Clifford Chance

The government is currently consulting on a series of "targeted" amendments to existing insolvency arrangements for insurers in the hope of enabling UK authorities to better manage an insurer in distress. Despite the UK insurance sector being 'well-capitalised and resilient to shocks', HM Treasury ("HMT") outlined in the consultation paper published in May 2021 that insurers may still experience unexpected financial difficulties and, in rare cases, become insolvent. The timing of the consultation is significant: although the UK insurance sector withstood the uncertainty of Brexit, the UK retail insurance sector was hit hard by the coronavirus pandemic and suffered significant losses for commercial and personal line risks following the business interruption insurance test case brought earlier this year.

As policyholder protection remains high on the UK regulators' agenda, there is a concern that if an insurer fails, then businesses depending on insurance coverage may be unable to operate, and consumers could be affected - particularly through the loss of long-term insurance arrangements, compulsory insurance policies (such as motor insurance) or the loss of life insurance policies which can provide the main source of income for some policyholders. There is also a concern that insurer failure could disrupt the continuity of critical functions, cause disorder in financial markets and result in spillover to the wider economy. For these reasons, the government wants the UK regulators to have the tools to manage the failure of an insurer in an orderly way and, in doing so, provide protection to policyholders. The consultation paper sets out HMT's proposals to amend the current insolvency arrangements for insurers (excluding Lloyd's underwriters) to remain up-to-date and consistent with best practice, and by extension ensure they fully achieve these objectives.

The Proposals

Enhancement to write-down powers

The proposals include enhancements to the court's existing power under section 377 of the Financial Services and Markets Act 2000 ('FSMA') to order a reduction ('write-down') of the value of an insurer's contracts and clarifying that the write-down may extend to all unsecured creditors. The court has not invoked this power to date, and the drafting of the legislation is ambiguous. It is unclear (among other things): which interested parties may apply for a write-down; which debts may be written down; and the extent of any such write-down.

Accordingly, the government proposes to clarify the scope and use of the existing power, including allowing it to be exercised earlier than the proved insolvency of an insurer. Greater protection would therefore be afforded to policyholders as the write-down, which is intended to offer an alternative to a winding-up order that triggers compulsory liquidation, occurs earlier to increase the resilience and continuity of the insurer. It is also proposed that the write-down will not permanently extinguish the liability of the insurer. Instead, the liabilities would be deferred until "re-activated" by certain events e.g. write-up, and would remain off the balance sheet of the insurer whilst deferred.

Write-down manager

To support insurers throughout the write-down process and protect the interests of policyholders, the consultation proposes the creation of a new position of a 'write-down manager' - an officer of the court who would oversee and support the implementation of the order, lead the design of the write-down proposal put to the court, and review the proposal against the test the court would apply (i.e. whether the write-down is reasonably likely to lead to a better outcome for the insurer's creditors as a whole). Court applications for write-downs will require consent from the PRA.

Moratorium

A new moratorium would also apply to certain termination rights in both service contracts and financial contracts held with insurers, once insolvency or write-down takes effect. The reforms seek to clarify that the write-downs of liabilities would not affect recoveries under outgoing reinsurance payments.

Stay on life insurance surrender rights

For Iife policies only, HMT proposes the introduction of a stay (suspension) on policyholder surrender rights upon application to the court for and during an administration, write-down or winding up. Surrender rights allow life insurance policyholders to terminate their contract in return for some proportion of its cash. The proposals manage the risk of instability arising from a significant number of policyholders exercising this right whilst an insurer is experiencing financial difficulties. By subjecting the stay to prescribed termination triggers, the proposal ensures policyholders are not affected longer than necessary.

FSCS protection

The consultation paper proposes amending existing legislation to ensure that, in the event of a write-down, the value of those policyholder claims which are protected by the Financial Services Compensation Scheme (FSCS) would be the higher original value (subject to normal compensation limits) as opposed to the lower post write down-value. It also intends to amend legislation to ensure that the PRA has the powers to, at its discretion, amend the relevant PRA rules regarding compensation through the FSCS.

Conclusion

The proposals are a positive step as they should allow financially troubled insurers more flexibility and clarity on the process of writing down debts to avoid insolvency. The proposals should also promote continuity of cover by allowing earlier intervention by the regulatory authorities. The increased accessibility of write-down and reduced value reduction in the subsequent insolvency of a distressed insurer also has the potential to reduce costs to the industry by unlocking additional loss absorbency. The enhanced tools available to manage insurer distress in an orderly way should also continue to maintain public confidence in the UK insurance sector.

In the consultation, HMT also confirms that it is actively engaging with the Bank of England to develop a proposal for the introduction of a specific resolution regime for insurers aligned with internationally agreed standards and best practice, and intends to set out further detail in due course. Although insolvency proposals are not intended to pre-empt the consideration of a 'recovery and resolution' regime, it is significant that HMT has publicly flagged that insurers should expect such a regime soon.

The consultation closes Friday 13 August 2021.