Insuring for the future

What will happen if a financially stressed New York monoline insurer is placed in receivership?

A rehabilitation or liquidation of a monoline has little precedent. Very few monolines have experienced receivership. In 2008, ACA Financial Guaranty Corp. suffered severe financial stress. The Maryland Insurance Department then fostered a consensual solution that may become a precedent for restructuring other monolines.

ACA creditors, whose claims derived from nontraditional business, received a controlling interest in the insurer in exchange for the commutation of their policies. This arrangement effectively subordinated their claims to the carrier's other policyholders.

The insurance regulators may place a troubled monoline in rehabilitation or liquidation. In rehabilitation, the regulator takes possession of the monoline's property and conducts its business.

The insurance regulator has broad powers, including the cancellation of policies with unmatured claims, to remove the causes and conditions that precipitated the rehabilitation.

Alternatively, the regulator may bring a liquidation proceeding against an insolvent insurer. Liquidation law strictly determines the priorities of claims against the liquidation estate. Administrative costs and expenses come first. Policyholders' claims come second. Matured claims under monoline financial guaranties would receive priority. It is unclear how contingent claims or incurred but not reported claims would be treated. Originally, monolines guaranteed municipal or other public debt. Under a typical policy, if the issuer failed to pay, the monoline would pay scheduled interest and principal. Later, monolines began to write nontraditional business covering: (1) asset-backed commercial paper, collateralized debt obligations and other structured securities; and (2) special purpose vehicles or transformers. The transformers entered into credit default swaps covering a broad array of debtors, "reference entities." In 2007, monolines backed CDSs with an aggregate exposure of $62.2 trillion dollars. About 75% of this book of business consisted of "naked" credit default swaps.

A CDS is a contract that entitles a protection buyer to a specified payment from a seller if a credit event occurs with respect to a reference entity. If the seller could not pay, it would look to the monoline. CDSs provide protection to those exposed to reference entities and are legitimate risk management tools, provided that the buyer has actual exposure to the reference entity. Importantly, it is not necessary for a buyer to have actual exposure to a reference entity; a buyer can buy a naked CDS.

When the monolines took on non-traditional business, their underwriters constructed what they believed were highly sophisticated models to anticipate the default probability of the risks they insured. These models, among many other failings, failed to account for certain significant risks inherent to naked CDSs.

It has long been fundamental that insurance should cover only an insurable interest in the risk, life or property insured. Generally, a carrier would never issue fire insurance that covered a policyholder's neighbor's house. The only way that policyholder would benefit would be from his neighbor's misfortune. The holder of a naked CDS has a compelling interest, and a perverse incentive, in the demise of the reference entity. Buying a naked CDS is, in effect, an efficient and opaque alternative to shorting the stock of a reference entity.

The risks of the naked CDS business unfortunately were not captured by the monolines' models. Now these risks have materialized and, compounded by a general decline in asset values, threaten the monolines.

Regulators are somewhat attuned to the problem. On Sept. 22, 2008, the superintendent of the New York State Department of Insurance issued a best practices letter (currently indefinitely delayed) for financial guaranty carriers. It's clear regulators are pondering the prohibition of coverage of naked CDSs.

The lack of insurable interest pre-
sents a real and intolerable risk that either the receiver or other interested parties will seek to deny priority to claims arising under an insolvent monoline's policies backing naked CDSs. Since these priorities apply only in liquidation, a consensual arrangement or plan of rehabilitation resembling the ACA model may finesse the issue. Market participants who are exposed to a monoline endgame should take heed.

Allan E. Reznick is a partner at Kramer Levin Naftalis & Frankel LLP.