The UK Treasury has published draft plans to implement an EU directive on the reorganisation and winding up of insurers for the Lloyd's market, as Steve Goodlud reveals
Currently Lloyd's and Lloyd's members are not subject to the new insurance insolvency regime and they are excluded from the scope of the Winding Up Regulations.
Instead, Lloyd's market insolvencies, such as occur, are still dealt with under the previous insolvency regime in which all unsecured claims rank equally (direct claims of policyholders receive no special priority).
For all insolvencies of members at Lloyd's that have occurred to date, Central Fund assets have been applied by Lloyd's towards settling in full Lloyd's-related insurance liabilities. Accordingly to date, insurance creditors have been paid in full.
There would need to be a failure of a significant Lloyd's member, a number of members, a catastrophic escalation in claims in any one or more lines of business, or a market systemic problem to exhaust all surplus resources available at Lloyd's (including 'callable' contributions).
It is to deal with these potential circumstances and enable European Union (EU) compliance that the UK's Treasury, in conjunction with the Financial Services Authority (FSA) and Lloyd's, have prepared their proposed insurance insolvency regulations for Lloyd's.
The proposals introduce co-ordinated measures to deal with the circumstance of insolvency of the Lloyd's market or, in other words, should the Lloyd's Central Fund fail when called upon to cover insurance liabilities of Lloyd's members. Proposed regulations provide that, if such a situation occurs, various organisations involved in the Lloyd's market may become subject to a market reorganisation plan prepared by an appointed 'Reorganisation Controller' - an insolvency practitioner.
In March 2001, Directive 2001/17/EC1 of the European Parliament was adopted and subsequently implemented in 2003 by the UK2 (the principal Winding Up Regulations). However, it was not implemented for the complex Lloyd's market.
The main purpose of the EU directive, which does not apply to pure reinsurers, is to establish common rules for the reorganisation and winding up of insurers:
- Co-ordination rules to ensure reorganisation measures and winding up proceedings commenced in the home member state are recognised and have full effect throughout the European Community (principles of unity and universality)
- Rules governing the priority of claims of creditors (direct insurance claims should have precedence over other unsecured claims).
In November 2004, the European Court of Justice found that the UK was in breach of its obligations under the EU directive for failing to implement the EU directive for Lloyd's. In December 2004, the Treasury issued its proposals for implementation for Lloyd's, with a deadline for consultation of March 11, 2005, and a plan for legislation to be laid before Parliament in May 2005.
Structure of Lloyd's
To appreciate the Treasury's proposals, it must be considered how an insolvency event may arise in the Lloyd's market.
Lloyd's is an insurance market, not a single insurance entity, which is now regulated by the FSA. Business is introduced to the market by authorised Lloyd's brokers, and insurance is underwritten by underwriters acting on behalf of Lloyd's members. Lloyd's members (companies and private individuals) underwrite individually or collectively in syndicates, which are managed by authorised Lloyd's managing agents (managing agents employ the underwriters).
Authorised Lloyd's members' agents act for private individual members, who can underwrite on a limited liability or unlimited liability basis; members' agents introduce their client members to syndicates and manage their Lloyd's affairs generally.
Lloyd's members are responsible for the settlement of their insurance liabilities, and the resources available to meet a member's liability are as follows (in order):
1. Member's Premium Trust Funds (PFT) and other assets held in trust at syndicate level;
2. Member level trust assets comprising Lloyd's deposits, personal reserve sub-funds of the Premium Trust Fund and special reserve funds (collectively known as Funds At Lloyd's, or FAL);
3. Other available assets of the member;
4. Regulatory deposits including overseas trust funds; and
5. Lloyd's Central Fund and other central assets (where the relevant discretion is exercised by the Council of Lloyd's to make these assets available).
A member's assets held in trust in PTFs or FAL, which may represent the majority of their assets, are not available to non-insurance creditors in the event of a member's insolvency: they are held separate from the member's estate.
Lloyd's Central Fund
One of the principal features of the Lloyd's market is the existence of a Central Fund, a pool of monies available to cover insurance liabilities which members are unable to meet in full.
The Central Fund is maintained by annual contributions from Lloyd's members and also 'callable' contributions as may be levied by Lloyd's from time to time. It is at Lloyd's discretion whether to apply Central Fund monies to meet members' liabilities, and any exercise of this discretion is normally for a period not exceeding 12 months: the discretion can be renewed. Where the Central Fund is applied to meet a claim made on a member, Lloyd's is entitled to seek reimbursement from the member.
In addition to the Central Fund (which is supported by the recent issue of £500m of subordinated debt), other assets of the Society of Lloyd's could be made available at Lloyd's discretion to meet underwriting liabilities as a last resort.
The existence of the Central Fund and other central assets of Lloyd's are what allows the market to be given its own credit rating (currently 'A') and also a reason why Lloyd's does not support the rating of individual syndicates.
The table below shows, on an annual accounting basis, how Lloyd's capital, reserves and central assets are comprised.
On this basis the Lloyd's market appears financially healthy. Insolvency of the market on a balance sheet test would arise if approximately £10bn in losses were to accumulate with no new capital injected. Of course, a regulatory breach would occur much earlier in accordance with minimum margin of solvency requirements.
However, insolvency must be measured at member level. In this respect, assuming no capital injection or cash calls are made, a member's (or group of members') insolvency occurs at Lloyd's if their insurance liabilities exceed their available assets (according to the list set out above).
For private individual members, unlike corporate members who are prohibited from carrying on non-insurance business activities, bankruptcy can be brought about by virtue of non-insurance related liabilities and/or Lloyd's-related liabilities. The members' insurance liabilities would still be met in full, unless Lloyd's did not provide access to the Central Fund or unless Central Fund resources were exhausted (Central Funds assets are expected to be expended on a 'first come first served' basis).
The thrust of the new proposals is that, upon application by the Society of Lloyd's and/or the FSA only, the court may grant a Lloyd's Market Reorganisation Order and appoint a Reorganisation Controller. The objectives of the Order are:
- To preserve or restore the financial situation of, or market confidence in ... the Lloyd's market to facilitate the carrying on of insurance market activities ... or
- To assist in achieving an outcome that is in the interests of creditors of members, and particularly insurance creditors.
The conditions for the making of the Order are firstly that any Lloyd's regulatory solvency requirement is not, or may not be, met and secondly that the Order is likely to achieve one and/or both of its objectives.
For these purposes, the Lloyd's solvency requirement is one that is imposed upon any one or more Lloyd's members or former members, acting alone or together, or imposed upon the Lloyd's market itself.
The Treasury have chosen an early trigger (breach of regulatory solvency rather than conventional insolvency tests) presumably on the grounds that, given the complexities of the Lloyd's market, intervention may be required at an early stage to respond effectively to a serious threat of insolvency in a co-ordinated and controlled manner in order to achieve the Order's objectives.
The Order applies to:
- Every member, former member, managing agent, members' agent, Lloyd's broker and approved run-off company (who has not been excluded specifically in the application for the Order);
- Every coverholder (who has been included in the Order); and
- The Society of Lloyd's and its subsidiaries.
The scope of the Order is very wide: at the beginning of 2004, there were 53 corporate members and 2,685 private individual members (2,048 with unlimited liability) writing business in 66 syndicates, 168 Lloyd's brokers, 45 Lloyd's managing agents, four Lloyd's members' agents and a growing number of run-off companies managing the liabilities of open syndicate years. On top of this there are a vast number of former members of Lloyd's and coverholders.
Whichever of the Society and/or the FSA that may apply for the Order, they must have first carefully considered which Lloyd's organisations should be included or excluded from its scope. In arriving at their decision, depending upon the nature of the insolvency threat, important strategic decisions may have to be made quickly, especially as the market contains a number of publicly-listed vehicles.
It should be expected, therefore, that contingency planning would need to have been done and that a 'pre-packaged' reorganisation plan may need to have been prepared to deal with a major collapse.
The Order may be varied afterwards, including disapplying it to particular assets or particular members, or applying it to additional coverholders.
Consequences of the Order
While the Order is in force, except with the permission of the court, under the proposed Lloyd's Winding Up Regulations no proceedings or other legal process (including insolvency proceedings and enforcement of security) may be commenced or continued against any of the organisations at Lloyd's to whom the Order applies, nor against their assets (held directly, in a relevant trust fund or in overseas regulatory deposits, save in respect of approved debts). The moratorium provisions as drafted prevent any actions being taken by creditors, not just those relating to claims arising out of Lloyd's business.
This blanket moratorium provides wide protection to the Lloyd's market from the anticipated storm of litigation while the Reorganisation Controller prepares the plan for reorganisation.
At the same time as making the Order, the court shall appoint a Reorganisation Controller. The role of the Reorganisation Controller is to assess the difficulties facing the Lloyd's market and to identify ways of meeting the Order's challenging objectives. This includes the development of a plan for the reorganisation of the Lloyd's market, the terms of which are subject to acceptance by the FSA.
Any organisation involved in the Lloyd's market, whether caught by the scope of the Order or not, may be required by the Reorganisation Controller to provide him with information he considers useful in the achievement of the objectives of the Order and the development of the reorganisation plan.
Once the Order has been made, in order to control and co-ordinate individual proceedings affecting Lloyd's members, the Reorganisation Controller must be notified of any intention to commence insolvency proceedings (including a scheme of arrangement) otherwise they shall be void. The Reorganisation Controller will be entitled to be heard on any application to the court to lift the moratorium and on any petition to commence insolvency proceedings.
The proposed Lloyd's Winding Up Regulations anticipate that the Reorganisation Controller may choose not to object to certain Lloyd's members entering into an insolvency process and in that situation the member is treated as if it were a UK insurer under the principal Winding Up Regulations.
In this way, the EU directive provisions and the new creditor priorities are applied to insolvent Lloyd's members. However, a petitioner for the insolvency of a Lloyd's member, who may be the Reorganisation Controller himself, has the right to apply to court for an order disapplying the EU directive provisions for that member, but the court will only grant this if the insurance liabilities of the member will be satisfied.
Reinsurance to close and set-off
The process of reinsurance to close (RITC) at Lloyd's means that only the original underwriting member of a syndicate will have a liability to a direct assured and that member may have successfully passed all of its risk to a subsequent underwriting year of that (or another) syndicate.
The policy of the EU directive is to give preference to direct policyholders over all other unsecured creditors. In order to achieve this priority, under the Lloyd's Winding Up Regulations the liability under an RITC arrangement passed to a succeeding year of account is treated as a direct insurance liability in those cases where the liability of the closing underwriting year (or earlier closed year of account) to the policyholder was a direct insurance liability.
Interestingly, the same treatment of direct claims is not applied to Equitas, a pure reinsurance company into which pre-1993 Lloyd's insurance liabilities were reinsured.
As another pragmatic approach to the web of internal relationships between members at Lloyd's, the Treasury propose to permit set-off to occur between members at syndicate level, for each underwriting year.
Implications for Lloyd's
The introduction of regulations for the reorganisation or winding up of Lloyd's is expected to be an administrative (and academic) exercise in compliance with EU directives. There are few insurance insolvencies in the UK, and the Central Fund at Lloyd's has so far ensured that all members' valid insurance liabilities have been met in full, even where individual members have become insolvent.
It would require extreme (but not necessarily farfetched) circumstances for the Lloyd's market to fail and the proposed regulations to be activated.
Nevertheless, partly in response to the principal Winding Up Regulations introduced in 2003, there was a segregation of UK direct insurance and reinsurance business into separate business units.
The new insurance insolvency regime elevated the claims of direct policyholders, to the disadvantage of other policyholders reinsured by the same entity, which gave pure reinsurers a potential competitive advantage. The same situation exists at Lloyd's where both direct insurance and reinsurance business is conducted by Lloyd's members. The protection offered by the Central Fund may, however, reduce the extent of similar segregation of direct and reinsurance business at Lloyd's. In relation to third party service providers carrying on both Lloyd's and non-Lloyd's insurance business (brokers, run-off companies etc), unless the proposed moratorium provisions are restricted to claims arising only from business at Lloyd's, it is possible that service providers may separate these activities into different trading entities.
A concern may exist for capital providers of Lloyd's members, whose ability to enforce their security would be impaired under the moratorium provisions.
A similar concern may exist for policyholders who are entitled to payment out of PTFs, FAL and overseas trust funds, which under the new proposals will not form part of the member's estate. The claims settlement process under those trusts may be conducted under an entirely different priority regime to that required by the EU Directive, depending upon the nature of the relevant trust rules. In some cases, the settlement process may be entirely at the discretion of the trustee.
The other major consequence for Lloyd's would be the effective handover of the management of the market, and the Lloyd's Franchise, to the Reorganisation Controller. The responsibilities of the Reorganisation Controller are potentially very large, and the regulations currently provide no protection to him against possible significant personal liabilities (in which case it would be interesting to speculate where he might take out personal liability insurance).
How do the new regulations affect run-off at Lloyd's? The simple answer is that business in open syndicate years is treated no differently to ongoing business; however, syndicates in run-off may be ahead in their planning for closure.
At the time of writing, the proposed Lloyd's Winding Up Regulations are only in draft and subject to change as the Treasury is still in the process of consultation. Whether the final regulations will ever be required is something that may not bear thinking about.
1 2001/17/EC: Directive on the reorganisation and winding up of insurance undertakings.
2 Insurers (Reorganisation and Winding Up) Regulations 2003 (SI 2003/1102), which were revoked and replaced with the Insurers (Reorganisation and Winding Up) Regulations 2004 (SI 2004/353).
The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP (UK).
The information contained is of a general nature and is not intended to address the circumstances of any particular individual or entity.
- Steve Goodlud is a director in the insurance team of KPMG's corporate recovery.