Eight months after Eastern Indemnity, an insurance company, set up business in Montgomery County in early 1980, Burton J. Kitchen, chief examiner of the Maryland Insurance Division, wrote a memo to the insurance commissioner saying that Eastern was "newly formed and in a very volatile business." He recommended to Commissioner Edward J. Birrane Jr. that the company's financial condition be watched closely.

For more than four years after that, as a specialist in surety bonds, Eastern wrote a form of insurance that guaranteed the work of small contractors on public and private projects. Small contractors paid Eastern for such insurance, and they often posted collateral as well.

In late 1984, Eastern collapsed. State examiners say it has less than $1 million left in real assets and is faced with nearly $70 million in claims as a result of problems on 800 construction projects in 32 states and the District.

Eastern won waivers around the nation to expand more rapidly than normally allowed, ducked Maryland's requirements for the establishment of adequate reserves and wrote financial reports that made the company appear more stable than it was, according to an examination of Eastern's financial reports, correspondence with the insurance division and dozens of interviews.

In short, it ran rings around the regulatory system that is intended to protect the public by detecting and preventing insolvencies, not unlike several Maryland savings and loans did -- with another Maryland agency -- until the thrifts collapsed last year. Two insurance commissioners, Francis B. (Bill) Burch and then Birrane, served on Eastern's board of directors after leaving their jobs with the state.

Eastern's demise has thrown a cloud over some local projects, including the reroofing of the Nevey Shalom Synagogue in Bowie, the repair of a roof at McGogney Elementary School in Southeast Washington and the completion of the new Bibleway Free Will Baptist Church in Baltimore. In addition, claims are pending on Eastern-bonded projects as diverse as the Beech Tree Elementary School in Fairfax County and an Amtrak maintenance facility in Washington.

"There are some things that have happened that should not have happened," said Edward J. Muhl, the current insurance commissioner who served as Birrane's deputy. " . . . It doesn't set well with us, and we are proceeding now in the direction that we hope will correct a lot of those things."

The state took over Eastern in December 1984, and Muhl is conducting an investigation into the Eastern collapse. He plans to file a civil suit this month that, like civil suits filed against former savings and loans, will be aimed at recovering money that can be applied against Eastern's liabilities.

Eastern's founder and president, Curtis Graham Perkins, could not be reached for comment on this story; state officials say they have no knowledge of his whereabouts. Other Eastern officials either declined to comment or could not be reached, with one exception.

Dr. Peter Santucci, who served as a board member from the time the company was founded, said he was never aware of any financial problem with Eastern and, in fact, had relied on state regulators to monitor the company.

Although Eastern is no longer in business, Maryland companies and institutions -- which have filed about $8 million in claims -- may recoup some of their money because Maryland is one of a few states where a state-chartered association of insurance companies covers claims that a surety bond company cannot pay because it is insolvent. A similar body in the District also covers such claims. Claims in the Eastern situation have been estimated at $1.1 million.

In both cases, however, everyday insurance policyholders may well end up footing part of the bill, for the insurance companies that are assessed for the Eastern loss are allowed to pass on those costs to their policyholders.

In Virginia -- where residents have filed claims totaling about $2.2 million involving Eastern-backed projects -- and in most other states, insurance associations do not cover surety bond losses. Eastern's claimants in those jurisdictions may have to swallow their losses.

Eastern was a relatively small insurer compared with the giants of the industry, and problems should not have been difficult to detect and correct, according to industry and government officials.

"Unquestionably, there was a breakdown in the regulatory process with Eastern . . . as there was with the savings and loan associations," said state Sen. Howard A. Denis (R-Montgomery). Denis has called for an investigation of the Eastern collapse, the regulatory role played by the insurance division and the personal relationships between the company and the division.

"I am really amazed that the Maryland insurance division didn't have some indication that there was trouble before they took action against Eastern," said Bruce Wallace, executive vice president of the National Association of Surety Bond Producers, a Chevy Chase trade organization.

The division examined Eastern's finances before granting it a license in February 1980. Also that year, it ordered the company to file quarterly financial statements, starting with the quarter ending Sept. 30. With one exception, however, quarterly statements could not be found in a recent review of division files.

In 1983, the division audited Eastern's finances for the period 1980-81. Then in late summer 1984, after receiving complaints that Eastern was not paying claims, the division conducted the investigation that led to the takeover.

That action brought to an end the spectacular rise of Eastern, from a one-office operation to a national network of offices operated by a president who was regarded by family and friends as a mathematics wizard with a burning ambition to become a millionaire before he reached the age of 40.

Established in Maryland

Perkins, a Danville, Va., native who is now 43, approached authorities in his home state and the District about locating Eastern within their boundaries. He chose to establish the company in Maryland, where start-up requirements were looser.

Only a few months after Eastern commenced business, commissioner Birrane received a letter from Eastern listing the states in which the company wanted to open new offices immediately. State rules typically require an insurance company to operate for two or three years in its home state before expanding into other states.

"Dear Ed," the letter said, " . . . I thought you might like to have this list of states in advance of the NAIC meeting in New York."

The letter to Birrane was from Francis B. Burch, Eastern's general counsel from 1980 to 1982, executive vice president in 1983 -- and insurance commissioner in 1965-66. Burch ended the letter by saying he "look ed forward to being in touch with you on Saturday evening, Nov. 29, 1980, at the Waldorf." Burch could not be reached for comment last week.

In 1981, Birrane wrote a series of letters to other state commissioners asking them to waive their waiting rules and admit Eastern immediately.

In the letters, Birrane said he could make similar arrangements for companies in those other states. In an April 27, 1981, letter, for example, to E.J. Voorhis, then commissioner of insurance in Texas, Birrane said that "if a company licensed in Texas met the same standards as the Eastern Indemnity Company of Maryland and should apply for a license in the state of Maryland, the Maryland Insurance Commissioner could license said company to do business in the State of Maryland and waive the waiting period."

Birrane said last week that it is not unusual for state insurance commissioners to promote companies in their states and to help them expand into other states, as long as the companies meet certain requirements.

In mid-1982, Birrane left the insurance division after he was criticized in a 154-page report by the state attorney general's office for his management of insolvent insurance companies in matters unrelated to Eastern. The report, which was based on a nine-month investigation, alleged that Birrane had used his position to help his friends. No action was taken against him.

Birrane said then that his resignation had nothing to do with the report. At the time the report came out, he said the report's authors had no management experience on which to base their observations.

After resigning from the division, Birrane joined Eastern's board of directors and took Burch's place as general counsel.

Birrane said that he resigned from Eastern in mid-1984 after he began to have questions about Eastern's operating practices.

Capitalization Questioned

In its early months, Eastern had about $381,000 in capital and showed a surplus of $381,000, according to an examination by the insurance division. That was enough money to start up in Maryland, where state law requires $250,000 in capital and a $375,000 surplus.

It would not have been enough to satisfy Virginia law.

"As a practical matter, we require $1 million minimum capital, $1 million in surplus and a cushion of $300,000 -- altogether, a minimum of $2.3 million," said George King of the Virginia Bureau of Insurance.

It also was not enough in the opinion of some Maryland insurance executives. Minor Carter, who was general counsel at that time for Maryland Casualty Co., said that officials there "complained informally" to then commissioner Birrane that Eastern was undercapitalized.

When Illinois regulators agreed to admit Eastern in mid-1983, it was on the condition that the company come up with more capital.

"They did -- they came back with $2,999,769 as their additional capitalization," said Kenneth Smith, deputy director of the Illinois Department of Insurance. "But when their financial statement for 1983 came in, in March 1984, we saw that there was a conditional surplus note for $2,999,769. So obviously they had put that in as their additional capitalization."

Smith's department had problems with the note. In most cases, a loan transaction is reported as both an asset and a liability. A surplus note, on the other hand, can be counted as an asset but not as a liability, and thus can be used to increase a company's capital, but only under certain conditions. Eastern did not meet those conditions, according to Smith.

For one thing, there was no indication who the lender was. Eastern's 1983 financial report said that the note represented an amount advanced to the company by the Perkins-controlled EHC Associates, but it did not say where EHC got the money or explain the terms of repayment.

In addition, the interest rate on the loan exceeded a 7 percent ceiling established by Illinois for surplus notes. (In Maryland, the ceiling is 6 percent.) The interest on Eastern's $3 million note, according to its 1983 financial statement, was 4 percentage points above the prime rate. The prime that year averaged 10.5 percent.

Illinois sent Eastern several questions regarding the surplus note, and when Eastern failed to respond, it issued an order suspending the insurance company. Smith said that if Eastern had been an Illinois-based company, it would have been required to describe the $3 million note as a liability. In that case, its financial report for 1983 would have looked a lot worse.

How did the Maryland examiners miss this red flag?

"I don't have an answer for that," Muhl said.Small

Contractors Bonded

Eastern did the bulk of its business with small minority contractors who were entering the construction business in growing numbers but could not get the traditional bonding houses to write them insurance.

If a contractor Eastern had bonded failed on the job, Eastern was responsible for either getting the job done or paying additional costs that might arise as the job was finished.

Eastern intended to protect itself against such claims by charging its high-risk contractors up to 4 percent of the construction contract. Bonding companies typically charge established contractors 0.5 to 1 percent of the amount of the contract.

In addition, Eastern required contractors to post cash deposits, sign over mortgages on their private houses and buy life insurance policies in order to get Eastern bonds. If the contractor defaulted, Eastern could take the collateral to satisfy any losses that it suffered.

To traditional bonding company specialists, the Eastern fees, combined with the collateral requirements, took unfair advantage of small contractors.

"We had the feeling that a number of smaller contractors, who were desperate for bonds and perhaps unable to get them any other way, fell within their grasp . . . agreed to pay their rates," said Wallace, the spokesman for the bond producers association.

"It is highly unusual for a company to take cash and home mortgages as collateral," said Al Walker, a veteran surety bond expert who was hired by Maryland last year to work on the Eastern underwriting files. "Because if a contractor is so risky that you need collateral from him, it probably means he can't do the job."

State officials were aware from the beginning that Eastern planned to require collateral from some contractors; what they may not have known was how many contractors would be involved and the problems it could trigger.

According to a May 1984 letter to the insurance division from Thomas J. Mitchell, who replaced Birrane as Eastern's general counsel, Eastern was holding collateral from 2,000 contractors in 15 to 20 jurisdictions.

Mitchell said that about 90 percent of Eastern's contractors had posted collateral. That compares to about 10 percent of the contractors bonded by traditional bonding companies.

Court papers filed by Maryland insurance officials in a Perkins bankruptcy case in Florida allege that he withdrew more than $500,000 illegally from the collateral funds.

Red Flag in Minnesota

Eastern's underwriting expenses -- the costs associated with assessing risk on a project and writing a bond, such as agent commissions -- were also a red flag, at least in Minnesota.

Minnesota refused to license Eastern to do business because its underwriting expenses were so high, according to Minnesota Commerce Commissioner Michael A. Hatch, who oversees insurance regulation in his state.

Expressed as a percentage of paid premiums, Eastern's 1981 underwriting expenses amounted to 89 percent, according to a company financial report. That compared to the surety bond industry average of 55 percent. Eastern's 1982 expenses were 87 percent, compared to the industry's 54 percent, and the company's 1983 expenses were 68 percent, compared to the industry's 53 percent.

A new company can be expected to have higher underwriting costs than an established company, but Hatch said Eastern's expenses were the highest he had ever seen.

Maryland regulators said they did not regard the expenses as unreasonable given Eastern's goal of working closely with high-risk contractors.

Minnesota regulators also were troubled by Eastern's corporate structure, according to Hatch.

"It would appear from financial reports filed by Eastern with Minnesota that Eastern was owned by a holding company . . . which contributed $800,000 to the insurance company in 1982 and $3 million in 1983," Hatch said. "In 1983, the debt of the parent holding company increased by $3.3 million. And on Dec. 31, 1983, the parent holding company's total debt was $6.6 million."

Minnesota regulators, Hatch said, "don't want somebody taking over an insurance company who is going to bleed it."

Eastern first applied for a Minnesota license in July 1982, Hatch said. Eastern never got a Minnesota license.

Maryland's view of the parent company, and other Perkins-controlled companies which Eastern paid for various services, was different from Minnesota's.

Burton J. Kitchen, the examiner and author of the 1980 memo to the insurance division, wrote another memo on Nov. 19, 1982, raising the question of whether Eastern's agreements with these companies were legal.

He attached to his memo copies of agreements that said that the parent company would be paid an annual fee of $720,000 for management and administrative services. Kitchen said that it appeared that the Maryland law prohibited such agreements, and he asked for an assistant attorney general's opinion.

At the time, Eastern was paying G&J Leasing, a company controlled by Perkins, for automobiles, office furniture and houses, according to Eastern financial reports. And Eastern had contracts with EHC Associates Inc., another Perkins-controlled firm, for management and administrative services, the reports said.

Also, the reports disclosed that Eastern sometimes advanced money to its holding company and to EHC Associates at no interest.

In court papers filed in late 1985 in the Perkins bankruptcy case, Maryland officials alleged that Perkins used the loan transactions, management agreements and lease arrangements to defraud Eastern of millions of dollars in 1982 to 1984.

Three years earlier, in response to Kitchen's question, Thomas P. Barbera, then an assistant attorney general, had said the management agreements as reported to him were within the law. "They didn't ask if it was okay to have fraudulent management agreements," Barbera said in a recent interview.

Barbera is now deputy insurance commissioner.

When an insurance company receives notice that a claim will be filed in connection with one of its policies, the company is required by state law to establish a reserve fund to pay that claim. The reserve must cover the actual claim and expenses associated with paying the claim.

An analysis in January 1985 of Eastern's 1983 annual statement by William J. Sheppard, executive vice president of Allianz Insurance Co., said that Eastern "had no reserves for expenses allocated to accident year 1982 or the accident years prior to 1982." In the analysis, which has been filed with the insurance division, Sheppard said it was impossible to determine the adequacy of Eastern's reserve system because the forms Eastern filed with the state were incomplete.

"It is inconceivable that any regulatory body or insurance professional" would accept the improperly prepared statements he had examined, Sheppard wrote.

Ray Rose, a surety bond specialist working since last year on the claims records seized by the state, said he has found no evidence that the company ever established adequate reserves.

That should have been obvious to anyone auditing Eastern records during the four years it was in operation, Rose said