The Cypriot authorities have agreed to impose a levy on the assets of depositors with Cyprus’ two troubled banks (to the extent that they exceed €100,000), in order to avoid winding up both banks. The proposed EU Recovery and Resolution Directive contains provisions to make systematic write-downs of this kind possible in bank “bail-ins”, Europe-wide. In a banking context, these ideas are novel. But the concept of writing down an institution’s liabilities to its creditors as an alternative to winding it up has been around in the world of insurance since 1870.
In this memo, the provision is examined as is its future, to see what lessons insurance law may have for banking law.
BACKGROUND TO S 377 FSMA
Section 377 of the Financial Services and Markets Act 2000 (FSMA) provides that:
- This section applies in relation to an insurer which has been proved to be unable to pay its debts.
- If the court thinks fit, it may reduce the value of one or more of the insurer’s contracts instead of making a winding up order.
- Any reduction is to be on such terms and subject to such conditions (if any) as the court thinks fit.
These provisions form part of a number of modifications to general UK insolvency law which apply to insurance companies. They form part of a body of supplemental rules concerning insurers that are attached to the general insolvency provisions of Part XXIV of FSMA1.
In essence, s 377 provides the courts with an alternative to making a winding-up order in the event of an insurer’s insolvency. It grants them instead an extremely broad power to reduce the value of any of the insurer’s contracts. This facility is aimed at expediting the payment on or transfer of the contracts in question, in an attempt to avoid any delays associated with leaving such matters to be resolved at the end of a lengthy insolvency process.
The idea of reduction in lieu of liquidation has been present in legislation since the introduction of s 22 of the Life Assurance Companies Act 1870. That section was aimed at minimising the negative effects of the failure of a life assurer on assured persons. The consensus amongst actuaries at the time was that the most equitable way to handle any deficiency of an assurer’s reserves would be to reduce the sum assured whilst keeping premiums intact. This measure consequently retained at least some level of coverage for insured persons, as opposed to the total loss of any benefit from the policy and the receipt of a limited surrender value.
The court’s power to reduce the value of an insurer’s contracts was more recently supplemented by the Insurers (Reorganisation and Winding Up) Regulations 2004 (the “Regulations”). These impose an obligation on the court to notify the Financial Services Authority (the Prudential Regulation Authority (PRA) since 1 April 2013) of such a reduction being made2, and provides that the courts may only exercise the power under s 377 in relation to UK insurers3.
Section 377 is applicable only when an insurer is found unable to satisfy its debts. However, FSMA does not itself provide any further explanation of what kind of debts may (or may not) be relevant for its purposes.
The Insurers (Reorganisation and Winding Up) Regulations 2004 (2004/353) (“Winding Up Regulations”) (which represents the UK’s implementation of Directive 2001/17/EC on the reorganisation and winding-up of insurance undertakings (the “Directive”)) add some further clarification, in that under Art 10 of the Directive, member states were permitted to decide whether to give insurance claims priority over other claims on the insurance undertaking, or whether these claims should take precedence over all claims with the possible exception of:
- claims by employees arising from employment contracts and employment relationships;
- claims by public bodies on taxes;
- claims by social security systems; or
- claims on assets subject to rights in rem.
The UK approach to this permission in the Winding Up Regulations has been to take the latter option, and in Reg 21 (2), the Winding Up Regulations provide for the order in which the debts of a long term or general insurer must be paid:
- First in respect of preferential debts4;
- Secondly, in respect of “insurance debts”; and
- Thirdly, in respect of all other debts.
At Reg 2(1), an “insurance debt” is defined as “a debt to which a UK insurer is, or may Butterworths Journal of International Banking and Financial Law May 2013 263 SPOTLIGHT Spotlight become liable, pursuant to a contract of insurance, to a policyholder or to any person who has a direct right of action against that insurer, and includes any premium paid in connection with a contract of insurance (whether or not that contract was concluded) which the insurer is liable to refund”.
Note that in respect of a debt owed by an insurer to a floating charge holder, the Winding Up Regulations stipulate that in certain circumstances, these may rank over all other unsecured debts in the priority of payment, including insurance debts (other than preferential debts, and subject to payment of the “prescribed part”5).
In particular, Reg 21(5) provides that (subject to the order of priority set out in Reg 21 (2) as discussed above), to the extent that the assets of an insurer available for the payment of unsecured creditors are not sufficient to meet its preferential debts, those debts (and only those debts) have priority over the claims of holders of debentures secured by, or holders of, any floating charge created by the insurer, and must be paid out of any property comprised in or subject to that charge. As a consequence, it is arguable that the rights of a floating charge holder could be considered as taking priority to insurance debts in this scenario (and therefore fall outside of the definition of insurance debts for this purpose).
WHAT IS THE EXTENT OF S 377 AND HOW SHOULD IT BE EXERCISED?
The implementation of s 377 does not appear to have ever been specifically tested in the courts. The closest the courts have come to considering the power to reduce the value of an insolvent insurer’s contracts was in the matter of In re Capital Annuities Ltd  3 All ER 704, in which Slade J examined the measure as it then stood in s 50 of the Insurance Companies Act 1974 – although he did not apply the reduction as he eventually determined that the company in question was not in fact insolvent. In any case, Slade J was still able to make two important observations:
- that the “contracts” whose value could be reduced under the legislation could only be the company’s current insurance contracts; and
- the court should try as far as possible to reduce the amount of the company’s contracts pari passu amongst its policyholders.
In considering whether the court could potentially reduce the amount of the contracts of the company otherwise than pari passu, Slade J concluded (at p 726) that, whilst it would not be mathematically possible for the court to achieve strict equality across a range of widely differing policies, it should nevertheless “proceed on a principle of ‘broad equality’ of reduction in the case of all policies concerned”.
“In my judgment ... the court, in making an order for reduction, must have it constantly in mind that, ex hypothesi, it is doing so ‘in the place of making a winding-up order’. In other words, in exercising its discretion, it has to make a careful comparison between (a) the financial position of the policyholders if the order for reduction is made and (b) their financial position in the event of a winding-up order. As counsel for the Department of Trade put it, any scheme for reduction ought to reflect the position in a winding-up. And, of course, the general rule in a winding-up is that a company’s liabilities fall to be discharged pari passu (see s 302 of the Companies Act 1948).”
Applying these principles, there is a good argument to be made that the power under this section should not be exercised so as to place secured creditors in a worse position than they would have been on a winding-up. If the true principle is that “any scheme for reduction ought to reflect the position in a winding-up”, then secured creditors ought, to the extent of their security (and subject to the statutory priority given, eg to costs, expenses and certain other sums over holders of floating charges), to be paid in full, just as they would be on a winding up.
The question then is whether a Court would be prepared to use its power under s 377 to disturb the position of a secured creditor. Unfortunately, the response to this question cannot be regarded as entirely free from doubt. First of all, the position of secured creditors was not specifically under consideration in Slade J’s ruling, and equally the DTI’s concession and the judge’s obiter observations were not directed to that issue. Secondly, the wording of s 377 is perfectly general. There is no express exclusion for contracts under which the insurer’s obligations are secured. Simply as a matter of statutory construction, it could therefore properly be argued that the power under s 377 extends – at least in principle – even to obligations which are secured. After all, the security held by a secured creditor simply stands as security for the insurer’s performance of its obligation to him. It does not change the nature or extent of those obligations, which might (on this basis) be said at all times to have been liable to be reduced under s 377.
It must be open to question whether the FSA (now PRA) would ever feel it right to propose, or whether a court would ever consider it just to agree, to reduce liabilities owed to creditors that hold security in respect of an insurer. The fact that a security interest may be in respect of a specific pool of assets in a specific account or accounts might, in ordinary circumstances, make this scenario relatively unlikely. However, given a situation in which a major component of the UK financial system was at imminent risk of collapse (such as during the course of the global economic crisis), the FSA (PRA) (and a court) might be more inclined than at other times to do whatever was necessary to effect the required rescue, and to exercise the discretion under the section so as to ensure the necessary result. If, in practice, the best way to achieve this was to reduce an insurer’s obligations across the board, including those which were secured, then the FSA (PRA) might be able to persuade the court to agree to such a measure. In addition to this, recent events have also shown that the collapse of a major financial institution may reveal inadequate record keeping and/or the improper mixing and use of assets. As a consequence, (particularly at the moment when emergency action has to be taken immediately to prevent the collapse) it may not always be possible for the FSA (PRA) or the court to be confident that the assets of an insurer, including those which are subject to a security interest, can reliably be separated and allocated.
The important distinction between the position under s 302 of the Companies Act 1948 and the position under the Insolvency Act 1986 (as modified by the Winding Up Regulations) is, of course, that, on a winding up of an insurance company, the “general rule” is no longer that the company’s assets fall to be discharged pari passu. Instead, a special priority is accorded to preferential debts and insurance debts – reflecting the consumer protection objectives of Directive 2001/17/EC on the reorganisation and winding-up of insurance undertakings. It may, therefore, equally be arguable that the court should exercise the power under s 377 so as to mirror the effect of liquidation, by favouring insurance liabilities over (for example) reinsurance liabilities.
THE POTENTIAL IMPACT OF S 377
The potential effect of s 377 can be illustrated by reference to a scenario in which two parties propose to enter into a reinsurance agreement, with Party A as the reinsurer and Party B as the reinsured. By way of premium for the reinsurance, Party B transfers to Party A the reserves that it currently holds against the risk of the policies to be reinsured. Party A has in turn agreed to hold these assets in a custody account and will return them to Party B on the expiry of the reinsurance contract. As security for the refund of the premium, Party B takes a floating charge over the assets which will crystallise if Party A becomes insolvent during the life of the reinsurance.
Party B will have considered the obvious risks arising from a potential insolvency of Party A, not least whether the floating charge over the assets will be sufficient to ensure that it enjoys a higher priority in the insolvency process than other creditors of Party A. However, what it has not considered, is the effect of s 377 in the event of Party A’s insolvency. What are the issues that Party B faces should a court decide to exercise its discretion to reduce Party A’s reinsurance obligations?
Security may not always be secure
The first point to note is that in the event that a court considers the reduction of the value of the contract between Party A and Party B, Party B could be in no better or worse a position than other creditors of Party A despite the existence of the security arrangements. In the ruling in In re Capital Annuities Ltd, Slade J considered that the court should try to reduce the amount of the contracts of an insolvent insurance company pari passu amongst policyholders. However, Party B would clearly wish to rely on the fact that it has taken a floating charge over the assets to argue that none (or at least, fewer) of Party’s A obligations towards it should be reduced as it has taken security over them.
Applying the principle that the court’s exercise of the reduction power should reflect the outcome of a winding up, Party B would have a strong case, and therefore a court may well decide not to disturb Party A’s obligations towards Party B. Unfortunately however, the success of this argument is not guaranteed, especially where the failure of Party A could present a substantial threat to the UK financial system. This would potentially impose public policy pressure on the courts to mitigate any systemic risk posed by Party A’s failure, which may in fact best be achieved by the reduction of Party A’s obligations.
Although this particular scenario may be relatively unlikely to occur, it would be entirely open to the court to make such a determination in the circumstances, given that s 377 makes no distinction between contracts that the insolvent insurer has entered into with secured or unsecured creditors.
Depleted value may leave other obligations in doubt
Secondly, should the court decide to exercise its discretion to reduce the value of the contract, Party B would find itself in a significantly disadvantageous position in that the value of the policies subject to the reinsurance would by default be worth more than the value of the reinsurance obligations that Party A would remain bound to carry out, perhaps considerably so.
- How, if such a mechanism was not previously included in the parties’ arrangements, any excess collateral value could be returned to Party B before the maturity of the reinsurance agreement, especially if the parties do not agree on the method for calculating the surplus amount.
- Whether any arrangement to return excess collateral that has been incorporated in the reinsurance terms would be “looked through” by the courts and therefore be treated as part and parcel of the obligations to be written down.
- How Party B would find coverage for insurance obligations that would not be covered by the reinsurance as a result of the reduction, especially in a time of heightened economic uncertainty. Regardless of the reduction, Party B would still be obliged to insure the ultimate policyholders – however, this would be without the backing of the reinsurance arrangements as originally contemplated.
It remains difficult to answer such issues in the absence of precedent and guidance.
FAST FORWARD TO 2013: A S 377 FOR FINANCIAL INSTITUTIONS?
In his speech to the British Bankers’ Association on 17 September 2012 with regards to the implementation of a bail-in resolution power in respect of financial institutions, Andrew Gracie, Director of the Special Resolution Unit of the Bank of England, echoed the pragmatism of the “antique” provision of the insurance legislation as captured by s 377, when speaking of the bail-in tool as a means of:
“avoiding the financial instability and disruption to critical functions that a sudden insolvency…would otherwise cause”.
Since the endorsement by the G20 of the Financial Stability Board’s international standards for resolution regimes in November 2011, a “bail-in” mechanism for financial institutions has been under development at both the EU and UK level. This mechanism is aimed at enabling regulators to prevent the need for systemically important financial institutions to be bailed out by national governments, through the use of various resolution tools including the writing down of an institution’s debts.
At the European Union level, the European Commission has proposed a series of reforms in its June 2012 legislative proposal for the Recovery and Resolution Directive (RRD). Section 5 of the proposal for the RRD currently provides for a debt write-down tool by which resolution authorities will have the power to impose losses on a firm’s stakeholders, including its shareholders and unsecured creditors, either when the firm is still a going concern (with a view to preventing liquidation) or during the winding-up process.
The scope of the bail-in tool is provisionally set out at Art 38 of the proposal; in particular, the tool may be applied to all liabilities of an institution with the exception of liabilities such as secured liabilities, liabilities with an original maturity of less than one month6, and certain liabilities to employees, commercial or trade creditors and tax and social security authorities. The Commission intends for member states to finalise their implementing legislation for the RRD by 31 December 2014, with measures on “bailing-in” to come into force from 1 January 2018.
In the UK, the Independent Commission on Banking made a number of recommendations with respect to “bail-in” in its September 2011 report, including:
- a “primary bail-in power” to impose losses on a set of a pre-determined liabilities that are the most readily loss-absorbing; and
- a “secondary bail-in power” for regulators to impose losses on all unsecured liabilities if primary bail-in should prove insufficient.
The UK Government indicated in June 2012 that it would implement the recommended bail-in measures as part of implementing the RRD.
The absence (as yet) of the RRD (or any domestic equivalent) has meant that the Cypriot authorities have had to craft their own unique write-down mechanism. According to a recent statement from the Bank of Cyprus 7 under the re-organisation measures that have been adopted, depositors in the Bank of Cyprus will receive shares in the bank worth 37.5% of any savings over €100,000. Of the 62.5% of uninsured deposits not converted to bank shares, about 40% will continue to accrue interest but will not be repaid unless the bank does well, while the final 22.5% will cease to attract interest. Account holders in Laiki Bank stand to lose up to 80% of their money, as the bank is wound down and its insured deposits (ie those up to €100,000) transferred to the Bank of Cyprus.
Jeroen Dijsselbloem, who chairs the Eurogroup of 17 eurozone finance ministers, said the move in Cyprus to inflict losses on banks’ shareholders, bondholders and large-scale savers should become Europe’s default approach for dealing with ailing lenders. Whether it will do so remains to be seen.
The extent and operation of the power under s 377 is in need of further analysis. This could be supplemented in the form of concrete examples of judicial precedent or statutory clarification. It would seem appropriate that, in the crafting of “bail in” tools for banks, this early version for insurers might benefit from modern reflection and some additional legislative guidance.