Financial Services and Markets Act Part VII – Legacy Transfers: Part 2

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The United Kingdom and the United States have long been ‘two nations divided by a common language’. Notwithstanding differences in everyday word choice and meaning, the American legal system is structured upon the historically developed wisdom of centuries-old English law, most often called ‘Common Law’. Time and experience have informed the development of the Common Law, as well as the eventual development of the distinct but increasingly complementary regulatory systems in both nations.

Current insurance regulators in the UK and the US have had similar experiences in many aspects of insurance regulation. They face rather extraordinary challenges, including how to efficiently oversee and facilitate run-off business, in particular legacy transfers. In 2000, the UK adopted the Financial Services and Markets Act (FSMA), Part VII of which mandated a next generation approach to permit insurers to transfer direct and assumed insurance portfolios with continued coverage for re/insureds with a full release for the transferor without completion of a novation process and concomitant opt-in/out rights for re/insureds.

The US insurance market has marvelled at Part VII and has been pining for an American counterpart. ‘Traditional’ direct insurance novation and reinsurance/loss portfolio have been on the books for many years, supported and supplemented by statutory mechanisms, including those facilitating business division for the transfer of insurance liabilities from one entity to another, with or without the aid of receivership proceedings. However, the commercial market has decried the often cumbersome, time and expense-consuming and, ultimately, incomplete nature of the relief such mechanisms provide, especially when there is no full release of the transferor insurer. Market participants have urged, and state insurance regulators have taken on, the construction of ‘new’ models for importing Part VII into the US, for a variety of reasons.

Most recently, regulators have focused on long-term care (LTC) insurance as the latest line of insurance in need of a long-term solution. The debate over whether and how to effect transfers is now focused, at least in part, on LTC but the application of developing laws to address LTC challenges remains relatively uncharted. The authors recently represented a state commissioner as receiver in a large long-term care receivership that brought this issue to the fore. With a view toward contributing to the discourse, we will briefly explore the current opportunities.

Part VII Transfers in a nutshell

The Part VII Transfer is a court-approved transfer of all or portions of an insurer’s portfolio to another company. This type of transfer has various uses, with particular importance in legacy business where companies desire to either join or segregate portfolios of like business among companies within an affiliated group, or transfer portfolios to third parties. Through a process that generally takes anywhere between six months and two years and culminates in court approval, independent experts review proposed plans that are distributed to policyholders (who may object) under the supervision of the Prudential Regulation Authority and pursuant to statute, regulations, published handbooks and guides. The result has often been the successful transfer of legacy business via judicial novation for the long-term run-off of liabilities.

The development of Part VII Transfer regulation reflects the proliferation and increasing complexity of the transactions, from long-tail property-casualty business, to life and annuity business and, more recently, employment-related obligations. In May 2018, the Financial Conduct Authority (FCA) published ‘finalised guidance’ on its ‘approach to the review’ of Part VII transfers pursuant to the FSMA. The guidance includes suggested procedural steps (eg, pre-plan meetings with the FCA), as well as detailed criteria (eg, documentary content and the qualifications of and content of reports by required independent experts) by which the FCA determines whether to suggest that the court approve or disapprove a transfer plan.

While the English model has been subject to much debate and review, the concept is deemed one upon which American regulators might offer similar options to US insurers.

Importing Part VII into the US

Before Part VII, US states offered a variety of transfer mechanisms, within and outside of receivership law. Post-Part VII, other states have focused on creating specific statutory mechanisms by which insurance companies may transfer insurance portfolios. With the developing challenges created by various lines of business, some states view the mechanism as a potential option to effect insurer strategies for long-term legacy business.

With an eye on Part VII as a template, various US states have been experimenting primarily with two regulated alternatives: business division and business transfer. In short, business division is a statutory mechanism offering companies the ability to divide business operations into two of more entities upon the approval of the regulator, while business transfer is a distinct transaction involving the transfer of policies via novation; both have regulatory and judicial components.

Business division

Pre-Part VII, the Commonwealth of Pennsylvania adopted a business corporations division law (not limited to insurance companies) allowing for the division of an entity, effectively the reverse of a merger.[1]  To date it has been employed once in the context of insurance business (1996 allocation of runoff liabilities to Brandywine Holdings) but its provisions are plainly relevant for consideration in allocating legacy insurance liabilities. The Pennsylvania Title 15 Pa. CSA section 368(i) states that ‘the conditions in this section for freeing one or more of the resulting associations from the liabilities of the dividing association and for allocating some or all of the liabilities of the dividing association shall be conclusively deemed to have been satisfied in the plan of division has been approved by the… Insurance Department… in a final order… that is not subject to further appeal.’

Post-Part VII, states have experimented with a variety of business division initiatives. In 2017, Connecticut passed Public Act 17-2, which permits domestic insurers underwriting any line(s) of insurance to divide, pursuant to a proposed plan, creating new entities and allocating assets and insurance obligations among the resulting entities.[2]  The new entities are successors and assume the assets and obligations upon the Commissioner’s approval. Except as provided for in the plan and approved by the commissioner:

‘an allocation of a policy or liability does not: (1) Affect the rights under the law of a policyholder or creditor owed payment on the policy, or payment of any other type of liability or performance of the obligation that creates the liability, except that those rights are available only against a resulting insurer responsible for the policy, liability or obligation under this section; or (2) release or reduce the obligation of a reinsurer, surety or guarantor of the policy, liability or obligation’.[3]

The Commissioner determines whether a hearing is required in the public interest and there is no judicial review.

The utility of the Connecticut Act is yet to be determined. While it is not limited to certain lines of insurance,[4] the Act is limited to Connecticut companies within the same corporate family. Does it offer a meaningful adaptation for LTC? Commentators, regulators and industry participants question such application where underpricing and under-reserving issues have plagued companies for years, where maintaining guaranty association protection is critical and where rate increases are frequently approved.

Earlier this year, Georgia legislators embarked on a mission to permit domestic companies to divide. Notwithstanding the agreement of the state legislators, the law did not have the support of Governor Deal and HB 754 was vetoed.

On 29 June 2018, Illinois’ Domestic Stock Company Division Law passed both legislative houses as part of an omnibus bill with unrelated provisions, but the Governor vetoed and returned it to the Illinois Senate on August 26, requesting deletion of certain unrelated provision. Like its Connecticut counterpart, the Illinois Act would be applicable to any domestic stock entity transacting any of the kinds of insurance permitted under the Illinois Insurance Code.[5] The Illinois law would permit a domestic company to divide into two or more resulting companies, pursuant to a ‘plan of division’. Within the plan the applicant would set out, among other things: the manner of allocation among the resulting companies of the assets of the domestic stock company that will not be owned as tenants in common by all of the resulting companies; and the liabilities of the company, including policy liabilities, to which not all of the resulting companies will become jointly and severally liable.[6] The plan would provide:

‘a reasonable description of the liabilities, including policy liabilities, and items of capital, surplus, or other assets, in each case, that the domestic stock company proposes to allocate to each resulting company, including specifying the reinsurance contract, reinsurance coverage obligations, and related claims that are applicable to those policies.[7] 

The Director would provide for notice and a hearing if in the public interest, and conduct a hearing if requested by the dividing company. The Director would approve the plan unless she finds that: (1) policyholder interests will not be protected; (2) each new company would not be eligible to receive a license to do insurance business; (3) the division violates the Uniform Fraudulent Transfer Act, (4) the division is being made for purposes of hindering, delaying, or defrauding policyholders or other creditors; (5) one or more of the companies will not be solvent; or (6) the remaining assets of one or more of the companies will be ‘unreasonably small in relation to the business and transactions in which the resulting company was engaged or is about to engage.’[8]

The conditions of the Act would ‘be conclusively deemed to have been satisfied if the plan of division has been approved by the Director in a final order that is not subject to further appeal’.[9]

From a legacy portfolio perspective and, particularly, in terms of LTC, Illinois could provide the forum in which such a transfer could well be effective ‘by operation of law,’ not a mere novation.[10] Critical in such a scenario are the considerations related to policyholder protection and asset adequacy. Where a legitimate business strategy is developed under a proposed plan, an application (likely relying upon conservative reserve estimates – always a challenge with LTC), will present an opportunity to host a division of LTC portfolio business for the specific purpose of running off decades of policy liabilities. No doubt legal issues may be raised (eg, recognition/objections by other jurisdictions) and long-term investment strategy challenges will arise, but an LTC transfer vehicle seems close to enactment in Illinois.

Business transfer

Under a different US approach, states are beginning to regulate ‘insurance business transfers’ more akin to Part VII Transfers. For example, in 2015, Rhode Island approved a process involving both a regulatory and judicial review component. The effect, like the Part VII Transfer, is a judicial novation of the policies in the transferred portfolio. However, the Rhode Island statute does not apply to a life or personal lines, and so cannot be utilised for LTC. Moreover, the ‘policies or contracts that are the subject of an Insurance Business Transfer must have a natural expiration which occurred more than sixty months prior to the filing of the Insurance Business Transfer Plan and be in a closed book of business of a reasonably specified group of policies’.[11] On 2 July 2018, Rhode Island enacted an amended Act addressing Voluntary Restructuring of Solvent Insurers, which still would not apply beyond the commercial setting but would include protected cells.

In 2014, Vermont passed the Legacy Insurance Management Act.[12] However, personal lines are excluded from the process in which a non-admitted insurer can transfer discontinued commercial business to another entity.[13]

The latest business division entrant, Oklahoma, recently adopted broader legislation similar to the Part VII Transfer.[14] Effective from 1 November 2018, the Insurance Business Transfer Act will provide a mechanism for the judicially ordered novation of policies to an assuming Oklahoma domiciled insurer without policyholder consent and could include transfer of LTC business. Similar to a Part VII Transfer, it incorporates the filing of a plan with the Oklahoma regulator and review of an independent expert report. The regulator may approve submission of the plan for judicial review absent a finding that that transfer would have a ‘material adverse impact on the interests of policyholder or claimants’. A notice procedure and comment period enable policyholder objections.

Where might we be heading?

Many insurers operating in the US support insurance business divisions or transfers. There is no doubt that the great legacy regulatory oversight challenges facing regulators that will persist for decades would benefit from the broad flexibility that division and transfer are intended to provide. LTC may eventually be one of the lines which could benefit from business division or transfer. Pricing and reserving practices have evolved to match the underlying liabilities and it may take some greater understanding, study and data to reach a broad accord. Nor do business division and transfer offer the only options (enter the capital markets?). However, our sense is that consumer protection groups, regulators and courts would support the development of such efforts and we would be happy to assist.

 

Notes

[1]          See 15Pa CSA s 361–368.

[2]          See, eg, Public Act No 17-2, s 2(b) (‘Each plan of division shall include: …the manner of allocating between or among the resulting insurers: …those policies and other liabilities of the domestic insurer to which not all of the resulting insurers will be jointly and severally liable …[and] a reasonable description of policies or other liabilities, items of capital, surplus or other property the domestic insurer proposes to allocate to a resulting insurer, including the manner by which each reinsurance contract is to be allocated’).

[3]          Conn Public Act No 17-2, s 7(f).

[4]          See Public Act No 17-2, s 2(a).

[5]          See 215 ILCS s 5/4 (defining classes of insurance in Illinois).

[6]          215 ILCS s 35B-15(4).

[7]          215 ILCS s 35B-15(6); see also215 ILCS s 35B-35 (describing effects of division); 215 ILCS s 35B-40 (resulting company liabilities).

[8]          215 ILCS s 35B-25(b).

[9]          215 ILCS s 35B-25(j).

[10]         215 ILCS s 35B-40.

[11]         230-RICR-20-45-6.4.

[12]         See 8 VSA s 7111 – 7121

[13]         See 8 VSA s 7111(18) (defining ‘Policy’).

[14]         See Okla Sen Bill 1101.

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