Insuring change

The way in which UK insurance company insolvency will be handled is set to change with the introduction of a statutory instrument made pursuant to the Financial Services and Markets Act 2000 (FSMA), allowing an insurance company to be placed into administration under the Insolvency Act 1986. The instrument also seeks to limit creditors' rights of set-off if the company then goes into liquidation after administration.
Administration for insurance companies is part of a major overhaul of UK insolvency law, which includes the Government's forthcoming Enterprise Bill. The proposed legislation aims to modernise the insolvency regime, part of which will include the streamlining of the administration procedure.
The FSMA also introduced a new compensation scheme for policyholders of failed insurance companies, which is administered by the Financial Services Compensation Scheme (FSCS) in place of the Policyholders Protection Board (PPB). Unlike the PPB, the FSCS has the power to provide financial assistance to policyholders.
The new legislation will apply to all UK insurance companies, whether operating in the life, general or Lloyd's market. However, the rules of Lloyd's, under which all insurance assets are held in trust for policyholders, may in practice restrict the use of the administration procedure for Lloyd's corporate members.
Since 1989, 30 UK insurance companies have become insolvent and gone into provisional liquidation. The most recent failures occurred last year to the general (non-life) insurers, Independent Insurance and Chester Street Insurance Holdings.
The problems experienced by Equitable Life, which is now subject to a scheme of arrangement under section 425 of the Companies Act 1985, show that the life insurance sector is not immune from the financial difficulties facing the rest of the market. In recent months a number of Lloyd's corporate members have also ceased underwriting and gone into provisional liquidation.
The size of the losses arising out of the attack on the World Trade Center along with the problems faced by non-life insurers in respect of historic asbestos pollution and health claims, leads the market to predict that further insurance insolvencies are likely to occur.
Provisional liquidation
The making of an administration order in respect of an insurance company was excluded from the ambit of the Insolvency Act 1986 on the grounds that specific winding up rules for insurance companies provided a mechanism for the liquidation of the company and treatment of creditors claims. However, the liquidation procedure for insurance companies is inflexible and disadvantageous to creditors. For example, claims in foreign currencies have to be converted into sterling at the date of liquidation. A liquidator will often leave contingent claims to mature before any assets are distributed to policyholders. This might ensure fair treatment for all creditors, but means that no payment is made to any creditor for years.
Resolution of disputes can be lengthy and may require court intervention. The assets under the control of the liquidator must be deposited with the Insolvency Services Account, which permits only a limited range of investment options and charges ad valorem fees on monies deposited. The winding up regime for insolvent insurance companies has not, therefore, been widely used, apart from one to two life company insolvencies.
Instead, provisional liquidation has been used to facilitate the development of a scheme of arrangement which avoids ISA fees, deals with creditors claims, provides a quick method of dispute resolution and allows payment of a dividend to creditors far quicker than a liquidation would. The disadvantages of liquidation are thus avoided. Provisional liquidation involves the presentation of a winding up petition and the court's appointment of licensed insolvency practitioners with wide powers to take over the running of the company under which the assets of the company are protected by a stay on creditor action against it for the duration of the court order, subject to leave of the court.
So provisional liquidation has become a widely used procedure. It is ordinarily intended to be a temporary regime to protect the assets of the company pending the court hearing winding up petition, but in practice, the complexity of the affairs of an insolvent insurance company often means that provisional liquidation is anything but short term. The procedure has thus been described as 'a distortion' of the liquidation process and requires the continued adjournment of the winding up petition at regular intervals while a scheme is developed. The regime has become akin to the administration procedure, but lacks a number of its advantages.
In its current form under the Insolvency Act 1986, administration allows the court to appoint an administrator to a company where the company is insolvent or likely to become insolvent. It is also applicable where the making of the order would be likely to achieve one or more of the purposes set out in Section 8(3) of the 1986 act; namely, the survival of the company and the whole or part of its undertaking as a going concern; the approval of a company voluntary arrangement; the sanctioning of a scheme of arrangement; or a more advantageous realisation of the company's assets than would be effected on a winding up. It is likely that under the Enterprise Bill these four purposes will be reduced to two, maximising the chances of saving the company, or securing a better return for creditors than would be achieved in an immediate liquidation.
Following the appointment of a provisional liquidator, an application for an administration order creates a statutory moratorium preventing creditors from enforcing their claims against the company. If an order is made during the period for which the order is in force, the statutory moratorium continues and the affairs, business and property of the company are managed by the administrator. Assuming administration is introduced for insurance companies, the scheme of arrangement is likely to remain the procedure by which the assets of the company are distributed to creditors unless the survival of the company can be achieved.
The benefits of administration
Administration should offer a number of benefits over provisional liquidation for creditors and the company.
First, the court can appoint an administrator where the company is likely to become insolvent, unlike provisional liquidation which requires an actual insolvency before a winding up petition can be issued and provisional liquidators appointed. Coupled with the powers of the FSCS under the new compensation rules to provide financial assistance where a company goes into administration short of actual insolvency, the prospects of avoiding a terminal insolvency with the attendant stigma, negative publicity, and distress for policyholders, and thus implementing a rescue of a troubled insurer, might be enhanced.
Second, an administrator has the power to investigate and apply to the court to set aside antecedent transactions involving the company, although the administrator has no power to bring a wrongful trading claim under section 214 IA 86 – a power which would be a useful additional remedy. A provisional liquidator has no power to pursue a claim for a transaction at an undervalue or a preference (or wrongful trading), and in order to do so would first need to put the company into liquidation, thereby giving rise to a number of disadvantages. Delay has occurred in previous insolvencies, where provisional liquidators have felt unable to propose a scheme of arrangement without having first satisfied themselves on whether the company should be put into liquidation.
Third, the Employment Rights Act 1996 provides that when an insolvency includes the making of an administration order, certain payments in respect of holiday pay and payment in lieu of notice may be made to employees out of the National Insurance Fund upon application of the Secretary of State. The appointment of provisional liquidators does not constitute an insolvency for this purpose, and so no payment can be made to the employees from the fund. However, in the recent case of Independent Insurance, the High Court sanctioned payment of these claims in full, on the grounds that under any future scheme of arrangement, claims of this type would have to be paid in order to reduce any risk that the scheme would not be approved or sanctioned.
Fourth, the costs of applications to the court in dealing with matters such as the continued adjournment of the winding up petition, upon which the provisional liquidation is based and other matters such as the fixing of the provisional liquidators' fees, should be much reduced.
Changes to rights of set-off
The draft statutory instrument also proposes to modify the rules of set-off contained in Rule 4.90 of the Insolvency Rules 1986. It will exclude any sums due from the insolvent insurer to another party from the ambit of set-off – which applies automatically on liquidation – if at the time those sums became due, a petition for the appointment of administrators had been presented. This is designed to maximise the assets available for all creditors by preventing a creditor, such as a reinsurer of the company, from attempting to reduce the amount it might have to pay to the insurer by acquiring the claims of third parties against the insurer after an application has been made for the appointment of an administrator which it can use to maximise its rights of set-off if the insurer subsequently goes into liquidation.
There appears to be no good reason why this proposal should be restricted solely to the administration of insurance companies.

Although provisional liquidation followed by a scheme of arrangement is now a well established and successful insolvency procedure, the introduction of the administration regime to insurance companies should result in a number of benefits for creditors and help insolvency practitioners and lawyers maintain and build upon the innovative developments of the past 10 years.
Laurence Elliott is a solicitor in Herbert Smith's corporate recovery group