Legal Briefing

What can you do if your insurer goes bust?

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Insurance | 01 February 2010

History shows that, at least since the 1950s, the likelihood that any authorised insurance company will not be able to pay its claims in full is reassuringly small. The level and composition of assets required by insurers, and their liquidity in particular, is carefully regulated by the Financial Services Authority (FSA), as is the standard of their management.

The FSA rigidly enforces its regulations because a problem with an insurer can result in disproportionate loss to its policyholders. Past examplesSuch stringent regulation is the result of some high-profile collapses. The failure of Emil Savundra’s Fire, Auto & Marine Insurance Company to pay debts owed to 400,000 motorists in 1966 led to a significant tightening of UK insurance legislation and responsibility for insurance supervision shifting to the Board of Trade under the Companies Act 1967.

The insolvencies of Vehicle and General Insurance Company, London United Investments plc and others have also contributed to current regulatory standards.1The most prominent insolvency of recent times was that of the Independent Insurance Company Ltd (IIC), whose founder and chief executive, Michael Bright (previously awarded Entrepreneur of the Year and Insurance Man of the Year), was sentenced to seven years in jail in 2007 for his role in the company’s downfall. The collapse of IIC cost £357m in compensation.

Three months before it imploded, IIC was the ninth-biggest insurer in Britain, with a market value of almost £1bn. RegulationThe current recession is also a threat to insurers’ financial stability, as defaults on corporate bonds, downgrading by rating agencies, falling asset values in real estate and the number of fraudulent claims increase during harsh economic times.2 Following its establishment in 2001 as the sole financial regulator (in place of eight independent regulators), the FSA responded by implementing a fundamental change in the way that insurers are regulated.

These measures include a more proactive and challenging relationship between insurers and the FSA, and a risk-based approach that places explicit responsibility on senior management to ensure that firms’ systems and controls are adequate. The FSA uses a range of tools, including focused on-site work, and reports by external auditors, actuaries and other professionals, to test the controls put in place by management.

EVEN TIGHTER CONTROLS?

New controls are constantly being developed. Solvency II, the title given to the benchmark for the next statutory financial regime and the subject of much debate between insurers, trade organisations and regulatory bodies, is designed to harmonise regulatory standards across Europe and reduce the scope for regulatory arbitrage between EU countries by October 2012. Its prudential regime is divided into the three ‘pillars’ of minimum capital requirements, supervisory review, and public transparency and market discipline through public reporting standards, disclosure, and other tools. Financial controls put in place by the FSA have considerably reduced the possibility of insurer failure but the current economic climate has resulted in many apparently reliable and well-managed insurers being downgraded by rating agencies, a problem that may worsen before it improves. What can you do if your insurer has financial problems?If you hear of such problems before they become official, you would have to decide whether to trust what may be no more than rumours. A conversation with your broker might yield useful information, although it is worth remembering where their interests compete with your own. Agreement that the insurer might not be solvent could indicate that the insurance should never have been placed with it and brokers will be eager to avoid any losses resulting from such an admission.If you decide that the rumours are true, or that the risk of the insurer collapsing is too high, you could activate any cancellation clause in the policy, ensuring that any debt owed to you by the insurer pre-dates its liquidation. Although gaining an advantage over other creditors through judgment and execution would probably be an unrealistic expectation, given the likely time frame, one advantage that you would gain through such action is a head start over policyholders that had waited until insolvency proceedings had begun. The latter may have to pay higher premiums as a result of increased demand and an urgent need for replacement policies at any cost, owing to statutory or contractual requirements, such as security for loans. As a general matter, you could also consider including a clause in all your insurance contracts that enables you to cancel the policy if the security rating of your insurer falls below an agreed standard, with a pro rata return of premium. Having arranged alternative ongoing insurance and put your mind at rest in respect of future claims, you should then consider the recovery of claims that have been filed with your insurer but not paid and the premium for the unexpired portion of the policy period. If there has been no official insolvency attachment, there is nothing that you can do in respect of claims. Usually the insurer will insist on dealing directly with a claimant against any policyholder, with a view to minimising its liability. Equally, in the absence of an express clause dealing with your cancellation, you would generally not be entitled to recover any premium because the premium is payable in full the moment that the insurer is at risk. It is at this point that the insurer could be liable for any claim up to the policy limit. The only way around this common law position is to show that the insurance is divisible into more than one constituent part. Frequently, the insurer will have agreed to a cancellation clause under which the premium will be returned pro rata, subject to front-end loading for administration if cancelled within a specified time after its inception. Either way, the claim is unsecured. Insureds with premium financing arrangements will be liable for continued payments, as contractually agreed with any applicable third parties, in the absence of any contractual release mechanism.Where an official insolvency attachment emerges, you will be subject to the Micawber Principle: £1 of assets and 19/6d of claims – result happiness; 19/6d of assets and £1 of claims – result misery.3 Where insolvency proceedings have begun, it is unlikely that the happy version of the formula will exist. The best that you can hope for will be a prompt reconciliation of assets and liabilities, and some dividend thereafter. The two most common forms of reconciliation are the schemes of arrangement and administration.4

SCHEMES OF ARRANGEMENT AND ADMINISTRATIONVARIETY OF PROCEDURES

Schemes of arrangement were for a long time used as a compromise between an insurer and its insureds because they avoided the rigidity of winding-up rules for insurers and the delays in declaring dividends.5 Directors would usually petition the court for a winding-up order, obtain an adjournment of proceedings and appoint a provisional liquidator (an independent, licensed insolvency practitioner). Such an approach prevents the automatic termination of any policies underwritten, and ensures that there is no breach of statutory obligations to maintain insurance under the Road Traffic Act 1998 and the Employers’ Liability (Compulsory Insurance) Act 1969.Insurers are protected from attack by creditors seeking to gain an advantage over other creditors pending the hearing of a winding-up petition. This status could continue for years, with constant adjournment of the final petition. Claims arising from long-term issues, such as asbestosis and related reinsurance disputes, might not be resolved for decades and the resulting legal paralysis required a mechanism to enable an orderly run-off with the maximum possible distribution to creditors in the shortest practicable time. These factors resulted in the administration procedure becoming available for insolvent insurers from 2002.6AdministrationAn administrator is an officer of the court whose primary goal is to rescue the company as a going concern. If they cannot, their secondary goal is to achieve a better result for creditors than would be possible if the company were wound up, by continuing to trade and selling the business as a going concern. Frequently, however, an administrator will move with little delay to their third goal, that of realising assets for the purposes of a distribution. Alternatively, the administration is used as a precursor to a scheme of arrangement. The duration of the appointment is 30 months, in comparison to 12 months for non-insurance companies, and can be extended by an agreement of the creditors or an order of the court. Administrators must carry out their functions as quickly and efficiently as reasonably possible. Creditors have a right to complain to the court if they do not consider that administrators are satisfying this obligation.Although recent case law might have made it more difficult to utilise schemes of arrangement, owing to logistical complications and the right of creditors to argue prejudice even if they are in the minority, they remain the primary tool in insurer insolvencies.7However, if the insurer’s funds are inadequate to discharge its liabilities, alternative remedies might be available.

REMEDIES

Government protection

The Financial Services Compensation Scheme (FSCS) provides consumers and small businesses with some statutory protection. Although the FSCS’s main objective is to maintain continuity, which it does by trying to find another provider to take over the policy in the event of an insolvency, it is also a fund of last resort designed to compensate customers of FSA-authorised financial services firms, including insurers and insurance intermediaries, that are unable to pay claims or return premium.The limits of the compensation depend on whether the policy is compulsory or not. Compensation for compulsory insurance, such as third-party motor and employer’s liability insurance, is 100%. The limit for non-compulsory insurance is 100% of the first £2,000 and 90% of the remainder. Businesses with a turnover of £1m or more are not usually eligible for compensation under the FSCS, except in relation to claims against them that should be covered by compulsory insurance or where the business had an annual turnover of less than £1m on the date that the general insurance contract was entered into. Larger businesses are unable to claim compensation from the FSCS unless one of these exceptions applies, and will have to take their chances in the scheme of arrangement for any return of premiums and/or claims under the policy.

Cut-through clauses

A cut-through clause is usually included where an insurer wishes to satisfy clients that sufficient security exists to prevent any losses in the event of an insolvency or is acting as a front for a reinsurer, or where an insured is anxious about the continuing ability of its insurer to meet claims. A cut-through clause might take the form of a priority payment arrangement in circumstances in which it is intended that the insured have the benefit of any reinsurance receivables due to the reinsurer, in priority over other creditors. It might also take the form of a direct payment arrangement under which the insured is entitled to hold the reinsurer secondarily responsible for meeting its claims. Unfortunately, in situations in which the insurer becomes insolvent, such expectations are false.Although a cut-through clause would clearly satisfy both limbs of the test under the Contracts (Rights of Third Parties) Act 2001, it is a cardinal principle of English insurance law that all creditors of an insolvent company should receive equal treatment of the limited funds available to the liquidator of that company on a pro rata basis. This is subject to the Insurers (Reorganisation and Winding-Up) Regulations (IR) 2004, under which an order for the priority of payment of debts of a UK-authorised insurer is that ‘preferential creditors’ (essentially employee salary and pension claims) are given priority over insurance debts and all other debts.8Cut-through clauses are intended to ensure that an otherwise unsecured insured is paid in priority to other creditors. However, it is not acceptable for an insolvent debtor (the reinsured) to contract out of this principle to the benefit of one of its creditors. Although the position is not entirely clear, and a cut-through clause might be distinguishable from a distribution of the insolvent estate on the basis that the insured will be paid directly by the reinsurer and the insurer no longer requires payment to be made to it, it may also conflict with the aims of IR 2004. On balance, it would be unwise to rely on the payment of any claim by a reinsurer.

Brokers’ obligations

There is very little English case law defining the extent of brokers’ duties in relation to their selection of insurance security. From what little there is can be distilled the principle that the broker is under a duty to select an insurer that it reasonably believes to be solvent, which effectively means that it must be capable of meeting claims as they fall due and is likely to remain in such a position. English courts have not yet provided any guidance on the extent of the investigations that brokers must carry out to satisfy this test, although HIH Casualty & General insurace Company Ltd v JLT Risk Solutions Ltd [2007] did confirm that the broker could be subject to ongoing obligations in certain circumstances.The leading English authority on brokers and their obligations in relation to security is Osman v J Ralph Moss Ltd [1970], in which insurance brokers placed a contract of motor insurance with an insurer whose ‘shaky financial foundation… was well known in insurance circles at that time’. The Court of Appeal held that the brokers were guilty of negligence in recommending that Mr Osman purchase insurance from a company known to be in financial difficulties and in failing to advise him in clear terms as to its position. When he was fined £25 for driving without an insurance policy, the Court of Appeal held that Osman was entitled to recover the premium he had paid, the £25 fine that had been imposed and various other costs, on the basis that these were reasonably foreseeable consequences of the broker’s breach of duty to inform Osman that he was uninsured. This obligation can be qualified by the fact that the brokers in Osman were aware that the insurer was financially unsound when the insurance was placed.In Australian Lewis v Tressider Andrews Associates [1987] considered various English authorities and concluded that brokers are obliged to inform the insured of any information that it receives, indicating that the insurer might not remain financially sound, even if the broker is personally satisfied that no real problem exists. Brokers are accepted as owing professional obligations and, even where an insured has asked a broker to place the insurance with a particular insurer, they will generally be unable to avoid liability for any later insolvencies by stating that they acted only as an intermediary in carrying out the insured’s request.In General Accident Fire and Life Assurance Corporation v Tanter, The Zephyr [1985] the court stated that:

‘The broker’s skill and expertise extends beyond merely giving his client advice and complying with his client’s instructions. He must make use of his knowledge of the market and use appropriate skills.’

This may come as a shock to some brokers but a client’s knowledge of the market may be based on invalid or obsolete information, and the broker should be better placed to evaluate the market in any event, particularly as that is one of the most important aspects of their job. A further reason for brokers’ liability in this area is that they might have access to market knowledge that is unavailable to the client, such as information on an insurer’s unwillingness to pay claims. On renewal of insurance, brokers must reassess the quality of each insurer, particularly those that have been chosen by the insured. However, the broker will not be liable to the insured where they can show that the information available to them, exercising reasonable diligence, indicated that the insurer was neither insolvent, close to insolvency, nor likely to be incapable of meeting future claims.

The long and the short of an insurer’s insolvency is that you will generally recover little more than unearned premium and claims in respect of compulsory insurances. Any sum that you may receive for other insurances may offset the cost of replacement insurance but would be very unlikely to cover the expense of any substantial property or public liability claim.

NOTES

  1. London United Investments plc was an insurance holding company with a network of over 40 companies in a variety of jurisdictions.
  2. The Financial Services Compensation Scheme is currently dealing with 26 insolvent general insurers, some of which became insolvent in the early 1990s.
  3. The Micawber Principle is derived from Wilkins Micawber, a character in Charles Dickens’ David Copperfield, whose other maxim was that ‘something will turn up’.
  4. Not to be confused with administrative receivership, in which the protagonist is appointed by and solely looks after one party’s interests through the realisation of the assets of the company in reduction of the secured debt of their appointor, rather than objectively, and who has no authority to deal with the claims of unsecured creditors. The Enterprise Act 2003 was a positive step by the government to phase out the use of administrative receivers.
  5. See s895 of the Companies Act (CA) 2006, which replaced s425 of the CA 1985. Section 899 of the CA 2006 provides that the court may sanction a scheme if it has been agreed by at least 75% in value of a company’s creditors or class of creditors.
  6. Now governed by Part 26 of CA 2006.
  7. See, for example, solvent schemes of arrangement such as Scottish Lion Insurance Company Ltd (2009) CSOH 127 and the British Aviation Insurance Co Ltd (2006) BCC 14.
  8. SI 2004 No 353, implementing the Insurance Undertakings Directive. In essence, insurance claims now have priority over other unsecured creditors.