OGC Opinion No. 08-12-08

The Office of General Counsel issued the following opinion on December 31, 2008 representing the position of the New York State Insurance Department.

RE: Treatment of Collateral Held by an Insurer in Liquidation or Rehabilitation

Question Presented:

If an insurer is placed into rehabilitation or liquidation, would the cash collateral placed with the insurer by a policyholder (pursuant to the terms of a payment agreement governing the insurance program existing between the insurer and the policyholder) be treated as general assets of the insurer’s estate?

Conclusion:

The treatment of cash collateral will depend upon the facts and circumstances pertaining to the particular situation presented. However, if a policyholder can demonstrate that cash collateral was placed with the insurer pursuant to the terms of a bona fide payment agreement governing the insurance program existing between the insurer and the policyholder, and that the collateral does not in fact constitute premiums earned by the insurer, then the collateral should not be treated as part of the insurer’s general assets.

Facts:

Many of the commercial property/casualty insurers in a corporate holding company system enter into various kinds of insurance agreements pursuant to which the policyholders provide collateral to the insurer in order to secure future obligations to pay losses.¹ The collateral requirements are typically set forth in a separate payment agreement governing the entire insurance program with the insured.

The collateral consists of letters of credit, funds or securities held in trust, and cash collateral held by the insurer on an unsegregated basis. Cash collateral is reported as an asset on the insurer’s balance sheet with an offsetting liability.

Certain policyholders are concerned that in the event an insurer is placed into rehabilitation or liquidation, any cash collateral provided by the policyholder would become a general asset of the insurer’s estate and could be applied by the liquidator or rehabilitator for purposes other than those intended by the agreement between the policyholder and insurer.

Analysis:

This inquiry involves the proper treatment of an insurer’s assets in cases where the insurer is under the control of the receiver. Unlike certain statutes² enacted in other states, nothing in Article 74 of the New York Insurance Law specifically addresses the treatment of cash collateral. Cash collateral, unlike other collateral vehicles, can be difficult for a liquidator or rehabilitator to categorize. Because of the inherently fungible nature of cash, when it is held on an unsegregated basis it usually is presumed to be part of an insurer’s general assets. That presumption, however, may be overcome if sufficient evidence is presented that a given amount of cash is being held as collateral and is not in fact simply part of the general assets of the insurer.

New York Insurance Law § 7408 (McKinney 2006), which sets forth the definitions used in New York’s adaptation of the Uniform Insurer’s Liquidation Act, is instructive. In particular, Insurance Law § 7408(b)(7) provides as follows:

Under this definition, assets that are specifically deposited or otherwise encumbered for the security or benefit of specific persons are excluded from the general assets of the estate to the extent necessary to discharge the sums secured thereby.

Insurance Law § 7408(b)(7) does not refer specifically to policyholder collateral. Nevertheless, policyholder collateral could be excluded from the general assets of an insurer under the statute’s definition. Policyholders deposit collateral with an insurer precisely for the “benefit of specific persons or limited classes of persons.” For example, many employers with high deductible workers’ compensation coverage are typically required contractually to make large collateral deposits with their workers’ compensation carriers where the carriers are required to pay benefits from the first dollar of loss. Such collateral deposits are necessary to secure the making of benefit payments to their covered employees. In certain instances, however, amounts of cash collateral that have been placed with an insurer may constitute premiums earned by the insurer. If that is the case, any such amounts would be included in the insurer’s general assets. See Matter of Liquidation of Union Indemnity Insurance Company of New York, 132 Misc. 2d 102 (Sup. Ct. N.Y. Co. 1986) (noting that an insurer’s fully earned premiums are part of general assets).

Union Indemnity is the only New York case to date to address the statutory definition of general assets. But the case did not involve the treatment of collateral; rather, it involved determining whether or not certain funds held by a third party acting as an agent of the insurer were part of the general assets of the insurer. In Union Indemnity, the insurer had agreed to provide workers compensation insurance for an association of various municipalities and local governments (“PERMA”). Under the operation of the program, the insurer’s agent, Frank B. Hall and Co. (“Hall”), collected the premiums, administered and paid claims, and was responsible for investing the funds held. Seventy percent of premiums paid were held for the payment of claims, and the balance was used to pay commissions, taxes, and to obtain reinsurance. When Union Indemnity went into liquidation, the Superintendent, as Liquidator, sought to recover the funds held in a bank account constituting the remaining balance of the amount set aside for the payment of claims. PERMA and Hall sought to retain these funds, arguing that the insurance program was essentially self-funded and that Union Indemnity was not entitled to the funds. The court disagreed, and in siding with the Superintendent, concluded that the funds held represented premiums fully earned by Union Indemnity. Id. at 104.

The view that collateral should not be included in the general assets of an insurer undergoing liquidation or rehabilitation is generally consistent with the practice of the New York Liquidation Bureau, which has indicated to the Department that, in situations where there is a bona fide agreement between a policyholder and an insurer that specifically characterizes an asset as collateral and not part of the general assets of the insurer, such collateral will not be included in the general assets of the insurer’s estate in liquidation or rehabilitation.

With respect to cash collateral held on an unsegregated basis, it is not possible to state categorically in advance how such collateral would be treated. A decision regarding such assets can be made only after an examination of the particular facts and circumstances of the case. Nevertheless, in cases where such cash collateral does not represent premiums earned by the insurer, and where a policyholder can demonstrate that it has posted an amount of collateral with an insurer for a specific purpose, that policyholder’s contractual expectations as to the use, application, and return of its cash collateral will be respected even in the event of the rehabilitation or liquidation of the insurer.

For further information you may contact Supervising Attorney Michael Campanelli at the New York City Office.

¹ These agreements include retrospectively-rated policies (i.e., policies available only to large commercial insurance buyers in which the final premium for the covered risks are adjusted, subject to an agreed-upon maximum and minimum limit based on actual loss experience); policies that cover self-insured or high-deductible programs (often used in the context of workers’ compensation insurance where the insured retains liability on a great part of the risk) and captive insurance programs (where a captive insurer is used to provide reinsurance for all or most of the risk initially written by a conventional insurer).

² See 215 ILCS § 5/205.1 (2005) and 40 P.S. § 221.23a (2004), enacted by Illinois and Pennsylvania, respectively, which expressly exclude policyholder collateral from inclusion in the estate of a rehabilitated or liquidated insurer’s estate.