On 20 May 2021, the UK government published a consultation paper in which it set out its proposals to revise the current regime for insolvent insurers (excluding Lloyd’s underwriters). The proposals seek to clarify and enhance aspects of the existing “write-down” power of the court under Section 377 of the Financial Services and Markets Act 2000.
Related measures will be introduced for the purposes of minimising business disruption for insurers, specifically the introduction of a moratorium on certain contractual termination rights. Crucially, the protection of policyholders will be strengthened through changes to the Financial Services Compensation Scheme (FSCS).
OBJECTIVES OF THE REVISED REGIME
The UK insurance industry is regulated by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). By enabling these regulatory bodies to intervene at an earlier stage in an insurer’s financial distress, it is hoped that the risk that this insurer will spiral into insolvency will be reduced and that an insurer could achieve a solvent run-off and be able to continue to make prompt payments (albeit at a reduced level) in respect of valid policyholder claims.
In turn, policyholders will receive greater protection in the form of continuity of cover and can, in certain circumstances, benefit from the FSCS to make up any shortfall in payments made under a policy.
SECTION 377 OF THE FINANCIAL SERVICES AND MARKETS ACT 2000
Section 377 of the Financial Services and Markets Act 2000 (FSMA) grants the court a high-level authority to reduce the value of an insurer’s contracts, including policies (known as a write-down), in the event that it can be demonstrated the insurer is unable to pay its debts, rather than making a winding-up order, which would result in the compulsory liquidation of the insurer.
The practical effect of this power is that if a policyholder subsequently brings a valid claim on its insurance policy, it will not receive the full amount of cover under that contract.
The court has not invoked this power to date, and the drafting of the legislation is ambiguous. It is unclear (among other things): (1) which interested parties may apply for a write-down; (2) which debts may be written down; and (3) the extent of any such write-down. Accordingly, the government considers that it is necessary to enhance and clarify the scope of the existing power.
It is proposed that the scope be broadened such that the court can order a write-down not solely when insolvency can be proved, but in three other circumstances: (1) when an insurer “is, or is likely to be become, unable to pay its debts” (prior to the insurer entering into formal insolvency proceedings); (2) as an alternative to an administration order; or (3) as an alternative to a winding-up order.
It is hoped that the expansion of the write-down procedure in this way will increase the ability of the insurance industry to absorb losses, helping an already distressed insurer and, in turn, its policyholders.
It is envisaged that an application to the court for this write-down procedure could be made by the following parties: (1) the directors of the UK-authorised insurer; (2) the shareholders of the UK-authorised insurer; (3) the PRA, after consulting with the FCA; (4) a policyholder (or group of policyholders or creditors); or (5) any combination of the above.
Prior to making an application to court, the relevant party (if it is not the PRA) must obtain the explicit prior written consent of the PRA. In support of its application to court, the applicant may submit a proposal on the scale and extent of the requested write-down, justifying why the write-down would be reasonably likely to produce a more favourable outcome for the insurer’s creditors (including policyholders) as a whole.
The government’s proposal recommends that the court could sanction a write-down in respect of almost all of the insurer’s unsecured creditors, with regard given to the creditor hierarchy as stated in the Insurers (Reorganisation and Winding Up) Regulations 2004 (SI/2004/353). The proposal excludes from the scope of the write-down unsecured liabilities where they (1) have an original maturity of less than seven days; (2) relate to employees of the insurer (including pay and pensions, but excluding bonuses); (3) arise from financial contracts; or (4) arise from commercial and trade creditors for critical services. Secured creditors rank ahead of policyholders and other unsecured creditors, and as such are excluded from the scope of any write-down.
If it transpires following the write-down that the insurer is in a better financial position than previously assumed, an application can be made to the court by (1) any of the parties entitled to apply to the court for the write-down; (2) the FCA after consulting the PRA; (3) the FSCS; or (4) the relevant write-down manager for an order that the written-down liabilities are to be subsequently written up.
The aim of the current proposals is not to permanently relieve the insurer of its liabilities. The insurer’s liabilities (and the interests of creditors) will instead be “reactivated” upon the occurrence of certain trigger events, including (1) a write-up; (2) the insurer’s entry into liquidation proceedings; or (3) sufficient distributable surplus becoming available pursuant to a solvent run-off of the insurer. In the period when the liabilities are deemed to be deferred (following the write-down and until reactivated), the contingent liabilities of the insurer would remain off the insurer’s balance sheet. Furthermore, it is not anticipated that any write-down would have an adverse effect on recoveries under outward reinsurance.
The impact for policyholders is likely to be greater clarity on the circumstances in which they can apply to the court in order to obtain a write-down of their insurance policy (and the process for doing so), thereby enhancing policyholder protection and improving continuity of cover in the event that the insurer is in financial distress.
FINANCIAL SERVICES COMPENSATION SCHEME
The FSCS, pursuant to the Policyholder Protection Part of the PRA Rulebook, serves to compensate policyholders when insolvent insurers cannot satisfy a valid claim and default on their payment obligations under a policy. The FSCS can compensate policyholders by providing (1) in respect of long-term insurance contracts, 100% of the value of the claim; (2) 100% of the value of the claim for compulsory insurance, professional indemnity insurance, sickness/injury insurance, and building guarantee insurance; or (3) at least 90% of the value of the claim payable for all other types of general insurance.
At present, there are two possible situations for a policyholder whose claim has become due and payable and the value of that claim has been subject to a write-down under Section 377 FSMA:
- The insurer avoids becoming insolvent and a policyholder eligible for protection under the Policyholder Protection Part of the PRA Rulebook (a protected policyholder) will not benefit from any FSCS protection, which only bites on a “default event” as set out in Rule 10.4 of the Policyholder Protection Part of the PRA Rulebook (such as an insolvency event).
- Alternatively, the insurer may become insolvent irrespective of the write-down. The policyholder may seek FSCS protection, but because the FSCS can only provide compensation following a default event, any FSCS compensation payment will be limited to the extent that it represents the liability owed by the insurer to the policyholder at the point of default, by which time the value of the claim will have already been written down. For example, an insurance contract may be written down from £1 million to £600,000. The insurer may become insolvent (the default event) after this write-down. The maximum amount of FSCS protection available will be £600,000.
In either situation, a protected policyholder would only receive the lower post-write-down value of its claim, or the FSCS-protected part of such value (if applicable), such value being less than that which they would recover from a financial perspective than on an insolvency absent a write-down.
Under the new government proposal, following the occurrence of a write-down under Section 377 FSMA, there are two possible (and more advantageous) situations for policyholders, in respect of which the PRA will be afforded the necessary powers to amend its rules:
- The insurer will make an initial payment of the lower post-write-down value of the policyholder’s claim. The FSCS (without declaring the insurer to be in default) will then make a top-up payment (either to the policyholder or to the insurer, which will then make onward payment to the policyholder), in respect of (a) outstanding claims at the point when the write-down is effective; or (b) claims which become due and payable after this point. The top-up payments are intended to bridge the gap between the original and post-write-down value, but they will not exceed the normal FSCS compensation limits on an insurer insolvency. For example, a policyholder may have a general insurance claim for £1 million. That claim may be written down to £600,000. The FSCS will provide a top-up payment of £300,000 (30% of the original claim value) to reach the FSCS compensation limit for general insurance claims, which is at least 90% of the claim value. The result is that the policyholder can recover at least £900,000 (90% of the original claim value) rather than the lower post-write-down value of £600,000 (60% of the original claim value).
- Alternatively, the FSCS will, subject to its compensation limits, make compensation payments to the policyholder based on the higher original value of the claim (as opposed to the post-write-down value). For example, a policyholder may have a general insurance claim for £1 million. That claim may have been written down to £600,000. Unlike scenario (1) above, the insolvent insurer will not make any payments and the FSCS protection will not be in the form of a top-up payment. Instead, the FSCS will provide a compensation payment of at least 90% of the claim value (£900,000).
The consultation paper sets out the government’s intention to enable the FSCS to make recoveries in respect of these compensation payments.
The government plans to create the role of a write-down manager, a court-appointed officer with the requisite skills to (1) lead on the design of the write-down proposal to be presented to the court; and (2) facilitate and monitor the implementation and execution of the write-down order under Section 377 FSMA. It is intended that, in carrying out its responsibilities, the write-down manager will take into account the effect of the write-down on the interests of creditors (including policyholders) and ensure continuity of cover for policyholders.
MORATORIUM ON CONTRACTUAL TERMINATION RIGHTS
It is proposed that an automatic moratorium will be introduced in respect of termination and/or suspension rights in financial contracts and service contracts, where such rights arise solely as a result of (1) a write-down procedure under Section 377 FSMA; (2) the insurer’s entry into an administration or a winding-up; or (3) an application in respect of any of these proceedings. The objective of the moratorium is to alleviate the risk of any further detrimental impact on the insurer’s financial position. If the contracts were terminated, the insurer’s inability to pay its debts may be exacerbated, thereby causing further loss to policyholders.
The following measures are intended to protect the rights of counterparties: (1) the insurer must continue satisfy its substantive obligations under the relevant contract; (2) the court will have the power to vary the moratorium; (3) termination triggers will limit the length of time for which counterparty rights will be affected (including automatic termination after 12 months, subject to court-approved extensions); and (4) the court can grant an exemption from the effects of the moratorium where the continuation of the contract with the insurer will cause the counterparty to suffer hardship.
It is envisaged by the government that this proposal, through achieving greater certainty, stability, and continuity of cover, will minimise any harm suffered by policyholders which may arise from a write-down under the current regime or from a formal insolvency procedure in relation to an insurer.
HOW TO GET INVOLVED
The government invites views on the proposals set out in the consultation paper, or on any issue in relation to the insurers’ insolvency regime in the UK. Access the response form online.
Responses can also be submitted by email to email@example.com, or posted to: Resolution Policy Unit, HM Treasury, 1 Horse Guards Road, SW1A 2HQ.
The consultation will close on 13 August 2021.
Trainee solicitor Charlotte Warke contributed to this LawFlash.
 The consultation paper also outlines a proposal for a stay on policyholder surrender rights, which is applicable only to life insurance policies. This proposal is not discussed in this LawFlash.