Ipe Jacob argues for the concept of automated triggers in schemes of arrangement.
Solvent schemes of arrangement are hardly a new mechanism in the UK and certain other jurisdictions, but their recent introduction into legislation in the US - the largest insurance market in the world - has boosted interest in their use. Certainly, now there is tacit acknowledgement that certainty and finality for re/insurance portfolios is probably best achieved by this methodology, wherever in the world and by whatever name it is called.
Simply put, schemes of arrangement in the UK enable a consensual restructuring of a re/insurance company. A simple majority in number and a 75% majority in value of the company's creditors, present and voting at a meeting called for the purpose, can, with the approval of the court, bind all the creditors to a revision of the standard pre-existing contractual terms.
Of course, there is no reason at all why any company anywhere shouldn't renegotiate terms with creditors, individually or en bloc. What is special about schemes of arrangement is the facility that enables all creditors, including those who might have dissented and those who for one reason or another may not have become aware of or participated in the proceedings, to be bound by those who do turn up, personally or by proxy, and vote.
For re/insurance companies - particularly those still in the grip of broker accounting, reporting timelags by agents and other similar antediluvian practices, and therefore unable to describe precisely the population of their creditors - this facility is crucial in any attempt at voluntary restructuring.
Certainly, the concept could lend itself to abuse. Hence the checks and balances of judicial oversight and, at least in the UK, regulatory approval. The latter occurs currently by dint of good practice but it is to be hoped that the Financial Services Authority(FSA)'s future plans involve subjecting such schemes put up for approval in the UK courts to its compulsory prior consent.
Although there is clear evidence that the process itself is becoming better understood and more widely accepted by all the relevant stakeholders, take-up has been slower than anticipated by industry watchers. Many point out the inherent conflicts of interest within the process: between shareholders, who believe their reputations would suffer if they were seen to `let a portfolio go', and management tasked with maximising the profitable use of scarce capital; between management incentivised by performance measures related to the run-off portfolio and staff whose jobs come to an end with the demise of the portfolio in question; between regulators, who would prefer maximum capitalisation and shareholders and management, who would prefer the opposite; and so on.
All of these arguments probably have some valid elements. However, none is sufficient in itself to deny the plausibility of capital release for a re/insurance portfolio or company in run-off by way of a solvent scheme of arrangement. This is particularly the case now that we are entering an era in which capital requirements and capital utilisation come under increasing scrutiny.
As a result, the questions surrounding the issue have changed. No longer is the most burning issue whether some capital inefficiently locked up in a portfolio in which there is no longer any current or future underwriting interest should be repatriated and put to better use. Neither is it about how certainty and finality can be achieved, since sale or a solvent scheme are the only available methods. In fact, the most important question is no longer if or how, but when.
From the owners' point of view, capital release is available unconditionally only by sale or scheme, either of which may be appropriate. Deciding which of those exits to use depends on a number of factors, principally around timing and price. It is likely that however long the process of due diligence might take, however long the inevitable haggle with the regulators, a sale will be quicker than a solvent scheme. The key issue then is how much discount/profit the vendor is prepared to give up to the buyer, who, assuming real value is changing hands, presumably wants to realize the surplus capital.
Although there have been sales of portfolios and companies for a token sum, these, generally are driven by different business dynamics; only portfolios and companies in run-off with real net worth are addressed here.
In the past, it was thought impossible to even contemplate a solvent scheme for a re/insurance business. Now, the situation has changed from `never' to `not yet'. That is often based on an honest misconception of how schemes of arrangement work. Solvent schemes are invariably designed as `cut-off' or `estimation' schemes. In essence, the policyholders, actual and potential creditors agree that the company's liabilities to them may be determined by some agreed estimation method, often involving actuarial input. Payment of this estimated amount is taken in full and final satisfaction of the company's obligations on the relevant policy or policies.
While it has indeed been the norm for the estimation process to commence soon after a scheme has been voted in and approved by the court, that timing is not inevitable. Estimation can be designed to commence at some time in the future, determined by conditions set out within the scheme. For example, it would be perfectly feasible to agree that the estimation process only applies when all of several conditions have been satisfied, and these conditions could deal mathematically with the state of claims development, the proportion of reinsurance collectibles, the company's net worth as a proportion of technical reserves, and so on. And until the estimation process is triggered automatically by the preset conditions being met, the portfolio continues to be run-off as normal. That is, I believe, the route to be preferred wherever possible. The decision to propose a scheme should be a natural, and immediate, consequence of the decision to cease underwriting.
Why bother with pre-set automated triggers? Why not wait until the portfolio is judged ready for estimation?
By opting for the pre-set automated trigger route, rather than waiting until the portfolio is judged ready for estimation, the commitment to an estimation process at some indeterminable time in the future will incentivise every policyholder and reinsurer to try to come to an agreement, rather than submitting to an `automated' estimation process. As a consequence, the run-off is accelerated and shareholder value is enhanced. Reinsurers are included among those who would seek voluntary agreement not because they are bound by the scheme in the way policyholder creditors are - indeed, they cannot as debtors be bound in this way - but because in sharing a proportion of the inwards book, they too have a stake in the outcome of the estimation process.
The pre-commitment strategy then is the prime motivator for commutations, which are generally recognised as the principal driver for value added in the run-off sector. The knowledge that there is a formula-driven deadline helps to accelerate negotiations that might otherwise meander for too long. And unrealistic expectations may also be lowered by the knowledge that time-wasting posturing might result in the game being taken away and played by different rules.
As with all schemes of arrangement, with or without automated estimation triggers, they have to be voted in, approved by the regulators and by the court. There is no prospect therefore of procuring a scheme that is patently unfair or prospectively unworkable. Although the statutory hurdle is a mere numerical majority of those voting representing at least 75% in value, I believe it is necessary to persuade the overwhelming majority of those entitled to vote that the scheme is in their interests. Some might say that the Achilles heel of the strategy lies precisely at this point, but it is for those who craft these schemes to ensure that the terms have a commercially compelling appeal for the majority of policyholders, at a fair price for shareholders. This includes the price that must be paid to ensure that regulatory consent is obtained and that management and employees embrace the proposals. The fact that a broad spectrum of interests needs to be addressed does not make it impossible to do so successfully. The key is to identify and deal with common interests effectively.
Not only is it essential to get the commercial prerequisites right, it is also vital that the advocacy for the proposal is properly planned and properly executed. Many are the propositions, put together by the extremely able and well-intentioned, that fail to make progress because they haven't been effectively or persuasively presented to those who would buy them.
Solvent schemes with automatic triggers do not yet exist, as far as I am aware. So how can I support my argument that the strategy is a workable one, and that such schemes should be considered at the very point that underwriting ceases?
The nearest simile I can find in the market is Equitas, the reinsurer of Lloyd's pre-1993 exposures. The pre-commitment strategy is evident in the constitution of this vehicle which was pivotal to Reconstruction and Renewal of the Lloyd's market. The world is aware that Equitas exists to collect its assets and pay off its liabilities. It is not exactly the best-capitalised run-off in the world and there is no expectation that it will raise fresh capital. Moreover, Equitas' liabilities cannot exceed its assets. In extremis, it would make proportional payments in satisfaction of its obligations to Lloyd's Names reinsured into it. Although in theory policyholders and cedants could look to Names to satisfy their obligations that Equitas cannot meet, few consider that a realistic prospect.
So, although Equitas has for some years been meeting its liabilities in full, and continues to do so, it operates to a considered plan that envisages controlled shrinkage of both sides of the balance sheet, rather like a solvent scheme prior to the estimation process kicking in. The end game is known and, like any scheme, involves both downside risk and upside potential. The trade-off between the two is a personal balance for the counterparties, and in a world where risk is the everyday backcloth to all decision-making, it is interesting to see how those balances have been struck.
In the year 2000 when asbestos-related liabilities caused an upward revision of £1.5bn in Equitas' liabilities - a situation totally unforeseen at the time Equitas was established and sufficient to wipe out its capital several times over - it announced a change in net worth of only £12m. How so? Presumably the main counterbalance to the asbestos shock was the net result of other balance sheet management - commutations - elsewhere in the organisation. And a cursory glance at the numbers demonstrates just how effective that commutation programme must have been. `Proof' that signalling that the end is nigh indeed makes it so, at least in the world of re/insurance.
So there you have it. At the point underwriting ceases, there is no continuing justification to maintain truly surplus capital in a run-off portfolio. The commercially rational strategy must be to extract that capital in a manner acceptable to all the stakeholders. That must eventually involve a process akin to a solvent scheme of arrangement, perhaps via one or more sales. And solvent schemes are best proposed and effected at the earliest possible opportunity, which may be several years before an estimation process is triggered and closure - true certainty and true finality - is obtained.
By Ipe Jacob
Ipe Jacob is head of the financial markets group at Grant Thornton.