Insurers generally require large amounts of cash and collateral to protect their.financial interests when providing many types of insurance. When a company files for bankruptcy, the debtors must determine how much of this collateral is recoverable by the estate. Finding and quantifying these insurance-related assets is the first step in the recovery process. The task of convincing the insurer to release the collateral is the final step, and it usually involves a battle over whose cash it is.

As expected, insurers will posture to protect themselves when bankruptcy is filed. Insurance policy cancellation notices are sent, collateral is seized, reserves on insurance claims are adjusted upwards and a proof of claim is filed with the court. Insurers generally believe that they are entitled to hold all excess cash and collateral based upon their agreement with the debtor. No consideration is given to the debtor’s rights under bankruptcy law.

The world of insurance can appear incomprehensible to those who are unfamiliar with its mechanics, especially when dealing with sophisticated loss financing programs. The debtor, its advisors and other parties in interest may not recognize that recoveries are available or practical and may, in fact, dismiss the possibility of any recoveries simply on insurance carriers’ representations.

Beware of These Representations

•Outstanding tort or workers.I>’.I> com-pensation claim reserves equal or exceed the collateral. What the debtor may not recognize is that the insurer or the insurer’s agent, the third party administrator (TPA), establishes those reserves. The insurer may arbitrarily and unjustifiably set or increase the reserves on all open claims, particularly when a bankruptcy filing is anticipated. Without the knowledge of the true ultimate value of the claims, the debtor cannot evaluate whether the insurer is holding any excess collateral. An experienced claims person should be retained by the debtor to evaluate the adequacy and reasonable-ness of the reserves established by the insurer and adjusted where necessary. Appropriate valuation of claims will enable the debtor to determine the fairness of the collateral being held by the insurer and negotiate appropriate financial returns to the debtor. The claims professional also possesses the expertise to assist the debtor’s attorney in the successful objection to an insurers’ filing of a proof of claim based on inflated reserves.

•The amount of the reserves on open claims plus costs associated with incurred but not yet reported (IBNR) claims justify retention of collateral. Although it is standard industry practice to price insurance programs based on IBNRs, it is not valid in bankruptcy proceedings to include IBNRs in the calculation of collateral retention. Insurers are entitled to seize collateral but cannot hold cash in excess of the reasonable ultimate value of outstanding claims. Any amounts in excess of this, usually identified as IBNRs, are considered contingent claims and should be disallowed.

•The policies and agreements do not allow for early return of the collateral. Most risk financing agreements are silent on the issue of collateral retention in a bankruptcy filing. If anything, they may simply state that the insurance company has the right to draw down on the letter of credit.

Once these hidden assets are discovered, the debtor should develop an action plan for recovery.

As noted above, insurers often will attempt to justify the retention of the debtor’s cash based upon their inflated value of the outstanding claims. Therefore, the debtor should determine the reasonableness of those reserves. This usually requires that experienced claim professionals be retained to perform an audit of the outstanding claim files on behalf of the debtor. The debtor should conduct a risk management analysis of the financial impact of the reserves as it relates to the amount of cash being held by the insurers. In addition, archival research should be performed to verify the cash payments credited by the insurer.

Recovery

Once the debtor knows how much excess cash the insurers are holding, the difficult task of recovery begins. In order to get its reserves back, the debtor must assume the administration of all open claims. This will ensure cost-effective settlements. The debtor should conduct an alternative dispute resolution (ADR) process to settle remaining tort claims, if warranted.

The debtor also should reevaluate the risk management analysis of the insurance program costs based on the settlement results, negotiate return of the excess cash with insurers and litigate, if the insurers are unwilling to negotiate. The debtor should present its case, as outlined above, in bankruptcy court, supporting its contention as to the amount of the excess cash being held by insurers. Lastly, the debtor should negotiate with alternate insurers to assume the debtor’s responsibilities as a possibility, if all else fails.

A Case in Point

A national toy retailer filed for bankruptcy protection. The insurers denied the existence of any excess cash collateral due the debtor from the money they controlled. The insurers went even further to protect their interests by filing an administrative claim with the court for additional monies.

The workers’ compensation coverage was purchased by this retailer on what is referred to as a "paid loss retrospective rating plan." To simplify a complicated insurance industry practice, this means that the insurers’ ultimate premium is based on the policyholders’ actual losses. The insurers’ fixed costs are paid up front, and the losses are reimbursed by the debtor as they are paid by the insurer. It is usual practice for the insurer to require some form of collateral to support the debtors’ future obligations to pay claims. In this case, coverage had been purchased from the same insurer over a period of six years, including the year straddling the bankruptcy filing date. Six letters of credit had been posted to collateralize the debtors’ responsibilities as outlined under the agreements with the insurer. Immediately upon the retailer’s chapter 11 filing, the insurer drew down on the letters of credit totaling $2.5 million. At the same time, the insurer filed a proof of claim with the court requesting an additional $8 million to support the maximum premium payable under the terms of their agreement with the debtor.

When questioned about an accounting of the program costs and any excess cash and collateral, the insurers contended that the agreements required the debtor to collateralize their obligations for an additional 56 months. The insurers then argued that open claims produced earned premiums under the plan agreements far in excess of the cash paid to date, including the cash proceeds from the letters of credit draw down.

The professional claims consultants reviewed the status of the open claim files and discovered that the reserves were substantially overstated. The reserves had, in fact, been increased across the board just prior to the debtor filing for bankruptcy. The professionals calculated the program costs based on appropriate reserves and discovered that not only was the $8 million proof of claim inappropriate, but the insurer was holding approximately $2.3 million in excess cash.

As a result of the above analysis, the court expunged the administrative claim for $8 million. Then the negotiations for the return of the excess cash began. The following arguments were presented to the insurer:

•The proceeds of the letter of credit draw down supporting the policy year, which straddled the petition date, was used to pay pre-petition premiums. The letter of credit proceeds must be prorated between pre- and post-petition debt. This produced a return to the estate of $500,000.

•The reserves established by the insurer were unjustified based on review of the claim files. This resulted in a reduction in claim reserves of approximately $450,000 and program costs of approximately $525,000.

•Administration of the open claim files was assumed by the claim consultants to assure timely and cost-effective settlement of claims. Estimated savings to the estate amounted to $300,000. Knowledge of the bankruptcy process and the circumstances surrounding the closing down of the insured’s locations is key to effective settlement.

•Including IBNRs in the calculation of the program cost is not appropriate since these amounts represent contingencies under bankruptcy law. The program cost was reduced by $600,000.

•The insurer’s cash accounting did not include $375,000 in escrow money paid by the debtor. This resulted in a return of $375,000 to the estate.

•The insurer is entitled to be paid for its fixed costs and the estimated ultimate value of claims. The cash held in excess of these amounts is being held to pay contingent claims and must be returned to the estate. The agreements between the insurer and the debtor support this statement. The agreement is silent regarding any other actions in the event of bankruptcy.

After considerable analysis, dis-cussion and negotiation, the insurers agreed to relinquish their claim to $2.1 million in excess cash, which was returned to the debtor.

This sample case is not atypical of bankruptcy situations. The subject of collateralized insurance costs is very complex and is often misunderstood or misinterpreted, and as a result, assets of the estate may go unrealized. It is always prudent and usually productive to get the perspective and outline of services that a professional risk management firm can provide. The debtor and its professionals must be aware of the battle that is often never fought over: Who’s cash is it?