Nicole Woodland and Andrew Rose explain the possible effects of administration on troubled insurance companies.

The UK Financial Services and Markets Act 2000 (FSMA) has introduced a power to allow financially troubled English insurance companies to be placed into `administration'. The UK Treasury recently issued a consultation paper stating that it plans to use this power early this year. The availability of the administration procedure could have a significant effect on `troubled' insurance companies in England and third parties dealing with those companies.

Until now, English insurance companies in financial difficulty have either gone into liquidation or provisional liquidation often followed by a scheme of arrangement (`scheme') under the Companies Act. Traditionally, these have been the only routes available as insurance companies were not permitted to follow the English Insolvency Act procedure of administration. This was the situation because administration was considered inappropriate given the long-tail nature of insurance business.

In an attempt to overcome the distortion of the use of provisional liquidation, which was originally intended for use as a short-term measure, the UK Treasury has now proposed to use its power to allow insurers to be subject to administration orders.

Administration orders
As these orders may not be familiar to those dealing with troubled insurance companies, it is important to reflect on this `new' animal. An administration order is a court order appointing an administrator to a company, in financial difficulty to manage and continue the business of the company at least until the administrator is in a position to put substantive proposals to the creditors.

The advantage of an administration order is that it imposes a moratorium on actions by creditors, including realisations by secured creditors. In addition, no winding-up order can be made against the company. Where a company is not yet irretrievably insolvent, this procedure gives the company time to put its affairs in order with the hope of salvaging the business or at least provide a reasonable and realistic timeframe in which to develop plans for payments to all creditors. The process therefore has similarities with the US Chapter 11 procedure.

Provisional liquidation vs administration
Both provisional liquidation and administration are procedures that can lead a company to a scheme of arrangement or winding-up. In fact, a successful administration can even return a company to `business as usual'. Although they are fairly similar procedures, there are some inherent differences.

A provisional liquidator can only be appointed after a winding -up petition has been presented, whereas an administration order can be made at any time. Furthermore, a winding-up petition can only be issued where a company is unable to pay its debts. The test is not as strict for an administration order, where the company must simply show that it is unable to pay its debts or is likely to become unable to pay its debts.

In addition, an administrator's role is to manage the company with a view to putting the company back on track, while a provisional liquidator's role is to preserve the company's assets so that they may be divided between the entitled creditors. In an insurance context, both are appointed to protect the company's assets and to consider the viability of a scheme.

Impact on insurers
1 Insurance letters of credit
The administration regime imposes a prohibition on secured creditors from taking steps to enforce any security over a company's property without leave of the court or the consent of the administrator. This prohibition is probably the most controversial aspect of extending the regime to insurers and will be of particular interest to banks that issue letters of credit (LOCs) on behalf of insurers to third parties in return for security from the insurer.

If an insurer goes into liquidation or provisional liquidation, the third party will claim on the LOC issued by the bank. The bank will then realise the security it obtained from the insurer and, being a secured creditor, it takes priority over other creditors. Enforcement of security is not subject to control by a liquidator, unless he can attack the validity of the security.

The new regime means that where an insurance company goes into administration, the secured creditor will have to apply either to the court or to the administrator in order to realise its security. The view set out in the consultation document is that this is unlikely to be a problem as there is no reason why administrators or courts would not allow the security to be drawn down as LOCs are honoured.

This rule, however, increases the complexity of the system for lending banks and, at a minimum, means that there will be another hoop for them to go through at a time when the LOC will be payable immediately on receipt of a proper demand. A potential delay in realisation of security could mean that the level of collateral required by the bank will be increased. It is clear that from the perspective of both the secured creditor and the insurance market, this will raise serious concerns. For example:

l banks may require insurers to secure their letters of credit with cash, thereby lowering income for insurers and reducing the capacity of the market as a whole; and

l the cost of letters of credit will increase as the timely availability of collateral decreases. New administrative, and possibly legal, costs would be incurred.

2. Set-off
The insolvency set-off rules do not apply where a company is in administration. The Treasury has suggested only one substantial modification to Part II of the Insolvency Act (and the corresponding insolvency rules). While set-off in liquidation is mandatory for other companies (by virtue of the operation of Rule 4.90 of the insolvency rules), the setting-off of debts that arise after a petition for an administration order is presented will not be permitted if an insurer goes into liquidation.

This modification is required because the number and size of dealings between an insurer in administration and third parties are likely to be particularly high compared to non-insurance companies. Thus it was feared that debtors would try to obtain a commercial advantage by purchasing creditors' claims at a discount.

Although beneficial for the individual debtor and creditor, applying traditional insolvency set-off would mean that the pool of assets available to be distributed would have been reduced and the monies available to the creditors as a whole would be diminished. The contractual set-off provisions which are normally found in a scheme are designed to achieve a similar result.

3. Limitation/time bar issues
Winding-up orders stop time running for creditor claims whereas administration orders do not. This is a significant difference, but from a practical point of view may make little difference for the following reasons. Provisional liquidation also does not stop time running under the Limitation Act, in respect of creditor claims (except for the creditor which petitioned for the winding-up order). Therefore under current procedure, if an insurance company goes into provisional liquidation, creditors need to protect their rights during the course of the provisional liquidation period (by, for example, a standstill agreement or bringing court proceedings if the leave of the court is obtained). Creditors would need to take the same steps once an administration order has been made.

However, the important difference is that if an insurance company then goes into liquidation, time will stop running at that date, but while a company is in administration, time will not stop running. If the administration leads to a scheme, agreement will usually be reached with the creditors of the company. That will therefore resolve any time bar issue that may arise in relation to claims on the company.

By Nicole Woodland and Andrew Rose

Andrew Rose is a partner and Nicole Woodland is an associate in the insurance and reinsurance department of London-based law firm Berwin Leighton Paisner.