Meltdown at Lloyds A Few Topical Issues

Meltdown at Lloyds A Few Topical Issues

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The legal know-how required to manage an orderly meltdown of the heterogenous, intensely abstruse Lloyd's enterprise has not yet been developed. The auspices are not good. Specialist insurance lawyers do not even use relevant elementary legal terminology correctly. For example, the pandemic notions that Lloyd's sells insurance, or that a syndicate at Lloyd's sells insurance, are based on the misunderstanding of the true nature of Lloyd's (a mere corporation1 that does not sell insurance) and the true nature of syndicate-year-of-account participation.

Reprieve for the Lloyd's Enterprise

The need to address enterprise-level meltdown scenarios—and not just in anticipation of years of well-paid claims litigation—was first seriously mooted in 1995-96 when numerous components of the Lloyd's enterprise, including Lloyd's itself (properly so-called), were insolvent, principally on account of asbestos-related liabilities contracted in underwriting years before 1993. In the 1996 back-office exercise at Lloyd's known as "Reconstruction and Renewal" (R&R), the then-U.K. insurance regulator, the Department of Trade and Industry, agreed—subject to conditions, some of which remain secret2—that the Lloyd's enterprise could erase all those liabilities from its balance sheet simply by buying outward reinsurance from a reinsurance company, Equitas Reinsurance Ltd., which was capitalised virtually entirely by money already in or subject to the control of the Lloyd's financial system. The reinsurer thus brought to the table no money that was not already available within the Lloyd's financial system—and already adjudged inadequate—to pay relevant liabilities.

As part of R&R, the outwardly reinsured liabilities appeared to depart the Lloyd's enterprise to Equitas Re, and the enterprise was thereby restored to apparent sound financial health. Since 1996, the apparent extrication has enabled the Lloyd's enterprise to continue doing business as usual as if solvent, as if those liabilities had never existed, and as if the enterprise's insistent blandishments about policyholder security at Lloyd's had never been made. As then New York Superintendant of Insurance, Ed Muhl, pointed out at the time, the alternative was too bleak to contemplate.3

The phenomenon of Equitas Re should occupy U.S. malpractice courts and legal psychologists for years to come.

Reprieve Revisited

Recently, the Financial Services Authority (FSA)—a U.K. insurance regulator—has reconsidered, to a small but significant degree, its rule4 empowering the Lloyd's enterprise to take unconditional 100 percent balance sheet credit for Equitas Re outward reinsurance. For as long as Equitas Re remains regulatorily solvent, those liabilities will soon be expressly liable to return to the Lloyd's enterprise's balance sheet as contingent liablities.5 If Equitas Re (more on this later) is to be taken at its insistent word that it is impecunious and bound shortly to become formally insolvent, presumably insurance insolvency lawyers will begin to appreciate that the liabilities merely outwardly reinsured by Equitas Re will rebound as actual, current liabilities right back to the Lloyd's enterprise. Equitas Re's own dire predictions, plus the forthcoming change of accounting emphasis, are already leading a few lawyers to revisit the need for that legal know-how.

EU Law Needs Implementing

Meltdown technology happens also now to be in the forefront of the mind of the U.K. Treasury (, yet another U.K. insurance regulator, because of a recent EU directive, Council Directive 2001/17/EC (March 19, 2001) on the reorganisation and winding-up of insurance undertakings. The directive does apply (though not specifically enough to be of any illumination) to underwriters at Lloyd's as well as to conventional insurers throughout the European Union. The United Kingdom has already implemented the directive6 in relation to conventional insurers within its jurisdiction, but expressly7 not in relation to underwriters at Lloyd's, principally because the Treasury had no idea how to do so. The Treasury is now more than a year late in implementing the directive in relation to the Lloyd's enterprise and has yet to issue even a consultation paper on the subject. When eventually published, the consultation paper will give the first indication in the 300-year history of the Lloyd's enterprise of the legal approach appropriate under English law when Lloyd's collapses.

What of Equitas Re?

The phenomenon of Equitas Re should occupy U.S. malpractice courts and legal psychologists for years to come. The 1996 plain-vanilla, back-office outward reinsurance from underwriters at Lloyd's to Equitas Re appears to have convinced significant portions of corporate America and their lawyers, without seeing any probative documents (there aren't any), that the cedant underwriters have been not merely outwardly reinsured but utterly extricated from their insurance liabilities. U.S. Lloyd's policyholders appear to have been easily persuaded by Equitas Re—even in its overt capacity of claims handling agent for Lloyd's underwriters—to accept materially less than 100 percent of their valid claims, and to sell back insurance contracts not yet matured into claims. Some U.S. Lloyd's policyholders have even sued Equitas Re in various U.S. jurisdictions as an assumption reinsurer.

Equitas Re's formal insolvency is likely to precipitate a more careful examination by relevant U.S. Lloyd's policyholders of their recourse rights at Lloyd's, and an increasing appreciation of the various claims payment securitisation trust and other funds that have always been available to pay qualifying claims 100 percent and that continue to be protected by the negotiating strategies of Equitas Re, the silence of insurance regulators, the operational techniques of Lloyd's brokers and the "expert" advice of the claimant's own lawyers.

More Local Insolvency

Insurance at Lloyd's is conducted by individuals, natural or corporate—any of whom could become insolvent at any time. At least in ordinary circumstances, a relevant Lloyd's policyholder's right to recourse to relevant claims payment securitisation trust funds is independent of a Lloyd's underwriter's personal financial condition. How an insolvent underwriter wraps up its financial affairs is therefore of no concern to the Lloyd's policyholder or, indeed, to any insurance regulator. Consideration is increasingly being given to wrapping up a solvent and insolvent corporate Lloyd's underwriter's affairs using a Companies Act 1985, s.425 scheme of arrangement.'

Companies Act 1985, s.425 Scheme of Arrangement

The "scheme of arrangement" device available under Companies Act 1985, s.4258 enables a solvent or insolvent debtor "company",9 in certain circumstances and subject to certain conditions, to devise and implement a payment methodology with its creditors. The section builds on the general freedom a solvent or insolvent company has, in principle, under English law to propose a compromise or arrangement with its creditors. A s.425 scheme has five components: (1) the company devises a scheme; (2) the court has a discretion to order the holding of a creditors' meeting to discuss the scheme; (3) creditors have the opportunity to vote on the proposed scheme at the meeting; (4) after the vote, the court has a discretion to sanction the scheme; and (5) if sanctioned, the scheme is implemented.

The scheme device, which includes various types of share capital reorganisation10 and transfers to another company,11 is available only to a "company"12 liable to be wound up under Companies Act 1985.13 Since none is a s.735 "company", the following cannot be schemed: a natural Lloyd's underwriter, Lloyd's itself,14 a syndicate (a mere entrepreneurial idea in the mind of a managing agency at Lloyd's) and the "syndicate year of account" device through which Lloyd's underwriters sell insurance (however corporate the latter's participant(s)).

The scheme device—sometimes suspected by U.S. insolvency lawyers confounded by such an ostensibly pain-free and potentially "lawyer-lite" path to release—is congenial to a debtor, solvent or insolvent, wishing to gather in and discharge all relevant debts by a certain date, thus achieving certainty of time. It can be useful for an insolvent debtor constrained to discharge its liabilities at less than 100 percent, the putative scheme administrator using commercial sense and sectoral experience in positing to creditors and the court a rational way to ascertain, marshall and distribute the company's estate.

Where the company is insolvent, a s.425 scheme can either stand alone or (more usually) be the means of consummating another insolvency process such as provisional liquidation,15 or actual liquidation16—indeed, on the liquidator's or administrator's own application to the court.17 A scheme lends itself to being tailored to the debtor company's particular circumstances, and special types—viz., "cut-off", "reserving" or "hybrid"—have evolved specifically for insurance companies.

Not an "Insurer"

A corporate Lloyd's underwriter (including a foreign one18), being neither a statutory "insurer" nor an FSA "insurer", appears to be free to construct a s.425 cut-off, reserving or hybrid, solvent or insolvent, scheme in relation to its relevant liabilities free of all insurer-peculiar statutory and FSA-regulatory provisions, and to choose not to discriminate, for class or other purposes, between insurance and general assets and liabilities. Similarly, there appears to be no law preventing a natural Lloyd's underwriter from scheming his insurance liabilities via an appropriate corporate vehicle. And what can be done at the level of sole Lloyd's underwriter can in principle equally be done—though it is an increasingly intricate and disruptive19 practical and professional20 undertaking—at the level of (among others) all participants on a particular syndicate year of account, and all participants on a particular insurance slip.

The Bucket Company

Creating a properly authorised and certified21 bucket company as a repository for the relevant liabilities (divided, if appropriate, into classes22) of one or more Lloyd's underwriters23 (presumably at least at stamp level)—query if the device works equally at syndicate or slip level—is apparently the subject of current discussions in the London market. The liabilities would be formally transferred24 by a lone transferor, acting on behalf of the Lloyd's underwriters25 concerned, presumably appointed by the Council of Lloyd's26 (among other customised modifications27)—to the bucket, enabling any corporate Lloyd's underwriter transferee to be then wound up and dissolved, and only then would relevant creditors be invited to vote28 on it. Query what would happen if they did not approve it. Before the vote, the usual due diligence must be performed to identify and flush out all creditors and liabilities, a particularly intricate exercise at Lloyd's. Highlighting the potential difficulties is the fact that discharge of an insurance liability in the front office has no effect whatever on the continuing existence of the Lloyd's underwriter's various back-office contractual and trust-deed financial obligations, including to make payment to common funds for the discharge of other Lloyd's underwriters' relevant liabilities. Exhaustive due diligence would have to be timeously performed on every relevant instrument, including in order to ascertain the mechanics of extricating the Lloyd's underwriter from its clutches.


1 See Lloyd's Act 1871, s.3. Return to article

2 The FSA's so-called "scope of permission" notices (which replaced as of Dec. 1, 2001, the DTI's Notices of Requirements) for Equitas Re and Equitas Ltd. are not public documents. They presumably confer some secret privilege or enable the FSA to bestow some latitude in relation to either company's solvency or insolvency, or require (without their present knowledge) current members of Lloyd's to support Equitas Re financially or bail out the Lloyd's enterprise. Return to article

3 See, e.g., Commissioner Ed Muhl, Superintendant of Insurance, New York State Insurance Department, New York Law School Center for International Law Symposium Implications of the Reconstruction of Lloyd's of London, Nov. 6, 1996 ( "New York is basically a port of entry of Lloyd's for the United States because we oversee all the U.S. trusts. We also control its status as an eligible writer in the U.S. market as well as in the excess and surplus lines. I asked my senior management if they realized what would happen if I signed the order. The general answer was very simply that Lloyd's would be de-accredited. I responded by saying, 'If I sign this order, the insurance world as we know it would change.'" Return to article

4 See the FSA Lloyd's rulebook, LLD §12.3.3R: "For the purposes of this chapter, the following liabilities may be left out of account:...(4) liabilities for 1992 and prior general insurance business reinsured by Equitas Reinsurance Ltd." Return to article

5 See FSA consultation paper 04/7, Lloyd's: Integrated Prudential Requirements, and Changes to Auditing and Actuarial Requirements Including Feedback on CP178 (FSA, April 30, 2004), §§2.99-2.100 (p.34; numbers in [ ] editorially added):

2.99. The liabilities reinsured by Equitas could potentially affect members of Lloyd's in future, most importantly: [1] members whose business was reinsured by Equitas remain liable under the original contracts: Should the reinsurance fail, assets in those members' premiums trust funds may be used to meet liabilities reinsured by Equitas; and [2] assets from the joint-asset trust fund (JATF), a mutual fund which is held in the United States, may be used to meet liabilities reinsured by Equitas, which U.S. regulators might require in turn to be replenished by the Society and/or continuing members of Lloyd's (most but not all of Lloyd's members are exposed to the JATF). 2.100. In addition, the Society may use its central assets to support members' losses, in which case the ongoing membership might be called upon to contribute to replenish the central fund. So, the Society and all current members have a contingent liability (albeit small in some cases) which could crystallise should the reinsurance by Equitas fail. We propose to clarify our rules to distinguish the current concessionary treatment (which we propose should continue) from the previous (pre-1996) treatment. So the proposed rules do not require the original business to be accounted for within Lloyd's, but instead there is a contingent liability and the value of that liability (if any) would need to be accounted for in line with GAAP under PRU 1.3.
See, also, ibid., Annex 8 ("Proposed Changes to Handbook Text"), proposed PRU §7.7.78R:
In recognising and valuing a "member's" liabilities, the "Society" and "managing agents" may leave out of account the original liabilities in respect of 1992 and prior "general insurance business" reinsured by Equitas Reinsurance Limited. 7.7.79G. There is a contingent liability associated with the reinsurance into Equitas, which PRU 1.3 requires "managing agents" and the "Society" to treat in accordance with generally accepted accounting practice (GAAP). Depending on the circumstances, "managing agents" or the "Society" may need to disclose or account for such a liability. Return to article

6 See Insurers (Reorganisation and Winding Up) Regulations 2003 (SI 2003/1102). Return to article

7 Insurers (Reorganisation and Winding Up) Regulations 2003, §3. Return to article

8 Companies Act 1985, s.425 (so far as presently relevant):

(1) Where a compromise or arrangement is proposed between a company and its creditors or any class of them, or between the company and its members or any class of them, the court may on the application of the company or any creditor or member of it or, in the case of a company being wound up, or an administration order being in force in relation to a company, of the liquidator or administrator, order a meeting of the creditors or class of creditors, or of the members of the company or class of members (as the case may be), to be summoned in such manner as the court directs. (2) If a majority in number representing three-fourths in value of the creditors or class of creditors or members or class of members (as the case may be), present and voting either in person or by proxy at the meeting, agree to any compromise or arrangement, the compromise or arrangement, if sanctioned by the court, is binding on all creditors or the class of creditors or on the members or class of members (as the case may be), and also on the company or, in the case of a company in the course of being wound up, on the liquidator and contributories of the company. (3) The court's order under subsection (2) has no effect until an office copy of it has been delivered to the registrar of companies for registration, and a copy of every such order shall be annexed to every copy of the company's memorandum issued after the order has been made or, in the case of a company not having a memorandum, of every copy so issued of the instrument constituting the company or defining its constitution... (6) In this section and the next, (a) "company" means any company liable to be wound up under this Act, and (b) "arrangement" includes a reorganisation of the company's share capital by the consolidation of shares of different classes or by the division of shares into shares of different classes, or by both of those methods. Return to article

9 Per Companies Act 1985, s.425(6)(a), "company" as used in the section means "means any company liable to be wound up under this Act." Return to article

10 Companies Act 1985, s.425(6)(b). Return to article

11 See Companies Act 1985, s.427. Return to article

12 Defined at Companies Act 1985, s.735. Return to article

13 Companies Act 1985, s.425(6)(a). Return to article

14 Nor is the corporation presently included among the other entities (see Enterprise Act 2002, s.255(1)) to which the Treasury is empowered (by Enterprise Act 2002, s.255(2)(c)) to extend s.425. Return to article

15 See Insolvency Act 1986, s.135; Insolvency Rules (SI 1986/1925 as amended), Part IV, Ch. 5. Return to article

16 See Insolvency Act 1986, Part IV; Insolvency Rules (SI 1986/1925 as amended), Part IV. Return to article

17 See Companies Act 1985, s.425(1), (2). Return to article

18 See Re Drax Holdings Ltd; Re InPower Ltd. [2003] EWHC 2743 (Lawrence Collins J). Return to article

19 At its most superficial, such a radical reconfiguration of the enterprise would require the permanent cessation of self-regulators'-at-Lloyd's insistent blandishments of superior securitisation. Return to article

20 The exercise would require, on the professional adviser's part, the deepest knowledge of all relevant FO-MO-BO, PU and CU aspects of the Lloyd's enterprise. Return to article

21 See (for example) FSMA 2000, s.111(2)(a), read with ibid., Sch. 12, §1(1), etc. Return to article

22 See Companies Act 1985, s.425(1) and (2), s.426(1), etc. Return to article

23 Financial Services and Markets Act 2000 (Control of Business Transfers) (Requirement on Applicants) Regulations 2001, §§3, 4(b), 5(a) and 5(b) use the word "member" infelicitously. Return to article

24 See FSMA 2000, Part VII, read with ibid., s.323:

The Treasury may by order provide for the application of any provision of Part VII ["Control of Business Transfers"] (with or without modification) in relation to schemes for the transfer of the whole or any part of the business carried on by one or more members of the Society or former underwriting members.

Read with Financial Services and Markets Act 2000 (Control of Transfers of Business Done at Lloyd's) Order 2001 (SI 2001/3626) (reproduced at Appendix II). Ibid. applies the following to a transfer of liabilities incurred at Lloyd's: (1) (per ibid., §3(a)) FSMA 2000, ss.104 and 107-114; (2) (per op. cit., §3(b)) Financial Services and Markets Act 2000 (Control of Business Transfers) (Requirements on Applicants) Regulations 2001 (SI 2001/3625) (reproduced at Appendix II), as being made under FSMA 2000, s.108; (3) (per op. cit., §3(c)) FSMA 2000, Sch. 12 ("Transfer Schemes: Certificates"), Part I ("Insurance Business Transfer Schemes"). Also see the detailed provisions at SUP, §18.2. Return to article

25 Financial Services and Markets Act 2000 (Control of Business Transfers) (Requirements on Applicants) Regulations 2001, §4(b). Return to article

26 See Financial Services and Markets Act 2000 (Control of Business Transfers) (Requirements on Applicants) Regulations 2001, §§3 and 4(b). Return to article

27 For example: (1) per FSMA 2000, s.104, the transfer must be the subject of an ibid., s.111(1) order; (2) per ibid., s.107, an application to the court may be made for the order; (3) per ibid., s.108 read with Financial Services and Markets Act 2000 (Control of Business Transfers) (Requirements on Applicants) Regulations 2001, §3, notices must be published; (4) per ibid., s.109, a scheme report must be prepared, etc. Return to article

28 See Companies Act 1985, s.425(2). Concern, heard expressed by U.S. assureds that a solvent scheme enables a solvent insurance company to evade paying claims in full, is allayed by the need for agreement of a majority in number representing at least three-quarters in value of the company's relevant liabilities. Return to article

Journal Date: 
Wednesday, September 1, 2004