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CHICAGO-The federal government's defeat in a dispute over the priority of claims against an insolvent insurer is seen as a significant victory for insurance guaranty funds, policyholders and taxpayers.

A federal district court judge in Chicago late last month upheld a provision of the Illinois insurance liquidation statute that gives claims filed by guaranty funds equal priority to claims filed by policyholders and third parties-including the federal government-against insolvent insurers.

In what many liquidation experts said is a first-of-its-kind decision-and one that could have national implications-the federal government lost its bid to knock guaranty funds farther back in the line to recover assets from insolvent insurers and at the same time to strike down a state's liquidation law entirely.

In another significant setback for the government, the federal court judge also upheld the Illinois liquidator's right to hold the federal government to specific deadlines for filing claims against an insolvent insurer's estate.

If the government had prevailed in the case, the federal statute that gives federal claims priority over all other claims in bankruptcies would have become the controlling law in insurer insolvencies in the state.

Under that scenario, guaranty funds likely would see little or no recoveries from insolvent insurance companies' estates, liquidation experts said.

The guaranty funds then would have to boost their insurer assessments, which could lead to reduced tax revenues for several states.

As a result, either the cost of insurance would increase, or "there would be intense efforts to rewrite state laws to deprive consumers of a lot of the protection they currently get from guaranty funds," said Peter Gallanis, Illinois' special deputy receiver.

In addition, policyholders' claims would have fallen behind some potentially mammoth federal liability claims, such as environmental liability claims. That could have substantially reduced the amount of assets available to pay policyholder claims.

Perhaps even more important, many liquidators would become reluctant to close out any liquidation if they thought there would be any chance that the government might file a long-tail liability claim years after the claims-filing deadline had passed or even after a liquidation had been completed. Under the federal priority law, liquidators can be held personally liable for the government's claims if no proceeds remain from a liquidation to pay those claims.

The Illinois case, after any appeals have been fully litigated, may have nationwide implications, because all states have similar liquidation laws based on a National Assn. of Insurance Commissioners model law.

"If Illinois' statute is invalid, then every state's statute would be invalid," according to Carlisle Herbert, a partner with the law firm Hopkins & Sutter in Chicago who is representing the Illinois liquidator.

Dale Stephenson, president of the Indianapolis-based National Conference of Guaranty Funds, said, "It would be real bad precedent."

"It was an example of as high-handed arrogance as the government could pull, arguing, 'We don't have to live by anybody else's rule,' " Mr. Stephenson added.

The Illinois decision is not binding on federal courts outside the state.

But, other liquidators who later face a similar challenge from the government likely will cite the decision, because of the lack of federal court rulings on this issue, predicted liquidation attorney Dean Hansell, a partner with LeBoeuf, Lamb, Green & MacRae in Los Angelesfc.

The government has not decided whether it will appeal the Sept. 25 ruling, said Randy Harwell, a U.S. Justice Department trial attorney who represented the government. The government has until late November to file an appeal. Mr. Harwell would not comment further on the case.

At the heart of the case is how much authority states have over federal claims in insurer liquidations.

In U.S. Treasury vs. Fabe, the U.S. Supreme Court in 1993 narrowly ruled that because states' insurer liquidation laws are part of "the business of insurance," the McCarran-Ferguson Act partially exempts them from a 1797 federal law that gives federal claims "superpriority" in bankruptcies.

Since then, though, the federal government has tried-and in at least one case has succeeded-in narrowing the scope of the high court's ruling.

Ironically, U.S. District Court Judge Ruben Castillo considered

withholding judgment in the Illinois case because of the minuscule value of the federal government's liability claims in the dispute. But, he concluded that the conflict between state and federal interests should be resolved.

The case involves $580 of non-contingent liability claims the government has filed against the estate of Reserve Insurance Co. The property/casualty insurer, which went into court-ordered liquidation in 1979, has about $66.4 million of assets and $111.4 million of liabilities, according to court records.

The government argued that Illinois' insurer liquidation statute violates the Fabe decision because the statute gives guaranty funds' claims and the government's liability claims equal priority for payment purposes.

Mr. Herbert, the attorney for Reserve's liquidator, said the federal government argued that guaranty funds' claims reduce the assets available to pay policyholders' claims.

The government also argued that if the guaranty funds' priority standing under Illinois' liquidation law is invalid, the entire statute should be struck down. Under that scenario, the federal priority statute would control insurer bankruptcies in Illinois, and federal liability claims would be paid before all other claims.

In a summary judgment, Judge Castillo rejected those arguments.

"Policyholders who receive payments or other benefits from a guaranty association are deemed to have assigned their rights under the covered policies to the association to the extent of the benefits provided. Thereafter, the guaranty association is entitled to the same priority as the policyholder would have had.*.*.*." Judge Castillo wrote.

Judge Castillo also ruled that the government must comply with the claims-filing deadlines the Reserve liquidation court sets for contingent claims.

Judge Castillo refused to use a 1993 government victory in a tax claim dispute with an insolvent insurer's estate as an opportunity to give the government unlimited time to file claims against Reserve.

In that ruling, which came down after the Fabe decision, the 1st U.S. Circuit Court of Appeals ruled the government did not have to comply with the deadline under Puerto Rico's insurer liquidation statute for filing tax claims against an insolvent insurer. As a result, the federal priority statute pre-empted the territory's liquidation law.

Mr. Gallanis hailed Judge Castillo's ruling on the deadline compliance issue.

It was just as important as his ruling on the priority of guaranty funds' claims, said Mr. Gallanis, who sits in for Illinois Insurance Commissioner Mark Boozell as chairman of the NAIC's Insolvency Subcommittee and Model Act Working Group.

"If these liquidation proceedings are going to be handled on any kind of rational basis, there has to be a beginning, a middle and an end," he said.

The ruling is a significant victory for state insurance guaranty funds, said Mr. Hansell, a liquidation attorney not involved in the case.

If the government had prevailed, he said, guaranty funds would have faced the prospect of recovering very little from the estates of insolvent insurers. That would have forced the funds to eventually raise either their assessments against insurers or the premium surcharges that are imposed on policyholders in a handful of states.

In the 13 states where insurers can offset their tax liabilities by their guaranty fund assessments, "to the extent funds have to assess more, it has a direct impact on the state treasury," observed Jose Montemayor, associate commissioner in the financial division of the Texas Insurance Department. Insurers in Texas can take such offsets.

Texas regulatory representatives said Judge Castillo's ruling is timely as well as significant. The state's new insurer liquidation law, which became effective Sept. 1, treats policyholder, guaranty fund and federal government liability claims equally.

The previous law did not explicitly state how government liability claims would be treated, but those claims probably were given the same priority they were given under the new law, said James Kennedy, a staff attorney with the department.

J. Robert Hunter, director of insurance for the Consumer Federation of America in Washington, described the decision as a modest loss for policyholders.

Mr. Hunter agreed with the government that guaranty funds' claims reduce the amount of insolvent insurers' assets that could be used to pay policyholders' claims.

However, he would not want the state's entire liquidation law struck down.

Mr. Stephenson of the NCIGF disputed Mr. Hunter's assertion. Mr. Stephenson said that in the Employers Casualty Co. liquidation in Texas, for example, less than 1% of the amount that guaranty funds recovered could have been used to pay policyholder claims that had not been paid already and that were recoverable under state law.

Mr. Montemayor of the Texas department agreed that the benefits of giving guaranty funds' claims as high a priority as policyholders' claims outweigh the adverse effects.

The greatest benefit of such equal claims treatment is that there are lower insurer assessments by guaranty funds and therefore smaller drains on states' tax revenues, he said.

Mr. Hunter tempered the enthusiasm over the liquidator's victory in the Reserve case.

The protection from federal pre-emption that state liquidation laws enjoy now could be fleeting, he said.

Congress could decide to amend the federal priority statute to override McCarran-Ferguson and provide federal liability claims priority over all other claims in insurer liquidations, Mr. Hunter said.

Mark Boozell, Illinois Director of Insurance, as liquidator of Reserve Insurance Co. vs. United States of America, U.S. District Court for the Northern District of Illinois; No. 96 C 6270