Part VII transfers have become a more popular way to resolve legacy insurance and reinsurance business, as well as a tool for restructuring live business. Their use is set to increase still further, but companies going down this route should beware of the growing likelihood of legal challenge, say Paul Murray of EMB and Pollyanna Deane of Berwin Leighton Paisner.
The use of Part VII transfers has grown in both frequency and scope in recent years, and it is no longer the specialist life business activity it used to be. By 2006 the number of general business Part VII transfers had reached an all-time high of 29.
The fact that Part VII transfers go ahead without requiring individual policyholder consent give them an obvious attraction. Nonetheless, they got off to a slow start after Part VII of the Financial Services and Markets Act 2000 (FSMA) first set out how they should operate.
At the time, they were seen as complex novelties. General insurers that wanted to dispose of their liabilities via a transfer rushed to use the quicker and cheaper methods available before the measure became law. A lull inevitably followed, and companies were reluctant to test the waters until they had seen how others fared under the new rules.
In time, the more Part VII transfers were seen to work, the more companies were encouraged to go down this route. In short, the process started to achieve a momentum of its own.
Not only have Part VII transfers become an established, growing part of the run-off and restructuring scene, they are being put to an unprecedented range of uses. Most notably, whereas they were previously the province overwhelmingly of large insurers wanting to consolidate legacy business of acquired operations (e.g. Aviva, RSA), we are now seeing transfers across groups. And these relatively contentious transfers are beginning to throw up more realistic challenges to the Part VII process.
Whenever any practice or process becomes more widespread there is normally an increased risk of things coming unstuck. The temptation grows to use it inappropriately or in new, untested ways. The higher the profile of Part VII transfers, the greater the likely levels of scrutiny. In addition, we have to consider the growing and changing roles of the regulator and the potential influence of Solvency II.
In this article we consider three factors:
• The role of the court and regulators;
• The position of the independent expert;
• The likelihood of successful objections by policyholders or reinsurers.
The role of the court and the regulatorsAnyone who thinks that the role of the court in a Part VII transfer is to provide a rubber stamp should think again. Certain proposed transfers have never made it to court because of concern about objections or potential objections or issues raised by the independent expert. Indeed, no UK transfer has yet been put to the High Court with FSA or Lloyd’s opposition. More recently, the court criticised the FSA’s approach and this has prompted them to reconsider their role.
Part of the FSA’s job is to approve an independent expert to report to the court on the proposed transfer. They also have the right to appear in court and object to a transfer. Following the recent judicial criticism, they now look to produce their own report for the court on each transfer. Initially, as the FSA report process bedded down, they were also represented in court. Going forward, while they will continue to submit their reports, they may well not appear in court without a particular reason. Where Lloyd’s syndicates are concerned, it is reasonable to assume Lloyd’s also has the right to appear in court, even though this is not explicitly stated in the legislation.
Were a regulator ever to make a formal objection in court, then obtaining court approval would at the very least become highly problematic. In practice, it would probably never even get to court. If the FSA suggested that the scheme involved persons who were not acting in a fit and proper manner or there was a danger that the firm was not treating its customers fairly, then this would probably be enough to kill the plan, even though there is scope to ask for a judicial review.
Although Lloyd’s has a different procedure, the regulatory drivers are the same. The Corporation of Lloyd’s has sent out unambiguous signals that it will take a strong line on anything that might endanger the market’s financial integrity.
The independent expert
In the event of a portfolio transfer challenged by regulators or others, the report of the independent expert would be pivotal.
His brief is to ensure that the policyholders’ security is protected (whether they are transferring, are left in the transferring company or are already in the transferee company). The FSA’s relatively new ICAS regime sets out a new, more sophisticated way to view company security, including an ICA (Individual Capital Assessment) showing the capital required to ensure company survival at a given probability level. Building on existing ICA work allows survival probabilities before and after the transfer to be used to compare security levels. It should be noted that the key test is whether or not the arrangement has sufficient financial security; that is to say, the sort of level that the FSA would demand to write similar business now. It does not necessarily require the same level as the transferring company.
The key risks that the independent expert must consider for security are:
1) Uncertainties surrounding the liabilities;
2) Reinsurance security;
3) Nature of the other assets;
4) Manner in which the transfer will be capitalised;
5) Any existing ICA or capital models;
6) Other risks, such as operational and liquidity risks;
7) Any over-riding factors that reduce / eliminate the need for above analysis (third party guarantees / obvious extremely high solvency).
It is worth focussing a little more on 5): the existence (or not) of capital models. Although an integral part of the ICAS regime, the FSA has tended not to insist on seeing models for run-offs (except in transfers, sales and purchases or capital extractions). But they are increasingly alive to this issue and many run-off companies are starting to investigate ICAs to better understand the risks they face and to be ready for any future exit strategies or reorganisation. [Indeed the FSA has suggested that in time they may increasingly wish to see models for run off companies.]
Unless a transfer is very clear-cut, previous more simplistic ways of checking solvency are no longer likely to be good enough. Simple ratios might once have been used. Now you will need to produce a model that estimates all potential outcomes and their likelihoods, including extreme or unlikely events (i.e. ones that could affect policyholder security). This reflects the more complex methods used for life transfers.
For companies still writing business, their ICA model should provide most of the necessary detail. For a run-off company, one pragmatic solution is to produce an equivalent model restricted to those elements of the company that will change as part of the transfer. Regardless, you will still need to produce models of the resulting companies post-transfer. If the transferring policyholders include reinsureds, you will need to establish their solvency position as they would rank behind direct policyholders in the event of insolvency.
The fact that the Part VII transfer process enables companies to override the need for policyholders’ consent puts the onus on all parties to a transfer to demonstrate both rigour and technical expertise. All too often these days, the expert's report and the scheme collude to tell a third party very little about what is happening and why. It remains to be seen whether the introduction of the FSA report improves matters.
Objections by policyholdersMost policyholder objections to Part VII transfers tend to be prompted by individual grievances. As the aim of most, if not all schemes is to leave policyholders in a position better or no worse than if the scheme had not occurred, reassurance can usually be given. In some cases it can be clearly demonstrated that policyholders will be much better off after the transfer.
There are a couple of exceptions to this rule: the fabled “retired actuary” who wants to exercise the little grey cells; and US objectors. The latter have been easy to deal with to date, mainly because objections have tended to centre around arguments along the lines of “It’s not fair” or “They cannot be serious” - which the court has tended to disregard.
It is, of course, only a matter of time before the US objections take on a more solid and substantial air and indeed start raising substantive points. This brings us to the final type of policyholder objection, namely that raised by well-prepared, experienced participants in the industry who have a particular concern or indeed have good reason to oppose the scheme.
It is usual for the court to hear such applicants with great interest. Where the applicants’ points are pertinent, the court would normally expect the terms of the scheme to be amended to take them on board. Equally, the presence of the independent expert in court will be required so that any amendment to the scheme can be blessed, in so far as it does not affect the conclusion of his/her report.
So far, the most troubling objections to schemes (at least for the insurers involved) have been those presented by reinsurers. Given that the legislation now permits the transfer of reinsurance contracts without the consent of the reinsurers, there is plenty of scope for reinsurers to allege that they are adversely affected by the scheme, particularly with a view to avoiding a poor bargain under an existing contract. Most firms will settle with the reinsurer rather than lay themselves and their financial security open to argument in court.
It is fair to say that the FSA would be interested and not a little concerned if the reinsurance community decided to take this position more often. Perhaps a concerted effort to gain reinsurers’ views on the effect of the Part VII transfer regime would be worth undertaking.
Looking ahead
As Solvency II rolls out across Europe, more companies will have an understanding of risk-based capital models and be in a better position to consider Part VII-type solutions. With Solvency II, more focus will need to be placed on run-off books of business across Europe, and their effects on policyholder security will be analysed through risk-based capital models. A greater awareness of these books may encourage more internal reorganisation or transfers of non-core business to those who specialise in such business.
The way things are going it may become harder for solvent schemes of arrangement to be used for direct business as the FSA’s proposals for policyholder advocates kicks in. While the mass commutation approach of schemes may still appeal to some creditors, particularly on reinsurance books, for direct books a Part VII transfer may become the more natural exit route.
Paul Murray is a director at EMB, the non-life actuarial and management consultants. Pollyanna Deane is a partner in the corporate and regulatory insurance team at City law firm, Berwin Leighton Paisner.
This article first appeared in Run off & Restructuring in February 2008
