The insurance industry's relationship with the government could have been badly damaged had the industry not paid compensation following the Chester Street Insurance collapse, the Association of British Insurers (ABI) has warned its members.

Employers' liability insurer Chester Street was put into provisional liquidation at the beginning of this year, leaving shipyard workers uncompensated for their asbestos-related illnesses.

The Policyholders' Protection Act did not cover many workers, whose employers are insolvent, because their injuries were incurred before employers' liability insurance became compulsory in 1972, and thus would receive no compensation from the Policyholders' Protection Board (PPB).

The ABI admitted in a letter to members, sent last week by general insurance council management committee chairman Ian Chippendale, that failure to reach a compensation deal would have “coloured the new government's perception of the industry in the same way that pensions mis-selling did the previous government's”.

The letter said it was difficult to accurately estimate the cost of the pre-1972 claims, but said the PPB's working estimate was £1bn, to be paid over the next 20 or more years through normal PPB levy.

The letter said: “As soon as the problem of pre-1972 claimants with insolvent employers arose, it became clear that the government, especially just prior to a general election, would not be prepared to see them go uncompensated.”

It said the ABI took legal advice on whether the PPB was liable for the pre-1972 claims and, although the advice was inconclusive, the ABI board agreed that the legal position should not be tested in court. “There would have been massive damage to the industry's reputation from being seen to try to deny compensation to people dying from asbestosis on the basis of fine legal distinctions,” the letter said.

The initial compensation levy will be £2m, to be paid by insurers, in proportion to their share of general insurance premium income.

The letter concluded: “Resolving the Chester Street problem has been difficult, but in the circumstances the outcome is the best that could be achieved. Above all, it has avoided a PR disaster and allowed the industry to build constructive relations with key Treasury ministers.”