May 2009 Insurance Issues Related to Bankruptcy This paper will discuss insurance-related issues for companies in or on the threshold of bankruptcy. It will provide an overview of the bankruptcy process, to lay the basic foundation for that discussion. The paper will then review specific issues for companies in bankruptcy. Particular attention will be paid to the effect a company s financial problems will have on the relationship with its insurers. With ever changing statutes and regulations, and the steady stream of opinions being issued by courts, state and federal laws which impact bankruptcy are constantly evolving. Clients should consult legal counsel for updated and current information on the material contained within this white paper before taking any action. The discussion within this paper is not provided so that readers can become experts on bankruptcy, but rather as a tool in evaluating risks and issues to be considered during such difficult periods. We confine our advice to risk transfer and risk management issues. What is bankruptcy? Bankruptcy is the process by which debtors (individuals and business entities that owe money) obtain a discharge from the claims of creditors (the individuals and business entities to which that money is owed). It is initiated through the filing of a petition with the bankruptcy court. Once filed, it activates what the Bankruptcy Code calls the automatic stay. The automatic stay operates to bar all creditors (with certain narrow exceptions) from attempting to collect pre-petition (incurred before bankruptcy) debts. Upon discharge from the bankruptcy court, those debts cannot be collected. The process is designed to allow a debtor to achieve a fresh start, free of the burden of crippling debts. While there are several forms of bankruptcy (depending on the status of the debtor), this paper will focus on two types that apply most commonly to corporations: Chapter 7 and Chapter 11.
Chapter 7 Chapter 7 is one method of corporate dissolution. If an entity cannot be revived through reorganization, and the debtor company wants to dissolve in an orderly fashion, without the necessity of contending with creditor suits and collection actions, Chapter 7 is the option such a debtor would select. Assets are marshaled, suits are stayed and the business is shuttered. Eventually, a tally is made of legitimate debts owed, and creditors are paid some fraction of the amount of their claim, after expenses of administering the debtor s estate. Chapter 7 results in liquidation and the company goes out of business. Keep in mind that Chapter 7 does not cancel expired policies. If a policy expired before the petition was filed, bankruptcy has no effect on the insurer s obligations thereunder. This remains true even if additional premium may be owed to the carrier, above the standard or initial premium collected. Chapter 11 Chapter 11 allows a business to reorganize its obligations so that debt levels are more manageable. A company with an unsustainable debt load, or a company facing large scale liabilities, perhaps from multiple product liability suits, can file a Chapter 11 petition. This prevents a rush to the court house with each creditor trying to gain an advantage to the detriment of every other creditor. In theory, the company, by restructuring existing liabilities and debt levels, can emerge from bankruptcy. Unlike Chapter 7, where the bankruptcy court appoints a trustee who runs off the debtor s estate, under Chapter 11 the petitioner typically becomes its own trustee, called the debtor in possession (DIP). The DIP will either file an already completed plan (called a pre-packaged reorganization plan) or develop one in both instances in conjunction with creditor representatives. The DIP has a 120 day period within which it may only propose a reorganization plan, called the exclusivity period. Inevitably the plan, which must be voted upon by the creditors and confirmed by the court, will repay some creditors (although perhaps not fully or in as timely a manner) while discharging others. Occasionally, unsecured creditors may have to accept equity in the new company for debt of the old. Chapter 11 affords a company the opportunity to remain in business while reorganizing, with the goal of emerging from bankruptcy as a viable, but often smaller company. Like Chapter 7, reorganization under Chapter 11 does not impact expired policies. The insurer must continue to honor its policy obligations. Therefore, a debtor may be discharged from numerous products liability suits, while the insurer remains on the risk. Indeed, plaintiffs often file a motion for relief from the bankruptcy stay to pursue their claims. These claimants agree to satisfy any judgment solely from the proceeds of applicable insurance which means the insurer might pay, but the debtor will not. What is the significance of the petition date? The filing date marks the divide between pre petition debt, which may be discharged or restructured, and post petition debt, which is not affected by the bankruptcy. Post petition creditors are not discharged, nor are they barred from collection efforts by the automatic stay. Because Chapter 11 debtors hope to remain in business, this fact has implications for how they deal with their insurers, as discussed below. What is a preference claim? The petition date also impacts preference actions. The goal of a bankruptcy proceeding is to treat similarly situated creditors the same way. No creditor, therefore, should be preferred over any other. A preference is the transfer of an asset to a creditor in payment of an existing obligation (termed an antecedent debt), if made within the 90 day period before the bankruptcy petition is filed. For corporate insiders, the look back period may be extended to one year before the petition. A preference action is a lawsuit filed by the bankruptcy trustee, creditors committee or the DIP to recover preferential transfers. Bankruptcy law presumes that the debtor was insolvent during that 90 day period prior to filing. The law also assumes that the payments the debtor made were preferential to those creditors, while other creditors either did not get paid or received less than they should have. The preference action is designed to recoup such preferential transfers for redistribution among all the creditors. 2 Marsh
How is a secured creditor affected by the bankruptcy petition? Bankruptcy draws a distinction between secured and unsecured creditors, with the latter at serious risk of being unable to collect amounts owed by the debtor. An unsecured creditor is a party holding a claim against an entity that files a petition in bankruptcy, which claim is unsupported by collateral or a perfected security interest. Unsecured creditors rely solely on the debtor s promise to pay. There are no assets or funds dedicated to the repayment of the sums owed to them. Secured creditors are in a far better position in the event of bankruptcy. Holders of perfected security interests have recourse to the collateral posted by the debtor for repayment of the underlying debt. These rights are outlined in the Uniform Commercial Code (UCC), enacted in almost all states with slight variations. The Bankruptcy Code relies upon state law for the determination of property rights, such as security interests under the UCC. These distinctions are important because bankruptcy law follows a strict hierarchy of priorities. Those at the top of the list (secured claims and administrative claims) are normally paid in full. Those creditors at the lower end (unsecured creditors) are likely to recover a small fraction of the amount owed to them, if anything at all. This makes sense because if a debtor could pay all creditors, the necessity of bankruptcy relief presumably would be obviated. What is an administrative claim? An administrative claim represents debt incurred by the debtor s estate, with either express or tacit permission of the court, after the petition has been filed. Included in this category are necessary costs for maintaining or reorganizing the company, such as legal and accounting representation, employee salaries and insurance coverage. If one cannot be a secured creditor, and nevertheless must endure a debtor s petition in bankruptcy, this is the best position in which to be. What is a proof of claim? A proof of claim (POC) is a form filed by the creditor with the Bankruptcy Court that details how much the creditor is owed as of the petition date. It is usually accompanied by supporting documentation. As part of its initial or first day orders, the court will set a bar date, which functions as the due date for all POCs. POCs received after the bar date are untimely, and will likely result in the claim being forever barred. Therefore, like all legal documents, POCs must be carefully managed. Marsh 3
Can the insurer cancel the policy if the insured files a bankruptcy petition? After the bankruptcy filing, insurers are prohibited from canceling a policy for non-payment of prepetition premiums. A notice of cancellation sent by the insurer after the bankruptcy filing may not be effective, because it may be subject to the automatic stay. For these reasons, carriers with customers in distress are vigilant in sending notice of cancellation, particularly for nonpayment of premium. However, even if the cancellation notice was sent pre-petition, if the policy was not cancelled before the bankruptcy filing, the automatic stay would prevent it from being cancelled without the permission of the bankruptcy court. This protection does not apply prospectively. Insurers cannot be forced to enter into new contracts of insurance with a bankrupt insured. Assumption / Rejection of Insurance Policies If a contract is deemed to be an executory contract (a contract in which performance remains due by both parties), the insured s bankruptcy trustee or the insured as DIP may affirmatively assume or reject that contract. A certain amount of planning must go into this decision because if a contact is assumed, past defaults (including pre-petition defaults) must be cured. Effectively, assumed contracts are not discharged and remain outside the debtor s estate. Insurers will often nudge the debtor along, by seeking an early hearing on their motion to assume, especially where the policy has yet to expire. Insurance policies, at their core, are contracts. As such, insureds must determine whether their existing insurance policies are executory or not. Policies which expired pre-petition, and for which basic premium was paid, generally are not considered executory. Failure by the insured to meet its obligations under a policy does not excuse the insurer from being required to perform its obligations. This is the case even if the sums owed represent retrospective premium or deductible reimbursement. Instead, and to its displeasure, the insurer is left with an unsecured claim for damages incurred from the debtor s breach of the policy. While a Chapter 7 debtor may not face the issue, reorganization under Chapter 11 cannot be successful without post petition insurance coverage. Many lines of insurance, after all, are required by state law. Accordingly, the debtor will need to make a choice. It must either retain its relationship with the incumbent carrier, or secure alternate post petition coverage from a new insurer. With insolvency as the context, and no restraints post-petition on what a new carrier may exact in premium and new collateral requirements, the latter option may not be appetizing. Yet the former can also be problematic. As a condition of maintaining coverage for the reorganization period, insurers will want to be made whole on pre-petition balances, and could require more collateral. Marsh can assist in determining what insurance a debtor must have to continue operating, and to the extent possible, and in securing available capacity to underwrite that coverage. Placement of Insurance Post Petition for Bankrupt Client It is often difficult to place coverage for insureds that have filed for bankruptcy. We strongly suggest that insureds keep their bankruptcy counsel fully informed of the timing of policy expirations. This will enable your counsel to take all necessary steps to attempt to maintain extant coverage via the bankruptcy court. Likewise, the insurance broker must be part of the solution. Insurers may decline to provide a policy to a debtor for underwriting reasons, or because corporate guidelines militate against insuring bankrupt entities. Alternatively, the carrier may be concerned about being compensated, especially for pre petition premium and other obligations. We can work with the insured, to the extent possible, to assuage carrier concerns. If the insured s existing markets will not renew, Marsh can also attempt to get extensions on the current policies, while we continue to seek alternate markets for the account. 4 Marsh
What is a set off, and when are set offs permitted? A set-off is a credit that is used to pay down a debit. The underlying concept is to net balances owed between parties for the sake of efficiency. For example, X owes Y $50 for one transaction, and Y owes X $25 for a separate transaction. Rather than exchanging payments, in the absence of a contractual undertaking to the contrary, X would set off the amount owed it by Y, and send Y a net payment of $25. This logical and expeditious use of set offs happens thousands of times each day. Bankruptcy changes everything. The filing of the petition, as noted above, activates the automatic stay. Creditors may no longer collect payment or file suit against the estate of the debtor. The trustee or DIP actively marshals assets, by collecting balances owed to the debtor. The petition means that creditors must pay the debtor, but the debtor need not pay them, absent a secured claim, or relief from stay. In the insurance context, set offs frequently occur with respect to additional and return premium. If the insured owes the carrier additional premium, the insurer is unlikely to want to send it return premium without deducting amounts owed by the insured. At a minimum, the credit and debit must arise out of the same transaction. The insurance carrier that generated the return premium (credit) must be the same carrier that is owed the earned premium (debit). In addition, both the credit and debit should either be entirely pre-petition or entirely post-petition transactions. Some courts may also require that the debit and credit derive from the same insurance policy. The rules governing set-offs in bankruptcy are complex, and beyond the scope of this paper. Insureds need to be aware of the concept, such that they can seek appropriate legal guidance from bankruptcy counsel if an insurer (or other creditor) sets off against the bankrupt estate. Marsh 5
Program Agreements and Collateral As a condition to the issuance of policies where the insurer assumes credit risk (for example, a high deductible policy), insurers often require the insured to post collateral most often in the form of a clean, irrevocable, evergreen letter of credit (LOC). The parameters of this portion of the relationship are normally documented in a payment, indemnity or collateral agreement (program agreement). These agreements detail the respective liabilities, obligations and rights of the insurer and the insured. They are designed to memorialize how and when the insurer will be paid for deductible losses, allocated loss adjustment expenses, taxes and other expenses. In addition, the agreement sets forth the amount, manner of calculation and method of securing the insured s obligation which can include premium (retrospective, installment, or otherwise), losses, defense and deductible obligations. Finally, the program agreement defines events of default and what the insurer may do under such circumstances, including the ability to draw down on the insured s collateral. The agreement is drafted by the insurer, and its provisions are heavily biased in the insurer s favor. The agreement is complementary to the insurance policies issued by the insurer. With the advent of long tail liabilities, such as asbestos and environmental, insurers sought to share more of the risk with insureds, through features such as high per claim deductibles and self insured retentions (SIRs). To secure payment of these obligations (for which the insurer might otherwise be liable, because its paper is on the risk), insurers require insureds to post collateral. In short, the agreement memorializes the financial obligations of the insured to the insurer in connection with the policies underwritten. What must the debtor agree to in order to secure insurance coverage post petition? As noted above, debtors often are required to maintain certain collateral to secure their obligations to their insurers under the program agreement. That collateral supports a secured claim, and will not be available to the estate to meet other needs. Nevertheless, the debtor will need insurance to be able to reorganize. Insurers often exact a heavy price for future coverage. First, the debtor and the insurer will typically commit their agreement to writing. That agreement, in which the debtor will assume its prior policy and program agreement obligations, will require court approval. The carrier for its part will consent to the assignment of those agreements to the reorganized debtor. The insurer likely will insist on a provision that nothing in the court order, or any other order or proceeding in the bankruptcy case (including any order converting the debtor to Chapter 7 liquidation), will alter or modify any of the terms and conditions of the program agreements. As a corollary, the insurer will insist that the order include full recognition by the court of its rights to the collateral, to the exclusion of all other creditors. The same order will frequently state that the insurer may set off against the collateral in accordance with its rights under the program agreements without further order of the court. Moreover, the debtor will acknowledge that it is obligated to satisfy all pre-petition obligations and to perform all pre-petition duties under the program agreement. Most significantly, debtor must cure any existing monetary defaults, perform all future monetary and nonmonetary obligations, and maintain collateral to secure its continuing obligations under the program agreement. 6 Marsh
Bankruptcy Clause in General Liability Policies Most current general liability policies contain a clause outlining how the policy will react to the insolvency of the insured. Typically found in the Conditions section, the clause provides that the bankruptcy of the Named Insured shown in the Declarations, or any other person or organization qualifying as a Named Insured, shall not relieve the insurer of its obligations under the policy. These provisions originated as requirements under state law. The bankruptcy clause dovetails with the automatic stay, as noted above, to maintain coverage for existing, unexpired policies, where the standard premium has already been paid. Drop Down Drop down is a related issue. What happens if the policyholder is unwilling or unable to pay its obligations, such as deductibles or self insured retentions? Who bears the risk of an insured s bankruptcy? Will the policy drop down to provide coverage? Under a deductible policy, the insurer must pay claims first, and seek reimbursement from the insured for its deductible obligation. In carrier parlance, the insurer has its paper out on the risk. If the insured cannot or will not pay, the carrier must defend and indemnify deductible claims. Thus, a deductible policy entails credit risk to the insurer. To secure that obligation, the insurer will likely seek collateral from the policyholder, often in the form of an LOC but occasionally in cash collateral. (See program agreements, above). To the extent a carrier is not fully collateralized at the time of a petition in bankruptcy, it holds a significantly less valuable general unsecured claim against the debtor s estate. A true SIR presents a different scenario. The obligations to claimants within the SIR are exclusively those of the insured. The carrier is in the position of an excess insurer. If the insured defaults, the carrier is not obligated to drop down and assume the risk within the SIR. Bankruptcy does not alter this situation. For this reason, SIRs typically are not collateralized, unless other aspects of the policyholder s financial profile lead the insurer to believe that the SIR obligations will not be satisfied. As a practical matter, though, there is risk to the carrier above an SIR. Particularly where the SIR is a low amount, the carrier may feel compelled to protect its position by monitoring or even assuming an associative role in the defense of claims within the SIR. This insecurity is only heightened by the advent of a bankruptcy petition. Conclusion Bankruptcy presents complex and often competing issues that an insured must resolve, if reorganization is to be successful. Marsh stands ready to assist its clients, in conjunction with the insured s bankruptcy counsel, in navigating these difficult risk management choices. For more information, please visit www.marsh.com or contact your local Marsh representative. Marsh 7
The information contained in this publication is intended solely for the use of Marsh clients. It provides a general overview of subjects covered, is not intended to be taken as advice regarding any individual situation, and should not be relied upon as such. Statements concerning tax, accounting and legal matters should be understood to be general observations based solely on our experience as insurance brokers and risk consultants and should not be relied upon as tax, accounting or legal advice, which neither Marsh nor the author provide. All such matters should be reviewed with your own qualified tax, accounting, and legal advisors. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy. Marsh makes no representations or warranties, expressed or implied, concerning the application of policy wordings or the financial condition or solvency of insurers or reinsurers. Statements concerning legal matters should be understood to be general observations based solely on our experience as insurance brokers and risk consultants and should not be relied upon as legal advice, which we are not authorized to provide. All such matters should be reviewed with your own qualified legal advisors. Marsh is part of the family of MMC companies,guy Carpenter, Mercer, and the Oliver Wyman Group (including Lippincott and NERA Economic Consulting). This document or any portion of the information it contains may not be copied or reproduced in any form without the permission of Marsh Inc., except that clients of any of the MMC companies need not obtain such permission when using this report for their internal purposes, as long as this page is included with all such copies or reproductions. Copyright 2009 Marsh Inc. All rights reserved. MA9-10182