Dan Schwarzmann and Nigel Rackham examine the growing popularity of schemes of arrangement
For discontinued insurance business, schemes are becoming increasingly popular, but the question continues to be asked, what is the attraction?The answer is simple. Whether we are talking about a solvent company seeking to balance the interests of policyholders and shareholders or an insolvent company looking to achieve an early return to creditors, the objective is finality and the scheme provides the flexibility to tailor an appropriate solution.In the UK, a scheme (scheme of arrangement, under section 425 of the Companies Act 1985) is a compromise or arrangement between the company and its creditors or any class of them. It becomes legally binding on all creditors or any class of creditors if the necessary majority vote in favour of the scheme and it is approved by the High Court.The first type of scheme developed for an insurance company was of the run-off variety, and this generally became accepted as a better alternative for dealing with insurance insolvencies than liquidation. Solvent insurers are now increasingly adopting the scheme process to provide early crystallisation of the whole (or certain classes) of their discontinued business. Further, innovative use of the scheme has facilitated the development of cut-off schemes for insolvent and solvent re/insurers including those with long-tail liabilities (including employers' liability business) or significant reinsurance assets. Schemes are now also being used for complex books of business involving insurance pools and, more recently, for non-UK entities.The scheme's attraction is its ability to provide a solution that balances the needs of all the company's stakeholders, an essential element if the scheme is to be accepted in the market and meet its objective of finality.The various stakeholders could include, amongst others, policyholders, claimants, reinsurers, brokers, the Financial Services Authority (FSA) and, where the company is insolvent, the Financial Services Compensation Scheme (FSCS).
Long-tail and insolvencyWhere insurance policies have been written on an occurrence basis, claims could arise indefinitely. As a result, it is very difficult to finalise the run-off of a company that has written long-tail business. To tackle this problem, a type of scheme has been devised which is effectively a commutation with all policyholders, allowing the company's ultimate liability to be estimated, a payment percentage to be set based on this estimation and a final distribution to be made to creditors.This is known as a cut-off or valuation scheme as, under the terms of the scheme, policyholders are typically required to submit claims by a certain date (the 'submission' type of cut-off scheme), called the 'bar date', following which the company will either agree the claims or submit them to independent adjudication. As claims cannot be submitted after this date, the process facilitates a wholesale estimation of all present and future claims with a view to making a final payment to creditors much earlier than would have been achieved under a long-term run-off scheme.An alternative model would be the 'allocation' type of cut-off scheme where instead of policyholders submitting their own claims, a scheme actuary would use the company's data to enable allocation of IBNR (incurred but not reported) to individual policyholders. Claims are then either agreed or, if necessary, can be adjudicated in the same way as the submission scheme. The most appropriate method adopted for valuing claims within a cut-off scheme will depend on the type of business written and the profile of policyholders.An example of a case where the valuation scheme methodology has been used is Andrew Weir Insurance Co Ltd. Andrew Weir became insolvent in November 1992 and a run-off scheme became effective in April 1994. This scheme provided for claims to be processed and agreed as they would in a normal solvent run-off, albeit creditors were only paid a percentage of their claims as and when they were agreed.Almost ten years later, a significant proportion of Andrew Weir's remaining $500m of reserves were in respect of asbestos, pollution and health hazard risks and it was considered likely to be many years before these liabilities fully matured.In addition, it was considered unlikely that the payment percentage could be increased for some time because of the company's low reinsurance cash flow. These issues meant that finality was not something the creditors could have expected in the short term. Following consultation with the creditors' committee, approval was achieved to trigger a valuation option contained in the original scheme. This option allowed for contingent liabilities to be valued as at a particular point in time. Andrew Weir is therefore currently in the process of crystallising its liabilities, and calculating and collecting its remaining reinsurance recoveries in order to pay a final dividend to scheme creditors and bring about finality for the estate. This means that the scheme will be closed and final payments made much sooner than would have been the case if the run-off were left to continue to natural expiry. This is one of the first such schemes, and the largest to crystallise a substantially direct book of business.
The 'double dip'In cases where there is potentially a significant reinsurance asset to collect, there is uncertainty about how reinsurers may react to the early crystallisation of inwards losses. Early commutation of the reinsurance asset may be considered risky and consequently practice has been to start with a run-off, rather than cut-off, scheme, and at some future date put in an estimation methodology to achieve closure.One solution to accelerate closure has been the development of the hybrid or 'double dip' scheme, so named because creditors have two opportunities to vote on the features of the scheme. Whilst it cannot bind reinsurers, this type of scheme provides a mechanism whereby they can more actively participate in the scheme process. In the first vote, the creditors decide whether to approve the scheme. Once sanctioned by the court, the company will crystallise its inwards book on a conditional basis and calculate reinsurance recoveries arising from this in order to progress commutation discussions with its major reinsurers. Following this, the reinsurers will be asked to indicate the sums they would be prepared to pay in settlement of their obligations should crystallisation proceed. Creditors then have a second opportunity to vote, this time on whether to accept the reinsurers' offers. Reinsurers will be aware that if their offers are not considered satisfactory, creditors will choose to revert to a long-term run-off which has the effect of removing the early prospect of certainty and finality for both the creditors and for the reinsurers.This scheme therefore enables reinsurers' participation whilst protecting creditors by giving them the ability to vote to revert to a run-off scheme if they consider this to be preferable based on the outcome of the discussions with reinsurers.
Employer's liability businessThe solution for long-tail liabilities has now been further developed to cater for insolvent insurers with protected policyholders eligible for compensation from the FSCS. The first example was for North Atlantic Insurance Co Ltd, a company with liabilities estimated to be in excess of $800m.North Atlantic's protected claims were largely professional indemnity and employer's liability business, and the first difficulty in concluding the run-off was that the FSA had strongly indicated its concern about the legality of any employer agreeing to commute a compulsory insurance policy such as an employer's liability policy because of the potential impact on third parties which might benefit from claims under the policy.Further, the IBNR reserve for employer's liability business is generally calculated on a class basis as it is impossible to determine in advance which policyholder will actually incur the loss in the future. This results in a difficulty in putting a present value on future claims from protected policyholders other than as a class.The fact that compulsory employer's liability business is protected by the FSCS made it possible to devise a solution which separated the cut-off of the estate from the run-off of the employer's liability business and other protected policies. This was achieved by placing a present value on all outstanding and IBNR claims in respect of the protected policies as a class. Dividends in the scheme will be paid to the FSCS based on this class valuation and protected policyholders whose claims are finally agreed at a later date within the scheme period will be paid directly by the FSCS at the appropriate protected percentage.Protected policyholders' claims that are finally agreed after the scheme period in a subsequent liquidation will also be paid directly by the FSCS whose obligations will be triggered by the liquidation in accordance with the FSCS rules.The first solvent schemes were for non-complex books of business. This methodology has now, however, been developed and applied for the first time to UK pools. Using a scheme for discreet portfolios rather than the whole of a company's liabilities is a further example of the range of scenarios that schemes can cater for.In this case, the members of an underwriting pool each effected a scheme for their participation in that pool. From a legal perspective, policyholders needed to approve each company's scheme, and this was achieved through having separate votes for each pool company at the same creditors' meeting.From a practical perspective, only one scheme document was required and once the scheme became effective only one 'pool-level' claim was required to be submitted by creditors.The scheme was able to simplify the complex arrangements and relationships commonly observed in pools, and formalise the sharing arrangement for the pool liabilities, enabling them to all be dealt with on a consistent basis.
Solvent schemesSolvent schemes have now been developed for a number of UK branches of overseas companies and companies deemed to have 'sufficient connection' to the UK, for example because of their policyholder makeup. There have also been schemes for companies domiciled in countries (typically Commonwealth jurisdictions such as Bermuda and Singapore) where section 425 Companies Act-type provisions are available.One such example of the application of solvent schemes for foreign companies was demonstrated recently for various subsidiaries of the ING Group. The schemes covered the international discontinued reinsurance business of four Dutch and one Australian company. All five schemes were presented in one scheme document, enabling the shareholder to adopt a parallel approach in developing, promoting and gaining the requisite support from policyholders.Whilst schemes may not be suitable for all types of business, because of legal, technical or commercial reasons, their flexibility means that they are growing in popularity for the very real benefits they deliver to all stakeholders.Dan Schwarzmann is a partner and Nigel Rackham is a director in the Solutions for Discontinued Insurance Business team at PricewaterhouseCoopers. Website: www.pwc.com/discontinuedinsurance. Email: email@example.com