Regardless of the efficacy of regulation to avoid insurer insolvency, such inevitably will occur giving rise to considerable hardship and financial losses to policyholders and their beneficiaries. Each insolvency leads to calls for better protection against such losses. To achieve the basic regulatory objective of security through assuring the reliability of the insurance institution, when an insurer fails, it is essential to (1) minimize insurer losses through various levels of regulatory intervention even to the point of closing the insurer down and (2) afford a means of guarantees to those members of the insurance-consuming public experiencing losses. To each of these elements we now turn.

When an insurer experiences substantial financial adversity, the insurance commissioner of that company’s state of domicile has the responsibility and the authority to act. If the commissioner believes that with proper management the insurer can be made solvent again, he or she can undertake to supervise or rehabilitate the insurer. If the insurer is hopelessly insolvent at the outset or if, after efforts to supervise or rehabilitate, it becomes apparent that the insurer cannot be saved, the commissioner can move to place the insurer into liquidation. The authority to conduct rehabilitation and liquidation proceedings applies to domestic insurers. If an insurance commissioner has concerns as to the financial condition of an out-of-state company, he or she may suspend or revoke that insurer’s license to do business in the state.

Although as a general proposition bankruptcy law is the province of Congress and the federal courts, in the context of insurance such authority has long been vested in the states. Prior to 1909, delinquency proceedings of insurance companies were handled through the courts by the appointment of receivers under the courts’ traditional equity powers. Virtually anyone could petition the court to put the insurer into receivership (for example, stockholder, creditor, the insurance commissioner). However, judicial receiverships proved inherently inadequate since the receiver’s powers were confined to the jurisdiction of the appointing court. As a result, a multiple state insolvency gave rise to a multiplicity of receivership proceedings in the various states involved. Furthermore, the receiver lacked legal title to all of the insurer’s assets thereby rendering him or her impotent to enforce judgments in foreign jurisdictions where company assets might be held, for example, statutory deposits required under state insurer licensing laws. Another concern was the lack of statutory standards and procedures to govern the receivership proceeding, leaving the receiver and the supervising court to their own devices. In turn, this led to time-consuming delays and a lack of uniformity from one proceeding to the next and sometimes to inequitable results.

In response to growing problems with judicial receivers, following the Armstrong Investigation into the life insurance business, in 1909 New York enacted a law replacing judicial receiverships with administrative receivership provisions applicable to all insurers to the exclusion of the existing judicial receivership system. Specific grounds were set forth for the initiation of delinquency proceedings by the superintendent of insurance who was also granted broad discretionary powers to rehabilitate or liquidate the insurer. In 1932 the legislature corrected problem areas with the statute with an enactment of the first comprehensive statute dealing with insurance company delinquency proceedings. The trend away from judicial receiverships in the context of insurance, which began in 1909 in New York, rapidly spread to other states.

Originally the procedure for liquidation was for the insurance commissioner to petition the proper court for the appointment of a receiver (someone other than the commissioner) who would then liquidate the company under direction of the court. Although perhaps still the procedure in some states, most jurisdictions now charge the insurance commissioner with the responsibility of directly serving as the liquidator. Typically, when the commissioner deems it necessary, he or she petitions the court for an order appointing him or her as receiver for the purpose of rehabilitation or liquidation. Some states have created a liquidation division within the insurance department itself to carry out this function.

The next landmark step in the evolution of state insurer receivership law was the 1965 total revision in the Wisconsin delinquency proceeding law. The new Wisconsin Insurance Rehabilitation and Liquidation Act drew upon the federal bankruptcy law and was designed to afford the state insurance commissioner the necessary tools to deal with the myriad of issues which can occur in delinquency proceedings. In addition, the Act sought to encourage the commissioner to take quick action when appropriate. In 1968, the NAIC recommended the Wisconsin law for adoption by the various states and, in 1977, it adopted a major revision in the Model Rehabilitation and Liquidation Act which drew heavily from the Wisconsin legislation. A substantial majority of states have adopted the Model Act or statutory provisions similar thereto.

The Model Act establishes a comprehensive and modernized system for rehabilitation and liquidation. Among other things, the Act provides for the vesting of exclusive authority in the domestic commissioner to conduct such proceedings and for finding alternative means to deal with impaired financial condition prior to utilization of formal proceedings, when an insurer might be able to work out its difficulties under the supervision and orders of the commissioner. In December 1994, the NAIC made several revisions in the Model Act to strengthen the position of the domiciliary receiver in multistate insolvencies and to alter the distribution of assets.

Nature of Supervision. The first tier, supervision, contemplates limited insurance department actions when the problem is deemed to be relatively easy to correct. However, the supervision portion of the Model Act was deleted when the NAIC adopted the Administrative Supervision Model Act in 1989. (As of 1992, about one-third of the states have adopted this model or something similar thereto.) Although already possessing significant general supervisory authority over insurers, often troubled insurers will challenge such authority in the courts resulting in either deterring or, at least delaying, timely regulatory action. Armed with greater statutory specificity, a commissioner is in a better position to act in a timely and effective fashion.

Under the Supervision Model Act, an insurer may be brought under insurance department supervision if the commissioner finds that the insurer’s condition renders the continuance of its business to be hazardous to policyholders, the insurer has exceeded its authority under its license, the insurer failed to comply with the insurance law, the insurer’s business is being conducted fraudulently or the insurer gives its consent. When under supervision, the commissioner shall inform the insurer as to what must be done to lift the supervision. The commissioner may prohibit the insurer from doing one or more of several specified acts such as conveying assets, withdrawing funds, lending funds, investing funds, incurring liabilities, and increasing salaries.

Nature of Rehabilitation. If supervision proves to be insufficient, the second tier of control is rehabilitation. Under a rehabilitation order granted by the court, the commissioner is given title to the insurer’s assets and management authority to carry on its business to reform and revitalize the insurer’s financial condition until the grounds for issuing the order have been removed and the insurer can be returned to private management. Unlike supervision, here the commissioner takes direct control and runs the company.

Nature of Liquidation. If rehabilitation is deemed or proves to be unworkable, the commissioner moves to the final step. Liquidation of a domestic insurance company constitutes the ultimate power of the commissioner. Pursuant to a liquidation proceeding, the commissioner is granted title to all assets of the insurer and is directed to take possession thereof. Notice is to be given to other state insurance commissioners, guaranty funds, insurance agents and all persons known or reasonably expected to have claims against the insurer. The commissioner, as receiver of the insurer, collects the insurer’s assets, reduces the assets to a degree of liquidity consistent with effective execution of the liquidation and distributes the assets in accordance with the priorities established by law. The statutory priorities are: first, the cost of administration of the liquidation followed by reasonable compensation to employees (other than the principal officers and directors), second, claims under policies for losses incurred (including those of third parties under liability policies), and third, claims for unearned premiums or other premium refunds as well as claims of general creditors. After one priority class is paid, the assets are distributed to the members of the next class. This process continues until the assets are depleted. When the assets become insufficient to meet all the claims within a priority class, they are distributed on a pro rata basis. Thereafter, classes of a lower priority receive nothing out of the assets of the insurer. However, as discussed below, unpaid or not fully paid insurance claims may find recompense under a guaranty fund law.

Grounds for Rehabilitation and Liquidation. If the insurance commissioner has reasonable cause to believe, after a hearing, that a domestic insurer has committed or is about to commit any act which would give rise to an order for rehabilitation or liquidation, the commissioner may issue orders which are reasonably necessary to remedy such conduct or condition.

The grounds for petitioning for an order of rehabilitation listed in the Model Act are numerous including the following: insurer financial condition such that further transaction of business would be financially hazardous to its policyholders, creditors or the public; embezzlement, diversion of insurer assets or fraud endangering the insurer’s assets in an amount threatening the solvency of the insurer; insurer failure to remove an executive found, after a hearing, to be untrustworthy in handling the insurer’s business; control of the insurer possessed by one found, after a hearing, to be untrustworthy; insurer refusal to submit to examination; insurer transfer or attempted transfer of substantially its entire property or business without commissioner approval; and insurer violation of the insurance law of the state and/or any valid order of the commissioner.

Grounds for an order of liquidation embrace the above plus insurer insolvency.

Although the commissioner’s authority to supervise, rehabilitate or liquidate arises primarily with respect to insurer financial difficulty, such authority also extends well beyond, for example, the violation of any state insurance law or regulation. Thus the commissioner possesses substantial life and death enforcement power over its domestic insurance companies.

Given the inevitability of at least infrequent insolvencies in a free market insurance system, while rehabilitation or liquidation of a financially troubled insurer may minimize insurer losses, financial losses to members of the life insurance consuming public promise to occur. Thus in addition to regulation for solvency and a means to deal with financially impaired insurers, to further enhance the reliability of the life insurance institution there has emerged a state insurance guaranty fund system.

Drawing upon the precedents of the 1933 Federal Deposit Insurance Corporation (FDIC) for banks and the 1934 Federal Savings and Loan Insurance Corporation guaranteeing, up to specified limits, the deposits in banks and savings and loans which fail, a few states enacted guaranty statutes in the areas of workers’ compensation and public motor vehicle liability insurance. In 1941, the New York state legislature created the New York Life Insurance Guarantee Corporation which involved the accumulation of a reserve pool through percentage of premium assessments against all New York licensed insurers. However, not until a 1960s Congressional investigation highlighted numerous insolvencies of property and liability insurance companies, especially high-risk automobile insurers, did the guaranty fund concept achieve widespread application as a means of enhancing the reliability of the insurance mechanism.

Responding to both the problem of insolvency and the threat of federal insolvency legislation, the NAIC adopted a model guaranty fund law in 1969 for property and liability insurance to assume the insolvent insurer’s claim-paying function and absorb the insolvent insurer’s funding deficiencies in the payment of claims. In 1970 it did likewise with respect to life and health insurance. The Act, known as the NAIC Life and Health Insurance Guaranty Association Model Act, was substantially revised in 1985 and amended in 1987. Within the 5-year period 1969–1974, 47 states enacted property and liability guaranty funds laws. States were slower to act on the life side. However, impetus arose from the collapse of Baldwin United in 1983. By 1991 all states enacted some type of guaranty fund laws for both life and health insurance on the one hand and property and liability insurance, on the other. A few such acts preceded but most are patterned after the NAIC models.

Especially when contrasted to the number of insolvencies in the property and liability insurance business, the insolvencies among life insurance companies have been relatively rare. In part this can be attributed to the practice of large insurers, in cooperation with the regulators and guaranty fund associations, for assuming the policies of failing life insurers by reinsurance or merger before such insurers actually collapsed. Nevertheless, more recent highly publicized state takeovers of a few substantial life insurers, coupled with the widely publicized financial troubles of several other large, highly regarded insurers, which fortunately found additional capital without having to resort to the regulatory insolvency mechanism, have caused concerns as to life insurance company stability. These insolvencies, financial impairments and embarrassments were caused in large part by investments in less-than-investment-grade bonds—so-called junk bonds—and/or by investments in unsound real estate ownership and mortgages. Consequently there has been decreased public acceptance of the certainty of life insurer financial soundness, increased emphasis on state insolvency regulation (with substantial focus on investment quality of insurer portfolios), and the enactment of life insurance guaranty funds in all states.

The purpose of the guaranty fund laws, as set forth by the NAIC Life and Health Insurance Guaranty Association Model Act, is to protect policyholders, insureds, beneficiaries, annuitants, payees and assignees against losses due to the impairment or insolvency of an insurer. The protection extends not only to paying claims, such as cash values and already owing death benefits, but also to continuing coverage since an insured may be in impaired health or at an advanced age rendering him or her unable to obtain new and equivalent coverage from other insurers. These purposes are to be achieved through the mechanism of a statutorily created Guaranty Association whose membership consists of all insurers licensed to do business in the state with respect to the coverages covered under the Act. When an insurer is declared insolvent, the guaranty fund assumes the responsibility for the payment of policyholder claims with the funds for such payments being derived from assessments against member insurers based upon a percentage amount of the insurer’s relevant premium written in the state.

With the 1985 amendments, protection is afforded primarily to persons who are residents in the state. The Model Act covers life, health and annuity policies and contracts and contracts supplemental thereto. However, coverage for certain insurance products has been excluded, such as nonguaranteed aspects of variable contracts. Furthermore, the collapse of Baldwin United, attributable substantially to the issuance of single premium deferred annuities with guarantees of high interest rates followed by a market decline in interest rates, resulted in major costs to Guaranty Associations. To address the high interest guarantee problem, the 1985 amendments eliminated coverage where contract interest guarantees were substantially in excess of a Moody bond index rate. Also the Association is liable for no amounts in excess of the obligations under the covered contract. Nor shall its liability exceed $100,000 in cash values or $300,000 for all benefits (including cash values) with respect to any one life, $100,000 for health insurance benefits, and a total $5 million limit on unallocated annuity contract benefits.

The Association is primarily intended to act after the insurer has been deemed insolvent pursuant to an order of liquidation. However, the Association, with respect to an impaired insurer (for example, an insurer found to be potentially unable to fulfill its contractual obligations by the commissioner), may guarantee, assume or reinsure any or all policies of the insurer or otherwise provide monies to such insurer as long as such activity is approved by both the impaired insurer and the commissioner. The Association may negotiate, as a condition of such early assistance, any requirements or safeguards it deems necessary if they are approved by the commissioner and accepted by the impaired insurer. This authority enables the Association to provide early assistance so as to avoid or minimize further deterioration in the situation and thereby save costs in the long run.

If a member insurer of the Association is impaired and is not paying claims in a timely fashion and if certain statutory conditions are met, the Association shall take such actions as those noted above or provide substitute benefits (subject to commissioner approval) for policyholders in "hardship circumstances."

If the insurer is found insolvent by a judicial order of liquidation, the Association shall (rather than may) in its discretion, either (1) guarantee, assume or reinsure (or cause the same) the policies and contracts of the insurer and, assume payment of the insolvent insurer’s contractual obligations, providing moneys or pledges to discharge such duties or (2) with respect to life or health policies, provide benefits and coverages. Any new contracts shall be offered without new underwriting.

Any person receiving benefits pursuant to the Act is deemed to assign the rights under the covered policy to the Association thereby enabling the Association to recoup, at least in part, the claims it pays and the costs it incurs from the assets of the insurer.

Although the Guaranty Fund Association provides the funds to make up losses due to the financial impairment of the insurer, the Act recognizes that the source of these funds is other insurers and ultimately the costs thereof are absorbed by other policyholders, taxpayers and/or insurer stockholders. Thus there is a strong public interest in minimizing assessments to the extent consistent with fulfilling the purposes of the guaranty fund law. Consequently the Act reflects concern as to "runs" (that is, a policyholder rush to withdraw assets by, for example, taking out cash values) against an impaired insurer, thereby forcing significant sales of assets perhaps at a time of depressed value in a tight money market. As result, under certain circumstances, the Act provides for the imposition of temporary or permanent policy and contract liens and moratoriums subject to court approval.

For purposes of administration and assessments, the Association maintains two accounts, one for health insurance and one for life and annuity contracts. The latter account is made up of three subaccounts: life insurance, annuities, and certain unallocated annuities. To provide the funds needed to carry out its functions, the Association assesses the member insurers separately for each account, a percentage amount based upon the insurer’s relevant premium written in the state. With respect to the life and annuity account, the 1987 amendments provide that first a one percent assessment shall be made on the account of the particular subclass of business. If this is not enough, then all the subclasses shall be assessed subject to the 2 percent of premium maximum limit during any one year. If the assessments fail to provide sufficient funds in a given year, the Association is empowered to borrow funds which later can be repaid out of future assessments.

The Model Act authorizes a member insurer to reflect in its premium rates and dividend scales an amount reasonably necessary to meet its assessment obligations. This contemplates that the cost of the assessments to the insurer can be appropriately passed on to its policyholders, that is, the persons afforded protection by the Act. However, unlike the property and liability guaranty fund situation, life insurance premiums and premiums for certain forms of health insurance cannot be changed for existing policyholders. Building assessment costs into premium rates for future and nonexisting policyholders can be argued to be both impractical and unfair. Thus the Model Act offers an optional section, for acceptance or rejection by the individual states as they see fit. This option provides for reducing an insurer’s premium, franchise or income tax liability by the amount of the assessments. Commonly referred to as the premium tax offset, this provision has the effect of spreading the cost of the assessments among the taxpayers of the state.

Included in the NAIC Model Act is a prohibition against insurers, agents or affiliates of insurers from publishing, disseminating, circulating or placing before the public in any way any advertisement, announcement or statement which uses the existence of the insurance guaranty fund association for the purpose of sales solicitation or inducement to purchase insurance. The theory underlying this prohibition is one of fairness. The major cost of assessments is borne by the large companies. The major benefit of advertising the existence of a guaranty fund safety net is for smaller companies who might lose sales to those persons believing that larger insurers possesses greater financial stability. The larger insurers urged, and state legislatures and regulators accepted the notion, that it is unfair to permit smaller insurers to sell insurance on the basis of safety provided by other insurers through the guaranty fund associations.

When the original limitation was included in the NAIC Model Act, there was little doubt as to its constitutionality. Under the then-prevailing doctrine, advertisements of commercial products did not enjoy the same free speech protection under the First Amendment of the United States Constitution as political, literary, artistic and other noncommercial statements enjoyed. However, in the mid-1970s this began to change. Over time Supreme Court decisions expanded First Amendment protection to advertising in traditionally regulated industries including public utilities and the practice of law. Despite some changes in the Model Act, the basic prohibition remained virtually unchanged. Although the United States Supreme Court has not passed upon the prohibition against truthful mention of a state insurance guaranty fund’s existence and provisions, a state supreme court has declared such prohibition unconstitutional.

Although there exists a high degree of similarity in the overall structure of life insurance guaranty funds from state to state, few, if any, state laws are identical and many exhibit significant variations from one another in such areas as maximum claim amounts, insurance products covered, insurer assessment limits, and assessment recoupment provisions.

The vast majority of states followed the original pattern of the NAIC Model Act in affording coverage under three separate accounts: life, health and annuity. A few combine life and annuity coverages into the same account. Iowa deals with annuities under two separate accounts, one for allocated and the other for unallocated annuities. Two states have created a fourth account for defined- contribution plans, two states established a fourth account for administration and one state has a separate general account.

With the exception of Maryland, which provides guaranty fund coverage up to the contractual obligation of the insurer, all states impose some limit or limits on the maximum amount of guaranty fund liability on one life. Most states provide an aggregate all benefits maximum ranging from $100,000 in one state to $500,000 in three states. The preponderance of states, however, opted for the NAIC Model Act limit of $300,000 for all benefits, whatever their nature. Within the overall maximum, many states impose maximums on particular categories of coverage. The categories (such as death benefits, disability benefits, health benefits, cash values, and present value annuity) and maximums imposed thereon vary by state. Only a handful of states adopted a disability category with a $100,000 limit. Nearly half the states established a health category, usually with a $100,000 maximum but some applying a $200,000 or $300,000 maximum. Most states set forth a $100,000 limit on cash values and a $100,000 limit on present value annuity.

The guaranty fund laws set a maximum amount of assessments which can be levied annually against an insurer, currently ranging from one percent to 4 percent of annual premiums with most states opting for the NAIC Model Act figure of 2 percent.

Under the law of a few states, insurer members of the guaranty funds either absorb the cost of assessments out of their own funds or seek to recoup such costs through premium charges or policyholder dividend adjustments. However, over 40 states permit the assessed insurers to recoup in the form of some type of premium tax offset.

State variations have given rise to criticisms as to fairness and coverages. A common criticism of the state guaranty fund system has been the alleged lack of uniformity as to the manner in which policyholders are protected across the nation. For example, some question the fairness of two policyholders who possess identical coverage from the same insolvent insurer receiving different guaranty fund payments simply because they live in different states. Or why are claimants in one state eligible for payments, whereas claimants in other states are not covered? Large commercial insureds complain about the need to submit a number of claims to different states to recover losses under a single policy issued by an insolvent insurer. But it has been argued that there are no inequities between residents of the same state regardless whether he or she is insured by a domestic or foreign insurer. Differences in guaranty function between residents of one state vis-à-vis residents of another state reflect state diversity rather than inequity. In all fields of endeavor there are state-by-state differences which are not deemed to justify national uniformity. State differences reflect the specific conditions, perceived needs and acceptable solutions in each state.

Following recent state takeovers of several large life insurance companies, a major focus on guaranty fund coverage has been varying treatment of guaranteed investment contracts (GICs) and unallocated funding obligations (UFOs), which are primarily investment products sold as funding vehicles for corporate pension and 401(k) plans. But, unlike group annuity contracts, UFOs do not identify each pension plan participant’s individual share. The insurer simply guarantees the buyer (typically the employer or a pension trust fund) a fixed rate of return over the life of the contract.

During the high interest rate era of the 1980s, GICs became a very popular funding vehicle for employee retirement plans. Executive Life and First Capital Life wrote extensive business in this area before being placed under rehabilitation by California in 1991. Many buyers suddenly discovered that the GICs bought from these insurers to fund their employee retirement plans may be unprotected in the event of insolvency. Fifteen state life guaranty funds specifically exclude UFOs from coverage. Nineteen states specifically provide coverage usually conforming to the Model Act’s provision which calls for $5 million in coverage for any one contract, regardless of how many employees are under such contract. Guaranty fund coverage availability is unclear in the remaining states.

Most life insurance industry observers agree that the guaranty funds were not designed to deal with investment products marketed by insurers and should not provide coverage therefor. When an employer purchases a GIC, it is like investing in stocks or bonds. The test of insurance business is mortality and morbidity risks. If the transaction is not related to such, insurance guaranty fund protection is inappropriate. Some maintain that the Department of Labor or the federal Pension Benefit Guaranty Corporation for defined-benefit plans should be responsible for controlling the investment of retirement benefit funds, even though currently they are viewed as not being adequate for the task.

However, others maintain that state guaranty fund treatment of GICs is unfair. Many persons have sustained substantial losses in their retirement benefits when the insurer holding the assets that fund these benefits became insolvent. There are major variations between states in their coverage of GICs primarily due to the fact that many states base their guaranty funds on model legislation from the 1970s which predated the emergence of GICs as a major investment vehicle for pension plans. GICs are expressly excluded from coverage under the laws of several states; many states which do provide at least some coverage vary significantly as to the amount; some states explicitly exclude coverage for GICs purchased by defined-benefit plans which are protected by the federal Pension Benefit Corporation; and many states limit coverage to only those persons who are state residents. It has been urged that differences in treatment are inequitable because such variations affect employees of the same company who may have made identical contributions to the same retirement plan.

A concern raised as to state guaranty funds is whether the guaranty funds possess the capacity to meet current and future liabilities. When an insurer is declared insolvent, the fund assumes the responsibility for the payment of policyholder claims, with the funds for such payments being derived from assessments against member insurers.

Between 1976 and 1991, life and health insurance claims have caused $680 million of guaranty fund assessments with an estimated future potential up to $4.2 billion over time. Although concern has been expressed as to the adequacy of the current maximum annual limits on assessments and the industry’s capacity to meet future assessments, since guaranty fund claim payments are spread out over a period of time, not all liabilities need to be assessed against the solvent insurers in one year. Furthermore, in aggregate, the life and health industry’s current annual capacity approximates $3.0 billion. Thus, while the aggregate assessment costs are far from trivial, the National Organization of Life and Health Guaranty Associations (NOLHGA), maintains that the overall capacity of the system is adequate. This conclusion has been buttressed by evaluations performed by the NAIC indicating that for 1990, the life and health insurance guaranty fund capacity was $3.2 billion and that over the period of 1986 to 1991, net assessments against the guaranty funds averaged 5.4 percent of capacity with the highest assessment in 1991 representing only 14.4 percent of the 1990 capacity. Thus it appears that the state life and health guaranty funds possess adequate gross capacity.

Nevertheless, as to individual states there is the potential for gaps between needed guaranty fund assessments and that state’s annual capacity. In some instances, separate accounts may temporarily run out of money. However, the guaranty funds are authorized to borrow money and repay out of future assessments. Furthermore, most funds maintain reserves so that claim payments can begin even before assessments are collected.

To conclude, when both property and liability guaranty funds and life and health guaranty funds are considered, the states have created 100 separate funds presenting something other than a uniform monolithic insolvency protection system. While the funds have functioned reasonably well, critics of the system have not only questioned specific attributes of the system, but have also raised concerns as to whether the funds are structured to handle future insolvencies which may be larger. Suggestions for improvement include dealing with specific administrative and coordination problems, reducing variances in protection afforded between states, utilizing interstate compacts, or replacing the current system with a single federal insolvency fund. But no matter how the guaranty system evolves in the years ahead, in addition to regulation to prevent insolvencies and where such cannot be prevented to minimize their size, the provision of guarantees through some type of guaranty fund system has become a fundamental element in achieving the major insurance regulatory goal of assuring a reliable insurance mechanism.