An EU Directive, slipping quietly on to the statute books, will dramatically change the position of creditors of insolvent insurance companies. Richard Leedham and Ross Louden report
Within a few months, creditors of insolvent insurance undertakings will find themselves in a position that they had not bargained for.
The Insurers Reorganisation and Winding Up Directive [2001/17/EC] will affect how insolvencies take place within the EU and will also create a new "preference" of insurance policyholders' claims. These will be paid before those of any other ordinary creditors, including those who are reinsured by the undertaking and have claims.
The Directive, which dates back to 2001, will apply to any FSA-authorised life, non-life or composite insurer operating within the EU. This includes non-EU undertakings that have branches within the EU. It does not apply to pure reinsurers. But it does apply to companies that write a mixture of direct and reinsurance business.
Lloyd's is meant to be covered, but the Treasury states in the consultation document that, as it recognises that the market is a complex organisation, it is inevitable that additional legislative provision will be needed in order to achieve some of the Directive's intended outcomes.
The Directive will ensure that reorganisation measures or winding-up proceedings affecting an insurer are recognised in all member states without further formality.
Only the competent authorities in the member state where an insurer is authorised can authorise the adoption of reorganisation measures or winding-up proceedings for that insurer, including branches it may have in other member states. This will replace the current system where, if an insurance undertaking with branches across Europe has to be wound up, the authorities can instigate separate insolvency proceedings using local laws in each member state where the undertaking is represented.
The Directive affects reorganisation measures and winding-up proceedings.
Reorganisation measures involve "any intervention by administrative or judicial bodies intended to preserve or restore the financial situation of an insurance undertaking and which affect the pre-existing rights of parties other than the insurance undertaking".
Winding-up proceedings are "collective proceedings involving realising assets of an insurance undertaking and distributing the proceeds among the creditors, shareholders or members as appropriate, which necessarily involves intervention by administrative or judicial authorities of a member state".
The steps required for the Directive's implementation include:
Venue - The reorganisation and winding up proceedings will commence in an insurance undertaking's home member state and under the relevant laws in that state.
Once reorganisation measures or winding-up proceedings commence, the competent authorities in the member state must inform the state's supervisory authorities. That authority must then inform the relevant equivalent authorities in all member states that proceedings have begun. There will be only one set of proceedings and they will be recognised in all the member states where the insurance undertaking operates.
Claims protection - The Directive forces member states to protect insurance claims of policyholders and insured persons in the winding-up proceedings. For this to happen member states must ensure that insurance creditors are given special treatment by:
(a) giving insurance claims absolute priority over other claims with respect to assets representing the technical provisions
(b) making insurance claims a priority over all assets of the undertaking, subject, possibly, only to preferential claims and the expenses of the winding-up procedure.
If a member state opts for the first option, insurance undertakings in that state must keep a register of assets covering all claims, or the technical reserves for those claims. Every undertaking would have to keep a register of the technical reserves in each member state in which it operates. Technical reserves can include claims against reinsurers, where the member state allows this.
While the Treasury has invited comments on implementing the first option, they say the second one is the most appropriate arrangement for the UK, as this does not require a special assets register.
The introduction of this requirement is felt to be expensive and unnecessary because UK insurers do not maintain a comparable register. This means preferential creditors will still rank above the insurance claim in the UK, but general policyholders will come next.
The consultation paper notes that it was suggested that reinsurance creditors should be given preference behind direct insurance creditors, but ahead of other creditors.
The argument in favour was: as reinsurance creditors are likely to be unwilling to stand behind direct claimants, they may try to force firms that write both direct and reinsurance business to form separate undertakings to deal with each area separately. It was claimed that allowing them a secondary priority might have helped to mitigate this.
But this suggestion has not been incorporated into the draft legislation and the Treasury says it will make little difference to reinsurance creditors.
Those who undertake both reinsurance and direct business may incur extra cost due to the legislation. This is because other creditors may wish to change the terms on which they do business, once they know direct insurance creditors will be given preference.
As reinsurance claims have not been classified as "insurance claims" the security of reinsurance obtained from insurers who carry on both direct business and reinsurance will be reduced. In reality, where a reinsured may have recovered several pence in the pound after an insolvency in the past, when the Directive becomes law, the pot of money to satisfy claims may well be exhausted before reinsureds have even been considered.
Reinsureds, therefore, might consider how they deal with reinsurers who are close to financial difficulty. Pressure for payment of debts might be advanced earlier than it would normally. This extra pressure may force undertakings into insolvency, with reinsureds falling down the queue in terms of payment priority.