Neil Golding explains changes afoot in insolvency law which will have major implications for the run-off sector.

The law relating to the insolvency of insurance companies in the UK is about to undergo a number of fundamental changes. This will have a big impact on all those who have any dealings with companies which are in, or which might at some stage end up in an insolvency or reorganisation process. The changes include a radical alteration to the rules regarding the priority of the payment of claims; in a fundamental change to the current system, insurance claims will have priority over the claims of other unsecured creditors.

The aim of this article is to explain briefly how the present regime for insolvent insurance companies operates and then to consider the nature of the changes which are about to be introduced.

Over the past 15 years or so, the insolvency of UK insurance companies has developed well-established procedures:

  • provisional liquidators are appointed. These are invariably selected from a handful of partners at the bigger accountancy firms which specialise in this area;

  • a scheme of arrangement is then put forward. Creditors with similar interests are divided into different classes for the purposes of the scheme;

  • creditor meetings vote on the scheme. Each class must vote in favour of the scheme by the requisite majority for the scheme to be approved (they being a majority in number and three-quarters in value of those attending); and

  • the final stage in the approval process consists of obtaining the Court's blessing;

    So far as distributions are concerned, the terms of the scheme will broadly reflect the position which would have applied if the company in question had gone into liquidation. In other words, all unsecured creditors (whether the policyholders, reinsurers or otherwise) are treated similarly. In general terms, no group of unsecured creditors would have any form of priority. Finally, the provisional liquidators ultimately become scheme administrators.

    The system has worked perfectly well in practice. Critics have said that the system is too slow and that estates could be wound up more quickly, but everybody was familiar with the rules of the game.

    But that position has changed recently. Firstly, the prohibition on insurance companies going into the insolvency procedure known as administration has been removed so that administration became available to insurance companies from 31 May 2002. Even though there has only been one case to date where administrators have been appointed - Folksam International Insurance Co (UK) Ltd - the likelihood is that, going forward, any new insurance insolvencies will involve administrators rather than provisional liquidators being appointed. While the change is of great interest to those who specialise in the area of insurance insolvency, it will be of less significance to the industry more generally. In practice, it is likely to consist of broadly the same people doing broadly the same job, but merely wearing a different hat.

    Directive introduction
    The same cannot be said of a much more significant change which is to be introduced following the adoption on 15 February 2001 by the European Union of the Insurers (Reorganisation and Winding-up) Directive. The directive has no direct effect under English law, but has to be brought into force in the UK by means of secondary legislation by 20 April 2003. Recently, there has been a consultation process taking place in which the UK government was considering the best means of implementing the directive. The government issued a consultation document in November 2002 and requested responses by the end of January 2003. A range of interested parties (including the Association of British Insurers) have submitted responses.

    Although the government has issued a draft of the statutory instrument which would give effect to the directive, this may well be amended in light of the consultation process. As a result, the precise method by which the directive will be brought into force remains unclear.

    What is beyond doubt, however, is that the directive will have a big impact on insurance insolvency in the UK. Several key points should be noted:

  • currently, if an insurance company with operations throughout Europe is wound up, the authorities in each individual member state where the company is represented can begin separate proceedings. Each set of proceedings will be run under local law, which can lead to conflicts of law and unequal treatment of creditors. The directive aims to simplify that process by allowing for a single set of proceedings. This would be commenced in the member state where the relevant undertaking had its head office. The law of that member state would then apply (subject to a handful of exceptions);

  • the directive applies to all insurers (whether writing life or non-life business). It has no application to pure reinsurers. For reinsurers, there is a further piece of European legislation which should be borne in mind - the Regulation on Insolvency Proceedings;

  • the directive applies to winding-up proceedings or `reorganisation measures' which are commenced by reinsurers after the directive comes into force. It is fairly clear what is meant by winding-up proceedings. However, there has been considerable debate about whether schemes of arrangement under section 425 of the Companies Act would amount to reorganisation measures. The view the UK government appears to be adopting is that schemes will fall within the scope of the directive;

  • because the directive is aimed at providing greater levels of consumer protection, there are new requirements regarding the information to be provided to creditors (for example, about how to dodge a claim) and about which EU language such information must be provided in;

  • most importantly, the directive provides for `insurance claims' to have priority over the claims of other unsecured creditors, including reinsurance creditors. `Insurance claim' is defined to mean any amount which is owed by an insurer to an insured, a policyholder, a beneficiary or to any injured party having direct right of action against the insurer and which arises from an insurance contract;

  • EU member states are given a choice of how the requirement to give priority to insurance creditors is to be implemented. The first option requires insurance claims to have absolute priority over all other claims with respect to assets representing the technical provisions which insurers are required to maintain. If this option is chosen, a special register of those assets representing the technical provisions must be maintained by every insurer. The second option requires insurance claims to have priority over the entire assets of the insurance undertaking, subject to the claims of specified categories of preferential creditors such as employees. The responses to the consultation process have all indicated that the second method is the preferred choice for UK companies; and

  • the directive also provides that where the rights of insurance creditors are protected by a guarantee scheme (such as the Financial Services Compensation Scheme), member states have the option of excluding such schemes from the scope of the directive, such that these claims would not have priority.

    Major change afoot
    The new regime is going to have a big impact on the industry. For insolvency professionals, the approach currently adopted towards preparing schemes of arrangement will have to change to reflect the fact that `insurance claims' and other unsecured claims will now need to be dealt with separately, and will therefore amount to different classes. It remains to be seen how the professionals will deal with the existing schemes which have already been approved though for commercial reasons need to be amended, but for which the amendment cannot take place until after the directive is introduced. The directive may also call into question the abilities of English officeholders (whether provisional liquidators or administrators) to obtain relief under section 304 of the US Bankruptcy Code. This has become a staple part of existing best practice, and obtaining an injunction restraining the piecemeal break-up of an insurance estate in the US has almost become a matter of course. It may not be so easy to obtain (or maintain) such injunctions following the introduction of the directive.

    Questions posed
    For a reinsurer, the directive raises a difficult question when dealing with a party which is in some difficulty (or which might at some stage find itself in that position). For example, would it now make sense for a reinsured to commute as soon as possible rather than risk being in a much worse position if its insurer were to end up in an insolvency or reorganisation process which was governed by the directive? In addition, so far as future business is concerned, reinsurers will need to give even greater thought than before to the possibility of obtaining security to ensure that their position is protected.

    However, it will not be possible to deal with all the ramifications of the directive until the final form of the statutory instrument is available, and to see how the industry deals as a matter of practice with the issues which seem certain to arise.

    Note
    In a discussion document released after this article was prepared and at the time of going to press, the UK government now appears to be taking the view that schemes of arrangement do not fall within the scope of the directive.

    By Neil Golding
    Neil Golding is a partner in Freshfields Bruckhaus Deringer's restructuring and insolvency group.

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