In the current market turmoil, several banking and insurance names have already had to be rescued by government-brokered packages. It is therefore timely to review what rights institutional investors have in the event of counterparty insolvency. Unfortunately, the picture is complicated, not just because the question of how pension fund investors can get their money back may have an international dimension, but also because governments keep moving the goalposts on the availability and adequacy of compensation schemes.

Where does the claim arise?

The first question which needs to be addressed is a jurisdictional one. Where does the claim actually arise? This article focuses on the position of UK investors claiming in the event of a UK-based institutional default. However, it is often a fact that overseas investors are treated less favourably than domestic (i.e. voting) customers when an insolvency occurs. This is not just the case in the Icelandic banking sector as we are seeing at the moment; US federal banking legislation also prioritises US depositors over foreign interests.

Class of assets: what is covered?

The next and perhaps more obvious question to consider is what type of investment has been lost by the defaulting party, since the limits on compensation vary according to whether it is a bank, life (or general) insurer, or investment manager or adviser. The relevant limits for pension fund eligible claimants under the UK’s Financial Services Compensation Scheme (“FSCS”) are given in the table

Furthermore, recoveries from the FSCS on an insolvency under the limits above may be augmented by additional monies recovered by investors via the assignment of their rights to the FSCS.

Who is covered?

Whether or not an investor qualifies as an eligible claimant is the next problem to consider. Many commentators in the pensions industry have been confused by this area of the FSCS rules, which were amended as a consequence of changes brought about by the Markets in Financial Instruments Directive. With the exception of noninvestment insurance policies such as PHI, trustees of occupational schemes might have claims under each of the main categories covered under the table above. They do not, however, automatically qualify as eligible claimants for FSCS compensation.

Trustees of schemes which are sponsored by an employer with an annual turnover of more than £1m are generally excluded from being eligible claimants under the FSCS, but there is an exception for claims made in relation to longterm insurance business, which includes group life and annuity policies.

The compensation payable where the subject of the claim is a long-term insurance contract is, as set out in the table above, 100% of the first £2,000 plus at least 90% of the remaining value of the policy. Only if trustees hold more than one policy with the same insurance company would there be a restriction and even then it would only apply to the first £2,000, which is only covered once. As Gemma Hanley points out below in her article on Buy-outs, this 90% upper limit can give rise to a significant exposure. The potential exposure of a bank failure could also be material of course.

There is, however, a slight wrinkle where an insurance policy is bought as an investment of the scheme which uses a fund of fund arrangement, which is an increasingly common structure for DC fund offerings. Under such a structure one insurance company offers a tax and administration platform in order to access the funds of another insurer (and potentially other non-insurer fund managers). If this is the case and the ultimate insurer fund manager becomes insolvent, because the trustees are not direct policyholders and are only re-insureds (the direct insurance contract being between the administration provider and the ultimate fund manager), the compensation arrangements do not apply as there is no direct link and the trustees are excluded from being eligible claimants. The policyholder, as another insurance company, is also automatically excluded. When “manager of manager” products became popular a few years ago there was a lot of debate among insurers and lawyers about this issue and how to get around this problem and mechanisms were designed to circumvent the problem by giving separate preferential security rights. To our knowledge these rights have never been tested on an insolvency.

The FSA is going to consult on the FSCS rules later this year and it may be that the rather labyrinthine nature of those rules can be simplified. In the meantime, we can only hope that calls on the FSCS will be minimised.