Bringing finality to underwriting pools

The advent of solvent schemes of arrangement as a recognised technique for dealing with risk carriers' discontinued books of business has led to real progress in recent years on dealing with the legacy problems of insurers and reinsurers.

Prior to the development of solvent schemes as a mechanism for delivering finality, complete finality solutions had proved elusive. Reinsurance or the outright sale of a problem portfolio simply recycled the issue within the market and often carried unpalatable requirements for a hefty injection of capital.

Similarly, accelerated commutation strategies were frequently met with indifference on the part of policyholders, or with demands for high 'contingency' payments to protect policyholders against future deterioration, while reinsurers were often be reluctant to pay any contingent element of commutation payments.

As such, the attractions of solvent schemes as the only mechanism that currently allows the exposure to be extinguished once and for all, and at an acceptable cost, are becoming ever more widely acknowledged, with 42 schemes now having been approved in the UK.

However, even though many London market insurers and reinsurers also wrote considerable amounts of business via underwriting pools, until recently, rather less progress had been made on closing down defunct pool business.

This is despite the fact that pools have suffered the same legacy problems as the rest of the London market with, consequently, many now being in run-off and many of those run-offs having at least one insolvent pool member.

Indeed, such pools as CR Driver & Co and HS Weavers (Underwriting) Agencies rank among the better known of the London market failures of the late 1980s and early 1990s.

The challenges

Often established to enable several companies to share the underwriting skill of the lead underwriter and to provide greater clout when negotiating premium rates by taking a larger proportion of the risks being underwritten, pools vary greatly in their capacity and the number of participating companies.

For instance, some have as few as three participants, others as many as 25.

It is this additional complexity that has caused pools to be one area that has largely been avoided when implementing solvent schemes; from the standpoint of a company that participates in a pool, there are a number of additional problems that need to be overcome when bringing finality.

For instance, the fact that individual pool participants often only underwrote a small percentage of the total risk written often means policyholders are simply uninterested in bringing finality to such a small proportion of the risk.

In other words, from the policyholder's perspective the effort required to complete a commutation greatly exceeds the benefit derived from it, especially if that policyholder would still potentially have other pool members wanting separately to commute their small proportions of the risk at later dates.

Similarly, on the reinsurance side, many pools purchased cover as a group rather than as individual participants. What is more, for a large percentage of the risks underwritten this cover was proportional, thus further enhancing the "buying power" of the pool when premium rates were being negotiated with policyholders.

But again, when it comes to unravelling such business, this means that an individual pool participant will have difficulty persuading a reinsurer of the benefit of bringing finality to only a small slice of the overall large risk.

Further complicating the picture is the fact that not only the participants' respective proportions of a pool would commonly vary from year to year, but also the very pool participants themselves.

The scenario is further complicated by the fact that most pool participants were not actively engaged in the management of the pool liabilities, receiving at best only quarterly reports of the pool's underwriting activity.

A significant consequence of this is that participants often do not have even the most basic information that they need to enable them to exit from the pool, and attempts to obtain that information can be met with reluctance from the pool manager - not to mention a hefty bill for the cost of the work.

A solution

Given such difficulties, the obvious answer to the question of how to tackle discontinued pools must be to bring all of the liabilities into one single entity, thus re-establishing the negotiating power of the pool as a whole rather than leaving it fragmented down to its individual constituents.

Once consolidated, the pool is then much better placed to pursue true finality through such devices as solvent schemes of arrangements.

Key to the ability to consolidate pools in this way is the regime for business transfers that came into force under Part VII of the Financial Services and Markets Act 2000 ('Part VII FSMA'), although, interestingly, it was not until last year, when Ruxley acquired Aviation and General, that this tool was first used as part of the process of bringing finality to a pool in run-off.

But of course, while the idea of consolidation of pools may sound very simple in theory, in practice there are still a number of hurdles that need to be overcome if this approach is to work.

For instance, such initiatives require the specific agreement of each pool member, because such a radical reorganisation is usually outside of the scope of the relevant pool agreement and cannot be forced upon individual pool participants.

Similarly, insolvent pool members may have to be excluded from such a proposal. However, usually this only presents problems where such participants make up a significant proportion of the pool.

Another obvious question is that of who should manage this consolidation.

While the obvious answer may seem to be that of the current manager of the pool (either the principle pool member or the pool management company), this solution may not be as appealing to pool participants as it would at first appear.

Clearly, a managing pool participant would wish to minimise the cost of achieving finality for the pool's liabilities. However, there may be conflicts of interest if, due to that risk carrier's wider underwriting activities, the pool manager has other ongoing underwriting relationships with pool policyholders that are not shared with other pool participants.

This potential for conflict is even more acute with third-party pool management companies that carry none of the pool liabilities but may well have other ongoing relationships with pool policyholders.

One way of overcoming such issues is for the members of a pool to agree to dispose of the whole entity to a third party, as in the approach taken by the members of the Aviation & General Insurance Group Pool in May 2004.

Under that initiative, a mixture of disposals and business transfers was used to pass the ownership of the entire pool went to Ruxley Ventures.

Ruxley, in turn, was then left to pursue ultimate finality for the entire pool, which it is doing by means of a solvent scheme.

By using an independent third party in this way, the pool participants achieved accelerated finality because, for them, finality occurred at the time the pool was consolidated and disposed of rather than after a post-consolidation solvent scheme, a process that can take some time.

The participants also removed a potential distraction from their businesses while transferring the run-off to external dedicated experts with the skills and experience to execute the run-off and solvent scheme as efficiently as possible, thereby reducing the overall costs of achieving true finality.

Interestingly, the example of the Aviation & General Insurance Group Pool consolidation is now being followed by others.

Conclusion

Achieving finality for liabilities resulting from participation in an underwriting pool has been a thorny problem for many members of the London market.

But the experience of Aviation & General has shown that there is now a proven method to achieve the desired finality by combining pool consolidation with a solvent scheme. This creates another way for London market players to end their legacy problems and concentrate on future, rather than past, business.

BUSINESS TRANSFERS UNDER PART VII OF THE FINANCIAL SERVICES AND MARKETS ACT ('PART VII FSMA')

Part VII FSMA business transfers are a process by which a defined set of liabilities can be transferred from one authorised insurer to another.

The process is highly regulated for the protection of policyholders, and requires the approval of both the High Court and the UK's Financial Services Authority (FSA).

The process has the following main steps:

- The liabilities to be transferred must be defined in a complete and unambiguous manner. This is not always as simple as it first appears, and may be complicated by common market practices such as fronting arrangements.

- An independent expert, approved by the FSA, must be appointed to assess the impact of the proposed transfer on policyholders, (including the remaining policyholders of the entity from which the liabilities are being transferred).

- The independent expert will also recommend the level of capital that will need to be transferred with the liabilities to ensure the protection of all relevant policyholders in accordance with regulatory and statutory requirements.

- The transferring entity is required to give formal notice of the proposed transfer to all interested parties, including the policyholders of the transferor and transferee entities. In addition to writing to policyholders, this process includes advertising the proposed transfer throughout the European Economic Area in accordance with the requirements of each individual EEA member's regulatory body. The High Court in the UK must approve the nature and means by which notice is given.

Approximately three months after notice has been given, a hearing is held at the High Court to allow any objections to the transfer, (including those of the FSA), to be heard, and if thought appropriate, High Court sanction to the transfer is granted.

Following High Court sanction of the transfer, it becomes effective.

This process may seem daunting and time-consuming to those unfamiliar with it - and indeed it can be. However, in experienced hands, Part VII FSMA business transfers can now be achieved in four to six months.

The independent expert may also impose substantial requirements on the capital to be transferred with the liabilities. Ruxley has recently developed some imaginative solutions to the requirement for additional capital for business transfers, most notably having released all of the additional capital provided by the transferees of the Aviation & General Insurance Group Pool liabilities back to the transferees only seven months after the transfer took place.