Winding up a solvent insurance operation may be a lot more expensive in future. Policyholders stand to benefit, but insurers face sharply higher payments. Jonathan Broughton of EMB explains.
The insurance industry has yet to absorb the full significance of last month's judgment, in which the High Court refused to allow BAIC (British Aviation Insurance Company Limited) permission to proceed with a solvent scheme of arrangement.
The judgment is now subject to appeal. The outcome will have far-reaching implications, because it calls into question an increasingly popular method of winding up insurance operations. At a conservative estimate, there are at least twenty solvent schemes in the pipeline, and some of them are huge. The ruling would fundamentally change the balance of power between insurers considering a scheme of arrangement and their policyholders.
To appreciate the ramifications of the High Court decision, we need to consider why people enter into solvent schemes in the first place. They provide a relatively straightforward process for an insurance company to fulfil all its obligations to creditors and then return whatever remains to shareholders. They can be a highly capital-efficient way for an insurer to make a strategic departure from the market.
There are alternatives, of course. Sale or portfolio transfer, purchasing stop loss reinsurance or commuting while in a solvent run-off are valid options. However, all require the insurer to pay a market risk premium in order to gain finality. The unique advantage of the solvent scheme is that, up to now, it has sharply reduced the necessary risk premium or eliminated it altogether. To put it another way, insurers have been able to settle their outstanding claims at broadly best estimate values instead of paying extra to achieve finality.
Under a scheme, policyholders give up insurance coverage bought to provide indemnification against unknown future claims in return for a cash equivalent estimate. In this way, the insurer returns the risk back to the policyholder.
For it to happen, though, a scheme requires the agreement of 50% of creditors by number and 75% by value. In this scenario, policyholders whose outstanding claims have been agreed normally take a positive view of the exercise. The group most likely to resist, on the other hand, are those with substantial IBNRs (Incurred But Not Reported).
In theory the uncertainty surrounding IBNRs should require a risk premium to make the scheme acceptable to them. So how have companies managed so far to avoid paying these risk premiums?
Schemes to date have generally lumped all creditors into one class. Before the vote, agreements may be made with major policyholders contingent on the scheme being sanctioned. It is thus possible to isolate or dilute the opposing IBNR creditors such that they lack the voting power to prevent the scheme from going ahead. Some of BAIC's opposing IBNR creditors argued, furthermore, that the monetary value of their claims had been underestimated for voting purposes, further reducing their ability to influence the outcome.
All this will now change if the BAIC case is any guide. Amongst the many, often complex legal points to emerge from Mr Justice Lewison's judgment, a critical one relates to the status of IBNR creditors. He concluded that BAIC should have treated IBNR creditors as a separate class.
The company should then have held two separate votes, one for creditors with accrued claims and one for those with IBNR claims. Pre-agreed claims would fall into the accrued class. The scheme could only proceed by winning the necessary majorities in both camps. In other words, the scheme would have had to win 75% of the votes by value of those creditors least likely to accept the deal, representing a significant shift in the balance of power.
Assuming the judgment stands, one way for schemes to resolve this dilemma is to incentivise IBNR creditors by paying them significantly more than best estimate, just as already happens with alternative exit strategies. Good news for policyholders, but expensive for insurers.
Another related issue is how are IBNR claims to be evaluated for voting purposes? Although some IBNRs are relatively straightforward, others are anything but easy to resolve.
They could include, for example, claims relating to tobacco law suits and electro-magnetic fields (EMF), not to mention asbestos. How on earth do you quantify the value of a class of risk like EMF that has a tiny chance of producing an enormous loss at some unspecified time in the future?
Maybe IBNR claims with huge uncertainty are simply unsuitable for solvent schemes. There is plenty of scope in this situation for blue sky thinking. Could this, for example, present an opening for a new breed of run-off entrepreneur? Will we see the most difficult liabilities transferred, prior to a scheme with a huge risk premium, to a specialist run-off company? The remaining bulk of the risks could then enter a solvent scheme.
Where does this leave the run-off industry or any insurance or reinsurance group that may want to withdraw from the market? Solvent schemes still have many attractions to insurers and policyholders alike. However, the alternatives may now be more attractive for some insurers.
Above all, many run-off managers will be praying that the Appeal Court overturns the High Court judgment. If not, then the insurance industry's exit costs have just got a lot bigger.
This article appeared in Post Magazine in August 2005
