UK: The Implementation of the Insurers Reorganisation and Winding-Up Directive

The Directive on the reorganisation and winding-up of insurance undertakings (the Directive) came into force on 20 April 2001. The purpose of the Directive is to ensure that measures to preserve or restore the financial soundness of, or to wind up, an insurance undertaking are automatically recognised by all Member States without further formality.

The Directive was implemented in the UK on 20 April 2003 by way of regulations (the Regulations), which were the subject of a consultation paper issued by HM Treasury last November entitled "Implementation of the Insurers Reorganisation and Winding-Up Directive". The purpose of this article is to give an overview of the key provisions of the Regulations and to explain how they will affect insolvency law in the UK as it currently applies to insurers.

Where they apply to UK insurers, the Regulations apply to all life, non-life and composite insurers authorised by the FSA. Although they do not apply to pure reinsurers, they do apply to companies that write a mixture of direct and reinsurance business. The Directive itself clearly applies to the reorganisation or winding-up of insurance business by corporate members of Lloyd’s. However, the Treasury has indicated that separate legislation will be required in order to implement the Directive in relation to Lloyd’s, due to the unique nature of the organisation of its insurance business. The Treasury intends to consult on this legislation in due course.

It was however clear from the consultation paper that the Treasury recognises that members of Lloyd’s underwrite insurance business for their own account and are not responsible for the liabilities of other Lloyd’s members, other than through the obligation to pay levies to the Central Fund.

The main purpose of the Directive is to ensure, for the protection of creditors, that "reorganisation measures" and "winding-up proceedings" affecting insurance undertakings are recognised in all Member States. The Directive also requires that direct insurance (as opposed to reinsurance) creditors should be given priority over ordinary unsecured creditors on a winding-up and ensures that they receive information about the effect of a winding-up, or reorganisation, on their policies.

• A reorganisation measure is defined in the Directive to include any intervention by an administrative or judicial body (in practice in the UK this simply means the courts) which is intended to preserve (or restore) the financial situation of an insurance undertaking and which affects third parties. Possible examples of reorganisations are administration under the Insolvency Act 1986, or the reduction in an insurer’s obligations under section 377 of the Financial Services and Markets Act 2000 (FSMA).

• Winding-up proceedings are defined in the Directive to include court intervention which results in the realisation of an insurance undertaking’s assets and the distribution of the proceeds among its creditors or members. A court order for the compulsory winding-up of an insurer would fall within this definition.

The Regulations do not, unlike the Directive, attempt to define reorganisation measures or winding-up proceedings. Instead, the Treasury has sensibly tried to avoid any potential uncertainty in the application of the Regulations by identifying, in the case of each individual regulation, the particular UK insolvency law concepts to which it will apply. After some debate, the Treasury has taken the view that section 425 schemes of arrangement should, for most purposes, fall outside the scope of the Regulations.

One of the most important provisions in the Directive is Article 10. This Article obliges Member States to give precedence to "insurance claims" in the event of the winding-up of an insurer.

Prior to the Regulations coming into force, the FSMA (Treatment of Assets of Insurers on Winding-Up) Regulations 2001 and The Insurers (Winding-Up) Rules 2001 provided that the assets and liabilities attributable to an insurer’s long-term business would effectively be ring-fenced. The effect of this ring-fencing was that the assets backing the long-term business would be used only for meeting the liabilities attributable to the long-term business and the remaining assets would be used to meet the liabilities attributable to business which was not long-term business. These ring-fencing arrangements did not, however, apply to the extent that there was an excess attributable to either type of business.

The old regime provided some protection for those with long-term policies but it did not actually afford long-term policyholders priority over non-policyholders with claims against the long-term business assets. Part IV of the Regulations (which implements Article 10 of the Directive) alters the position in that it explicitly requires those with "insurance claims" (ie, those with policies of direct insurance) to be given precedence over all other creditors, except for those with preferential debts or debts secured by fixed or floating charges.

The definition of "insurance claims" in the Directive is limited to claims arising from direct insurance (as opposed to reinsurance) business. It is clear from the consultation paper that the Treasury intended that the Regulations should reflect the approach taken in the Directive, although, unfortunately, this is not entirely clear from the wording used in the Regulations and, specifically, the definition of "insurance debts" in regulation 2.

Some of the key changes brought about by the Regulations are as follows:

• Where a long-term or general insurer is wound up, debts will be paid in the following order of priority: preferential debts, insurance debts and the debts of ordinary unsecured creditors.
• Where the assets of an insurer are insufficient to cover all preferential debts, those debts will be reduced in equal proportions. If the preferential debts are paid, but not all the insurance debts, the insurance debts will be reduced in equal proportions.

• Preferential debts (but not insurance debts) will have priority over property secured by floating charge.

• Where a composite insurer is wound up, the long-term business assets will be used to pay debts attributable to the long-term business and the general business assets will be used to pay debts attributable to the general business.

• The order of priority described above for general and long-term insurers will apply, but so that the long-term business and the general business will be dealt with independently of the other.
• Any excess in the assets of one type of a composite insurer’s business (i.e. either long-term or general business) may be used to pay the debts of the other business type.

The effect of the new regime is that the long-term assets of life companies will no longer need to be separated from the other assets of the business on a winding-up. Part VII of the Regulations revokes the FSMA (Treatment of Assets of Insurers on Winding-Up) Regulations, along with rule 5 of the Insurers (Winding-Up) Rules.

The Directive allows, but does not require, Member States to provide that, where the rights of insurance creditors in a winding-up are transferred to a guarantee scheme (in the UK, this means the Financial Services Compensation Scheme), such scheme will not benefit from any priority given to insurance debts. The Regulations leave the position under the previous regime unchanged, so that the FSCS will automatically benefit from the priority which the policyholder would have enjoyed as a result of the Regulations, had their policy not been assigned to the FSCS.

The Treasury’s proposed approach in this regard seems to be appropriate. Altering the law so that the FSCS will not stand in the place of the individual claimant would be a significant change and also inconsistent with the Treasury’s policy of leaving the existing law unaffected wherever possible. It should also be noted that any failure by the FSCS to make as full a recovery as possible is likely to be felt by the insurance industry generally, in the form of higher levies.

• Part II of the Regulations prohibits the UK courts from sanctioning the adoption of reorganisation measures, or the commencement of winding-up proceedings, in relation to EEA insurers and branches of EEA insurers. Reorganisation measures and winding-up proceedings commenced by competent authorities in respect of EEA insurers will, however, be effective in the UK without further formalities being required.
• Part III of the Regulations requires certain UK reorganisation measures and winding-up proceedings to be notified to EEA regulators and to creditors. The Regulations also require the administrator, liquidator, or other relevant official, to procure that details of certain UK reorganisation measures or winding-up proceedings be published in the Official Journal of the European Communities.

The Regulations came into force on 20 April 2003, which was the latest date allowed by the Directive. Certain reorganisation or winding-up proceedings in respect of EEA insurers which were partly completed on this date may however be completed under the legislation which was in force at the time that the proceedings in question were commenced.

On the whole, the Directive is to be welcomed; it is appropriate that the position as regards the winding-up and reorganisation of insurance undertakings in Member States should be consistent. Against the background of the current economic climate and recent difficulties encountered by certain participants within the industry, the proposals seem particularly timely.

The Treasury also seems to have devised what appear to be a workable and pragmatic set out of Regulations which implement the Directive in a manner which is sympathetic to, and which complements, existing UK law. However, it remains to be seen what problems arise in practice. One problem on which we have already been asked to advise is that insurers who reinsure business with firms which write both direct and reinsurance business will find that, on a winding-up of the reinsurer, their claims will rank behind these of holders of direct insurance policies. This may lead to reinsurers dividing their direct and reinsurance businesses between separate legal entities.

Article by Nicholas Moore

For more information on this or other Herbert Smith publications, please email us.