The PRA has put down a clear marker that policyholder interests must come first when insurers are looking for ways to return capital to shareholders. It is particularly concerned that schemes of arrangement used by solvent insurers to achieve an early exit from the market can expose policyholders to a forced commutation of their cover and to settlement of their claims at less than full value. Shareholders, on the other hand, benefit from having earlier access to their capital than if the business had been run off in the usual way.
The PRA's conclusion that this type of scheme is "unlikely" to be compatible with its policyholder protection objective (see CP6/13, issued on 9 September 2013) has generated a considerable amount of unease. Its approach is representative, perhaps, of the shift of both the PRA and the FCA towards greater protection of consumers. However, the PRA needs to recognise that it may also deter proposals that would be supported by the vast majority of a properly defined solvent creditor class.
1. Key messages
- Opinions on the use by solvent insurers of schemes of arrangement to exit insurance markets tend to be polarised.
- For some, this type of scheme unjustifiably favours shareholders in giving them early access to their capital while exposing policyholders to a loss of cover and/or under-valuation of their policies.
- For others, the Companies Act 2006 (CA 2006) establishes a mechanism that insurers may legitimately use to cut short the run-off process and which safeguards policyholder interests through voting requirements and the involvement of the court.
- The PRA's approach is likely to mean that fewer schemes get to court.
- There is an argument, therefore, that its proposals represent an unwarranted intrusion into a statutory process that Parliament has provided for varying creditors' contractual rights. That process depends on approval by the necessary majority of each affected class of creditors and the court's assessment of the merits of a proposal, not the decision of another body that has no formal powers under the CA 2006.
- A consequence of the PRA's new approach may turn out to be the increased use of Part 7 transfers as a way for firms to exit insurance markets, but this process will inevitably depend on finding a willing transferee.
The PRA's consultation on capital extractions by general insurers in run-off (see CP7/13, also issued on 9 September 2013) is less controversial than CP6/13. Both consultations close on 26 October 2013. This briefing considers the PRA's comments on schemes of arrangement and their implications for insurers.
2. PRA consultations
On 9 September 2013, the PRA published draft supervisory statements describing its approach to:
- CA 2006 schemes of arrangement proposed by PRA-authorised insurers (CP6/13); and
- proposals for capital extractions by general insurers in run-off (CP7/13).
CP7/13 does little more than elaborate on the principle that general insurers in run-off must maintain an adequate level of capital at all times and is not considered further in this briefing. The PRA's comments about solvent schemes of arrangement are, however, of greater interest to market participants. The supervisory statement being consulted on is intended to replace guidance issued by the FSA in July 2007, which was removed from the FSA website before Legal Cutover on 1 April 2013.
3. Use of creditors' schemes by general insurers
A scheme of arrangement is a compromise or arrangement between a company and its members or creditors (or any one or more classes of them) under Part 26, CA 2006. It must be approved by a majority in number representing 75% by value of all members/creditors of each class and sanctioned by the court.
Creditors' schemes, involving an insurance company and its policyholders, are increasingly used by general insurers wishing to bring an early end to their business in a way that releases capital that would otherwise be tied up while the company is in runoff.
This type of scheme – sometimes known as a “cut off” or “estimation” scheme – has its origin in schemes traditionally used by insolvent insurance companies in provisional liquidation as an alternative to liquidation, under which dividends are paid as claims become agreed in the ongoing insolvent run-off of the insurer. Schemes proposed by solvent insurance companies take a different approach in that they seek to “cut off” future liabilities under policies in return for a once and for all payment.
This type of scheme can be controversial. Policyholders may be forced to accept early termination of their cover (which may be irreplaceable) and settlement of claims at less than full value irrespective of whether they formed part of the required majority of policyholders that voted in favour of the scheme. Concerns of this nature have resulted in two high-profile court challenges to solvent schemes in Re British Aviation Insurance Company Ltd  BCC 14 and Re Sovereign Marine & General Insurance Co Ltd  BCC 774. Other schemes have been abandoned following concerted policyholder objections to their implementation. Objecting policyholders have also relied on the threat of objection to negotiate favourable cash commutations that have allowed those schemes to proceed unchallenged.
4. CP6/13 – PRA approach to schemes of arrangement by general insurers
The PRA's starting point in assessing solvent schemes
Although the formal scheme process is established by the CA 2006, not FSMA, the PRA's draft supervisory statement focuses on its statutory objectives under FSMA. Specifically, the PRA will look to ensure that, where insurers wish to exit the market, they take proper account of policyholders' need for an acceptable degree of continuity of cover.
Applying this general principle, the PRA's proposed starting point is that a scheme put forward by an insurer that still satisfies its regulatory capital requirements and expects to be able to meet claims as they fall due is "unlikely" to be compatible with the PRA’s policyholder protection objective. The reasoning is that use of a scheme in these circumstances could undermine the traditional shareholder/creditor hierarchy in allowing shareholders effectively to extract capital from the company while subjecting policyholders to a binding compromise in respect of claims.
Underpinning the PRA's starting point is the assumption that policyholders are always best served by preservation of their cover. The legislation regarding creditors' schemes has been part of English company law for well over a hundred years. In establishing and maintaining a statutory process for varying creditors' contractual rights, Parliament has recognised that there are circumstances in which policyholders might expect their contracts to change (the position is similar in the context of Part 7 transfers of insurance business) subject to the safeguards that are built into the CA 2006. Although it is applicable to all types of company, not just insurers, the existence of such a statutory process casts doubt on the PRA's assumption about continuity of cover. This must in turn leave the validity of its starting point on schemes open to question.
Rebutting the PRA's presumption
Overturning the PRA's starting point will depend on whether it can be persuaded that:
- there are compelling reasons to take a different approach in order to secure an appropriate degree of policyholder protection; or
- alternative safeguards are put in place to ensure an acceptable level of continuity of cover for dissenting policyholders.
Unfortunately, the draft statement does not define when a reason would be regarded as sufficiently "compelling" for these purposes.
We are not aware of any finalised scheme to date in which "alternative safeguards" have been offered by a general insurer to dissenting policyholders although the PRA's draft statement is likely to encourage work in this area to continue. The idea is that policyholders not wishing to commute their policy under the terms of the scheme could opt to take out replacement cover with an alternative insurer (this would need to be done by novation). This would give the scheme company the finality that it seeks, while providing policyholders with continuity of cover. The difficulty may be to find an insurer that is suitably highly rated to satisfy the PRA and that is willing to take on the relevant long tail liabilities.
Application of supervisory statement to life companies
The title of CP6/13 reads "Schemes of arrangement by general insurance firms". The heading to the draft supervisory statement also restricts its application to "general insurance firms". The text of the draft statement does not, however, limit its scope to general insurers and there may well be some life schemes where the unfairness of being bound by a majority approval and court sanction arises in the same way. In such cases it may well be possible to offer an "opt-out" mechanism to a policyholder who does not wish to be bound by the scheme, as has happened in one case to date.
The PRA should clarify its position in relation to schemes proposed by life insurers, in particular, given recent changes to rules on reattributions in the life sector (which now prohibit the use of schemes of arrangement as they do not provide the necessary "opt-out").
5. Likely practical impact of the PRA's approach
Although the court is ultimately responsible for deciding whether a scheme of arrangement should go ahead, experience indicates that it is likely to adopt the PRA's views absent strong arguments why it should not. In practice, this probably means that fewer solvent schemes will actually reach the court as insurers come to appreciate their difficulty in overcoming PRA objections to a proposal.
However, the PRA derives its statutory authority from FSMA, not the CA 2006, and it has no formal part to play in schemes of arrangement. Parliament has instead entrusted the court to decide whether a scheme of arrangement should go ahead and the court can be expected to exercise its powers with particular care when a proposal involves the variation of contractual rights. This will include looking at whether a solvent scheme is a reasonable one for policyholders to have approved. The PRA's involvement in schemes in the way it proposes arguably undermines the role that has been entrusted to the courts and it should perhaps revisit whether its approach can be justified.
The PRA's approach is also likely to deprive policyholders of the ability to negotiate themselves a better deal with insurers on the basis of withdrawing their objection to a scheme. There is little to be gained by the insurer in trying to agree an outcome with policyholders if the PRA is in any case going to challenge the scheme in court.
6. Some further considerations
The FSA's July 2007 guidance indicated that it was unlikely to object to a scheme that fell within the range of possible reasonable actions the firm might take, depending on what was fair in the circumstances. The approach proposed by the PRA in CP13/6 represents a significant change from the FSA's position, not least because it is, seemingly, founded on the assumption that solvent schemes are not in the best interests of policyholders.
There is a danger, in our view, in assuming that solvent schemes will be objectionable rather than approaching each scheme on its merits. The latter approach requires the regulator to reach an informed (and reasoned) decision about a scheme based on a proper understanding of its implications for policyholders. The risk with the former approach is that it becomes very difficult or impossible to rebut the PRA's presumption that solvent schemes are "unlikely" to be compatible with protecting policyholders, leaving insurers reluctant to propose schemes that would have been approved in the past.
In practice, insurers may seek to address PRA concerns by allowing dissenting policyholders to maintain their cover instead of being forced to accept its termination under the terms of the scheme. Whether they can achieve this (without retaining the liability themselves) will, however, be dependent on finding an insurer that is willing to take over the liabilities and that is regarded as suitable by the PRA. Alternatively, we may see an increase in Part 7 transfers of insurance business by insurers seeking to avoid run off. Use of this option will, of course, also depend on the availability of a willing transferee to take on the insurance liabilities.