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PART IV

CAPITALIZATION OF INSURANCE COMPANIES

The pace of growth, the challenge of competition, the changes in marketing techniques and the new consumer needs that face the insurance industry present something more than problems with which to cope. They provide opportunities for imaginative management and business innova

tion.

The holding company is, as we have suggested, only one device in the whole arsenal of available responses. Other alternatives would seem to have equal or greater promise and, in the long run, may well pose fewer problems for the insurance industry and the public.

We have thus far reviewed two of the prime alternatives to the holding company as the solution to the need of insurers for growth and diversification: they are a more vigorous use of investment powers and the innovative employment of subsidiaries. These can be supplemented with ways, as diverse as they are promising, to expand the line of insurance products and to link insurance more productively with other compatible services.

There is one other advantage claimed for the holding company that merits comment, namely its potential as a source of needed new capital for insurance companies. For present purposes it is unnecessary to observe that the holding company has been distinguished in American experience for its ability to drain capital from, rather than to supply it to, its subsidiaries and affiliates. It should suffice to note that there is an alternative to the holding company as a means of increasing the capital available to insurance companies. It lies in a more flexible approach to insurance company capitalization and in an expansion of the limits. invoked in New York with respect to the issue of debt, convertible securities, and senior equity.

The basic financing of stock insurers today under New York law is provided by the issue and sale of capital stock. Although the applicable statute refers merely to "capital stock", administrative rulings of the Department have, in general, confined insurers to the issuance of a single class of common stock. The issue of preferred stock seems to be restricted to use for rehabilitation measures and is subject to strict limitations as to the nature of the preference granted and the payment of dividends.

There is no inherent reason, however, why an insurance company should not be able to go to the capital markets with any form of equity security (and debt convertible into equity) that fits its own needs, as its management perceives them, and the tastes of the investing public. Abuses in the issue of equity securities that might distort the voting control of an insurer, or unfairly dilute the interest of the shareholders, or otherwise be

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undesirable, could be prevented through the use of mechanisms of disclosure and approval. Accordingly, rigid rules that limit insurers to certain types of equity securities do not seem to be necessary. They should no longer be invoked. Indeed, we urge that stock company insurers be permitted to issue senior equities enjoying the ample range of preferences and rights which financial ingenuity has developed to meet the needs of American business for growth and effective performance.

The present situation with respect to the issuance of debt by insurers is little better. Stock insurance companies possess, in common with other business corporations, the general power to borrow money and to issue notes, bonds, and other obligations in return. Yet, domestic insurers are prohibited from pledging their portfolio securities as collateral for loans unless such loans aggregate no more than 5 percent of total admitted assets or unless the Superintendent approves borrowing in excess of the 5 percent limit as necessary for the conduct of the insurer's business. And there are other restrictions. Thus, funds raised through secured borrowing cannot be used for the purchase of other securities, and must accrue directly to the insurer. Further, in the absence of a provision to the contrary in the Insurance Law, borrowing, whether secured or unsecured, results in the creation of an offsetting liability and prevents this method of funding from being utilized to raise surplus for insurance purposes. Thus, its use has been primarily confined to meeting temporary cash requirements.

Domestic mutual and cooperative insurers, by contrast, have the benefit of a special provision of New York Insurance Law which permits the borrowing of funds, without pledging assets, and the treatment of such funds as surplus, rather than as a liability. Such borrowing is confined, however, to enabling such insurers to carry on their insurance business and is limited in a number of other ways.

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We have concluded that this type of subordinated borrowing should be extended to stock companies and that it should be made a more effective source of capital for insurance operations, as well as for the ancillary activities we have recommended. A desirable increase in

This is consistent with the approach taken in Part V of this report with respect to potential abuses arising out of the control of insurance companies by non-insur

ance interests.

2Thus, the statutory limitations on such borrowings require:

(a) a maximum interest rate of 6 percent per annum;

(b) repayment only out of free and divisible surplus;

(c) approval of the Superintendent prior to repayment; and

(d) the reporting of the unpaid balance on such borrowings as a footnote to all financial statements published by the insurer, or filed with the Department.

Also the Superintendent's approval must be obtained in advance of such borrowing by mutual casualty companies.

might be obtained through permitting both secured and unsecured borrowing provided that the resulting debt is subordinated to the interests. of the policyholders in those assets required for the conduct of the insurance business.

Further flexibility can be given to insurance company borrowing to the extent that "surplus surplus" is found by the Superintendent to be available, that is, to the extent that funds or assets owned by an insurer are deemed excess to the potential claims of its policyholders and claimants and the other reasonable needs of its insurance business. For example, an insurance company could be permitted to segregate its excess assets and secure its debt obligations by pledging them if management deemed it desirable. Such borrowing, although secured, must be subordinated, however, to the policyholders' interests to the extent of any claim by the lender against assets required for the insurance business. Indeed, such borrowing might even be without recourse to any assets other than those actually pledged.

Further, insurance companies could be permitted to issue debt, provided it is subordinated to the policyholders' interests, in order to procure additional funds which are in excess of those required to support the insurance operations. Such debt, either unsecured or secured to the extent of available "surplus surplus", would, if treated for insurance purposes as producing surplus rather than a liability, yield funds that could be applied to the expansion of existing insurance capacity, invested in an insurance subsidiary, or used to finance ancillary activities.2 Thus, "surplus surplus" represented by specific assets could be used to support borrowing which is not a claim against "required surplus", and the debt capital so obtained could be used to increase the scale of operations.

Indeed, if subordinated borrowing for ancillary activities were permitted to the parent insurer (as well as to its ancillary subsidiaries), it might reduce the competitive advantage in moving into desirable ancillary activities that would otherwise favor those domestic stock insurance companies that have already accumulated "surplus surplus" and have not distributed it in dividends to their shareholders.

Obviously, if the policyholders' interests are to be protected, the complex provisions for the effective subordination of debt will have to be most carefully drafted. There is nothing so formidable about the legal drafting, either for the statutes or the operative financing documents, however, to warrant denying to insurance companies these methods of raising essential capital.

When "surplus surplus" is once so used it should not remain available for other purposes until freed from pledge.

2See Part II of this report.

The liberalization which we recommend for insurance company borrowing should be extended to mutuals and to stock companies, and to property-liability as well as life insurers. Whether a market for such debt securities could be made at any particular time, or on reasonable terms by any particular company, or class of companies-such as mutuals-is a problem outside our present concern. If there is a possibility, as we believe, that such borrowing could provide a sound and practical source of capital, it ought not to be barred by law, regulation or administrative practice.

We think that liberalization of borrowing by all insurers, and liberalization for the issue of senior equity by stock company insurers, offer New York an opportunity for constructive leadership in measures to strengthen the insurance industry in its services to policyholders and the economy as a whole.

CONTROL OF INSURANCE COMPANIES BY PERSONS
OTHER THAN INSURERS

The recommendations we have made appear to us to permit domestic insurance companies to achieve substantially all of the significant objectives that have been urged upon us as justification for insurance holding companies. We are persuaded that the alternatives we have suggested are preferable to the creation of a non-insurance holding company for the control of an insurance subsidiary and the resulting tendency to shift resources away from the insurance business and apply them elsewhere.

Nevertheless, the non-insurance holding company alternative must be considered, and with it the issue of policy as to whether insurance companies should be controlled' by interests not licensed to do an insurance business.2

Involved in this issue are large economic and social questions as well as narrow questions of insurance law. American experience with the holding company in other areas informs our judgment that, without close. and effective regulation, the control of insurance companies by persons. who are not insurers would be prejudicial to the interests of policyholders and the public. The risk involved increases in importance when such control does not offer any substantial compensating advantages in benefits to the policyholder or the public that cannot as readily be realized by a less worrisome route.

While the control of insurance companies tends to be attracting more attention from businessmen today than at any time in the recent past, it is not a new phenomenon for individuals or companies to exercise control over insurance companies. More than this, it has been the experience of the Insurance Department that insurance companies controlled by persons who are not insurers have not yet posed serious problems of regulation nor given rise to abuses, nor aroused concerns for the policyholders or the public interest, materially different either in kind or in degree from those presented by the operations of insurance companies, domestic and foreign, that are not so controlled. We record a caveat, however, that the control

1 For this purpose we use the word "control" as meaning the power to direct or cause the direction of the management and policies of an insurance company whether through the ownership of voting securities, by contract, or otherwise.

2We have already expressed our judgment, in Part II of this report, that while insurance companies may control other insurers, they should not control non-insurance enterprises other than those which are ancillary in character.

3Holding companies in the life insurance field constitute a relatively new phenomenon, however, and the Insurance Department has sought to anticipate and prevent possible abuses by administrative procedures.

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