Solvent Solutions

When an insurance company issues a policy, it will be liable for the run-off of all claims under it. The length of the run-off may be particularly long for certain types of coverages such as asbestos and other environmental liabilities. Until recently, it was only possible to eliminate policy liabilities using a policy buy-back or a commutation (if it was a reinsurance agreement). Alternatively, it would be possible to request the approval of the Office of the Superintendent of Financial Institutions (“OSFI”) for a transfer and assumption agreement. Following a transfer and assumption agreement, it is possible for a Canadian insurance company or reinsurer to transfer all of its policy liabilities to another licensed company without obtaining policyholder approval. However, it is necessary to comply with a number of OSFI requirements including newspaper advertising. A transfer and assumption agreement is very different from a Scheme of Arrangement as it only transfers the policy liabilities to another insurance company and does not attempt to settle or change them.

SOLVING THE LIABILITY PROBLEM

Solvent Schemes of Arrangement are based on England – its country of origin – bankruptcy laws. A Solvent Scheme of Arrangement, although it does not involve financially troubled companies, operates in a manner similar to a Companies Creditors Arrangement Act (“CCAA”) re-organisation in Canada or Chapter 11 in the U.S. A solvent insurance company that wishes to eliminate its policy liabilities on a book of business will make a proposal to all of its affected policyholders. The company will offer to make immediate cash payment to each policyholder under consideration regarding the elimination of policy liabilities. A court application will be made and the Court will supervise the process. All of the affected policyholders will be notified and a group policyholder vote will be required. A majority of the policyholders must approve the Scheme of Arrangement. Once approval is received, the Court will facilitate an order resulting in an elimination of the policy liabilities for all policyholders including those that did not vote in favour of it. Following a Scheme of Arrangement, there will be a cut-off date for all claims to be submitted. They will then be valued and a cash payment will be made to each policyholder in exchange for a buy-out of their policy liabilities.

THE SOLVENT ADVANTAGE

A Scheme of Arrangement is useful as a way of eliminating policy liabilities where there may be too large a number of policies to negotiate individual buy-backs. The big advantage of a Scheme is that if a majority of policyholders can be persuaded to accept the proposal, the minority dissenting policyholders will be required to be part of the transaction.

A solvent Scheme of Arrangement will have obvious advantages for an insurance company or reinsurer wishing to eliminate a long-tail book of business. A common reason for eliminating policy liabilities is to enable a company to withdraw from operating in a particular jurisdiction.

The major disadvantage of a Scheme of Arrangement from the affected policyholder’s point of view is that although a cash payment is received now, the right to future protection is eliminated. Policy liabilities are valued based on the most current information available. For long-term liabilities, such as asbestos, a policyholder will lose its right to future protection for claims that have not yet been reported under the policy.

“SCHEMING” ON HOME GROUND: THE OSFI CONNECTION

Until recently, it did not appear that a Solvent Scheme of Arrangement would be possible in Canada. Courts in the U.S. have rejected the use of Solvent Schemes of Arrangement. However, the Cavell application for a Solvent Scheme of Arrangement was recently made in Canadian courts, fundamentally changing how Canadian policy liabilities may be dealt with in certain circumstances.

Cavell’s Canadian branch, in run off since 1993, has approximately $23 million in assets in a vested trust account under the control of OSFI. A Solvent Scheme of Arrangement for Cavell has already been approved in the U.K. and was intended to cover Canadian policyholders. An application was made to a Canadian court to have the U.K. order made enforceable in Canada. Justice Farley approved the application based upon the concept of the reciprocal enforcement of a foreign judgement and found that it would be appropriate to recognise the U.K. Scheme of Arrangement approval judgement allowing for its Canadian implementation.

OSFI attended the initial hearing and did not object to the application. The position of OSFI is that the application is a contractual matter between Cavell and its Canadian reinsureds. It is important to note that in his orders, Justice Farley provided that OSFI still retains discretion as to whether or not it will decide to release the assets of Cavell in the vested trust account. He indicated that his orders would not affect OSFI functioning.

OSFI has not yet issued a guideline or formal statement of its position on Schemes of Arrangement. However, it appears that OSFI has taken the position that it will permit a Scheme of Arrangement to be implemented based upon the fact that it involves the contractual rights of policyholders. It would not be necessary for OSFI to provide any specific approvals with respect to a Scheme of Arrangement. Yet, OSFI will likely review all Schemes of Arrangement in order to ensure that they are fair and equitable to Canadian policyholders. If a significant number of Canadian policyholders objected to the Scheme of Arrangement, OSFI will likely attend court proceedings and object to the transaction.

OSFI is apt to have concerns with respect to Schemes of Arrangement where the Canadian business represents only a small percentage of the total liabilities. The effect of such a transaction might be that the majority of Canadian policyholders are in objection but that their votes is not significant enough to affect the approval of other policyholders involved in the U.K.-based transaction. Ultimately, OSFI will have the ability to control a Scheme of Arrangement as it is in a position to refuse the release of assets from a vested trust account of a U.K. insurance company’s Canadian branch.

OSFI has not yet authorised the release of Cavell’s assets intended to pay for the determined liabilities of all Canadian policyholders although the Canadian courts have already approved the Cavell Scheme of Arrangement. Because of this pending approval, the Cavell “scheme” has not yet been implemented.

It is important to emphasise that the final position taken by OSFI on a particular Scheme of Arrangement may be partially dependant on the attitude of Canadian cedants. It is unlikely that OSFI will allow a Scheme of Arrangement to proceed if a significant number of Canadian cedants are in objection.

THE STANCE ON SOLVENTS

Currently, a Solvent Scheme of Arrangement is only admissible concerning an U.K. company operating a Canadian branch. It is necessary for the Scheme of Arrangement proceedings to be initiated in the U.K. and then implemented in Canada. The insurance industry is experiencing a growth of companies set up to purchase run-offs of blocks of business from other insurance companies that are not in liquidation.

A U.K. run-off company – like Cavell – will typically enter into Schemes of Arrangement with the applicable policyholders. The Scheme of Arrangement will allow a release of excess reserves that would otherwise had to have been maintained. This process will result in the recognition of an immediate profit for the run-off company. This appears to be the first time that the rights regarding contractual obligations of policyholders have been allowed to be determined by a foreign court – the rights of a policyholder under a policy is actually a matter under provincial jurisdiction. However, because it controls the vested trust accounts of Canadian branches o f foreign insurance companies, OSFI is inherently involved.

There is an interesting jurisdictional issue as to how a U.K. court can change the contractual rights of Canadian policyholders whose policies are governed by provincial insurance legislation. It appears that Justice Farley may have avoided this issue by basing his orders approving the Scheme of Arrangement on the enforcement of the order of a foreign court.

It is likely that a Solvent Scheme of Arrangement will become just another “out” option for U.K. insurance companies and reinsurers wishing to withdraw from Canada or to eliminate their long-time liabilities on particular books of business. However, it will not be an acceptable or suitable option in all circumstances, particularly ones involving difficult to place coverages where the future liabilities may be very uncertain. It is possible that rules requiring Canadian policyholders to have a separate class vote from policyholders in other countries and for a specified majority such as 66% to approve the Scheme of Arrangement will soon be implemented. Such requirements might stop many Schemes of Arrangement from developing.

A Scheme of Arrangement may be best suited to a book of business that has been in run-off for a long period and where the future losses are likely to be predictable. A large number of Schemes of Arrangement will likely not evolve in Canada. However, it remains an important development that insurance companies and reinsurers alike should be aware of as Schemes of Arrangement might eliminate what was once believed to be long-term permanent coverages.