The Department of Insurance (department) is responsible for protecting California policyholders by regulating insurance companies (insurers), brokers, and agents operating in the State. The department's Conservation and Liquidation Office (CLO) assists the insurance commissioner (commissioner) in conserving, rehabilitating, or liquidating financially distressed or insolvent insurers. An insurer subject to a conservation or liquidation order is called an estate.
The Executive Life Insurance Company (ELIC) was a multibillion-dollar life insurance company that had its principal legal residence in California and operated in the State from 1962 to 1991. According to a 1994 report issued by the chief deputy insurance commissioner at the time, ELIC invested 55 percent to 60 percent of its portfolio in high-yield, noninvestment-grade corporate bonds, also known as junk bonds, during the 1980s. At the time, the insurance industry average for this type of investment typically ranged from 7 percent to 11 percent. In late 1989 the junk bond market experienced a significant decline in value, and in early 1991, the commissioner determined that ELIC's financial statements were grossly overstated and that the company was insolvent. On April 11, 1991, acting on a court conservation order, he took over the operation of ELIC.
On the date of conservation, the commissioner reported ELIC's assets to be $8.8 billion. Including the loss from the liquidation of ELIC's investment securities in 1992, investment income, litigation proceeds, and income from other sources, the total ELIC assets available between 1991 and 2006 were $10.2 billion. Of this amount, the commissioner has used $528 million to pay for the cost of administering the ELIC estate. As a result of the ELIC Rehabilitation Plan (rehabilitation plan) approved by the conservation court and upheld by the California Supreme Court on September 3, 1993, Aurora National Life Assurance Company (Aurora) assumed and reinsured nearly all of ELIC's policies; and the policies were revalued at approximately 78 percent of their original value. The commissioner transferred $6.7 billion to Aurora for use in its role as a successor insurer to ELIC. Of this amount, Aurora later paid $2.7 billion to policyholders who decided not to continue their insurance policies with the company by a certain date, which includes funds Aurora sent back to the estate for it to distribute to these former policyholders.
The commissioner has paid a total of $2.7 billion to policyholders and other beneficiaries of the estate, including the National Organization of Life and Health Insurance Guaranty Associations (national guaranty organization). These payments included $1.1 billion of death benefits and other payments made between the time of ELIC's conservation in 1991 and its acquisition by Aurora in 1993, as well as subsequent payments resulting from the sale of assets and from litigation proceeds. Payments were made both to policyholders who continued with Aurora (opt-in policyholders) and those who did not continue with Aurora (opt-out policyholders). As of December 31, 2006, $325 million remained of the ELIC estate, and $311 million of these remaining funds were transferred to Aurora for distribution in October 2007 to opt-in policyholders and other beneficiaries.
As with any insolvency of a public company, investors and creditors risk substantial losses. This was no different in the case of the policyholders of ELIC who incurred significant losses when the commissioner, in his role as regulator, determined that ELIC's liabilities far outweighed its assets and, on April 11, 1991, obtained a court order to take over its operations to conserve the company.
In August 2005 the department estimated that losses related to original policy rights for opt-in policyholders were $279 million and that opt-out policyholders had lost $657 million, for a total estimated loss of $936 million. The department's calculation subtracts subsequent distributions and the application of $2 billion by the national guaranty organization from the September 3, 1993, policyholder shortfall. The department stated, however, that its estimate did not include the time value of money. This value is important when measuring economic loss, as a policyholder who received $100 in 2005 did not have the same opportunity to earn interest on the money that he or she would if the $100 had been paid in 1993.
When we estimated the economic loss to policyholders, we included several specific factors that the department's analysis did not include; however, we recognize that more elaborate models could be developed. Nevertheless, taking into consideration changes to policy terms, the time value of money, estimated original policy value, and other factors, we estimated the total economic losses for both opt-in and opt-out policyholders to be $3.1 billion both as of August 2005 and December 31, 2006.1 Specifically, we estimated that as of August 2005 losses for opt-in policyholders were $1.4 billion and those for opt-out policyholders were $1.7 billion. The two models result in distinct measures to the degree that policyholders were made whole. The department's model estimates policyholders received 90 percent of their original policy rights. Our model estimates policyholders recovered 86 percent of their expected ELIC account values, measured as the estimated amount their ELIC policies would have been worth if ELIC had not become insolvent.
According to legal counsel for the department, neither the court-approved ELIC rehabilitation plan, the ELIC Enhancement Agreement (enhancement agreement), nor the agreements with third parties (collectively referred to in this report as the ELIC agreements2) give the commissioner, in his role as conservator, rehabilitator, and liquidator of the ELIC estate, the general rights to review or audit Aurora's records. The department indicated that although it lacks this general authority, through other reviews, such as examinations of Aurora conducted by the department in its role as regulator of the insurance industry, the department has gained confidence in Aurora's compliance with the ELIC agreements and thus has not needed to assert additional rights to monitor Aurora. In addition, as a result of settlement negotiations in 2005, the commissioner released Aurora from existing known and unknown claims of liability, which may further limit the commissioner's ability to monitor Aurora's compliance with the ELIC agreements prior to 2005. Despite those limitations, as part of a recent agreement negotiated by the commissioner in June 2007, the Conservation and Liquidation Office (CLO) was able to monitor Aurora's October 2007 distribution of the $311 million it had received from the ELIC estate. However, the commissioner did not monitor $225 million in distributions that occurred from 1998 through 2006, and therefore cannot provide policyholders and others the same level of assurance that the distributions Aurora made during this period were distributed in accordance with the ELIC agreements.
Our review of documents related to ELIC from the period beginning in 1990, before the commissioner conserved ELIC, through 2006 found a lack of consistent information available on ELIC estate operations and the disposition of ELIC's assets. For instance, some of the reports that are authorized by the California Insurance Code or required by individual trust agreements were not produced. Additionally, inconsistent accounting practices and inconsistent availability of supporting documents hinder a complete accounting of the ELIC estate, and limit the information available to interested stakeholders. From 1991 to 1993, the available financial information is contained in unaudited financial statements, while for 1994 through 1996, audited financial statements exist for the various trusts within the estate. However, for the 1997 to 2006 time period, audits were not consistently performed. For example, the consolidated audits performed of the ELIC estate from 1997 to 2000 are not comprehensive in that they do not include all of the entities making up the ELIC estate, and no audits were performed from 2001 to 2004. Various reports covering the 2001 to 2004 period commented on CLO accounting problems and internal control weaknesses. Inconsistent accounting practices may have contributed to the four months it took for the CLO to provide us with information on its sources and uses of ELIC estate funds from 1997 to 2006. During this four-month period, the vice president of the CLO's estate finance group worked to verify the accuracy of the data before providing us with a financial data extract from its general ledger for the ELIC estate.
To increase assurance that Aurora follows key provisions in the ELIC agreements, the commissioner should seek the right to review Aurora's future distributions of ELIC estate funds and review those distributions to ensure that it adds the proper amount of interest to the funds, and distributes the funds correctly.
In order to ensure that information is available to policyholders and other parties interested in the disposition of ELIC's assets, the commissioner should, as soon as practical after the end of each year and upon the termination of any trust, complete a report that includes the assets and liabilities; the amount of all distributions, if any, made to the trust beneficiaries; and all transactions materially affecting the trust and estate.
In order to ensure that the financial information reported by the CLO is accurate, the commissioner should continue the practice of auditing the ELIC estate and any trusts that remain open on a periodic basis as recently implemented by the current chief financial officer.
In order to ensure that it accurately records distributions in its primary accounting system, and its financial reporting is correct, the CLO should periodically reconcile the distributions reported in its general ledger to its subsidiary databases.
The department stated that it intends to implement all of the recommendations in our report. The department agreed with our analysis of the sources and uses of ELIC estate funds. Additionally, the department stated that the results produced by the model that estimated policyholder economic losses are reasonable, but questioned our inclusion of the accumulation of interest. However, the department disagreed with our conclusion that the commissioner has not consistently monitored, reported on, or accounted for the distribution of the assets of the ELIC estate. The department's full response begins on page 83 and our comments on the department's response begin on page 101.
1 The overall losses remaining the same is partly due to $98 million distributed to opt-ins and $178 million distributed to opt-outs during 2006.
2 We categorize the third-party agreements with the rehabilitation plan and enhancement agreement for ease of reference. However, unlike the rehabilitation plan and the enhancement agreement, the third-party agreements are not part of the restructuring of ELIC. Refer to Chapter 3 for additional discussion.