Schemes of Arrangement

Schemes of arrangement

a special supplement to

www.runoffbusiness.com PricewaterhouseCoopers

PricewaterhouseCoopers (www.pwc.com) is the world’s largest professional services organisation. Drawing on the knowledge and skills of more than 125,000 people in 142 countries, we build relationships by providing services based on quality and integrity.

The following areas of the firm have contributed to this supplement: Solutions for Discontinued Actuarial & Insurance Insurance Business Management Solutions PricewaterhouseCoopers’ Solutions for Discontinued PricewaterhouseCoopers’ Actuarial & Insurance Insurance Business team comprises 140 insurance Management Solutions (AIMS) practice is a global experts dedicated to dealing with issues facing practice of more than 450 consultants, providing life and discontinued insurance business. The team has an non-life actuarial and insurance advisory services. With a extensive range of specialists with expertise in proven track record across five continents and practices restructuring. in 14 countries, AIMS offers the global presence, resources and expertise to meet its clients’ most critical They include qualified chartered insurance practitioners, needs. Our actuaries regularly provide advice to both the accountants, restructuring practitioners and specialists insurance industry and broader financial services in risk management, treasury and business providers. management. As part of the world’s largest professional services firm, This team has a broad range of experience, including AIMS can also call on the global expertise of auditors, board level strategic management, claims run-off tax advisers, corporate finance and discontinued management, collections, underwriting, risk insurance business specialists who specialise in the management, investigations and finance. insurance sector. The team can also draw on the strength of offices Our non-life practice is the UK’s largest practice of its around the world including dedicated staff in the US and kind. We support our discontinued insurance business Bermuda. The team’s credentials include cross-border practice in the development and implementation of run- assignments in the US, Continental Europe, Australia, off strategies and exit solutions. We evaluate creditors’ Far East and Middle East. liabilities, including those for complex and long-tailed Unless otherwise indicated, PricewaterhouseCoopers claims, and develop sophisticated approaches to refers to PricewaterhouseCoopers LLP a limited liability allocating funds to insureds in an equitable manner in partnership incorporated in England. the context of solvent and insolvent schemes of PricewaterhouseCoopers LLP is a member firm of arrangements. PricewaterhouseCoopers International Limited. comment There are fundamental changes in objectives when a company enters run-off, whether solvent or insolvent. In the confusion that regularly occurs during this transition, it is all too easy to lose sight of these changes, and for the company to carry on as before. The resulting misuse of company resources, loss of significant personnel, and diminishing morale can jeopardise the long term chances of achieving a favourable run-off. The challenge for companies entering run-off is to implement these significant changes as rapidly and painlessly as possible. Given that most finality solutions for insolvent companies ultimately involve a scheme of arrangement, and that an increasing number of solvent run-offs are also looking towards solvent schemes of arrangement as a means of achieving finality, it is clearly important for the culture change accompanying a decision to allow the run-off to get to a position where a scheme is feasible within the shortest possible timeframe. One of the main ideas to get over, to both management and staff, is that being in run-off isn’t that bad. Providing new objectives are embraced on day one, enormous value can be provided to creditors in relation to an insolvent estate and to shareholders in relation to solvent run-offs. Not least among the advantages to shareholders is the release of capital that can accompany a successful finality solution such as a solvent scheme. Neil Bruce, PwC

2 run off business special supplement contents Introduction World applications What is a scheme? 4 Global schemes 17 Closure for captives 18 Alternative exit options Making an exit 8 Reserving Change of focus 20 Stakeholders Managing expectations 11 Valuing liabilities Value judgement 21 Timeframes When is the right time to scheme? 12 Taxation issues How long do schemes take? 13 The tax implications 23

Life market Information technology Life restructuring 14 The impact of IT 24

Portfolios and pools Tables A rescue from the pool 15 Insolvent schemes of arrangement 26 Solvent schemes of arrangement 27 Lloyd’s Exiting Lime St 16

Schemes of arrangement is a special supplement sponsored and written by:

Contributors:

Gary Bray Mark Jones Tel: +44 (0)207 583 5000 [email protected] Tel: +44 (0)207 583 5000 [email protected] Neil Bruce Emma Pugsley Tel: +44 (0)207 583 5000 [email protected] Tel: +44 (0)207 583 5000 [email protected] Simon de Young Nigel Rackham Tel: +44 (0)207 583 5000 [email protected] Tel: +44 (0)207 583 5000 [email protected] Paul Duffin Andrew Rothseid Tel: +44 (0)207 583 5000 [email protected] Tel: +44 (0)1 267 330 2024 [email protected] Diana Gardner-Brown Andrew Ward Tel: +44 (0)207 583 5000 [email protected] Tel: +44 (0)1 267 330 2027 [email protected] Neil Gayner Nick Watford Tel: +44 (0)207 583 5000 [email protected] Tel: +44 (0)207 583 5000 [email protected] Kevin Gill Clare Whitcombe Tel: +44 (0)207 583 5000 [email protected] Tel: +44 (0)207 583 5000 [email protected] Baljit Goraya Tel: +44 (0)207 583 5000 [email protected]

Schemes of Editors: Advertisement sales: arrangement Derek Austin William Barker Tel: +44 (0)1908 660836 Tel: +44 (0)20 7686 3997 a special supplement to Fax: +44 (0)1908 660856 Email: [email protected] Run Off Business magazine autumn 2003 Email: [email protected] ISSN 1477-7568 Printed by Newnorth Print Helen Perry © B D Communications (London) LLP Barbara Hadley Tel: +44 (0)20 7387 6620 All rights reserved. No part of this publication may be Tel/Fax: +44 (0)20 7916 2835 Email: [email protected] reproduced, stored in any retrieval system or transmitted Email: [email protected] in any form – electronic, mechanical, photocopying or otherwise – without the prior permission of the publisher. Published by: Every care has been taken to ensure that the information Design: B D Communications (London) LLP in this publication is accurate, but the publisher cannot Christine Narain 153 Simpson, Milton Keynes MK6 3AH accept and hereby disclaims any liability to any party for loss or damage caused by any errors or omissions. Email: [email protected] www.runoffbusiness.com Michelle Morgan Email: [email protected] 3 Introduction

Gary Bray and Baljit Goraya explain what exactly

s425 schemes are and how they are evolving in the

solvent and insolvent markets What is a scheme?

or a number of years now, schemes of arrangement F(schemes) have been used extensively when dealing with the unique issues arising in connection with insolvent insurance or reinsurance companies. The emergence of schemes as the primary tool of insolvency practitioners in the insurance industry reflects their distinctive features and inherent flexibility, which have enabled the run-off of insolvent insurance businesses to be specifical- ly tailored to the precise circumstances of each case. In particular, schemes are usually more beneficial to creditors compared to other insolvency procedures such as liquidation or company voluntary arrangements, typically resulting in earlier payments to creditors than might otherwise be the case. In recent years, there have been an increasing number of solvent insurance and reinsurance companies entering run-off, or placing specific books of business into run-off, both in the UK and overseas. This trend has been accelerated by increasing

4 run off business special supplement Introduction

commercial pressures arising from implement an exit strategy which is framework and possibly with the adverse claims development, poor fair and commercially acceptable to involvement, if agreement cannot be investment returns and increased all stakeholders involved. reached in the normal course, of an operating costs — particularly for Naturally, there are many parties independent adjudicator. long tail business — and the increas- with a legitimate interest in the terms In this way, schemes can provide a ing need to focus on the optimum of any scheme. Such stakeholders framework for an insurance compa- use of scarce capital. This is a combi- include shareholders, policyholders, ny in run-off to accelerate the agree- nation of circumstances and pres- service providers, employees, rein- ment and settlement of policyhold- sures that seems set to remain a fea- surers and regulators – the flexibility ers’ and other creditors’ claims and, ture of the landscape for the of schemes allows a ‘deal’ to be for- ultimately, to achieve finality, the foreseeable future. mulated that strikes an acceptable holy grail of run-off. In these conditions, solvent insur- balance between the needs of each. ance companies have increasingly Accordingly, each stakeholder must What are the benefits of a used schemes as a mechanism for be carefully considered and, where scheme? effecting planned exits from the mar- appropriate, consulted during the Although there are a number of ket or from specific sectors of it, promotion and implementation of a alternative strategies available to an enabling capital to be released and re- scheme to ensure that all perspectives insurance company seeking to exit a deployed in pursuit of key, or at least are considered and all parties satisfied market (see page nine), these do not more pressing, strategic objectives. with the final outcome (see page 12). necessarily provide the benefits Schemes have continuously evolved Schemes designed for insolvent afforded by schemes, the main and been adapted to address the insurance companies fall broadly advantages of which are typically: inevitable peculiarities and specific challenges or issues of each particular ‘The flexibility of schemes allows a 'deal' to be situation. This has frequently under- lined the basic flexibility of schemes formulated that strikes an acceptable balance and their applicability in varied circumstances, as is demonstrated by the between the needs of each stakeholder’ number and diversity of schemes that have been implemented in recent into two types: those which carry out ● Finality. Any doubt a policyholder years (see pages 14 – 19 and 26). an orderly run-off, paying a propor- or creditor may have with regard to tion of claims as they are agreed the solvency of a company, and What is a scheme of arrangement? (‘run-off’ schemes) and those which whether its insurance protection will A scheme is a compromise or introduce a wholesale estimation of perform, can be removed by a arrangement under English law (sec- all present and future claims (effec- scheme. Similarly, schemes can pro- tion 425 of the Companies Act, tively a ‘mass commutation’ with all vide reinsurers with a means of 1985) between a company and its policyholders) with a view to making achieving certainty and finality. creditors or any class of them, which a final payment to creditors and ter- ● Flexibility. A scheme can be becomes legally binding on all credi- minating the run-off (‘estimation’, designed to deal with the specific cir- tors or any class of them if the neces- ‘crystallisation’ or ‘cut-off’ schemes). cumstances of each case and the par- sary majority of creditors or class of Schemes for solvent insurance ticular needs of the stakeholders. them vote in favour of the scheme companies obviously fall into the lat- ● Early payment. A scheme will and the English High Court approves ter category and such wholesale esti- provide a mechanism for estimating it. In practical terms, a scheme is mation of claims is, in practice, and agreeing all present and future effectively a ‘deal’ between a compa- implemented either on a claims sub- claims against a company allowing ny and its creditors. It is similar, in mission or claims allocation basis. creditors to receive payment earlier many respects, to a plan of reorgani- Under the latter approach, policy- than would be likely if the company sation in the US. holders are provided with a value for were to run-off its business in the There are few statutory require- their claims based on an actuarially normal course. ments for a scheme and generally it determined estimation methodology. ● Run-off costs. Some of the costs of can be written on any basis that will In contrast, under a claims submis- the run-off, which may otherwise be attract adequate support from poli- sion approach creditors are invited to incurred in the normal course for cyholders and other creditors, pro- submit claims (including contingent many years, and which can therefore viding great flexibility for insolvency or future claims), together with sup- be significant, can be avoided by a practitioners, shareholders and porting evidence, which are agreed, scheme. This saving can in turn pro- directors seeking to devise and possibly within a stated actuarial vide financial benefits to stakeholders.

run off business special supplement 5 Introduction

● Shareholder equity. Residual ner. However, schemes are designed shareholder value, if any, can be in such a way so as to ensure, so far realised at the earliest opportunity as is practicably possible, that the through a scheme. estimation or claims agreement In addition to these generic bene- process is both reasonable and fair. fits, individual schemes can be tai- ● Finality. In order to provide lored to address specific issues. For finality, a scheme introduces a bar example, some recent schemes have date by which creditors must submit included a mechanism to safeguard their claims. Any creditor failing to against an unexpected influx of a high submit a claim by this date may not volume of unsupported claims. This receive payment under the scheme. mechanism allows a company to However, a company will seek to revert to a conventional run-off as the ensure that the scheme is brought best course of action for dealing with to the attention of all creditors, such a scenario. A solvent scheme indeed this is also supplemented by may also be designed so as more various legal safeguards, for exam- actively to involve or engage reinsur- ple, the obligation to advertise the ers by adopting a phased voting scheme widely and in appropriate process. This provides policyholders publications. and creditors with a greater level of ● Excluded policies. For either legal, direct influence and allows the needs technical or commercial reasons, schemes may not be suitable for all ‘Some recent schemes have included a types of business. For example, policies that provide protection for com- safeguard against an unexpected influx of a pulsory insurance, like employers’ liability or third party motor liability, high volume of unsupported claims’ which could be eligible for compensation from the Financial Services of shareholders, creditors and rein- Compensation Scheme in the event surers to be carefully balanced by, of an insurance company’s default, amongst other things, encouraging are currently excluded from schemes. commercial negotiations and ● Safety for policyholders. In a run- mutually acceptable commutation off scheme for an insolvent insur- agreements. ance company, there might be risks for those creditors whose claims Do schemes have any disadvan- mature in the future, if too much tages? cash were to be paid out early in the It would be disingenuous to suggest scheme. However, initial dividend that schemes are perfect in all cir- levels are usually set cautiously in cumstances – they are not. However, such schemes, so that no creditors the disadvantages are worth noting, should be prejudiced. not only for the sake of balance, but ● Loss of liquidators’ remedies. Under also to highlight that they can usual- UK insolvency law, there are certain ly be managed without fundamen- courses of action available to a liq- tally undermining the basic appeal of uidator if there has been any wrong- schemes. In our experience, the ful or fraudulent trading by a direc- main potential disadvantages tor, the company has given a encountered are: preference or the company has been party to any transaction at an ● Estimation. It is an unavoidable undervalue. These remedies are not fact that some policyholders or cred- available to an insolvent company itors may ultimately receive more or subject to a scheme outside of a liq- less than the amount they would uidation. However, the recent intro- have received had the company duction of the administration been run-off in the traditional man- process for insolvent insurance com-

6 run off business special supplement Introduction

panies may change the position ● Lloyd’s. The concept of schemes receive and agree claims, offering the except in relation to wrongful or can be extended to Lloyd’s syndicates prospect of significant cost savings, fraudulent trading, thereby reducing and corporate capital vehicles. This is operational efficiencies and flexible the extent of this potential disadvan- an area where there are potentially data collection. Given the typical size tage. In practice, before promoting a very significant development oppor- of scheme documents, particularly in scheme, appropriate investigations tunities (see page 16). larger cases with many thousands of would be undertaken to ensure that ● Life companies. Schemes can be policyholders and potential creditors, the loss of any such powers would applied to life companies in order to this can also provide significant envi- not result in the loss of material provide certainty in relation to the ronmental benefits! recoveries. unknown element and longevity of As this demonstrates, schemes certain types of life policies (see have proved to be flexible and adapt- A constantly evolving tool page 14). able in the myriad of circumstances Schemes are continuing to evolve in ● Captives, P&I clubs and mutuals. that can be and are found in the response to the increasingly varied Schemes can be applied to captives insurance world — which is why challenges and circumstances being and the concept can also be extend- more and more high profile compa- encountered in the marketplace. This ed to P&I clubs and mutuals (see nies are using schemes as a viable dynamic environment has resulted in page 18). and effective means of achieving the development of innovative, effi- ● US legislative changes. An oppor- finality. Recent schemes have dealt cient and effective solutions for com- tunity is now available for a solvent with tens of millions of insurance lia- plex books of business, which address scheme solution in the US. In 2002, bilities and are progressively playing the unique difficulties or circum- Rhode Island became the first state a part in dealing with the enormous stances facing each company. to enact a statute that allows a sol- amount of long tail liabilities ema- This is best illustrated by the fol- vent company in run-off to reach a nating from all over the world, not lowing list of situations where court supervised agreement with all least the US. With a carefully schemes can be applied: of its creditors to accelerate the com- planned and managed exit, a scheme pletion of a run-off. can be implemented early on in the ● Portfolios. Schemes are sufficient- ● Contingent schemes. A company life of a run-off, although the precise ly flexible to allow them to be may face uncertainty regarding its strategy and timing will be depen- applied to discrete portfolios, such as ultimate solvency. A contingent dent on the particular circumstances discontinued business or third party scheme can provide an effective of the business. ● business for captives. ● Pools. The application of schemes ‘Schemes have proved to be flexible and to portfolios rather than the whole of a company is particularly useful adaptable in the myriad of circumstances that when dealing with involvements in underwriting pools. A scheme can can be and are found in the insurance world’ bring finality to a pool and can also be designed in such a way so as to means of dealing with such a con- allow the pool members and their cern. A two part scheme can be policyholders formally to agree ways effected where the company oper- of simplifying existing complex ates its normal run-off within a sol- arrangements and relationships vent scheme until such time as it is commonly observed in pools (see determined that there are insuffi- page 15). cient assets to meet liabilities, includ- ● Overseas companies. Schemes can ing future liabilities. The scheme be applied to foreign companies with includes a trigger mechanism where- UK branches and any other compa- by the company will then pay a pro- ny incorporated outside England portion of claims, thus providing provided that there is ‘sufficient con- scheme creditors with a seamless nection’ with England. In addition, process from a solvent scheme to an schemes can generally be imple- insolvent scheme. mented in countries where the legis- ● E-schemes. In appropriate cir- lation stems from UK law, such as cumstances, a company can publish Bermuda, Hong Kong, Singapore and promote a scheme via a secure and Australia (see page 17). website, which can also be utilised to

run off business special supplement 7 Alternative exit options

In assessing the potential of the scheme of arrangement

route to finality it is important to be aware of the range of

alternative options available. Kevin Gill and Emma

Pugsley review the current choice of exit routes Making an exit

esearch indicates that the depend on the objectives of the key There are six main available exit worldwide total for liabilities stakeholder, the shareholder. Those options (as shown in Figure 1) and a Rin run-off is in excess of $300 objectives may not be complimenta- shareholder should consider carefully billion, with more entities entering ry, for example, to maximise value each option against its objectives. run-off each year. There are a num- and also to exit in a short time span ber of exit strategies to choose from and so the shareholder will need to a) Run-off to expiry and the exit route chosen will often prioritise the importance of each b) Aggressive commutation objective to reach an acceptable level c) Scheme of arrangement Figure 1 of compromise. d) Portfolio transfer

Exit options and ‘improvement’

Claims

Collections

Commutations Improvement Reviews

Risk Management Decision to Strategic enter run-off review IT

Run-off

Aggressive commutation Solvent exit Scheme

Portfolio transfer

Reinsurance

Sale

8 run off business special supplement Alternative exit options

e) Reinsurance tion, the systems and reporting facil- for the shareholder at an earlier stage f) Sale ities will need to be able to support than might otherwise be possible. A the requirements of an intense pro- key issue with schemes, however, is Each option is briefly described gramme of commutations, for exam- that they do not bind pure debtors, and considered below. Any company ple with the availability of a principal although this can be overcome by seeking to exit the market will need based ledger. careful management of reinsurers. to explore and consider each option Although this strategy can be effec- Schemes can be especially attrac- in detail. In particular each can have tive in reducing the size of the run-off tive when used in combination with different tax implications, which and reducing the risk of inwards an accelerated commutation strategy. may alter the merits of the solution deterioration and reinsurer failure, (see page 23). unless commutations are performed d) Portfolio transfer with each and every policyholder the A portfolio transfer can be effected a) Run-off to expiry timescale to finality will be the same under Part VII of the Financial The run-off of insurance business can as under option a), normal run-off to Services and Markets Act, which take many years, especially in the expiry. This strategy is likely to begin through a court driven process case of asbestos losses which could with a focus on the larger balances, moves the liabilities, and attaching take over 50 years to mature. and over time, as only the small bal- property (reinsurance asset) to Continuing a properly managed run- ances remain, this approach will another company. off to expiry means that only valid cease to be cost effective. Following This is a relatively quick process, sub- claims are settled to policyholders, an aggressive commutation strategy, ject to finding a company to take on ensuring that policyholders get the it may be appropriate to implement the risks of the run-off at an agreeable actual benefits of their policies. This an alternative exit strategy, such as a price, and achieves finality for the also ensures that the reinsurance scheme, to bring about finality. transferor in respect of the liabilities asset is fully and properly utilised transferred. However, the company reacting appropriately to each inward c) Scheme accepting the portfolio will seek to claim. Cash outflow can be managed A finality scheme is a global commu- price the transfer commensurate to the on an orderly basis and techniques tation with all creditors which uses risk transferred to give it an opportuni- adopted to minimise outflow which section 425 of the Companies Act ty of making a profit. This is likely to may be necessary in some cases. For many organisations, however, a long drawn out run-off is not attrac- ‘Following an aggressive commutation strategy, tive. There will be the continual risk of further claims deterioration, it may be appropriate to implement an increased failure of reinsurers and the ongoing costs of the run-off, which alternative exit strategy, such as a scheme, to will get proportionally higher as the claims liabilities tail off. Furthermore bring about finality’ the shareholders will be restricted in how much capital they may remove from the business and will face the 1985 to effect a compromise with reduce any value that the transferor prospect of having much of their cap- creditors. Essentially a scheme is a deal might have obtained from the run-off. ital tied up for many years. that is presented to all known and potential creditors for their approval e) Reinsurance b) Aggressive commutation through a meeting and vote of credi- Obtaining a stop loss reinsurance of An aggressive commutation strategy tors. Once approved by the creditors run-off business is another relatively involves collapsing the run-off by and sanctioned by the court, a scheme quick solution, following due dili- undertaking a strategic programme becomes binding on all creditors. The gence by the prospective carrier and of commutations to remove inward purpose of a finality scheme is to offer negotiation and agreement over the liabilities and exposures and to a fair and transparent process to cred- terms of the contract. secure value from the outwards rein- itors to have their policies valued on a Depending on the type of business surance programme. There will be once and for all basis. written, the costs of this option may heavy reliance on the efficiency and A scheme can be completed in a rel- be prohibitive, as the market for cer- effectiveness of the commutations atively short timescale, thereby avoid- tain business, eg. that containing team to perform the commutations ing some of the disadvantages of a asbestos, is very restricted. Whilst in an accelerated timeframe. In addi- long-term run off, realising any value this exit is intended to provide finan-

run off business special supplement 9 Alternative exit options

cial finality it does not give absolute above will involve retaining the busi- this area could therefore have a finality because most reinsurance ness for a period of time, depending material impact. policies are not unlimited and the on the strategy that is adopted and risk of reinsurer failure remains, the time necessary to implement an c) Collections and commutations however slight. In addition, exit solution. There are a number of Two of the exit options detailed although the ceding company typi- ‘improvement’ strategies that can be above, aggressive commutation and cally gives up control of the run-off, used to minimise the costs of the collection, for companies or portfo- it may retain an administrative bur- operation, as per Figure 1. lios with material amounts of rein- den as it monitors and accounts for surance, will involve using the skills the stop-loss arrangement. The key areas for improvement and strategies involved in this and review will include: improvement area. As standalone f) Sale a) Run-off management strategies, however, they can be The market for run-off sales has b) Claims management very effective in improving the increased dramatically in recent years, c) Collections and commutations results of an organisation, and with a trend which is set to continue as d) Third party relationships and careful planning can realise signifi- both the supply of businesses in run- outsourcing cant rewards. In some instances, off and the number of specialist run- e) IT effective strategy in this area can prepare the run-off for exit via a ‘The sale option can be very attractive, it can scheme.

provide the vendor with certainty and true d) Third party relationships and outsourcing finality since it passes over a company in its Many insurers and reinsurers have taken advantage of an opportunity entirety to the acquirer’ to outsource all or elements of their work to third parties. Where prop- off business acquirers grows. The sale As indicated in Figure 1, an exit erly controlled these arrangements option can be very attractive, it can strategy may be selected as the can be very beneficial, allowing the provide the vendor with certainty and appropriate strategy following a peri- company to focus on its key strate- true finality since it passes over a com- od of improvement. gic areas. In some cases, however, pany in its entirety to the acquirer these relationships can be financial- (subject to any warranties). Although a) Run-off management ly unsatisfying, and careful review there can be a significant amount of Properly controlling discontinued and subsequent improvements in preparation work required for a sale, business can minimise run-off these areas can be beneficial to the involving the marshalling of relevant operating expenses and mitigate company. documents, this exit can be a relative- the risk of underwriting deteriora- ly quick process, subject to finding a tion. It will be important to ensure e) IT buyer willing to acquire the company that any outsourcing contracts are An effective IT strategy and appro- at an agreeable price and regulatory properly worded and there are ade- priate IT systems are important tools consent. quate controls, procedures and for the company, both for the peri- As with a portfolio transfer the monitoring. Establishing an appro- od preceding exit and in some company taking on the run-off will priate strategy for the run-off will instances in assisting with the exit want to ensure that it has adequate- be key to the success of the opera- process. A good example of this is in ly valued the risks inherent in the tion, and may include a decision the development and implementa- run-off to give itself a reasonable regarding exit, its timings and tion of a principal based ledger. The opportunity of profit from the acqui- method. availability of a system which can sition. This valuation is likely to be at report on this basis will be useful for a heavy discount to the net assets b) Claims management providing valuations for conducting shown in the balance sheet of the Although claims represent around ad hoc commutations during the company being sold and the carrying 80 per cent of the total expenses of run-off period. It will additionally value in the vendor’s balance sheet. an insurer, attention is often driven be particularly important for an towards fixed and variable cost aggressive commutation strategy, Managing the run-off: reduction exercises, rather than on and also for a scheme in determin- improvement re-engineering the claims depart- ing key creditors and debtors for A number of the exit options detailed ment and processes. Improvement in strategy purposes. ●

10 run off business special supplement Stakeholders

Each scheme will have many stakeholders. Clare Whitcombe explains

who they are and how their interests should be addressed Managing expectations

hroughout the life of a run- these. The important thing to tations or discussions with the main off, understanding stakehold- remember is that if any key stake- reinsurers to ensure they understand Ter perspectives and managing holder rejects the deal it will not the scheme and to obtain their buy-in. stakeholder expectations is key to work, so fairness to all is imperative. Alternatively, a scheme can be ensuring things run smoothly. These A key stakeholder is the regulator. structured so that they are able to stakeholders include: shareholders, As long as a scheme satisfies the ulti- participate. Reinsurers are asked to directors, run-off managers, credi- mate requirement of fairness, the indicate what sums they are willing tors, reinsurers, regulators and staff Financial Services Authority (FSA, the to pay and creditors can be given the to name but a few, and it is critical to UK regulator) will generally be sup- opportunity to decide whether such understand the needs and motiva- portive of a scheme. Even if the com- offers are satisfactory or not. If sums tions of each stakeholder when the pany falls outside its jurisdiction, the pledged by reinsurers are insufficient, exit strategy is being formulated. FSA will need to be satisfied that UK in the eyes of the creditors, they can Each stakeholder should be consid- creditors are not adversely affected. vote to reject a scheme which seeks ered during the planning, promotion Support from any relevant overseas to crystallise all liabilities and choose and implementation phases of a regulator will, of course, also be vital. instead to return to the run-off. In scheme to ensure that all perspectives

are considered. Where there are con- Regulator flicting needs these must be carefully considered and managed to ensure that the deal presented balances the Reinsurers Cedants/ needs of each stakeholder and is a fair Policyholder solution for everyone. Each scheme Business in run-off will generally involve the same types Shareholders of stakeholders but the motivations will typically be different. The process will start with discus- Guarantor sions with the directors in order to Staff understand the business issues and their expectations in relation to the Policyholders will want to know this way, creditors retain a degree of scheme. Shareholders will obviously how much and when they can expect control. need to approve any exit strategy to receive payment under the scheme, Staff usually have vital experience before it can be implemented and and whether the claims agreement and knowledge in relation to the they must understand the process and adjudication processes are trans- business and will be key in the plan- including the risks and rewards. parent and result in fairness. Taking ning and implementation of a We would usually start with a blank early soundings from key creditors is scheme. Staff retention and bonus sheet of paper and shape out what the vital to ensure they understand and programmes can be designed to deal looks like depending on the size, support the scheme proposals. ensure that the risk of loss of key staff nature and complexity of the business. A scheme benefits reinsurers in that is minimised and motivation is main- Once we have a deal sketched out, it gives them certainty and finality, but tained. Given the increased populari- soundings will be taken from key if a company has a significant reinsur- ty of schemes, staff have the added stakeholders to ensure that their ance programme it will need to benefit of gaining valuable and prac- concerns and needs are reflected and embark on a carefully devised and exe- tical first hand experience of imple- the scheme will be shaped to reflect cuted strategy of pre-scheme commu- menting these exit strategies. ●

run off business special supplement 11 Timeframes

Neil Gayner examines the various factors involved in choosing when to

initiate a scheme When is the right time to scheme?

arly schemes were contemplat- what is their likely attitude to the ● Reinsurers generally welcome ed only for very old run-offs in scheme? finality and certainty. The key mes- Eorder to release any surplus ● Are there any ‘show-stoppers’ in sage is consult with key reinsurers in capital and bring finality and certain- the portfolio that need to be excluded advance of implementing the scheme. ty. Market perception of schemes is from the scheme or dealt with first? ● Most cedants will be happy to now maturing. Schemes are now For example, a scheme including achieve finality on fair terms, espe- seen as the end phase of an integrat- employers’ liability on a losses occur- cially if the scheme includes pay- ed and focused strategy for discontin- ring basis would probably meet resis- ment of a premium, possibly in the ued business. As a result, sharehold- tance from the FSA, and personal lines form of reserves undiscounted for ers are asking at what point in the business, whilst capable of estimating time value of money, or, if there is implementation of the strategy as a class, may not lend itself to a fair any doubt about the long term should a scheme be developed? IBNR allocation at policyholder level. claims paying ability of the company Unfortunately, there is no simple ● The reinsurance programme – being schemed. Again, the key mes- answer to the question. In fact, it how heavily reinsured is the portfo- sage is to consult with key cedants generates a number of further ques- lio, with what types of reinsurance, and gain their support before the tions starting with the overall share- how much set-off is there, are there scheme meeting takes place. holder objectives. Are these to max- ‘difficult’ reinsurers and what is the ● It is important to consult with, imise return to the shareholder, quality of the security? and consider attitudes and concerns preserve corporate reputation, min- ● What is the solvency and reputa- of, other key stakeholders, including imise risk or possibly a host of other, tion of the company being schemed? regulators and staff. sometimes conflicting, objectives? ● Are shareholders prepared to ● Schemes can deal with active lit- Other factors to be taken into pay a premium for certainty? igation or unresolved market issues account on timing of the scheme ● How much current litigation is through provision of a parking include: there? mechanism. ● The classes and type of business ● Are there major unresolved In conclusion, there is no single in the portfolio and the ability actuar- market issues? For example, it will answer to the question of when is the ially to estimate ultimate outcomes at currently be difficult to crystallise right time to implement a scheme; a contract level. How mature is the World Trade Center property losses the answer depends both on the key book? Are there still in-force policies? until the number of losses issue has objectives of the shareholders and ● The nature of the run-off to date. been finally resolved. the characteristics of the portfolio. How aggressive has it been? Have In our experience, having been However, the single most important some of the largest and most volatile involved in the majority of schemes factor is probably the nature of the exposures been commuted? to date, we have found: liabilities, and the answer is as soon ● The policyholder/cedant base – is ● Most reinsurers will pay on the as the portfolio is sufficiently mature it dominated by a small number or is basis of crystallised liabilities if they for reasonable actuarial estimates to it fairly evenly spread? If the former, believe the process to be fair. be developed at cedant level. ●

12 run off business special supplement Timeframes

Andy Ward explains the timescales involved in schemes

How long do schemes take?

ne of the major advantages It is often stated that schemes today a reasonable amount of time to con- of schemes of arrangement is are essentially in a boilerplate format sider the position and cast their vote. Otheir flexibility in that the and can be produced very quickly. The deadline for proxy form votes provisions and timescales of a scheme Whilst this is true to a certain extent, will be quickly followed – usually may be drafted to suit the particular and the number and variety of within one week – by a meeting of circumstances of the company in ques- schemes already produced assists in scheme creditors to vote on the pro- tion. Consequently, because of the drafting, each new scheme company posal. Creditors may attend in person unique circumstances of each scheme has its own idiosyncrasies which will at the scheme meeting or proxy votes company there is no set timeframe need to be catered for within the will be included in the voting process. for the completion of a scheme, drafting process. Assuming the scheme is voted for although there are fundamental by the requisite majority of creditors stages common to each scheme. Scheme drafting attending the scheme meeting in In broad terms, the two main types ➧➧ ➧ ➧ ➧ person or by proxy, then the scheme of scheme are: Distribute scheme will normally be ratified by the court ● An insolvent reserving scheme in the relevant jurisdiction within ● A crystallisation scheme for an Proxy form return one week. On receipt of court insolvent or solvent company approval the scheme becomes effec- Reserving schemes are generally tive and will follow the timetable set Scheme meeting used where there are long tail liabili- out in the document. ties and/or considerable uncertainty Court sanction The next important timing issue within the company’s data. The for an estimation scheme the reserving scheme will make regular bar date for the filing of claims. Scheme effective date

small value dividend payments to ➧ ➧ This is a key date that will be creditors with agreed claims, whilst determined by a number of factors: Bar date reserving cash for payment of other ● Where the scheme involves a creditors’ claims which will not mate- Clause agreement sophisticated actuarial estimation of rialise until some time in the future. and adjudication liabilities, then the bar date may be

Crystallisation or estimation ➧ in the region of six to nine months schemes seek to establish the compa- Payment to allow creditors to spend more

ny’s ultimate liabilities in early course ➧ time in evaluating their policies and – largely through the adoption of actu- Scheme termination reviewing the actuarial projections. arial techniques – and hence acceler- ● Where data quality may be poor or ate the closure of the run-off. There Once the scheme has been drafted where a company is small and has rel- are of course fundamental features and distributed to creditors, a atively few remaining creditors, then a which are common to all of the timetable will be set for the remain- submission style scheme may be used schemes and the key stages for an esti- der of the scheme and will initially where creditors send in their claims for mation scheme are shown in Table 1. provide a period for creditors to con- adjudication by the company and its The the process of drafting the sider the merits of the scheme and to scheme advisers. Typically the bar dates scheme and distributing the docu- return proxy forms voting for or may be as short as three months. ments to creditors is common to against the proposal. Once more, a Following the agreement of claims it both schemes and typically would typical timeframe for the return of is generally a short time – a month or take between three and six months, proxy forms will be in the order of two – before payments can be made to depending upon the legal complexi- three months – a period which allows creditors. Once payments have cleared ties involved in the scheme drafting. domestic and international creditors then the scheme may be terminated. ●

run off business special supplement 13 Life companies

Schemes of arrangement can also be used in the restructuring of life

assurers. Nigel Rackham considers the issues and potential solutions

for troubled life companies and the implications of applying a scheme Life restructuring

any life companies are fac- holders do not have the security they ment and can share this benefit with ing serious business issues, thought they were buying into. policyholders. Reducing widely dif- Mwhich are in some cases Depending upon the circum- fering policy terms within a group threatening the solvency of the com- stances there are a number of mea- may make the business administra- pany. Some examples of these are: sures which can be taken to stabilise tively easier to manage as well. ● Erosion of capital due to falling or strengthen a fund. Some involve a There are a number of issues asset values which are not matched capital injection (or pseudo-capital which have to be addressed which to policyholder obligations because such as a contingent loan or financial can be complex. For example tax, of guaranteed benefit terms. reinsurance). Some element of risk both for the company and for policy- ● Exposure to other guaranteed reduction can be achieved by true holders, can be a particular sticking benefits (for example guaranteed risk transferring reinsurance but this point (see page 23). The regulator annuity options) due to falls in is likely to be costly due to the lack of would also need to be involved. interest rates and improved mortality. appetite for some life risks in the ● Continued threat to solvency market. It is also possible to use Pros and cons of a scheme through asset volatility on a weak- derivative contracts to hedge some It is possible to achieve some level of ened capital base. market risks, albeit again at a cost. restructuring of policy terms through ● Pressure on margins from stake- There are also restructuring solu- a portfolio transfer providing the holder type products, possibly sold tions amending policy terms which court is satisfied that the restructur- by new entrants to the market with improve the position of the fund ing is necessary. Although a transfer cheap and flexible product distribu- whilst policyholders are not just to a third party may not be possible tion and/or critical mass. dealt with fairly but can share in the some intra-group restructuring may ● Costs arising from mistakes of benefits. For example: be possible. This does not need poli- the past, in particular mis-selling. ● Removing certain future guaran- cyholder consent although policy- ● Because of capital strain market- teed benefits and providing suitable holders still need to be circularised wide it is difficult to find reinsurance compensation. This may find favour and can be heard at the court hearing at an acceptable price for mortality with policyholders whilst removing necessary to sanction the transfer. risk and it is also hard to find a pur- the reserving and capital require- An apparently easy solution is to chaser for an ailing fund. ments on the fund. This is the solu- seek individual agreement from poli- In turn the impact on policyholders tion achieved by Equitable Life. cyholders to a change in terms. In has been significant: ● Ring-fencing existing policy practice, agreeing the documentation ● The fund may have closed to terms but offering more flexible and dealing with policyholder queries new business, lower (or no) bonuses alternatives for future premiums. may make the process as complex as declared, charges increased and ● A wholesale conversion from a scheme solution. The major draw- penalties imposed on early surrender. with-profits to unit-linked funds. back is that inertia and a lack of poli- ● An exit from volatile asset class- The latter two options more closely cyholder understanding may make es whilst protecting solvency gives align risk and reward. Policyholders the take-up rate of any option low. A policyholders little opportunity for can choose a more flexible invest- solution through a scheme of upside, indeed they may be locked ment vehicle, offering upside oppor- arrangement offers the beauty of into values at what may prove to be tunity, whilst also accepting the mar- binding all the affected policyholders the bottom of the market. ket risk. The fund has reduced risk once the requisite majority is ● Solvency concerns mean policy- and hence reduced capital require- obtained. ●

14 run off business special supplement Portfolios and pools

The flexibility of schemes means they can be applied

to discrete portfolios of business. They are also useful

when confronting the complexities of pools, say

Diana Gardner-Brown and Emma Pugsley A rescue from the pool

ne aspect of a scheme’s flexi- went over time, underwriting years the pool members and creditors for- bility is that only the defined were ‘closed’ by reinsuring into mally to agree ways of simplifying Oliabilities of the portfolios are other underwriting years and the complex arrangements and rela- dealt with. For example, some liabil- fronting on behalf of other partici- tionships that had built up during ities might be valued through a cut- pants became commonplace. The the life of the pool. The pool origi- off scheme, whilst other liabilities are popularity of pools and underwriting nally consisted of five companies, left to run-off normally. In addition, agencies has now declined and a but one was subsequently dissolved a scheme can define which assets great number are now in run-off. with the four remaining participants support the scheme liabilities, pro- Furthermore, a number of pools agreeing between themselves to viding a company with the ability to now contain one or more members share that member’s pool liabilities. ringfence liabilities of discontinued that are insolvent, compounding the The scheme formalised this sharing business. complications of pools and bringing arrangement with the pool creditors, The ability to limit a scheme to a its own difficulties. enabling all of the pool liabilities to defined portion of a company’s liabil- A scheme can be tailored to deal be dealt with in one scheme. ities is particularly useful for dealing with the particular circumstances An important issue for the mem- with business written through and issues facing the participants of a bers of the Dunedin pool was for underwriter or broker pools, provid- pool and is particularly useful for each member to retain the several ing participants with a facility for simplifying and streamlining the liability that each enjoyed in relation exiting one of the most problematic legal construction of the pool to the to their original participations, so areas of run-off. Pools were regular- benefit of the pool participants and that each did not become responsible ly used for many decades to provide pool creditors. for another member’s liabilities. The insurers and reinsurers with the Whilst an individual pool member scheme provided that each member chance to become involved in writ- can implement a scheme for its own was severally liable for its ‘scheme ing books of business in geographies portfolio in a pool, it can be much defined’ participation and was not and/or classes of business that would more powerful and straightforward if jointly liable for other members’ otherwise not have been available to all pool members seek a scheme exit. liabilities. them. A further attraction of pool This is what the surviving members Schemes can be drafted to bring arrangements was the opportunity of the Dunedin underwriting pool further benefits to the participants to share in overhead costs, a prospect chose to do, with each effecting a and creditors by catering for the that was particularly inviting when scheme for their participation in that impact of any of the pool members entering new areas of business. pool, resulting in the first solvent becoming insolvent, thereby avoid- As pools evolved they became scheme for a whole pool in the UK. ing some of the problems and the more complicated: for example, This scheme also demonstrated the hiatus surrounding the onset of underwriting participants came and flexibility of schemes as it allowed insolvency of a pool member. ●

run off business special supplement 15 Lloyd’s

Schemes may also be applied within the Lloyd’s market

to hasten finality, explains Kevin Gill Exiting Lime St

he Lloyd’s of London market is benefits that a scheme provides to the fer under Part VII of the FSMA 2000, faced with the same run-off underwriter and policyholder are no although there are other ways of Tissues as the company market. different than those derived from achieving a similar result. It has to face and manage the schemes in the company market. With the Lloyd’s brand being a prospect of deteriorating losses, the franchise, any company promoting a risk of reinsurance security failure Distinguishing features scheme in the Lloyd’s market will and the ongoing overhead costs of There are two distinguishable fea- need to be mindful of the other stake- performing the run-off. Traditionally, tures between the Lloyd’s market holders benefiting from Lloyd’s’ rep- the Lloyd’s market has dealt with its and the company market. utation. It will be important to dem- run-offs and open-year exposures The first is its capital providers. The onstrate that solvent schemes at least through a mixture of reinsurance to Lloyd’s market is characterised by uphold the reputation of Lloyd's, close (RITC), commutations and run- part of its capital being provided by given the fundamental importance off to expiry. More recently it has individuals, rather than companies. of Lloyd's never having failed to pay been able to take advantage of the The second is the Lloyd’s franchise. a claim in full. A solvent scheme can portfolio transfer options provided by The capital providers and managing provide clear financial benefits to the Part VII of the FSMA 2000 to transfer agents work under the name of market and in addition it also pre- run-off business out of the Lloyd’s Lloyd’s and their actions affect not serves and indeed can enhance By market. only their own fortunes, but also ensuring that the fair value of pre- Nevertheless, there are approxi- that of the Lloyd’s market. How do sent and future claims are paid in mately 70 syndicates in run-off, and these two features affect the ability full, Lloyd's can demonstrate positive it would seem that the current exit to implement a scheme? steps to bring finality to its run-off routes are not providing the capital Since a scheme is a Companies Act business. A scheme allows policy- providers at Lloyd’s with the desired mechanism that allows companies to holders to be paid in full at an earli- exit and finality that could benefit come to an arrangement or compro- er stage than would otherwise be the market. Many regard the tradi- mise with its creditors, where a cor- normal, providing policyholders tional closure route of RITC as being porate vehicle provides the capital with certainty and value from their too expensive, giving away profits to on a syndicate then technically it will policies in an expeditious fashion. a reinsurer that could be retained for be able to use a scheme to come to a With run-off managers now seek- the current capital providers. Is there compromise with its creditors (ie. the ing proactively to manage their run- now an opportunity for a scheme of policyholders). However, part of offs to provide value and benefit to arrangement to provide finality and Lloyd’s capital is provided by natural their clients, the shareholders of an certainty to Lloyd’s run-offs? names and schemes are not available underwriter, they are exploring and A solvent scheme is no more than a for individuals. To deal with this, implementing schemes to bring clo- deal whereby an underwriter seeks to natural names’ liabilities need to be sure to run-offs. This enthusiasm has arrive at a fair value with its creditors transferred from the natural names extended to the Lloyd’s market, with (policyholders) for its current and into a corporate body. That company a number now showing interest in future liabilities and to settle those lia- can then implement a scheme. One whether a scheme can be used to bilities in full at an earlier stage than way to move the names’ liabilities bring finality and certainty to a run- would be possible in a run-off. The would be by way of a business trans- off within Lloyd’s. ●

16 run off business special supplement World applications

Although solvent schemes in the UK are governed by UK

legislation it is not only UK-domiciled companies that can

benefit from them. Mark Jones and Andy Rothseid

examine the wider geographic applications of section 425

of the Companies Act Global schemes

any commonwealth and solvent schemes are likely to follow. for the court in England to allow for ex-commonwealth coun- As far as other countries are concern- a section 425 scheme to be imple- Mtries originally built their ed, a scheme for three Hong Kong mented in England for that foreign own corporate legislative structure subsidiaries of the insolvent HIH company. around that of England. This means Insurance Group was implemented What is considered to be sufficient that corporate legislation in coun- last year based on section 166 of the connection with England for the tries such as Bermuda, Hong Kong, Hong Kong Companies Ordinance purposes of winding up a foreign Singapore, Gibraltar and Australia (the first scheme for an insurance company has become more settled include provisions that are very sim- business based in Hong Kong). over time. It has always been consid- ilar to that of section 425, and there- ered as ‘sufficient’ if the company fore schemes, both solvent and insol- Foreign companies has carried on business in England, vent, can be implemented in these PricewaterhouseCoopers recently whether it is based in England or car- commonwealth and ex-common- advised on a particularly innovative ried on the business through a wealth countries. application of UK legislation in order branch in England. Therefore the There are several precedents for to implement solvent schemes for five most obvious application here would schemes for insurance companies subsidiaries of the ING Group. This be for a foreign company wishing to domiciled in these countries. Two of application involved, surprisingly for implement a solvent scheme for its the very early solvent schemes, a solvent scheme, the Insolvency Act UK branch that operated in the namely for Scottish and Common- in England. London market. wealth Insurance Company Limited Under section 221 of the However, the solvent schemes (now dissolved) and Trent Insurance Insolvency Act, any company incor- implemented for the five subsidiaries Company Limited, were based on porated and domiciled outside of the ING Group mentioned above section 99 of the Companies Act in England may be wound up in further clarified the position. Four of Bermuda. The solvent scheme for England, provided that there is ‘suf- the ING companies were Dutch and Ramus Insurance Company Limited ficient connection’ with England. one Australian, and all wrote busi- was also based on the same law in A most important legislative link is ness in the London market in the Bermuda. The level of insurance op- then made. If there is jurisdiction for period from the 1950s to 1984, in erations in run-off in Bermuda would a foreign company to be wound up one case into the 1990s. As a result, suggest that additional Bermudian in England, then there is jurisdiction the policyholders, cedants and rein-

run off business special supplement 17 World applications

surers of all five companies included tion 221 of the Insolvency Act. these companies were successfully parties that were based in England. Therefore all had sufficient connec- implemented on 20 December 2002. For each of the five companies the tion with England, and hence sol- A section 425 scheme will bind all proportions that these parties based vent schemes under section 425 creditors of a company who are in England bore to those elsewhere were possible. Furthermore, three of subject to the jurisdiction of the were not insignificant, and therefore the companies had continuing busi- English courts. It should be noted, all five companies could potentially ness that they wished to be excluded however, that a scheme will not be be wound up in England under sec- from the schemes. The schemes for enforceable against a creditor outside England, except to the extent that such creditor takes part and Closure for captives receives dividends under the scheme. The last few years has seen a steady growth in captive insurance company This means that a section 425 formations of around five per cent per annum, with the four most popular scheme will not on its own be suffi- domiciles being Bermuda, Cayman, Guernsey and Vermont. Surprisingly, cient to prevent a non-English despite numerous new captives being licensed each year, the total number creditor from obtaining judgement of captives has remained around 4500 over the last few years, due to an in any proper non-English jurisdic- equivalent number entering run-off or, worse still, liquidation. tion and then enforcing such judge- The ever changing corporate environment has fuelled the captive run-off ment against the assets of the com- market: mergers, acquisitions, sale of companies with captives, change of pany anywhere in the world domicile or a change in business strategy can result in captives no longer outside England. However, this can being needed to support the new venture or its strategic direction. The be mitigated by the company consolidation of risk management programmes of numerous captives obtaining further protection from within a group of companies can also result in redundant captives. the courts of other countries where The tax benefits available to captives are also reducing (with the US creditors and/or assets are based. Congress considering actions to close the ‘Bermuda tax loophole’). UK This involves applying to the courts parent companies with overseas captives are affected by the controlled of the relevant countries to seek foreign company rules attributing income from subsidiaries in low tax their recognition of the scheme. jurisdictions to UK taxable profits. Many of the schemes that have This myriad of changes has created a new and growing run-off market, been implemented to date have but little headway has been made to address this issue. involved the company obtaining a permanent injunction in the US Achieving finality under section 304 of the US Despite the increase in popularity of schemes within the run-off insurance Bankruptcy Code. This has provided market, until very recently this exit mechanism has not been mirrored in protection from parties potentially the captive market as a tool for achieving finality. In 2003, Ford became seeking to take action that are either the first company to successfully promote and complete a scheme for subject to US jurisdiction or are seek- third party business written by its captive Transcon, further demonstrating ing to take action in the US. the wide application of schemes and paving the way for increased Therefore where a foreign compa- recognition and acceptance of schemes in this market. ny has sold its insurance and/or rein- The diverse and flexible nature of schemes allows companies to achieve surance products into England, for finality for the company as a whole or for a portfolio of the company’s example through the London mar- business, making this a highly attractive exit option for captives with ket, whether or not it has a branch run-off business. based in England, provided that the The numerous advantages resulting from use of a scheme also extend proportion of its policyholders, to captives. Substantial savings in run-off costs, which would otherwise be cedants and reinsurers based in incurred in the normal course for many years, can be made. Finality is also England compared to those based achieved, therefore removing any doubt regarding the solvency of the elsewhere are significant, and there- captive. A scheme provides a mechanism for crystallising present and fore that company is capable of being future claims against the captive, creating certainty and facilitating earlier wound up in England, then a section payments to creditors, thus resulting in the earliest possible release to a 425 scheme could be implemented parent company of any residual value from a captive’s business in run-off. in England for that company. Additional protection in other juris- Baljit Goraya dictions can also be sought if deemed necessary.

18 run off business special supplement World applications

Rhode Island proposing a commutation plan Rhode Island that is) wishing to imple- In 2002, Rhode Island became the would be wise to seek to reach ment a commutation plan would have first US state to enact legislation to agreements with its reinsurers prior to redomesticate to Rhode Island. allow a solvent insurance or reinsur- to proposing such a plan. Depending on the particular state (or ance company in run-off to reach a If the company meets all the con- country) involved, the company court-supervised agreement, known ditions imposed on it, and obtains would have to obtain approval from as a ‘commutation plan’, with all of approval from the Superior Court both its current state (or country) of its creditors in order to bring finality then notice will be sent to all inter- domicile and Rhode Island. In order and certainty to its run-off. ested parties and, as with UK to accomplish this it would need to satisfy the Department, and possibly ‘Redomestication in order to take advantage of its current domestic regulator, that it, among other things, had sufficient scheme-like legislation, such as that found in reserves to meet its liabilities. This statute certainly represents a the UK, commonwealth and ex-commonwealth new level of innovation in the US insurance run-off market, and is an countries and the US, is likely to become more innovative and proactive measure to address the problems posed by an popular’ insurance business in run-off. At the time of writing, two companies in The legislation itself is very similar schemes, all creditors will be given run-off have applied for redomesti- to section 425 in the UK. In fact, it the opportunity to vote on the plan cation to Rhode Island. When the would appear that the legislators at a creditors’ meeting. redomestication has been effected, modelled the legislation on section Creditors, policyholders, reinsurers those companies will be the first eli- 425 in the UK and section 99 in and guarantee associations may file gible to take advantage of the new Bermuda in their drafting. comments or objections with the statute. It is likely that a number of In order to implement a Rhode court. Therefore, it is important that other companies are also now con- Island court-supervised commuta- the company has taken soundings sidering the Rhode Island statutory tion plan, a company must : from all the key parties and reacted process. accordingly in drafting the plan. In ● Have property and casualty lia- order to be implemented, the plan Conclusion bilities. must first obtain the approval of 50 Redomestication in order to take ● Be domiciled in Rhode Island. per cent in number representing 75 advantage of scheme-like legislation, ● Have ceased underwriting new per cent in value of liabilities of all such as that found in the UK, com- business. creditors or class thereof voting. monwealth and ex-commonwealth ● Be renewing business only as Once this is achieved the court will countries and the US, is likely to required by law or contract. ‘This statute certainly represents a new level of If a company meets all four of these requirements then it may innovation in the US insurance market’ apply to the Superior Court for an order implementing a commutation then enter an implementation order, become more popular. In fact coun- plan. Before making such an applica- subject to the comments and objec- tries like Gibraltar, which also has tion to the court, the company tions made to it by creditors and pol- scheme legislation similar to that of would review the plan with the icyholders, making the commutation England, and states like Rhode Island Rhode Island Department of plan effective. positively encourage it. Business Regulation (the Once payments have been made to It would appear that as more and Department), and its compliance all creditors under the plan, applica- more companies take advantage of with regulations issued by the tion will be made to the court for it scheme legislation, their advisers Department, in order to ensure its to enter an order of dissolution, come up with innovative ways of support. releasing the company from any fur- doing so, and the benefits of schemes As with UK solvent schemes, a ther liabilities, and allowing the com- become more apparent to the insur- commutation plan does not impose pany to release its capital to its share- ance industry, it is likely that any obligation on the company’s holders. schemes or commutation plans will reinsurers. Therefore, the company A foreign company (foreign to take off within the next few years. ●

run off business special supplement 19 Reserving

Neil Bruce stresses the importance of taking a completely different

approach to the reserving function in setting up schemes and the value

added benefits that can be reaped Change of focus

he reserving function will ready for major commutations as analysis of outwards reinsurance and normally be part of the well as preparing the way for differ- then set-off is made redundant. Tfinance function or a separate ent types of finality option. It also The identification of accurate pay- actuarial function providing all kinds helps identify commutation areas ment patterns becomes increasingly of statistical, planning, reserving and where quick wins can be made, such important, given that forced realisa- underwriting support. The change in as where large offsetting balances tions of investments may have a pro- objectives faced by the reserving could be dealt with to reduce under- found effect on the ability of the function following the decision to lying uncertainty. company to meet its eventual liabili- enter run-off is profound and repre- Commutations become one of the ties. Payment patterns are also one of sents a major change in culture for most important operations within the key assumptions in identifying those involved. The difference of the company. They can be used to an acceptable range of commutation emphasis required is made clear in create inwards cashflow, which is values for any transaction. the accompanying table. very important, as premium income As well as identifying best estimates of future liabilities, the reserving function needs to be able to pro- Ongoing company Run-off duce high or ‘worst plausible’ estimates of reserves in order to aid • Reserving at the class of • Reserving at the policy level in commutation discussions and ulti- business level • Policyholder security and equity between mately be able to make a proposal to • Shareholder return creditors policyholders that will reward them • Underwriting support • Claims management and commutation adequately for taking liabilities back • Brokers ensure relationships activity on to their balance sheets. This can with company • Company must ensure relationships involve detailed analyses of risk ver- • Absolute level of reserves with brokers, insureds and reinsurers sus reward and can lead to strains or • Best estimate reserves • Relative level of reserves (insolvent) but releases from company balance (mean) also absolute level of reserves (solvent) sheets according to different external • Market perception of the • Best estimate and worst plausible conditions (such as the prevailing security of the company reserves (mean and volatility) level of interest rates). • Market desire to commute with the In summary, the reserving func- company tion has to completely change its focus as a result of entering run-off. The types of action within the can no longer be relied upon. It does, however, have a one-off reserving function that will prepare a Effective commutation of outwards opportunity to add more value to the company for finality include the fol- reinsurance can also prepare the way company than ever before by being lowing: for an efficient scheme process in involved in practical commercial val- The reserving process in run-off that it can eliminate the major net uations and negotiations and, partic- will change its focus from a class of debtors who are not bound by a ularly, to prepare a company for a business or overall level to a focus on scheme (solvent or insolvent). It can finality option such as a solvent reserving at a policy or creditor level. also ease the mechanics of the crys- scheme. Actuaries seldom have so This has advantages in terms of being tallisation process if a significant much opportunity to create value. ●

20 run off business special supplement Valuing liabilities

One of the key decisions to be made when organising a scheme of

arrangement is how claims liabilities are to be valued. Nick Watford

compares and discusses two of the main approaches Value judgement

here are two main methods of always produce a fair solution to This, however, is in itself one of the valuing ultimate claims liabili- every individual creditor, the advan- main criticisms of the allocation Tties in a crystallisation tage of applying uniform actuarial approach, namely that creditors’ scheme. The first approach is ‘claims approaches to all creditors gives views on IBNR are not considered allocation’, whereby creditors agree some comfort that creditors will be directly by the scheme actuary, who is data with the scheme administrators which is then passed to the scheme actuary to apply an actuarial Claims allocation Claims submission methodology that has been pre- approved by scheme creditors as part Advantages Advantages of the resolution to close the scheme. • Objective and fair • Only option where data is poor This is often referred to as a ‘we tell • Efficient, effective and timely • Deals with creditors who want you’ approach, as the scheme actu- • Less onerous from creditors’ to participate ary sets the final claim amount, standpoint • Creditor views on IBNR are although the creditor does have the • Deals effectively with large taken into account opportunity to agree the data to be volumes of claims used. The second approach is ‘claims Disadvantages Disadvantages submission’, in which each scheme • Creditor views on IBNR not • Can be a problem for creditor is asked to estimate their taken into account unsophisticated creditors own claim amount and submit this • Perception that amounts are • Can be confrontational for review by the scheme actuary, agreed with disinterested • Process may be longer, together with sufficient support in creditors especially if large numbers of the form of policy level analysis and claims submissions received actuarial analysis to permit assess- ment of their claim. In contrast to treated objectively and fairly, or at entitled to disregard their views. There the ‘we tell you’ design of the claims least that the overall process will not is a difficult balance to draw in this allocation approach, claims submis- be subject to bias. respect, which also needs to recognise sion is often described as a ‘you tell The allocation approach can deal the size and complexity of the scheme us’ approach. equally well with 100,000 creditors or itself and whether a submission 1000 creditors and, in consequence, is approach is a viable alternative. Claims allocation less likely to be subject to delays as a A further common criticism of the The main advantage of a claims allo- result of unforeseen problems. It also allocation approach is that it may cation process for an insolvent estate places the burden of estimation and give money to potential creditors is that it can deal effectively with allocation on the scheme actuary who are uninterested in the crystalli- large volumes of claims in a manner with little burden on creditors them- sation process and who have played that provides at least rough justice to selves, other than agreeing that the no part in supporting the orderly all concerned. Whilst it is appreciated data used by the scheme actuary is wind-up of the business. This criti- that actuarial techniques do not correct. cism is less valid in that it is possible

run off business special supplement 21 Valuing liabilities

to operate an allocation scheme that likely to result in a prolonged process vent companies begs the question as only allocates liabilities to creditors of agreement. More than any other to how liabilities are divided up who have previously signed up to factor, this can dictate whether or between policyholders in a solvent the process and positively declared not a claims submission process is scheme. In this respect, the main dri- that they want to receive a dividend. likely to be a practical solution. There vers described above are equally It is also possible to run an allocation is therefore an inherent ‘gamble’ applicable to a solvent scheme as to approach that ignores minimal allo- taken in deciding upon a submission an insolvent scheme. There are, cations of, for example, less than $50 scheme in that the creditor response however, some very important dif- and puts these allocated amounts may be significantly greater than ferences as follows: back into the overall pot. anticipated. The same emphasis is not so rele- There are, of course, some vant to a solvent scheme. Here, it is Claims submission instances where a claims submission important that the overall estimation The claims submission approach is approach is the only alternative, is reasonably correct in the first place very different to the allocation notwithstanding the delays that can as, if it is not, then one or other of approach in that the initial onus is all occur. Where the insolvent company the company’s shareholders or the on the creditor to produce a claims has little or no historical information policyholders may be severely disad- submission, including allowances for of its own, it can be almost impossi- vantaged in the crystallisation IBNR. This needs to be done accord- ble for the scheme actuary to follow process. ing to agreed estimation approaches a claims allocation approach and It is also important that risk comes but, in practice, it is still common for claims submission may be the only into the equation. For a creditor in a some creditors to ignore the general practical alternative. solvent scheme, they are bringing principles laid down and, in some A claims submission approach can uncertain liabilities back on to their cases, to come up with ludicrous also be very effective where the in- balance sheet and would normally claims — for example, claiming for house claims department has a very expect to receive more than a dis- full policy limits on non-APH policies good understanding of the insured counted best estimate of their liabili- where there is virtually no possibility population and their expected future ties (otherwise why else would they of future claims arising. claim amounts, for example where agree to it?). There is therefore a The scheme actuary can usually IBNR is small or where the substan- reward that often needs to be paid by deal with these types of claims easily tial IBNRs that will arise are relative- the parent company to the creditors but there is still a significant amount ly easy to estimate, such as for some in a solvent scheme to recognise this of work to do in agreeing all claims asbestos assureds where policy limits transfer of risk. In some situations, with individual creditors. This are very likely to be exhausted. however, such as where creditors process may become confrontational may perceive there to be a significant and can lead to a further actuarial or Summary risk of future insolvency, the equa- claims adjudicator being involved in In deciding which is the right tion may change to also reflect cred- the process as a whole. There is also approach to take, the key issue must it risk. the potential for contentious legal be which approach is most appropri- In recent times, the simple use of issues to arise that will require the ate in reaching a fair and equitable an undiscounted liability (to be paid scheme actuary to seek legal advice answer for creditors and, of course, now) has sometimes been consid- to help resolve each case. In an allo- in minimising expenses so as to ered to be sufficient recompense for cation situation these issues will usu- improve overall dividends. It is no the risk being accepted by creditors ally be dealt with up front and good coming up with a sophisticated in this situation. This approach may appropriate legal judgments will be method that is equitable to all credi- now be out of date with investment factored into the scheme actuary’s tors if the actuarial fees necessary to income levels being low and insur- assumptions, rather than being dealt reach this position eat up a large slice ance companies in run-off normally with on a claim-by-claim basis. of the remaining distributable assets! being bought for a discount to net This difficulty in agreeing claims In some situations it is conceivable assets. This leads to a conclusion on an individual submission basis that a combination of elements from that some premium over undis- can lead to significant delays in the the two approaches may be used to counted reserves may be appropri- process. A crucial factor in deciding the overall benefit of the scheme ate, the size of this premium natu- whether a claims submission creditors. rally being dependent on the approach is appropriate is the num- parent’s desire for finality and the ber of claims submissions that are Application to solvent schemes creditors’ own capacity to bear risk expected and the number where dis- The rapid increase in the popularity and their attitude towards any credit agreement in the amounts claimed is of schemes of arrangement for sol- risk. ●

22 run off business special supplement Taxation issues

Rewards can be reaped by considering the tax implications of a scheme

of arrangement sooner rather than later, advises Simon de Young The tax implications here are four rules which any ● A poor trail of correspondence tainty in insurance accounting can be wise insurance business or means tax losses may be forgone. used to the advantage of shareholder Tscheme administrator should ● Losses have been previously dis- tax planning. For this reason the time attend to: maximise tax assets allowed by means of the discounting to set up tax efficient share structures (attributes) before entering into a legislation is before the scheme is implemented. scheme; set up/preserve the most tax Therefore, before entering into a efficient structure for the scheme; scheme a company should assess the Rule 3 – Tax benefits of scheme maximise tax benefits of being in a level of its tax losses (including a due This is where the exception to the scheme; minimise tax costs of exit. diligence of the loss trail) and consid- maxim ‘tax follows the accounts’ can The same rules apply to both sol- er opportunities for enhancing the make a real difference. FA 1994 intro- vent and insolvent schemes, though scheme pool by: duced new legislation (amending s94 the details may diverge. ● Acquiring losses through s107 TA 1988) to assist with business FA 2000 planning (either from a recovery, whereby profits resulting Rule 1 – Maximise the scheme’s company or a portfolio transfer). from releases of debts with creditors tax assets ● Taking advantage of proposed that take place within a scheme of As the purpose of a crystallisation changes to the discounting legisla- arrangement (CA 1985) or voluntary scheme is to release balance sheet tion (which mean that companies arrangement (IA 1986) are exempt liabilities, if the liabilities released subject to solvent schemes may be from tax. This law applies equally to exceed tax losses brought forward, able to disclaim tax losses in the insolvent and solvent schemes and scheme profits may be subject to tax future). can generate considerable tax savings. (but see Rule 3 for the exception). ● Obtaining value for losses which The same conclusion can also are surplus, by group relief or disposal. Rule 4 – Exits apply to insolvent schemes if the bal- ● Seeking to reduce the level of As noted above, for insolvent ance sheet residual liabilities are to tax profits arising in the scheme (see schemes it may be that the MVL be released in order to ensure mem- Rule 3). route is considered the preferable bers voluntary liquidation (MVL) exit strategy. However, to do this you exit and the tax losses brought for- Rule 2 – Tax efficient structure need to be satisfied that the balance ward are not sufficient to cover the The best tax structure very much of unpaid liabilities can be released liabilities released. depends on the specific circumstances without suffering further tax. In The tax losses entering into a of the scheme. However, careful addition, unclaimed dividends may scheme may be less than the net lia- drafting of the scheme documents is be held on trust suffering tax at 34 bilities on the scheme’s books for a required to ensure a scheme does not per cent. These issues will need to be variety of reasons: involve putting the scheme assets in resolved on the scheme’s closure. ● In surrendering its losses as group trust, giving rise to such tax complica- For solvent schemes the tax saving relief to another member of the group, tions as: forfeiture of all brought for- opportunities can be more immediate: a company may already have given up ward tax losses; capital gains liabili- if all has gone well the company could some of its historic tax losses. ties; inheritance tax issues. be sitting on a pool of cash to distrib- ● As the run-off was never expect- For a solvent scheme, the best struc- ute to shareholders. The hybrid nature ed to turn to profit there may have ture will be the one that gives rise to of a scheme may not apply on capital been an agreement with the the least tax on exit. Where a compa- exits. It is therefore important to give Revenue to disallow some historic ny is purchased at a net discount there due attention to tax opportunities at losses to achieve simplification of the may be significant profits/capital gains Rule 2 and a tax efficient structure to company’s tax affairs. on exit. However, the inherent uncer- minimise tax leakage. ●

run off business special supplement 23 Information technology

Paul Duffin assesses the importance of implementing effective IT

systems and processes when running a scheme The impact of IT

s with any process affecting a ● How are you going to circularise information held on the company’s run-off, the more flexible the the information? computer system will be circulated AIT systems are the quicker ● What responses are you expect- for verification by the principal. and less painful the scheme process ing from the recipients? Typically, this will confirm informa- will be. In essence, a scheme is a ● How will you deal with the tion about the type of business that global commutation and the same returns when they come? the policy covered and the extent of basic rules apply to this commuta- the financial exposure on the policy. tion as to any other. If you have good The remainder of this article will One method that can be used to quality information to back-up your focus on two of these areas: the evaluate the future claims is to allo- numbers and flexible IT systems that information that is to be circularised cate a proportion of the actuarially enable you to present the informa- and how that information is to be evaluated IBNR to each policy or tion in a variety of formats, then you circularised. policy/loss based on factors that are are in a stronger position to drive thought to be significant for the type through the process quickly and effi- Information to be circularised of business written. The advantages ciently. Typically, the scheme process is of this approach include: One of the main advantages of a about agreeing a claim figure at a scheme is the flexibility that you fixed point in time, often at policy ● It is equitable to all creditors can build into the process. This flex- level, with each of the principals that whether they are large or small. ibility means that deficiencies in did business with the company. This ● The allocation is based on a data or systems can be catered for claim figure is made up of three dis- methodology that has been agreed as and dealt with in an appropriate tinct elements: fair as part of the scheme and there- manner. However, if both the sys- fore cannot be disputed if this is the tems and data are good then more ● Unsettled claims and premiums line that the scheme administrators options are left open and the ● Outstanding losses want to take. scheme is less restricted in its ● IBNRs ● It handles high volumes of poli- design. cies at relatively low cost, as policies There are a number of key ques- The timing of when this informa- do not need to be dealt with and tions that will need to be answered tion is shared with the principal will analysed individually. and the flexibility inherent in the IT vary from scheme to scheme. The systems will, to some extent, deter- agreement of the unsettled element Once the IBNR has been allocated mine the best route forward in any of the claim should be a matter of to policy level then a very valuable given circumstance: factual discussion between the piece of information has become scheme company and principal. available to the run-off. If the sys- ● Who are you going to circularise? The other two elements are a little tems are flexible enough then it ● What information are you going more subjective. In order to assist the should now be possible to view the to circularise? evaluation of future claims, policy company’s ultimate debtors and

24 run off business special supplement Information technology

creditors. This enables credit control departments to focus on companies that will be the target debtors of the company with some very powerful information to back up any commutation discussions. The split of the balances between inwards and outwards business, the split between paids, outstandings and IBNR, as well as the split of these figures by types of business, all provide potentially invaluable negotiation tools. With ultimate level debtor creditor information available to the run-off it also becomes more practical to begin to model various run-off sce- narios. Which companies should be approached first for commutations? Based on a given collections and ‘A cost benefit exercise should demonstrate commutations strategy, what are the cash flows for the company going to whether it would be cheaper to process the be for the next few years? When is the optimum time to consider a returns via a more automated route ’ scheme as a closure mechanism? How and when will maximum value be extracted from the run-off? If ● How many principals are going changes that are being made to the IBNR estimates change as a result of to be contacted? data are below the level deemed to external influences or a further data ● What is the mix of principals be material then an automated sys- cleansing exercise then what is the between individuals, non-insurance tem could allow them to be impact of this new information on companies and insurance compa- processed with little or no further the run-off strategy? nies? checking, allowing staff to concen- By having the ultimate balances ● What is the expected level of trate on the higher value items. available at principal level sooner response? In many instances there may be a rather than later, the managers of ● What are the skills and experi- large number of staff available to the run-off are better placed to make ence of the team that will deal with process returns. The mindset of informed decisions about the future the returns? How easy will it be to many organisations is that the cost of strategy for the run-off and the increase staff numbers, if required, to using these staff to process returns is appropriate exit strategy, scheme or deal with peak periods? nil, as they are there anyway. While otherwise. potentially in the interests of the If the number of creditors to be cir- staff, this may not be in the best How to circularise the cularised is very small then a paper interests of all of the other stake- information? circularisation may well be the most holders. A cost benefit exercise Historically, paper has been sent out effective means of communication. should demonstrate whether it as the main means of communicat- As the numbers increase, all other would be cheaper to process the ing with principals. With the increas- factors being equal, the advantages returns via a more automated route ing use of the internet as a serious of an electronic solution begin to add and use fewer staff, freeing up peo- business tool in recent years it has up. ple to perform more valuable tasks. now become a more acceptable Once the returned data is available Knowing the full range of circular- means of inter-company communi- in an electronic format then it is eas- isation options available to a particu- cation and some recent schemes ier to analyse the returns via an lar scheme, their relative strengths have taken advantage of this. There automated or partially automated and weaknesses and the typical cost are a number of factors that need to process. For large circularisations the of each of the options, allows the be considered before deciding on the savings here can be great, as the team to be in the best position to most appropriate means of commu- number of staff required to deal with make the right decision for any given nicating in a given scenario: the returns can be significant. If the scheme. ●

run off business special supplement 25 Contact details

If you have any questions in relation to Schemes of Arrangement, please contact one of the following:

Dan Schwarzmann Paul Evans +44 (0) 20 7804 5067 +44 (0) 20 7804 5633

Mark Batten Nigel Rackham +44 (0) 20 7804 5635 +44 (0) 20 7212 6270

at Plumtree Court, London, EC4A 4HT, England. Telephone number: +44 (0) 20 7583 5000 Facsimile number: +44 (0) 20 7822 4652

You can also look up our web site: www.pwc.com/discontinuedinsurance Alternatively, email your questions to us at [email protected]