WHILE THE INSURANCE SECTOR IS NOT AS EXPOSED to the liquidity difficulties faced by many banks, following the unprecedented recent events in the financial markets, insurers may be as susceptible to the current pressures as any other financial institution. With news that the Financial Services Authority (FSA) has assembled a team of external lawyers to assist the regulator should there be a financial crisis in the insurance sector, as well as the loosening of the FSA’s individual capital adequacy requirements for insurers, companies may wish to check the financial stability of their insurers.
Despite repeated assurances from the insurance market that it will not require a financial bailout from the Treasury, insurers facing financial difficulties cannot be entirely ruled out. The insurance sector will have to address the multiple challenges of falls in equity prices, defaults in corporate bonds, downgrading by rating agencies (which has already occurred, in particular for US insurers), an increase in claims (especially fraudulent claims), and a downturn in income as businesses and customers seek to reduce their overheads.
This article comments on the unlikely but, in this climate, foreseeable eventuality of a UK insurer going into liquidation, and on what protection exists for businesses.
FINANCIAL SERVICES COMPENSATION SCHEME
Under the Financial Services Compensation Scheme (FSCS), consumers and small businesses have some statutory protection. The FSCS is a compensation fund of last resort designed to compensate customers of FSA-authorised financial services firms (to include insurers and insurance intermediaries/ brokers) who are unable, or are likely to be unable, to pay claims. The FSCS describes this as being ‘in default’. The FSCS is currently dealing with over 25 insurance in default.
The FSCS seeks to fund claims in respect of the return of premiums and/or to arrange the transfer of business to other insurers so cover can continue. If this is not possible, the FSCS may pay compensation in respect of any protected claim that is due under the policy but has not been paid by the insolvent insurer. In 2007/08 the FSCS made compensation payments for general insurance providers of £45.8m.
On discovering that your insurer has gone into administration, first enquires should be directed to the appointed insolvency practitioner or appointed run-off agent. Even if the insurer is no longer trading, there may be sufficient assets to meet relevant claims. In this case, the FSCS will be unable to declare the insurer in default.
To determine whether an insurer is in default the FSCS will calculate the total value of known liabilities, including any outstanding claims against the available assets, and assess these against the insurer’s available assets. Such a default investigation could take several months. The FSCS will notify the insurer of its intention to declare it in default, and the insurer can then object or comment on the proposed default action. These objections could include oral representations at a meeting or hearing before the FSCS chief executive and at least one FSCS non-executive director. Following any oral representations, the FSCS will confirm its default decision. An insurer could further challenge this decision by way of judicial review.
LIMITATION TO THE FSCS
The FSCS will only declare an insurer in default if it has received at least one eligible claim and the claimant has suffered a financial loss. Private consumers and small businesses are eligible claimants. A small business is defined as a partnership, body corporate, unincorporated association or mutual association with an annual turnover of less than £1m. In respect of a relevant general insurance contract, small businesses are eligible claimants if the contract was entered into after 1 December 2001 (the commencement date). If the contract was entered before the commencement date a small business is only an eligible claimant if it is a partnership. The same levels of compensation apply whether the claimant is a private individual or a small business. For most insurance contracts – save compulsory insurance contracts, which are protected 100% – the compensation limit is 100% for the first £2,000, plus 90% of the remainder of the claim.
INSOLVENT INSURANCE BROKER
Claims to the FSCS cannot only be made in relation to insurers in default. The FSCS can also consider claims against insolvent insurance brokers or intermediaries for policies arranged on or after 14 January 2005 (the date when insurance brokers became regulated by the FSA). In 2007/08, the FSCS received 110 new claims, an increase of over 210% from the year before, when it received 35 claims.
The FSCS gives examples of the types of claims, that may be made against insurance brokers in default:
- Fraudulent activity, to include inflated premiums, or where no cover is actually provided by an insurer despite the assurances of the broker.
- The broker uses the services of a secondary intermediary who in turn becomes insolvent before the premium is paid to the insurer.
- Insufficient cover is placed and/or the broker fails to inform the customer about an exclusion clause.
- The broker fails to secure cover with an insurer before it is declared in default by the FSCS. Here the customer would be entitled to the return of premium or payment of a relevant claim. Of course, under Principle 10 of the FSA's principles for businesses and the FSA's client assets rules (in particular, chapter 5 of the client asset sourcebook, ‘Client money: insurance mediation activity’), the insurance intermediary is required to arrange adequate protection for the clients' assets, to include premium payments.
COMPENSATION FOR LARGER CORPORATES
Businesses with a turnover of £1m or more are generally not eligible to claim compensation under the FSCS. However, there are some important exceptions to this, for example for claims in respect of certain compulsory insurances (eg third-party motor and employer’s liability insurance) or if at the date the general insurance contract was entered into the business had an annual turnover of less than £1m.
Larger businesses will be unable to claim compensation from the FSCS unless one of these exceptions applies. Faced with an insolvent insurer, the corporate policyholder will have to make a claim to the insolvency practitioner for the return of premiums and/or claims under the policy.
The insurance industry is in the business of risk, in respect of the assessment of and preparation for unexpected events, both natural and financial. If any sector can weather the financial storm it should be the insurance sector. However, with limited compensation available for large businesses in the event of an insurer going into liquidation, such corporate policyholders may wish to consider the following before taking out new insurance or renewing existing insurance policies:
- Consult with your insurance broker on how they assess the financial suitability of insurers and their market knowledge.
- Check the insurer’s credit rating, perhaps with multiple sources. This will be particularly relevant for businesses contractually required to purchase insurance for a particular project with an insurer that has a certain credit rating.
- Assess the insurer’s stress testing arrangements and the level of security. For example, policies written by a Lloyd’s syndicate are backed by the Lloyd’s chain of security, to include the Central Fund.
- Review the policy wording for cancellation terms in the event of the insurer’s insolvency or reduction in credit rating. Before cancelling a policy, the policyholder should take advice from their broker to ensure a seamless transfer of cover to another provider, and to clarify the position on cover for claims under the previous policy.
By Richard Burger, solicitor, and Charlotte Lilley, trainee solicitor, Reynolds Porter Chamberlain LLP.
For further information, please visit www.rpc.co.uk