Resolution risk: Potential pitfalls with the proposed UK regime

Bob Haken examines potential pitfalls with the proposed insurer resolution regime…

Late last year HM Treasury published its response to the consultation on introducing an insurer resolution regime in the UK. While it appears that most respondents were broadly supportive of the proposals, there remain several areas where applying tools designed for the banking industry do not produce equivalent results in the insurance sector.

One of the more marked examples of this is the ability of the resolution authority to transfer the business of a failing insurer to a third party without the involvement of the courts and against the wishes of policyholders. Insurance practitioners will be familiar with the initial concept, as it is based on the portfolio transfer regime contained in Part VII of the Financial Services and Markets Act 2000.

However, Part VII transfers involve important safeguards – supporting evidence is required from an independent expert, policyholders are notified of the proposals and given an opportunity to make representations and, crucially, the decision is taken by the independent judiciary. These safeguards play an important role, not least in ensuring that an approved transfer is recognised in other jurisdictions.

Considering the US as a prime example, it is customary where the transfer includes US business or where the business is protected by US reinsurance to obtain comfort in the form of a comity opinion, which essentially says that there would be no reason for a US court to intervene in a UK process. It is key to the application of comity, however, that there be nothing that would be objectionable under the US constitution. Due process is enshrined in the Fifth and Fourteenth Amendments (ultimately derived from the Magna Carta), which mean that where a person is to have a contractual benefit taken away, that person must be given a right to be heard and the decision must be taken by a neutral party.

Whilst the resolution authority may be regarded as a neutral decision maker, the rationale for not following the court process is that in times of failure it may be necessary to act quickly. It seems unlikely that there will be sufficient time to allow proper notification of all affected parties, affording them an opportunity to voice their opinions. That may lead to the transfer not being recognised in the US, which may in turn result in the transferring business losing extremely valuable reinsurance protection.

Another tool that is to be made available to the resolution authority is bail-in, giving it the ability to write down a failing insurer's liabilities. That includes policyholders and cedants (parties in insurance contracts who pass the financial obligation for certain types of potential loss to the insurer). Under the counterfactual (generally insolvency), it is likely that liabilities will not be met in full in any event, but with the added disruption of losing cover and needing to find replacement insurance. It is argued therefore that a write-down, potentially with compensation in the form of equity in the insurer, could yield a better result for policyholders.

This may be true in some circumstances, but it fails to appreciate the value of insurance which is that it effects a risk transfer. If the protection that a policyholder thinks they have purchased is illusory because it could be written down at any time, there must be questions as to how effective the original risk transfer was. Of course, the insolvency risk is always present, but the point of the insurer resolution regime is that it gives the authorities the ability to intervene earlier and prevent an insolvency. The Financial Services Compensation Scheme will protect retail policyholders, but commercial insureds could find themselves deprived of the very benefit for which they had contracted.

When this extends to liability covers, and indeed professional indemnity insurance, it is the innocent party who will bear the burden. The problem however goes deeper still – when other financial service firms purchase insurance (for example reinsurance, or insurance against the credit risk on counterparties), they are generally only permitted to take credit for the risk mitigating effects of the insurance if there is no provision, outside the control of the firm, which could allow the protection provider to avoid paying claims.

Again, it is arguable that this is analogous to the waterfall on an insolvency, but where the bail-in has to be recognised contractually because the relevant policy is governed by a non-UK law, it is unclear how this will be treated. It would perhaps be perverse to allow mandatory write-down in an insolvency but not permit regulatory write-down when they are both reflective on the same underlying credit risk, but the point is untested.

The government's view is that the resolution authority will be in a position to weigh up these factors (and many more) when deciding what form of resolution action to take. However, regulators are not infallible and can only ever have a rather superficial understanding of a complex organisation. It would seem likely that, if and when any of these interventions are utilised, litigation will follow.