Bankruptcy is one option for insolvent companies to manage their obligations to creditors and to provide an efficient mechanism to marshall assets for their benefit; an insolvent insurance company similarly may enter a bankruptcy-like process and pay the claims of its creditors – its policyholders – and marshall its assets (typically reinsurance). Over the past few years, however, we have seen increasing numbers of solvent insurance companies seek to ring fence their liabilities – and lock in profits or at least circumscribe losses – by entering into bankruptcy-like processes by which they forcibly commute their obligations to their policyholders. In 2002, Rhode Island established legislation permitting this type of solvent runoff, but most of the action in this area has been in England for London-market insurers that wrote substantial North American (especially US) risks under broad occurrence policy forms and that now wish to extinguish the long-tail liabilities that naturally follow. Because of a new English decision, however, the ability of London market insurance companies to forcibly terminate their obligations to their policyholders is now in substantial doubt.
London market insurance companies enter what are called “schemes of arrangement” – akin to US Chapter 11 proceedings – in which they seek to reorganize their debts (that is, obligations to policyholders). The advantages for the insurance company from such a scheme are obvious: they achieve finality and potentially release capital back to the company or its parent. The process involves formal application with courts and the division of creditors into classes who have meetings and vote on the proposed scheme. Usually, an application will be made in US bankruptcy court for a section 304 injunction (11 USC § 304), which enjoins US litigation against the company, notwithstanding service-of-suit clauses, and funnels all claims to the English reorganization proceeding. Creditors such as policyholders submit claims by a set bar date, which is the basis for a liquidation of their coverage rights.
Claims of policyholders fall into three basic categories: mature, unpaid claims where the amount of loss is known; mature claims where the policyholder’s liability has yet to be established; and incurred-but-not-reported (“IBNR”) claims which involve injury occurring in the period of the carrier’s coverage but which have yet to be asserted against the policyholder. This all echoes Donald Rumsfield’s famous quatrain:
As we know,
There are known knowns.
There are things we know we know.
We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.
But there are also unknown unknowns,
The ones we don’t know
We don’t know.
(Feb. 12, 2002, Department of Defense news briefing) The Secretary’s trenchant categorization applies with equal force to characterizing the nature of claims against policyholders covered by occurrence coverage and that are unasserted and unliquidated. Guarding against the risk of future of liability of course is the purpose of the policyholder’s purchase of insurance, and one crucial advantage of occurrence-based coverage is that it applies no matter when the claim is eventually asserted against the policyholder, so long as injury or damage occurred in the period of the carrier’s coverage.
Solvent schemes of arrangement seek to cut off the “inconvenience” of the long tail of claims under occurrence policies by forcing the policyholder into a compulsory commutation (buy-back) of its coverage. Therein lies their vice (from the perspective of policyholders), and the High Court of Justice recently invalidated a solvent scheme of arrangement. The case, In the Matter of the British Aviation Insurance Company Ltd., 2005 EWHC 1621 (Ch.), invalidates the scheme on various technical grounds, such how the voting classes were constituted (see paragraphs 83, 92, 93), and thus the court found itself without jurisdiction to uphold the scheme. More significant, however, is its ruling refusing to sanction solvent schemes of arrangement more broadly on the ground that they unfairly force policyholders to liquidate unknown asbestos and other health hazard claims that may or may not come to fruition. (One remains free always to commute policies voluntarily with an insurer for the known-unknowns and the unknown-unknowns; in a solvent scheme, policyholders are forced to liquidate coverage for their IBNR claims.)
In refusing to uphold the scheme essentially on the grounds of fundamental unfairness, Mr. Justice Lewison distinguished the situation of ordinary policyholders from that of insurance companies that may have inwards and outwards reinsurance with British Aviation Insurance Company (BAIC).
“Unlike the direct insureds, the insurers are in the risk business. Given the uncertainties of the extent of potential exposure to asbestos and other long-tail claims, it makes perfect sense for them to be keen to cap their liabilities. If the Company’s liabilities are capped, so are their liabilities as reinsurers. Their mutual liabilities are set off under the scheme. This does not apply to the direct insureds, who remain liable to those who contract asbestos-related diseases.”
(Paragraph 121) The direct insureds, the policyholders, thus face the prospect (were the scheme approved) of facing greater liabilities than were the basis for the claims estimation, yielding a gap in coverage to which they otherwise would have been entitled had the insurer simply continued in its solvent runoff. As the court explains, “So far as policyholders with IBNR claims are concerned, their right in a solvent run-off is to wait and see whether a claim materializes, and if it does, to have full indemnity against the claim. They have already paid their premiums for the insurance cover, so they are at risk of no further expenditure in relation to a valid claim.” (Paragraph 90). There is no risk of the insureds receiving less than that to which they are entitled if the insurance company simply pays claims as they come due.
In contrast, in the proposed solvent scheme of arrangement, in which the policyholders’ rights are cut off and liquidated, the very risk transfer the policyholder sought to achieve may be turned back to the policyholder involuntarily. As Mr. Justice Lewison explains:
“[It is] unfair to require the manufacturers who have bought insurance policies designed to cast the risk of exposure to asbestos claims on insurers to have that risk compulsorily retransferred to them. The Company is in the risk business; and they are not. This is not a case of an insolvent company to which quite different considerations apply. . . .[T]he Company is able to meet its liabilities under such policies as and when they fall due. The purpose of the scheme is to allow surplus funds to be returned to shareholders in preference to satisfying the legitimate claims of creditors. No matter how useable and reasonable [a claims] estimate may be, the very fact that it is an estimate is likely to make it an inaccurate forecast of the actual liabilities of policyholders. If individual policyholders wish to compound the Company’s contingent liabilities to them, and to accept payment in full of an estimate of their claims, there is nothing to stop them doing so. But to compel dissentients to do so would . . . require them to do that which it is unreasonable to require them to do.”
(Paragraph 143) Although the discussion of the fundamental unfairness of solvent schemes technically may be an alternative holding of the court, the breadth and power of the court’s analysis surely casts a pall on their continued popularity. On a going-forward basis, policyholders receiving notice of a solvent scheme of arrangement should arrange to vote in the creditors’ meeting and object on grounds of fundamental unfairness (and consider whether it is appropriate to object to the constitution of the creditor classes). For those solvent schemes that have been approved by a majority, the court retains continuing jurisdiction, and previous objectors presumably may be able to renew their objections. (For a recommended treatise about the English insurance insolvency process, see here.)
A solvent scheme is a mechanism that is too clever by half. Mr. Justice Lewison’s decision has become final, and no appeal was taken. Time will tell whether we’ll continue to see this particular form of scheming by solvent companies to cauterize their liabilities under the very broad coverage they sold to US policyholders.
A version of this article was published in 22 Tolley’s Insolvency Law & Practice 23(London 2006).