Run-off is a growing field with an increasing number of options.
Last year, at least 48 re/insurance companies and six Lloyd's syndicates ceased underwriting. This year appears to be sustaining the trend, with 19 insurers ceasing underwriting in the first two months of 2001. Substantial losses have been caused by casualty business, US workers compensation carve-out business, ships crew reinsurance, film finance gap insurance and life insurance. A recent ‘highlight' was the provisional liquidation of HIH Insurance Ltd on 15 March after announcing half-year losses of A$800m at the time.
Although there is an element of truth in the saying ‘lies, damn lies and statistics', there are some alarming figures which will have a significant impact on the insurance industry:
With such doom-laden statistics hanging over the industry, it is important to consider the issues which arise when a UK re/insurance company gets into financial trouble, and in particular the options available to the company's directors and creditors.
Directors need to ensure that systems are in place to monitor the solvency of an insurance company, including the adequacy of its reserves, security of its reinsurance program and accurate valuation of its assets given their potential liability if the company trades while it is insolvent.
One of the great problems faced by insurers is assessing future liabilities under policies already written. This is particularly evident with the occurrence-based casualty policies protecting US insureds written in the 1950s onwards. However, as has been seen with the high-profile problems in the London market relating to personal accident business written in the last ten years, insurers are a long way from resolving this general problem.
Alternatives for troubled insurance companies include:
Other possibilities – a statutory reduction under Section 58 of the Insurance Companies Act 1982, company voluntary arrangements under Part I of the Insolvency Act 1986 and administration orders – are not considered in this article as they are not available or have not been commonly used to date. The process of liquidation is also not addressed although we consider why some of the other alternatives discussed above may be more appropriate.
From a business point of view, run-off provides the company with difficult challenges, primarily in relation to minimising costs and ensuring that appropriately qualified and motivated people manage the run-off. The main disadvantages of conventional run-off are that it is time-consuming and costly, there is an increased risk of adverse claims development and a prolonged risk of reinsurer default. The outsourcing of run-off services to external companies does not immediately solve this as it is necessary to ensure that the inherent conflict between a service provider maximising its fees by continuing the run-off as long as possible and conducting it efficiently is addressed.
If the insurance company is underperforming, sale of the company or the relevant business (usually by way of portfolio transfer) or sale of the right to new or renewal business may yield the maximum return for shareholders. A sale obviously requires a buyer. If the problem faced by the company is short-term and there is value in the underlying business, a capital injection by existing or new shareholders may be possible.
The troubled insurer may consider non-statutory agreements with creditors which will be contractually binding on those with whom agreement is made and which will prevent the company from going into insolvency. Such arrangements are entirely flexible and will, if successful, avoid the expenses and delays that are often associated with statutory arrangements. An example would be commutation with major policyholders. This could be effected through a partial release of liabilities, or an exchange of debt for some form of equity. The directors of failed London insurer Walbrook promoted this idea in early 1992.
These voluntary arrangements are unlikely to be suitable for companies with large numbers of creditors, possibly spread around the globe, or where a large number of creditors cannot be identified. Other factors which mean that commutations are harder to achieve in practice include uncertainty as to the ultimate exposure and the fact that certain policyholders are entitled to payments from the Policyholder Protection Board under the Policyholders Protection Act 1975. A temporary moratorium or payments of claims may be easier to arrange.
Schemes of arrangements
In recent years schemes (under Section 425 of the Companies Act 1985) have become the favoured option for the orderly realisation and distribution of assets to creditors of insolvent insurance companies. The scheme, which must be sanctioned by the court, requires prior approval in a meeting by a majority in number representing 75% or more in value of the creditors or the class of creditors. Once sanctioned, the scheme is binding on the company and its creditors (whether they received notice of the scheme or voted at the meeting).
Typically, the company itself prepares a winding-up petition and provisional liquidators are appointed. The petition is then adjourned pending the preparation of the scheme proposal. Once the scheme has been sanctioned the petition is dismissed and the scheme operates outside of liquidation. Effectiveness of a scheme in relation to jurisdictions other than the UK will depend upon whether that jurisdiction recognises the procedure under Section 425. Separate agreements may also have to be negotiated with key third parties which are not bound by the scheme.
If the company has assets in the US or is engaged in litigation in the US, it is usual for the company, through its provisional liquidator, to apply for relief under the US Bankruptcy Code (Section 304) which provides protection from creditors while the scheme is developed. The scheme should contain provisions dealing with the outstanding litigation and a permanent injunction under Section 304 will usually be sought.
There are three common types of schemes; reserving, cut-off and hybrid schemes.
Reserving schemes mirror a run-off of a solvent company. Interim payments are made to creditors which have established their claims while reserves are maintained to protect those creditors with unquantified and contingent claims. Reserving schemes have been used for the KWELM companies and failed insurer English and American.
In cut-off schemes, also called ‘clean cutting' or ‘estimation' schemes, the liabilities (including contingent liabilities) are valued as soon as possible. Once the liabilities have been determined or ‘cut-off', a once and for all dividend may then be paid to creditors. Cut-off schemes have been used for ICS, Fremont Insurance Co, St Helens, RMCA, Pine Top Insurance Co Ltd and Hawk Insurance Co Ltd.
Hybrid (or combined) schemes are essentially reserving schemes that contain an option for the scheme administrator to institute a cut-off mechanism if they consider it appropriate. Hybrid schemes have been used for Bryanston Insurance Co, Andrew Weir Insurance Co, Scan Re Reinsurance Co, Orion and London & Overseas.
Schemes of arrangement have numerous advantages over liquidation. For example, a scheme can provide for creditors to receive some payment earlier than would be likely in a liquidation. There is also a degree of flexibility on the investment of funds received during the scheme. Payments to creditors can be made in the currencies of their policies.
Under English insolvency rules creditors' claims must be converted to pounds sterling at the rate of exchange at the date of liquidation, resulting in exchange rate risks for creditors. In addition, a scheme is not subject to the mandatory rules of set-off. It can provide for full insolvency rights of set-off, can restrict the rights of both parties to the position that would apply in a solvency or it can afford insolvency rights to creditors whilst restricting the company to the position in solvency.
However, certain actions available to a liquidator under English insolvency law, for example actions against company directors for wrongful or fraudulent trading, are not available to a company subject to a scheme.
In recent years, the scheme of arrangement procedure has been used as an exit solution for solvent companies. Similar to a cut-off insolvent scheme, its main advantage is that costs of a 20 to 40 year run-off are avoided. The agreement of the company's reinsurers will be critical for its success as otherwise reinsurance recoveries are likely to be prejudiced. Examples of solvent schemes are Scottish and Commonwealth Insurance Co, HIR (UK) Ltd, Osiris Insurance Co, Mutual of Omaha UK, Crombie, Trent and MMI.
The Section 304 procedure has also been used in support of the solvent schemes for Osiris Insurance Co Ltd and Hopewell International Insurance Ltd (which involved a solvent scheme of arrangement approved in Bermuda).
Where there are uncertainties as to the potential exposure of a particular book of business, a reinsurance solution may be a cost-effective way of providing stability to the insurance company. Reinsurance solutions may also facilitate mergers and acquisitions, and may protect the insurer against earnings volatility. Reinsurance solutions are essentially financial transactions with investment income often providing the reinsurer with the key motivation for the deal.
A wide variety of different structures for reinsurance solutions exist. They tend to involve a limited risk transfer and are very flexible. An example would be a loss portfolio transfer involving the transfer of all liabilities of a run-off book of business to a reinsurer. The transfer can be either ground up or involve an excess point. Turner & Newell, which was plagued by asbestos-related claims in the US, purchased such a policy.
Administration orders and the FSA
At present, insurance companies are expressly excluded from the class of companies in relation to which an administration order may be made. However, when the UK Financial Services and Markets Act comes into force, currently due before the end of November 2001, the Treasury will be able to make an order removing the prohibition on placing insurance companies into administration. Further, the UK Financial Services Authority (FSA) will be given extensive powers to initiate and become involved in insolvency proceedings relating to insurance companies. The FSA will also have the power to initiate other types of procedures such as preparing a scheme of arrangement pursuant to Section 425 of the Companies Act 1985.
The traditional approach of a provisional liquidation followed by a scheme of arrangement may change as the alternatives increase and the FSA becomes more involved in insurance company insolvencies.
Contracts (Right of Third Parties) Act 1999
The Act contains an important exception to the English contract law rule that only a party to a contract can enforce it against the other party. Appropriately worded cut-through clauses whereby an underlying insured is given a right against the reinsurer may be effective on an insurer's insolvency to allow the insured to enforce a reinsurance contract against a reinsurer even though the insured is not a party to the contract with the reinsurer. This Act has only recently come into force and its application to cut-through clauses is still to be tested. However, it may have a significant impact on the recoveries by insolvent insurance companies against their reinsurers.
Insurance company insolvency is not all bad news – it just depends on who you are. When an insurer becomes insolvent it is fair to say that reinsurers on average end up paying less and paying it later. The reasons why this is the case are varied. For example, many large insureds do not even pursue claims against an insolvent insurer even though moderate returns would be made as creditors in the estate. Where an insurance company becomes insolvent, its reinsurers typically have to pay (subject to any set-off) a 100% of the amount owing under the reinsurance contract even though the insolvent insurance company only pays a portion of the amounts owing to creditor policyholders. This means that there is a commercial incentive for the reinsurer and the creditor to agree to deal directly to their mutual advantage. Such an arrangement was held valid by the High Court in NEMGIA v AGF  2 BCLC 191.
It will be interesting to see if the recent legislative changes will affect the way in which insolvent and solvent insurance companies deal with their problematic or disastrous books of business. To date, schemes of arrangement have demonstrated great flexibility in relation to very complicated and large insolvencies. However, creditors will no doubt be enthusiastic to explore options which may conclude run-offs faster and for less. The next round of run-offs and insolvencies may result in more innovative solutions to the problems facing insurance companies.