With the development of more sophisticated approaches to discontinued insurance run-off, there are a number of different strategies available. Andrew Wilkinson and Stephen Doody report.

In recent years the insurance business has developed its own sub-business - which in this article I will refer to as the discontinued insurance market. This market never fails to surprise me. Taking some figures estimated by Swiss Re in a fairly recent Sigma report, global run-off gross liabilities have been estimated as follows:

Year General insurers - run-off
Global gross liabilities
$ billion
1996 - 230
2001 - 350
2006 - 505

To describe this business as a sub-business is to be dismissive. A rough estimate would indicate that the value of the worldwide run-off market represents perhaps as much as 20% of the total liabilities of general insurers worldwide. There is also little doubt that this market is largely concentrated in the United States, Bermuda and London.

Run-off in the London market is split between the Equitas run-off and the insurance company market. Taken together, run-off in the insurance company market and subsidiaries, or in branches of UK composites or non-UK parents, is estimated to exceed substantially the ultimate liabilities of Equitas. Current FSA estimates indicate that over 180 general insurance companies are in run-off in the London market, with some 37 of those subject to an insolvency process.

It is much too early to determine what will happen to all of these general insurance companies now in run-off in the London market. It is still too early to be certain what proportion of discontinued operations will be run-off solvently. There is still no assurance, for example, that the Equitas run-off will pay policyholders 100 cents in the dollar, although the early indications are that it may. There is no doubt that others will swell the ranks of those several dozen London market companies subject to an insolvency process as more companies' fortunes deteriorate from solvent run-off through provisional liquidation to insolvent schemes of arrangement. However, many companies with discontinued businesses will not become insolvent. What will happen to these companies?

There are now a number of developing alternatives these companies face. At the moment it is possible to discern three linked trends. First, there appears to be an increase in transaction based solutions for discontinued operations, principally, a sale of the company or the business. In recent months, there has been a significant increase in transactions concerning discontinued operations, particularly in the United States. A new group of investors interested in transactions concerning discontinued operations has emerged. No doubt for certain kinds of investors, discontinued insurance operations may present an attractive opportunity but probably remains a market best suited to longer term investors. The regulatory constraints fettering distributions of capital make it difficult to reconcile the interests of short term investors. As the techniques for facilitating these transactions develop and the regulators in the United States, Bermuda and London become more used to financial investors undertaking transactions concerning discontinued operations, I have little doubt that more transaction based solutions will be implemented. In this context, it should also be remembered that one of the long-standing disadvantages of the London market has been fragmentation of run-off. A cursory sampling of old year contracts of insurance issued through many of the well-known London market pools will indicate just how fragmented run-off administration has become through separate insolvent and solvent run-offs. By taking a wider perspective and looking at the interests of policyholders as a whole, the movement towards accumulating discontinued insurance operations should help bring about some economies of scale in the administration of run-offs. Both policyholders and investors alike would benefit.

The second trend in the market is that with the development of more sophisticated approaches to discontinued insurance run-off, there are a number of detailed different strategies available. Along the arc of possibilities, one will find the extremes of isolating the run-off in a quiet corner of the company with the hope it eventually evaporates without incident, to accelerating the run-off with an aggressive commutation programme. Another approach is to warp payout patterns with slow-pay practices (i.e., frequent inspections, staged litigation) designed to preserve as much shareholder value for as long as possible. Run-off specialists have a wealth of options to help shape strategies to given goals.

The third trend is a growing interest in the use of solvent schemes of arrangements to expedite the administration of a run-off. Before considering the view surrounding the use of solvent schemes in more detail, this article will look a little more closely at the background to policyholder protection and the more general points concerning schemes of arrangement in both the solvent and insolvent context.

Policyholders' protection
Under the Policyholders Protection Act 1975 (the “1975 PPA”), the Policyholders Protection Board (the “PPB”) administers a compensation scheme whereby policyholders who are holders of United Kingdom policies are reimbursed for any outstanding liabilities if their insurer goes into liquidation. Reimbursement is full for compulsory insurances and 90% for other classes provided the policyholder is a private policyholder, i.e. a policyholder who is an individual, partnership or other unincorporated body of persons, all of whom are individuals.

Where an insurance company is in liquidation, the PPB's obligations are automatically triggered. However, the PPB also has discretionary powers to assist an insurance company in financial difficulties (such assistance will almost invariably include participation in a scheme of arrangement), and the FSA may intervene to compel the PPB to provide such assistance. Marine, aviation and transport business and reinsurance contracts are excluded from the scope of the compensation scheme.

The scheme is funded by a levy on insurance companies. However, following:
(a) huge increase in the amount of levies, needed primarily to cover the collapse of the KWELM group of companies;
(b) the decision in the Ackman v Scher proceedings1#, which appeared to widen the geographical ambit of the compensation scheme by providing that overseas policyholders of UK authorised insurance companies would be afforded protection where the business had been written on a service basis, i.e. out of the UK office and not through an overseas branch; and
(c) concerns regarding “commercial risks”, i.e., the claims of large partnerships against the compensation fund (typically under professional indemnity policies),there has been concern in the insurance industry regarding the cost of the scheme. In 1994 the DTI issued a consultation paper regarding the 1975 PPA and subsequently the Policyholders Protection Act 1997 (the “1997 PPA”) was passed#.2 It redraws the boundaries of protection by replacing the concept of the “United Kingdom policy” with the twin concepts of “qualifying policies” and “protected risks and commitments”. The issues concerning “commercial risks” were not tackled. The 1997 Act may be remembered as an Act never brought into force.

In December 1997, the FSA issued a consultation paper concerning consumer compensation. The paper contains proposals which, when implemented, will have a significant effect on the compensation scheme existing for the policyholders of failed insurance companies. In brief, the FSA proposes to restrict the eligibility of claimants against the scheme which will mean that “commercial risks” will be excluded. Indeed, the latest update of the consultation paper, issued in June of this year, has widened the criteria of what can be considered a larger company. The FSA has stated that it intends to review responses to the consultation paper and then publish detailed rules in draft for consultation by the end of 1999.

Schemes of arrangement

What is a scheme of arrangement?
A scheme of arrangement is an arrangement under section 425 of the Companies Act 1985 providing a company with a flexible method of binding its creditors (and/or its members) to a proposed course of action, typically (although not exclusively) because the company cannot meet its existing liabilities, whether actual or contingent. Once the scheme has been:
(a) approved in a meeting by a majority in number representing three-fourths in value of the creditors or the class of creditors (or its members or class of members, as the case may be); and
(b) sanctioned by the court, with an office copy of the scheme delivered to the registrar of companies,it becomes binding on the company and its creditors (and/or members) irrespective of whether they received notice of the meeting to approve the proposed scheme or not, or whether they voted in favour of the proposed scheme or not. A scheme can only be between the company and its creditors and/or members. Third parties are not bound by a scheme and, therefore, if a third party is to assume obligations with respect to a scheme, it must do so by separate contract or undertaking to the court. The scheme may be prepared by the directors of a company (in circumstances where there are no impediments to their continued involvement with the company) or, alternatively, they may be prepared by provisional liquidators appointed under the Insolvency Act 1986 following the presentation of a winding up petition.

Different types of schemes
In insolvent run-off situations, three types of scheme have been used to date: “cut-off” schemes, “reserving” schemes and “hybrid” schemes (a combination of cut-off and reserving schemes).

(a) Cut-off schemes
Under a cut-off scheme, the value of all of the company's liabilities (including contingent and unquantified claims) is estimated and a once and for all dividend is then paid to the creditors.#3 Of course the precise manner of determining liabilities will differ. A number of different mechanisms have been proposed in the past; for example, an actuarial formula or by agreement on a case by case basis, with some form of alternative dispute resolution mechanism implemented as an appeal procedure. However, the danger with this type of scheme is that some creditors might receive a payment because a value is put on their claims, whereas, if the run-off had taken its full course, the claim may never have crystallised. Alternatively, a claim might be valued at a sum greater (or indeed less) than would ultimately have been provable.

It is also critical to ensure that a proposal for a cut-off scheme does not materially reduce recoveries from the company's own reinsurers. There is some doubt as to whether an insurer is entitled to claim any reinsurance recoveries where an artificial value is put on IBNR and possibly case reserve elements of a claim rather than it being settled in the ordinary course. Ideally, the prior support of the reinsurers for the scheme would be sought and obtained by the promoters of the scheme.

(b) Reserving schemes
A reserving scheme will provide a mechanism to enable interim payments to be made to creditors who have established their claims, while reserves are maintained to protect those creditors with unquantified and contingent claims. A balance must somehow be struck between the interests of short tail and long tail creditors. Normally, scheme administrators will be responsible for fixing at regular intervals the dividend payment that may be made to creditors with established claims. In so doing they must have regard to the assets of the company available for distribution and the need to ensure that creditors whose claims have not yet become established are able to receive the same dividend payment on their claims in the future.

Claims will be established in the manner provided for in the scheme. Typically, there is no formal proof of debt procedure, so that claims are agreed (or, if necessary, litigated or subjected to arbitration) in the normal way. As other creditors establish claims during the life of the scheme, payments can be made to them out of the reserves. Once these reserves are established, the interests of long tail creditors can be protected, for example, by use of trusts or through “hotch pot” provisions varying the order of distribution in an eventual liquidation.

(c) Hybrid schemes
A “hybrid” scheme is essentially a reserving scheme with a discretion granted to the scheme administrators, at any time during the course of the scheme, to institute a cut-off mechanism if they consider it to be in the best interests of creditors as a whole. Examples of hybrid schemes include the schemes implemented for Andrew Weir Insurance Company Limited, Bryanston Insurance Company Limited, Scan Re Reinsurance Company Limited and Trinity Insurance Company Limited.

There is some controversy surrounding these “hybrid” scheme proposals, and it is fair to say that they have predominantly been used for smaller estates. Although in theory cut-off schemes have great appeal for creditors eager to accelerate a run-off and receive payment, the fact is that for a complex insolvency with significant outstanding reinsurance, such cut-off proposals are very difficult to implement. In our view it is difficult to construct a cut-off proposal until the circumstances justifying acceleration and dictating its detail are clear. The criticism of the “hybrid” scheme is that there will be little detail possible on either the timing of, or the mechanism for, acceleration and creditors may legitimately consider that they simply cannot know what they are voting for in a hybrid scheme.In any event, where a reserving scheme is already in place, it will be possible for the scheme administrators to put a proposal to creditors for “cleancutting” the company's liabilities, in the manner envisaged in cut-off schemes. Such a proposal should be made when a company's business has been substantially run off and the majority of claims established, or as a way of bringing a liquidation to an end. It is at that point that the creditors should be fully aware of all known facts and information relevant to the decision they are required to make. A cut-off mechanism was adopted for terminating a reserving scheme in the Mediterranean Insurance & Reinsurance Company Limited closing scheme.

Particular advantages of reserving schemes
Historically, insolvent insurance companies were dealt with by way of liquidation and this worked reasonably well for those companies with a predictable tail of business. More recently, however, schemes, and in particular reserving schemes, have proved a popular alternative to liquidation.

Why is a reserving scheme a more popular alternative to a liquidation?
(a) Asset management
The investment and handling of a company's cash assets will not be subject to the fees and levies payable in accordance with statutory requirements applicable in a liquidation.

(b) Investment powers
In a liquidation the company's cash assets, to the extent not required for immediate purposes, can only be invested in United Kingdom government securities. With a scheme an investment policy may be adopted which is suitable to the requirements of a particular company.

(c) Earlier payment/set-off
A scheme may allow for the earlier payment of distributions to creditors. In a liquidation there can be a delay of many years whilst the liquidators ensure that substantially all liabilities of the company have crystallised before distribution of the reserves, with the risk of personal liability for over-payment. In addition, in a liquidation, the statutory regime imposes a mandatory set-off for mutual obligations between the same corporate entities. This is difficult to apply vigorously to IBNR between insurers as there is no mechanism for valuing contingent claims owing to the company in liquidation. There is some debate as to whether contingent claims can be taken into account for set-off until they have crystallised.4# A reserving scheme can vary these rules because in essence it constitutes a quasi statutory mandate for scheme administrators to:

(i) make partial payments to creditors, varying the pari passu rule of distribution (this is because the provisions of a scheme may bind longer tail creditors to accept the risk that too much money may be paid out too early in the life of a scheme);

(ii) vary the mandatory rules of statutory set-off, without prejudicing those rights which creditors would have been allowed to exercise in liquidation; and (iii) vary some of the other rules that would apply in liquidation; for example, establishing a regime for a company's run-off and incorporating detailed rules concerning the role of the scheme administrators and the creditors' committee.

(d) Currency conversion
A scheme may provide for payments to be made in the currency of claims, thus minimising creditors' exposure to fluctuations in exchange rates. In a liquidation, all claims are converted into pounds sterling at the rate of exchange prevailing at the date of the winding up order, even though many claims may not be quantified and agreed for several years.

(e) Resolution of disputed claims
It is possible to devise a method for resolving disputed claims which may avoid expensive litigation and produce substantial cost savings, which could not be achieved in a liquidation without a scheme of arrangement or special directions from the court.

When is a liquidation more appropriate than a scheme?
Despite the above mentioned advantages of a scheme, careful thought needs to be given as to whether there are any issues which may properly be dealt with in the context of a liquidation. For example, issues such as fraud or malfeasance on the part of the company”s management may require careful investigation and use of a liquidator's statutory powers of investigation under sections 234, 235 and 236 of the Insolvency Act 1986.

Solvent schemes
Outside insolvency, schemes of arrangement broadly similar to cut-off schemes are gaining ground. When a group of companies finds that it has insurance companies within its group that it no longer considers to be part of the group's core business, it may decide to place these companies in run-off, selling them if it no longer wishes to retain the administrative burden of maintaining them within the group. However, conventional run-off has a number of disadvantages.

Disadvantages of conventional run-off
There are two principal disadvantages with a conventional run-off - it is time consuming and costly. The lengthy nature of a conventional run-off means that:(a) while the final liquidation of assets may result in a surplus of capital being available to shareholders, extracting capital pursuant to this option is unlikely to be possible for many years;
(b) there is an increased chance of adverse claims development;
(c) there is a prolonged risk of reinsurer default; and
(d) it is more likely that the shareholders will face increased exposure to (i) any guarantees that may have been given and (ii) additional market and regulatory pressure to provide financial support.
These factors, when combined with the costs of run-off over an extended period of time, may prove to exceed earned investment income, especially if the company is required to litigate a number of coverage disputes. This is important to shareholders who face an erosion in equity value.

While commutation is a means by which the company in run-off can limit its exposure and adverse claims development, commutation on a piece-meal basis can be administratively expensive and time consuming. The company”s bargaining power is likely to decrease as the market learns of the earlier commutation terms and trade partners demand better deals. In addition, the ability to commute may be restricted where the company is part of a financially strong group.

Solvent scheme as an alternative to run-off
Developments in the London market now provide an alternative whereby the run-off process may be accelerated by way of a solvent “clean-cutting” or “crystallisation” scheme of arrangement. As explained above, schemes have historically been implemented for insolvent insurance companies as the preferred alternative to liquidation. However, schemes of arrangement may also be implemented for solvent companies as a means of bringing the run-off to an earlier conclusion, hopefully avoiding some or all of the problems relating to a conventional run-off. A scheme is a useful mechanism for a solvent company because, within the framework of a scheme of arrangement, the liabilities of a company may be determined much more quickly than would be the case if the company ran-off its business in the normal course. This is because a “clean cutting” scheme provides for a procedure for estimating the liabilities and hence crystallising them, instead of needing to wait for them to mature in the normal course.

In many respects a solvent scheme of arrangement will be similar to a “cut-off” insolvent scheme (for example, the MedRe closing scheme, in which claims were paid in full, the ACC closing scheme, the St Helen's scheme, the Mentor closing scheme, the RMCA Re/ICS Re schemes and the Fremont (UK) scheme). In the past year, four solvent schemes (Scottish & Commonwealth Insurance Company Limited, HIR (UK) Limited, Osiris Insurance Company and Mutual of Omaha UK Limited) have been approved. Other solvent schemes are being formulated and it is likely that several more solvent schemes will be approved in the coming year.

Cross border issues - United States - Section 304 of the United States Federal Bankruptcy Code
Many London market insurance companies have very considerable assets and liabilities in the United States. For both insolvent and solvent schemes the benefit of the scheme may be extended to creditors in the United States through the use of section 304 of Chapter 11 of the United States Bankruptcy Code. Section 304 is invoked by filing a petition in the US Bankruptcy Court for an ancillary proceeding in aid of another country's core proceeding.

Section 304 confers upon the US Bankruptcy Court broad powers to grant appropriate relief to non-US insolvency officeholders and those powers can be invoked to assist schemes at two critical stages. First, while the scheme is being prepared, those responsible may seek preliminary injunctions from the United States Bankruptcy Court to restrain the commencement or continuance of legal proceedings (including arbitration) against the company for a fixed period. Other relief the US Bankruptcy Court can provide is a limitation of LOC draws and a prohibition against discovery. This gives the company a “breathing space” while the scheme is in preparation. Secondly, at the point when the scheme is implemented, the scheme administrators may seek from the same court a permanent injunction which would directly enforce the scheme's provisions in the United States. The use of permanent injunction orders in this way was developed during the insolvency of the KWELM companies, in which case the Federal Bankruptcy Court for the Southern District of New York issued the first permanent injunction order to give full force and effect in the United States to a scheme in relation to an insurance company. This was a development of great significance and has set a precedent for most of the London market insurance insolvencies which have followed.

One should be aware, however, that the use of Section 304 to assist the establishment of solvent schemes has engendered a reaction by the US law makers. As a companion to proposed reform of bankruptcy protection for credit card debt, legislation has been proposed which could be interpreted as restricting the use of Section 304 to situations where an insolvency actually exists.

In its present form the proposed language may not prevent the establishment of Section 304 proceedings to assist solvent schemes. Many things have yet to be determined; the final language has not been settled, the new legislation has not been passed and the subsequent interpretation of that language could be a subject of dispute. At the present time, however, the opportunity presents itself for solvent schemes that enjoy the protection of the US Bankruptcy Court.

The development of the scheme of arrangement over the last 10 years as a method of dealing with difficulties of conventional insurance litigation and, more recently, run-off, has been both rapid and enterprising. The process is a continuing one and I have little doubt that schemes of arrangement will become much more widespread in the run-off industry - generally used in conjunction with section 304 of the US Bankruptcy Code - and more frequently implemented as an option for discontinued operations.
Andrew Wilkinson is a partner and Stephen Doody is an associate at Cadwalader, Wickersham & Taft.

#1. Scher v PPB; Ackman v PPB [1994] 2 AC 57.
2. The operative provisions of the 1997 Act are not yet in force.
3. Examples of cut-off schemes established outside liquidation include the scheme for ICS Insurance Pty Limited and for Fremont Insurance Company (UK) Limited and the closing scheme for The Mediterranean Insurance & Reinsurance Company Limited and, within liquidation, the schemes for Mentor Insurance Limited and St Helen”s Insurance Company Limited.
4. Rule 4.86 of the Insolvency Rules 1986. Following Re Charge Card Services Limited [1986] Ch 150, it is generally accepted that contingent liabilities of an insolvent company can be set off - the position of liabilities owing to the insolvent company is less clear.