TO THE COURT AND ALL INTERESTED PARTIES AND THEIR ATTORNEYS OF RECORD:

Steve Poizner, Insurance Commissioner of the State of California ("Commissioner" or "Liquidator"), in his capacity as Liquidator of Pacific National Insurance Company ("PNIC"), submits the following Status Report on estate matters.

INTRODUCTION

PNIC was an insurance company domiciled in California and transacted primarily workers' compensation insurance. It was also licensed to underwrite commercial multi-peril, commercial automobile, and other liability insurance. Due to its financially hazardous condition, the Commissioner applied to this Court for an order of conservation of PNIC. On May 14, 2003, this Court issued the order appointing the Commissioner as the conservator of PNIC.

As conservator, the Commissioner determined that it was futile to continue the business operations of PNIC and applied to this Court for an order of liquidation. On August 5, 2003, this Court issued an order of liquidation and terminated the Commissioner's appointment as conservator and appointed the Commissioner as liquidator.

Upon this Court's issuance of a liquidation order and a finding of PNIC' s insolvency, the Liquidator relinquished all open claim files to the California Insurance Guarantee Association ("CIGA") for the adjustment and payment of covered claims. CIGA thus became responsible for administering (reviewing, approving, paying) the claims of California policyholders.

This Status Report sets forth for the Court and all interested parties, in detail, the progress made to date on establishing an orderly and efficient liquidation of PNIC. The report is intended to provide the Court with an overview of the liquidation process, the administrative operation of the company in conservation and liquidation, and the actions taken by the Liquidator to marshal assets of the estate.

ADMINISTRATION OF THE PNIC LIQUIDATION ESTATE

1.   Roles of the Court and the Commissioner in the Liquidation Process

   The Insurance Code provisions that govern this proceeding are set forth in sections 1010 through 1062 (several other relevant Insurance Code sections are found in other chapters and articles of the Code, but the primary insolvency code is in sections 1010-1062). Although the Legislature has vested the Insurance Commissioner as Liquidator with very broad discretion to conduct the liquidation process in the manner that he determines to be in the best interests of policyholders and creditors, the Court plays a vital role in the process. In addition to assisting the Liquidator in enforcing the various injunctions set forth in the Liquidation Order (which injunctions were specifically authorized by the Legislature to assist the Court and the Liquidator in conducting an orderly and efficient liquidation), the Court acts as the arbiter of disputed claims (see Ins. Code § 1032), and several other provisions of the Insurance Code instruct the Liquidator to seek the guidance and approval of the Court on matters relating to the expenses of administration, compensation paid to consultants, professionals and legal counsel, asset dispositions, and larger investment transactions. (See Ins. Code § 1035, 1036 and 1037(d) & (g).)

   The Legislature has provided relatively little guidance with respect to the specific transactions and expenses that require Court approval, leaving it to the Liquidator and the Court to establish approval and oversight procedures that are reasonable and make sense given the particular needs of each insolvent insurer estate, and that facilitate the Court's assessment of whether the Commissioner is properly exercising his broad discretion as statutory liquidator. (See, e.g., Quackenbush v. Executive Life Ins. Co., 32 Cal.App.4th 344, 358, and 401-403 (1995) [standard of review for court's review of liquidator's decisions is "abuse of discretion;" and liquidator must supply the court with adequate information to permit intelligent evaluation of the basis for the liquidator's determinations].)

2.   Overview of Insurer Insolvency Administration.

   In many respects, an insurance company in liquidation is like a "regular" insurance company. Some obvious differences are: (1) the Insurance Commissioner was appointed liquidator (or statutory receiver) by order of this court; (2) the liquidator derives his substantial powers from the Insurance Code (Ins. Code §§ 1010-1062); and (3) the liquidator's primary goals are to marshal and collect all available assets, to aggressively prosecute appropriate claims against the companies, directors, officers and others responsible for the company's failure for the benefit of policyholders and creditors, and ultimately to wind up the business as quickly and efficiently as possible. Despite these distinctions, a company in liquidation is a business that must be operated and managed. The Liquidator therefore must employ people, utilize and update computers and facilities, contract with vendors and professionals and do the many other things described below to perform the necessary tasks to marshal assets and pay claims. (See Ins. Code § 1010 (authorizing the Commissioner "to conduct. . . the business of [the insurer], or so much thereof as to the commissioner may seem appropriate"); and § 1037(a) (granting the Commissioner the power and authority "to carry on and conduct the business and affairs of [the insurer]").)

   To meet these goals administratively, the Liquidator uses the services of the Commissioner's Conservation and Liquidation Office ("CLO"). These services are supplemented by specialized vendors, contractors and consultants. The Liquidator also employs a number of attorneys. Non-litigation legal services mainly are provided by the Department of Insurance's Legal Division. The Office of the Attorney General is the Liquidator's primary litigation counsel. Both sets of attorneys are supplemented by private counsel with expertise in specialized areas of the law.

3.   Commissioner's Conservation & Liquidation Office

   The CLO is an administrative service entity created by the Commissioner to administer the estates of insurers undergoing conservation or liquidation in California. Upon obtaining a conservation or liquidation order, the Commissioner generally delegates his statutory administrative duties to a special deputy insurance commissioners, pursuant to Insurance Code section 1035, subdivision (a).

   Shortly after liquidation, the Commissioner closed all of PNIC's offices (terminated office leases and sold all furniture, fixtures, and equipment) and consolidated operations (Accounting, Claims, Reinsurance, and Information Technology) into the CLO, These operations continue with the Commissioner's CLO personnel.

4.   Functional Operations Of The PNIC Liquidation Estate
   1.   Claims

      Shortly after this Court issued the liquidation order, the Commissioner mailed approximately 20,250 Proof of Claim ("POC") forms to persons possibly interested in PNIC's assets. With this Court's authorization, the Claims Bar Date was set at July 30, 2004.

      There were 4,445 POCs timely returned to the Liquidator. Most of the POC process involves CIGA's evaluation of covered claims, as defined in Insurance Code section 1063.1, subdivision (c) and 1063.2. As of September 30, 2007, the Liquidator and CIGA have administered and closed all but 682 of these claims. The CIGA is administering these 682 open claims.

      Insurance Code section 1033, subdivision (a), sets forth the priority for payment of claims against PNIC as follows:

      Class 1:   Expense of administration

      Potential Class 1 claimants include employees for employment benefits and vendors of services for services rendered to the Liquidator during conservation and/or liquidation. In the eight months after conservation, the Liquidator had two full time employees working on Class 1 claims for vendor services rendered between conservation and liquidation.

      Class 2:   Claims of CIGA

      These are payments made by CIGA to policyholders, including payments of unearned premiums, and payments they have made to injured workers and service providers (e.g., doctors) plus CIGA's administrative expenses.

      Class 2 claims also include policyholder claims that are not covered ("non-covered") by an insurance guaranty association ("IGA") and policyholder claims that exceed an IGA's statutory coverage limit ("overcap claims"). In California, the coverage limit for non-worker's compensation claims is $500,000. (See Ins. Code § 1063.1(c)(1) and (c)(7)). There are not any non-covered or overcap claims in the PNIC liquidation.

      Classes 3 through 9:   Other claims for federal and state taxes, by general creditor and shareholders.

      The Liquidator has determined that even under the most optimistic estimates of reinsurance and litigation recoveries and other asset dispositions, PNIC probably will not have sufficient assets to fully pay the approved Class 2 claims. If any portion of Class 2 claims remain unpaid, then the Liquidator will be prohibited from making any distribution to priority Classes 3-9. The Commissioner has further concluded that incurring administrative expense to review and adjudicate claims that fall into Classes 3 through 9 would constitute a waste of estate assets. Consequently, in 2006, the Commissioner mailed "no asset" letters (informing claimants that their claims fall into a class for which it is unlikely there will be a distribution of assets) to those claimants whose claims are subordinate to Class 2.

   2.   Disbursement of Assets to CIGA

      On January 30, 2004, the Commissioner released $23,416,358 to CIGA from PNIC's statutory deposit pursuant to Insurance Code section 11698.3. In accordance with Insurance Code Section 1035.5, subdivision (d), CIGA's final claim against PNIC will be offset by the amount of the statutory deposit.

   3.   Reinsurance

      Reinsurance is the transfer of risk from one insurance company to another insurance company. In summary, it is a process whereby the first insurance company (called the cedent) is indemnified by the second insurance company (the reinsurer, also called the assuming insurer) for all or part of the claim liabilities under policies issued by the ceding insurer, which pays the reinsurer a premium in return.

      Reinsurance recoverables are usually the largest assets of an insolvent insurer. As of March 31, 2007, the Commissioner has billed reinsurers a total of $527,650.94 and has collected a total of $524,126.92 since liquidation.

   4.   Information Technology

      PNIC's information technology support is provided by its parent company, Highlands Insurance Group ("Highlands"), which itself is in receivership in its home state of Texas. At the time of PNIC's liquidation, the Highlands system was not shut down due to the California liquidation. Highlands has agreed to cooperate with all requests for information. During PNIC's conservation, a data extract procedure was developed between the Commissioner and Highlands. Since liquidation, the Commissioner has taken PNIC' s data and converted it for use in the CLO's Guardian of Liquidated Data ("GOLD") system. The GOLD system contains PNIC's historical policy and claim information as well as the paid loss information from CIGA.

   5.   Accounting

      PNIC's Statement of Available Assets and Estimated Liabilities as of September 30, 2007 is appended hereto as Exhibit A. A summary of the financial condition of PNIC is as follows:

      As of September 30, 2007, PNIC had approximately $20.3 million in assets and had approximately $77.9 million in net liabilities which results in an approximate net deficiency of $57.6 million.

      The largest claim (approximately $101 million) against PNIC's assets is from Class 2 claimants; however, as noted above, that is slightly offset by the $23.4 million the Commissioner released to CIGA.

      CONCLUSION

      The Commissioner expects to continue to improve the manageability of the Pacific National liquidation estate and to accelerate its resolution.