AIRROC honors the memory of our long-time friend Terry Kelaher who passed away recently after battling cancer and kidney disease. Terry was a co-founder and vice chairman of AIRROC. He joined Allstate Insurance Company in 1988 where he served as vice president and general manager of the company’s Specialty Operations Division, responsible for the management of discontinued businesses. He was also responsible for Allstate’s domestic and international reinsurance activities. Prior to that, he served as chairman and CEO of Allstate Insurance Company of Canada and Allstate Life Insurance Company of Canada. In addition to AIRROC, Terry has contributed guidance and direction to many insurance and reinsurance boards and associations. He was chairman of the Insurance Bureau of Canada; chairman of the Insurance Institute of Canada; and vice chair of the Insurance Crime Prevention Bureau.
In honor of Terry Kelaher, we revisit an AIRROC Classic, a favorite article with a timeless quality. The article entitled “Claim Estimation” was penned by Terry and appeared in the inaugual issue of AIRROC Matters. This was the first in a series of articles on the pros and cons of accelerated claim estimation. Terry’s article offered a reinsurer’s critique of accelerated payment and buy-out strategies used to run-off distressed and insolvent business. Jonathan Rosen’s response entitled “Bringing Claim Estimation into Perspective,” appear in the Winter 2005 issue, Vol. 1, No. 2. Both articles in their original format can be found under the Archives tab.
Claim Estimation By Terry Kelaher
Vol. 1, No. 1 Fall 2005 Issue
An involuntary settlement of reinsurance recoverables through claim estimation is a highly controversial matter that much of the insurance industry and regulators continue to study. In theory, other than the contractual issues, it seems like a great idea. Most agree that speeding up and maximizing payouts to creditors and reducing the administrative costs of receiverships or distressed companies are noteworthy goals. Achieving those goals through the use of claim estimation, however, is not the right answer. Claim estimation, and the concomitant acceleration of reinsurance recoveries, violates the terms of the reinsurance contract, is riddled with inaccuracies and may, in turn, ultimately be used to trigger payment from guaranty funds.
Involuntary claim estimation to accelerate payments of reinsurance recoverables, unlike contractual commutations, violates the terms of the reinsurance agreement. Reinsurance is a contract of indemnity. By the express terms of the reinsurance agreement, a reinsurer is required to pay or “indemnify” the ceding company where the ceding company has paid or is required to pay. This is “we pay if you pay.” Claim estimation eviscerates this fundamental element of a reinsurance agreement. To require reinsuers to pay on the basis of an estimate of what the ceding company thinks it may pay – even if it never pays – destroys the core indemnification tenet of the agreement. A voluntary commutation allows the parties to voluntarily modify their contractual arrangement under the reinsurance agreement. This approach differs dramatically from a forced non-contractual estimation and payment acceleration.
Proponents of claim estimation point to the insolvency clause to suggest there are no contractual impairments to estimation. This clause exists to ensure the enforceability of reinsurance contracts by a receiver where the ceding company has become insolvent, but a claim amount is certain and owed by the insolvent insurer to the insured. The insolvency clause is then triggered by requiring the reinsurer to pay the receiver without diminution based on the insolvent’s ability to pay all or part of the claim amount due. The insolvency clause does not alter the nature of the reinsurance agreement or void the contractual liability provisions. Indeed, numerous courts have rejected attempts to use the insolvency clause to rewrite the parties’ obligation under the reinsurance. Moreover, the specific notification requirements contained in the insolvency clause binding the liquidator to provide notice to the reinsurers of the pendency of each claim reiterate the contractual difficulties with claim estimation. Such additional obligations, as to each pending claim contained in the insolvency clause, could not be honored where reinsurers are asked to pay based purely upon an estimate of unknown claims. Reinsurers are incapable of investigating a claim or interposing a defense where no notice has been received, where the identity of the claimant is unknown and it is not known whether the event has even occurred. The right to participate in a proceeding to determine claims, as provided for in the insolvency clause, is a contractual right that the estate must satisfy. This is an essential contractual right that protects the reinsurers from the possibility of exaggerated claims. Claim estimation abrogates that right.
The Inaccuracies of IBNR
Apart from contractual issues, claim estimation is fraught with inaccuracies due to its reliance on IBNR loss estimates to determine the values to be used. IBNR losses are actuarial estimates that insurers and reinsurers use for accounting purposes to ensure sufficient funds will be available to pay any meritorious claims which may arise in the future. A fundamental aspect of IBNR loss estimates is that they may and often are adjusted over the course of time to reflect many factors, including subsequent claim experience and fluctuations in the legal climate (which in the United States, is a significant variable). The calculation of IBNR was never intended to compel reinsurers to make loss payments or to accept forced commutation values as used in solvent schemes. Therefore, under claim estimation, a reinsurer is called upon to pay a claim where the injured party cannot be identified, the type of injury cannot be verified to determine the basis of coverage, the date and time of the loss cannot be ascertained to determine whether the event took place during the term of the policy and the estimate of the cost is fraught with inaccuracies. Because these essential elements are, by definition, absent in IBNR calculations, IBNR claims are not recoverable under an insurance policy and, in turn, a reinsurance contract.
Notably, actuaries recognize the inherent uncertainty of IBNR projections and typically establish ranges, not specific dollar values. Those ranges can vary significantly and fluctuate over time. Specifically, in the Integrity liquidation, numerous actuarial firms have been hired to estimate the liability of Integrity. According to the RAA, Mary Lou O’Neil, Milliman & Robertson, Tillinghast Towers-Perrin, and Ernst & Young in a peer review of O’Neil’s work have all performed actuarial studies on the Integrity estate. The Integrity estate is noteworthy not for the number of major actuarial firms which have reviewed its liabilities, but for the substantial disagreement among so many actuarial firms concerning Integrity’s liabilities. Rating agencies, too, have had difficulty estimating environmental and asbestos liabilities. In 1994, A.M. Best projected that environmental and asbestos liabilities would range between $55 billion and $623 billion. Those projections were revised in 1996. The result: its mid-range projection was drastically reduced from $260 billion to $57 billion and its worst-case scenario projection was reduced from $623 billion to $92 billion. The wide variance among different actuaries and the extreme difficulty in estimating industry wide exposures – not to mention the virtual impossibility of accurately estimating emergence at an individual claimant level – exemplifies the inherent difficulties with claim estimation. Requiring reinsurers to pay or cedants to settle based on such projections will ultimately result in significant inaccuracies.
Claim estimation also has the potential to harm guaranty associations. For example, under many state liquidation laws, claims by policyholders must be covered under insurance policies in order to share in the distribution of assets. This same requirement is often found in Guaranty Fund laws. If IBNR became the basis for billing reinsurers, policyholders and third parties could assert that the IBNR amount establishes a floor for their respective claims under Guaranty Fund laws. The obligations of the guaranty associations to pay such amounts as “covered claims” under policies issued by insolvent insurers could potentially have an adverse and unfair impact on the liabilities of those associations and, in turn, the solvent insurance industry, which funds the guaranty associations.
Several states – Illinois, Missouri, Connecticut and Utah – have enacted legislation permitting some form of claims estimation but have limited the ability to collect from reinsurers based on that estimate. According to the RAA, claims estimation has been defeated in bills in Alabama, California (introduced and defeated three years in a row), Idaho, Mississippi, Oklahoma, Pennsylvania, Rhode Island, and Tennessee.
Claim estimation is the subject of large debate in the insurance industry. While increasing payouts to creditors and reducing administrative expenses are important goals, claim estimation is not the proper remedy to achieve them. Claim estimation violates the sanctity of the reinsurance agreement, is based on actuarial assumptions which are riddled with inaccuracies, and has the potential to trigger numerous guaranty fund issues. Application of claim estimation and accelerated reinsurance recoveries sets a dangerous precedent and turns the hallmark of an indemnity agreement on its head.