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Legal Ease by Scott Sinder What If?

What if AIG actually failed? What happens then?

By  Scott Sinder

What would have happened if the government didn’t step in to rescue AIG and had allowed it to fail? What if another company with which you do business ends up in the same position?

I am not a bankruptcy lawyer. I don’t have extensive expertise in bank conservatorships or receiverships, and I have never worked on a carrier liquidation. I have, however, talked with colleagues with plenty of experience in these areas to figure out what might happen should the federal money tap be turned off.

As many state insurance commissioners have repeatedly advised, it is crucial to distinguish between AIG the holding company (or any other holding company) and its insurance subsidiaries. The subsidiaries remain healthy and unharmed by the fiscal problems that their holding company parent has been experiencing. That is by design. Every state has adopted some version of the National Association of Insurance Commissioner’s Insurance Holding Company Model Act, which essentially requires approval of all material transactions between a carrier subsidiary and its parent company. This includes almost all transfers of funds or other assets from the carrier subsidiary to the holding company parent. This means that the assets of the subsidiaries are protected and preserved to serve their intended function: paying policyholder claims.

As Sandy Praeger, the Kansas insurance commissioner and former NAIC president, put it in a statement in September: “The No. 1 job of state insurance regulators is to make sure insurance companies operate on a financially sound basis. If needed, we immediately step in if it appears that an insurer will be unable to fulfill the promises made to its policyholders.”

One way regulators do this is by protecting the carrier assets from the creditors of its holding company, even in bankruptcy proceedings.

If AIG, the holding company, files for bankruptcy, it should do so in a federal bankruptcy court. I say “should” instead of “will” because we have never seen an insurance holding company failure of this magnitude, and, inevitably, there will be legal maneuvering and battles. That said, AIG technically is a thrift holding company primarily regulated by the FDIC, and the FDIC’s rules make clear that thrift holding companies go through normal federal court bankruptcy proceedings.

Once in the bankruptcy proceeding, the thrift and insurance subsidiaries are assets of the bankruptcy estate and, absent a reorganization of the holding company under which it would emerge from bankruptcy still being AIG, those assets normally would be auctioned off to the highest bidders. Before any such sale of an insurance subsidiary can be finalized, however, the insurance regulator for the state in which the subsidiary is domiciled would have to approve the sale under its change-of-control standards. This approval is another mechanism designed to protect the solvency of the insurance subsidiaries. The NAIC has established a process intended to expedite such approvals to the extent possible during this time of tumult.

The process thus is (or should be) relatively straightforward and is designed to ensure that the carrier assets are insulated from any direct annexation by the holding company or the holding company’s creditors. I would fail as an attorney, however, if I did not close with two complicating issues.

First, carriers have mandatory capital requirements, and they may also have surplus—or non-required capital. Although payments from insurance subsidiaries to their parents must be approved, it might be difficult for an insurance regulator to prohibit a transfer of surplus capital because, by definition, the carriers are not required to retain the surplus and a bankruptcy court may well believe that those surplus capital assets should be made available to satisfy creditor claims. Theoretically, that transfer should not affect the carrier’s projected ability to pay claims, but, if it were to, that would be the basis for a regulator objection, which should overcome the bankruptcy court’s demand under McCarran-Ferguson.

Second, the manner in which the subsidiaries’ ratings will be affected by all of the developments is very unclear and warrants close monitoring. Most errors and omissions policies require placement with carriers rated at certain levels, and potential liability for a carrier insolvency also is tied to that same framework. The insurance rating process remains a bit opaque, but it appears that the ratings of insurance subsidiaries are to some extent influenced by the creditworthiness of their parent. Although this should probably not be true, there may be an implied expectation that a subsidiary’s inability to satisfy claims on its own may be overcome by a well situated holding company’s wherewithal, should calamity strike the subsidiary.

There is some precedent for holding companies stepping in to absorb the liabilities of a failed (or technically insolvent) carrier subsidiary, so the notion that a rating agency may factor in such potential credit support is tenable. The converse also is probably true, and we all will need to pay close attention to the ratings of AIG’s insurance subsidiaries as the odyssey continues to unfold. Ironically, a cut in the rating of a carrier—because its parent files for bankruptcy or some other reason—generally increases its mandatory capitalization requirements and thus could insulate that carrier from a potential raiding of its surplus capital.

Let’s hope this discussion is nothing more than an academic exercise, but it never hurts to consider “what if.”

Sinder, a partner at Steptoe & Johnson, is CIAB General Counsel.
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