before the last day fixed for filing proofs of claim, or (2) there is a surplus and the liquidation is conducted on the basis that the insurer is solvent.31 In addition, anyone who has filed suit against an insured with a liability insurance policy issued by an insurer in liquidation shall have the right to file a claim in the liquidation proceeding, even though the claim is contingent upon successful litigation of the matter.32 The claim generally is allowed if it meets the following standards:

? it may be reasonably inferred from the proof presented that the per-

son could obtain a judgment;

? the person provides suitable proof (unless waived by the court) that

no further valid claims arise out of the cause(s) of action asserted in the claim; and

? the total liability of the insurer to all claimants arising out of the same

act of its insured shall be no greater than its total liability would be were the insurer not in liquidation or rehabilitation.

[38.3] IV. OFFSETS AND RECOUPMENT

Commonly, an insolvent insurance company has debts and credits to the same party. Those circumstances often present a dilemma: the creditor is legally obligated to pay the insolvent insurer but the insolvent insurer may not be able to repay its debt in full to the creditor. Two similar but different remedies are available in this situation: offset and recoupment.

Under New York law, offset is a statutory right to set off "mutual debts and credits" arising out of separate transactions.33 For example, if A owes B $100, and B owes A $75, offset allows A, under certain circumstances, to net the liabilities and pay B only the balance: $25.34 For a debt to be mutual, the debts must be due (1) to and from the same persons, (2) in the

31 Ins. Law ? 7433(c).

32 Ins. Law ? 7433(d)(1).

33 Ins. Law ? 7427.

34 "The right of setoff . . . allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding `the absurdity of making A pay B when B owes A.'" In re The Bennett Funding Grp, Inc., 146 F.3d 136, 140 (2d Cir. 1998) (quoting Citizens Bank v. Strumpf, 516 U.S. 16, 18 (1995)).

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