When the Columbian Bank and Trust Co. of Topkea, Kansas failed in 2008, it was just one of a number of small banks that had collapsed in the wake of a severe economic downturn that threw the entire global financial system into a tailspin.

Columbian’s failure did not garner lasting nationwide attention, but perhaps it should have. For among its account holders was none other than leading annuity writer Aviva USA, which at the time of the bank’s failure had cash accounts worth some $11.3 million.

But what is telling about the accounts is the way they were classified meant that when the bank failed, the money was largely uninsured by the Federal Insurance Deposit Corporation.

This elementary error on Aviva’s part ultimately cost the company nearly $9.5 million, a loss verified when an appeals court recently upheld a ruling in Aviva Life & Annuity Company and American Investors Life Insurance Company v. FDIC, No. 10-3163.

The decision ends an embarrassing debacle for Aviva, which contends the lost funds were being held for annuity customers. But more importantly, Aviva’s loss underscores the need for insurance companies to make every effort to identify funds as being held in insurance company separate accounts.

The Appeal

The case stemmed from the failure of Columbian Bank and Trust Co. in Topeka, which closed and sold its deposits to a Chillicothe, Missouri bank on Aug. 22, 2008.

According to a press release issued by the FDIC, Columbian had $622 million in total deposits, plus $268 million in so-called brokered deposits. Outside of the brokered deposits, there was only $46 million in 610 accounts that exceeded the insurance limits. Of this, $11.3 million belonged to Aviva, in two uninsured corporate accounts–$4,242,854.60 held in an account for Aviva Life & Annuity operating account, and $7,098,344.56 held in account for American Investors Life Insurance Co. account.

Because the FDIC considered these accounts to be acorporate accounts, rather than pass through accounts being held for the benefit of annuity customers, when Columbian failed, Aviva received only the $100,000 insured deposit limit for each account. It received another $300,000 after the accounts received total deposit insurance of $250,000 each retroactively under a provision of the Dodd-Frank financial services reform law of 2010.

It also received $1,363,857 in two steps in 2009 as a bank creditor based on sale of Columbian’s assets.

Therefore, its aggregate loss, based on the additional $300,000 paid retroactively, was $9,436,143.

Aviva filed suit against the FDIC in a bid to retrieve its lost millions, but the lower court ruled in the FDIC’s favor. Aviva appealed the lower court decision.

Aviva lawyers told the appellate court that, “Because the deposit accounts were actually used to fund annuity contracts and benefits, the funds were entitled to pass-through insurance treatment pursuant to Section 330.8 and the FDIC’s determination to the contrary was arbitrary, capricious, an abuse of discretion or otherwise not in accordance with the law. “

On August 13, a panel of the 10th U.S. Circuit Court of Appeals upheld the lower court’s decision, rejecting Aviva’s claims that the funds were held for the benefit of Aviva’s annuity customers.

According to the appellate court case, FDIC field officials originally accepted the arguments of Aviva officials that the two accounts involved were pass through accounts held for the benefit of Aviva’s annuity customers.

But the panel noted that a number of smaller accounts containing from $1,000 to $10,000 were deemed by the FDIC to be held for the benefit of annuity customers, and were accorded pass through treatment, that is, each account was insured up to the $100,000 deposit insurance limit in effect at that time.

But, the panel said in upholding the lower court decision, that, “exercising its prerogative” under FDIC regulations, “the FDIC determined these deposit accounts records clearly and unambiguously indicated that the challenged accounts were corporate accounts, and refused to consider plaintiff’s evidence to the contrary.”

The panel’s decision said that if it had upheld Aviva’s claim, Aviva would have received $8.6 million upfront, and an additional 12.287 percent paid after sale of the bank’s assets.

“The court’s decision was limited to a narrow issue of administrative law regarding the FDIC’s authority,” Kevin Waetke, a spokesman for Aviva USA, said. “It is important to note that this issue occurred three years ago and the decision has no impact on our current operations. Aviva does not intend to pursue the matter any further.”

Aviva had placed its money in a small bank far from Aviva USA headquarters in West Des Moines, Iowa, because Aviva also has a presence in Topeka, Kansas, as it is the location of a predecessor company, American Investors Corp.

Waetke said the predecessor company had a banking relationship with Columbian Bank and Trust to process a variety of banking services including check clearing, processing electronic funds transfers, and accepting incoming wire transfers. Columbian was one of several institutions that provided banking services for Aviva at that time.

Although not specifically broken out, the loss stemming from Columbian’s collapse was reflected in the company’s year-end financial statement in 2009.

Where Aviva Went Wrong

Sam Caligiuri, a partner at Day Pitney LLP in Hartford and head of the firm’s insurance regulation and transaction practice group, said that Aviva’s error was in classifying its funds in an operating account instead of stating explicitly that they were for an insurance company separate account.

Caligiuri’s comments were based on a decision Aug. 16 by a panel of the 10th U.S. Circuit Court of Appeals, which backed the the Federal Deposit Insurance Corporation’s determination that the deposits were held in two corporate, rather than separate, accounts.

Caligiuri noted that this is the first case he can recall where this type of loss has occurred, and said that his primary job is working on separate accounts and related issues.

“Insurance company separate accounts are very important because they allow insurance companies to protect the assets of separate accounts contract holders, which support various annuities products from the insolvency of the insurance company,” he said.

“They very well could have been separate accounts, and they tried to demonstrate they were separate account assets,” Caligiuri said. “But by not clearly identifying them as separate accounts, they put themselves at a disadvantage of having to prove that they were, which they were ultimately unsuccessful in doing.”

Aviva’s ordeal offers an important lesson for the industry: to be exceedingly careful when identifying insurance company separate accounts, Caligiuri said of the deeply ironic nature of the appellate court’s decision.

“The tables have been turned,” Caligiuri said, “where a bank regulator is acting as an insurer, and it is the insurer that has to make a claim for insurance coverage that ultimately ends up being denied.”