Insurance Scrawl: Lloyd's / Equitas & London Market Archives

July 13, 2007

Discovery of NMA Wordings for Lloyd's Policies

One difficulty in pursuing London market insurance recovery has been putting together what the actual wording of the insurance contract was. While there have been efforts afoot to move toward "contract certainty," that is, to finalize the actual wordings in advance of the effective date of the policy, this aspiration seems to remain elusive in implementation. As a result, what one usually has is a "slip," which is essentially a commitment to contract where syndicates at Lloyd's indicate the proposed share the syndicate is willing to accept in the proposed policy (as indicated by the underwriter's "scratch", i.e., initials or imprimatur) and a general statement of what the policy wording is expected to be (a list of major terms, exclusions, and the like).

For most general liability policies, the bosom from which the language springs is the Non-Marine Association, given that most "inland marine" coverages have been created by this group of underwriting representatives. Lloyd's has now announced that NMA wordings will be centrally and broadly made available to market participants. Going forward, this should facilitate discovery on the underwriting side, though Hague Convention procedures and compliance with more stringent requirements of English process as to the scope of discovery, will continue to need to be abided by presumably. Nevertheless, policyholders pursuing recovery from Lloyd's underwriters should target the NMA repository unless they are sure they have final contract wordings. Even if the final wordings are in place, the NMA may have "drafting history" that may shed light on the intendment of the language, and thus may be able to be a source of evidence to show the "factual matrix" (as it is often put by English lawyers) or extrinsic evidence that may show "custom and practice" or other potentially relevant founts of interpretative evidence.

Posted by Marc Mayerson at 9:09 AM | Comments (1) | TrackBack

October 20, 2006

Berkshire Hath A Way Out for Equitas and Lloyd’s

A long-rumoured transaction between Equitas and Warren Buffett’s Berkshire Hathaway has been announced. This will be a two-step transaction whereby (1) Equitas will be absorbed into a National Indemnity Company subsidiary in exchange for a cash payment and a promise of providing additional reinsurance and (2) a channeling injunction will be obtained cutting off the exposure of Equitas, Lloyd’s, names, and Berkshire beyond the money in the new vehicle. If consummated, the deal will achieve the long-sought finality for names (the individual investors on the responsible pre-1992 syndicate years of account) and for the current Lloyd’s enterprise.

Under the deal, National Indemnity will reinsure all of Equitas’s liabilities and provide a further $7 billion of reinsurance coverage for Equitas. Equitas has reserves presently of $8.7 billion (as of March 31, 2006) and National Indemnity will commit an additional $5.7 billion of reinsurance capacity; Equitas will retain £172 million. National Indemnity gets all of Equitas’s assets, plus £72 million from the Corporation of Lloyd’s.

In Phase II of the deal, National Indemnity will be paid an additional £40 million (£18 million from the Corporation of Lloyd’s), which is to be paid on 31 December 2009. As part of this phase, National Indemnity will commit an additional $1.3 billion of reinsurance cover, for a total of $7 billion of additional reinsurance coverage. The Phase II commitment from National Indemnity, however, is contingent upon the English High Court issuing a channeling injunction directing all claims to the new National Indemnity entity and cutting off all rights of recourse that policyholders otherwise have to seek payment from Equitas or Lloyd’s (and presumably the various trust funds).

So what does all this mean?

1. Let’s start with Lloyd’s. As I have often argued, the Lloyd’s enterprise is the source of ultimate recourse for policyholders that are not paid in full on their claims. While we are shunted over to Equitas in the first instance, policyholders retain the right – pre-Phase II – to seek recompense through the various trust funds in the US backing the Lloyd’s policies and arguably against the current Lloyd’s enterprise, that is, to the current Central Fund and in turn through assessments by Lloyd’s upon the current members. Lloyd’s seems to recognize this exposure by agreeing to commit an additional £90 million to stave off future claims arising from an Equitas shortfall. The principal question here is where is that money coming from? Is it coming from Lloyd’s raiding the existing trust funds or will it come from assessments on the current membership of Lloyd’s? I assume if Phase II does happen, then Lloyd’s will close the existing trust funds and swipe that money.

2. As to the “Names” backing the policies under which assureds are seeking or will seek coverage (these are pre-1993 non-life Lloyd’s policies), while today there is contractual privity between the policyholder and the individual Name, the individual Name is at little risk of any policyholder chasing him or her for the small fractionated share of his/her individual obligation of an specific Lloyd’s policy. It is simply not cost effective for a policyholder to pursue this, nor is there any legal obligation on behalf of policyholders to chase the individual Name in a collection action as opposed to presenting a claim to the “cash window” at Lloyd’s and requiring Lloyd’s then to deal with the accounting/funding through the funds-at-Lloyd’s of the Name and the name’s individual assets more generally (down to the last cufflink, as the saying goes). But if Phase II of this deal goes through, it would appear that the rights of policyholders will be extinguished and a forced novation ordered channeling all claims to the new National Indemnity entity. Moreover, the Names can look forward to a return premium based on roughly the remaining £150 million pounds that will be in Equitas after the deal is done. It seems unlikely that the Names will object to this structure in favor of any of the alternative ways this could possibly play out. Presumably some constituencies will raise a stink in hopes of increasing the size of the return premium, but it is quite difficult to imagine the Names getting together in a fashion to crater this bailout from the nice people in Omaha.

3. The important question is what’s in this for Berkshire Hathaway, and the answer is straightforward: this is just a money bet. To see how the deal works, let start with the money that is presently in Equitas, which as of 31 March 2006 showed a retained surplus of £458 million. The deal in part shows that that “surplus” does not exist (as many of us have long argued), for otherwise why would Equitas and Lloyd’s need to buy an additional $7 billion of assets. If the retained surplus number were right, there is no economically rational need to purchase $7 billion of additional coverage. But hold that to the side, for the moment, and let’s assume that while the surplus number is significantly understated as compared with the entire stream of claims that can be expected to flow into Equitas, assume that the amount of money in Equitas is enough to pay claims for the next 20 years. (Demographers and actuaries tell us that asbestos claims will continue to be asserted for the next 40 years.)

Assuming that there is enough money in Equitas today to handle the next twenty years, the economics of the deal from Berkshire Hathaway’s perspective becomes clear. National Indemnity is taking the back end of the claim stream twenty years out. It is committing to pay up to $7 billion for that back-end portfolio of claims. In exchange for making that commitment, it is getting £286 million today in surplus (a number I derived from taking the current surplus and subtracting the amount that Equitas will retain from that in the deal), plus £90 million in cash from the Corporation of Lloyd’s, plus another £22 million from Equitas. While it gets that money over a couple of years, let’s simplify things and say that Berkshire Hathaway is receiving £398 million in cash today (approximately $746 million) for its $7 billion reinsurance commitment beginning in 2026.

If National Indemnity earns a return of 5.75 percent on that money annually over this period, National Indemnity breaks even on the deal. In other words, in exchange for the cash payment of $746 million, National Indemnity can grow that money to the $7 billion back-end reinsurance commitment as the asbestos claims wind down. What this means of course is that National Indemnity makes money on this deal if any of the following occur:

a. it gets more than 5.75 percent real rate of return (if the return is 6.25, it will make nominally $1.4 billion (with a $123 million present value))
b. the money in Equitas lasts longer than 20 years, allowing National Indemnity to grow its nest egg further

c. the claim stream becomes less than Equitas is currently projecting.

Pursuant to what Albert Einstein supposedly called the greatest mathematical discovery of all time, the miracle of compound interest, tuppence held over a long enough period turns into something of extraordinary value, and Berkshire Hathaway’s taking the long view allows it to enter into a deal like this that others wouldn’t have the stomach for, even though the numbers work on a straightforward basis.

4. How does this proposed deal affect holders of non-life policies issued by underwriters at Lloyd’s prior to 1993, that is, how does this affect those policyholders that today pursue payment of their claims via Equitas?

Phase I of this deal is of course simply a net positive for policyholders. More assets are being made available to Equitas to pay claims. One wonders how the reinsurance policy will work in the sense whether all policies for which Equitas is responsible are reinsured, but one can reasonably assume they all are. If so, then the retained surplus of Equitas improves significantly from £458 million. This is good news for policyholders and for insurance companies that had purchased reinsurance through Lloyd’s and for which Equitas is now the claims handler.

Phase II of the deal is more complicated. If Phase II goes through, the policyholders are benefited by an additional $1.3 billion (really, 1.26 nominally given the Equitas premium), but the policyholders’ recourse will be confined to the new National Indemnity entity, as is the case in approved “solvent runoffs” in the London market. Perhaps this is enough money ultimately to pay all possible claims arising on Equitas-backed policies, but that in part will be the key question in the Phase II court proceedings. In those expected proceedings in the London High Court, policyholders (direct and cedants) need to be prepared to present their own actuarial analyses of the value of the portfolio of claims. The difficulty here will be that no policyholder has enough information to evaluate the entire portfolio of potential claims from anyone who ever purchased a non-life policy through Lloyd’s before 1993. Given the significant politics involved and the absence of compelling proof of a swindle of policyholders, given the gravitas of National Indemnity and the sheer size of the nominal dollars/pounds involved, it seems highly likely that the High Court will approve the cutoff of claims to other assets and parties other than the new National Indemnity/Equitas vehicle.

The constituency that might be less than thrilled with this news are policyholders that liquidated their coverage with Equitas believing the myth that Equitas was the sole recourse and source of funds and fearing for Equitas’s continued solvency. As I have pointed out, of the reported surplus at 31 March 2006, a full 95 percent of that amount was due to policyholders that sold out their coverage for less than the amounts that Equitas had reserved for the claims (and substantially less than the actuarial value of their claims, since most believe that Equitas has systematically underreserved for a variety of reasons). With each passing year, those deals based on erroneous premises look worse and worse, and the Berkshire Hathaway bailout only underscores this.

Note: This analysis was in part quoted in London's Financial Times (Oct. 23, 2006) at 12.

Posted by Marc Mayerson at 1:58 PM | Comments (11) | TrackBack

Berkshire Hath A Way Out for Equitas and Lloyd’s

So what does all this mean?

a. it gets more than 5.75 percent real rate of return (if the return is 6.25, it will make nominally $1.4 billion (with a $123 million present value))
b. the money in Equitas lasts longer than 20 years, allowing National Indemnity to grow its nest egg further

c. the claim stream becomes less than Equitas is currently projecting.

Note: This analysis was in part quoted in London's Financial Times (Oct. 23, 2006) at 12.

Posted by Marc Mayerson at 1:58 PM | Comments (11) | TrackBack

June 29, 2006

Equitas Financials -- 2006 Version

As part of the Reconstruction and Renewal of Lloyd’s in 1996, various participants in the Lloyd’s enterprise established several companies for the purpose of reinsuring the then-open syndicate years of account and managing the runoff of claims under those and prior years’ insurance policies. In 1997, the liabilities of a Lloyds’ owned-entity called Lioncover were reinsured into Equitas too.

Equitas issues an annual report and accompanying press release that discusses its results to date. Some of the highlights this year:

* Equitas’ retained surplus – that is, the amounts of its assets minus its expected liabilities – was reduced to £458 million.

* The retained surplus expressed as a percentage of net claims outstanding fell to 12 percent. In other words, Equitas expects its net claims to total roughly £3.8 billion. (p.6)

* Equitas paid £672 million in settlement of claims, including payment for 32 direct asbestos claims and 15 direct pollution claims. (p.4, 7) In this context, this means payments in commutation of policy obligations. (Some of these payments likely were to policyholders with both asbestos and pollution liabilities, and perhaps with more than one stream of liabilities, so one should not assume that Equitas did deals with 47 (32 + 15) different policyholders.) In the reporting period, Equitas completed more asbestos-driven policy buyouts than in any previous year (p.6) In these asbestos buyouts, Equitas is making payment on the assumption that Federal asbestos-reform legislation is not passed, but if such legislation does pass it will receive a give back from the settling policyholders totaling £280 million. (p. 43)

* Even considering these settlements, Equitas increased its asbestos reserves by £103 million, roughly the same amount that it increased reserves last year (£116 million), which makes up 53 percent of Equitas’s total reserves (with environmental and other health-hazards constituting another 24 percent of the reserves) (p. 41). The present value of the asbestos reserves is £2.2 billion, with a nominal value of £3.4 billion (p.5). For the first time in seven years, Equitas increased its reserves for environmental liabilities too. Equitas assumes it will be making payments for these classes of claims for at least another 40 years (p.41). Further, Equitas assumes that the mean term of its liabilities, “that is the weighted average period to settlement where the weights are the undiscounted expected cash flows in each future period,” will be approximately 11 years, one year longer than the assumption made a year ago.

* Equitas continues its aggressive liquidation of its reinsurance asset, with an undiscounted asset of £700 million and a discounted value of £360 million (p. 7, 14). Reinsurers’ share of claims paid was reduced from last year from £209 million to £190 million, a reduction that is not surprising given the reduction in claims payment from Equitas and the dwindling value of the remaining reinsurance. One can express sympathy with Equitas for its problems in collecting from its reinsurers: “We see a growing trend for some reinsurers to dispute claims for no other reason than to demand discounts in the hope we will be afraid of the costs of collecting these balances.” (p.7)

* Equitas identifies the amount of “profit” it has made on settlements, profit in this context being the amount of reserves freed from a settlement at a figure less than the reserved amount. £435 million of Equitas’ surplus is acknowledged by it to be attributable to settlements it has made over the past four years at amounts less than the reserves it had previously established for the claims. Last year, settlements contributed £81 million to Equitas’s bottom line. (p.4) In other words, 95 percent (!) of Equitas’s net surplus is attributable to these reserving-freeing settlements.

* There are several related threads to follow to grasp the significance of this figure. When Equitas was established in 1996, it is known that the money it raised was reverse engineered based on predictions on what it could collect in settlements with brokers, managing agencies, and the reinsured names. The initial Equitas premium indication was widely viewed as being unacceptable to the individual participants at Lloyd’s, so the Equitas premium number was reduced to a level that the “names” would accept. When Equitas began operations in 1996, it had a “solvency” margin of 5.6%, meaning its then projections of liabilities were 5.6% less than its assets. In order to open for business, Equitas could not be insolvent the first day, so its reserves had to be reduced to allow it to (barely) show a solvency margin.

* Equitas has since hiked its reserves substantially, particularly for asbestos. Reserve adjustments affect the year they are made (p. 35), so a settlement with policyholder X in 2003 that yielded a settlement profit of, e.g., $10 million should be recognized as yielding a settlement profit of a significantly greater amount if the associated reserves would have floated upwards with other reserve adjustments in subsequent years. So Equitas’s announcement of its settlement profit in the prior year understates the true profit amount, since the policyholder sold out its coverage for an even greater discount than it may have anticipated at the time of settlement.

* So, the reserve number for any given settling policyholder is likely to have been underestimated for either of two reasons: (i) all reserves were understated in the reverse engineering process to generate an acceptable Equitas “finality” premium and (ii) reserves subsequently have been adjusted upward either to compensate for that (conscious) underestimation or because then-unforeseen events yield higher valuations of the claim streams.

* Given that virtually all of Equitas’s solvency margin (and surplus) is attributable to policyholders’ settling out their coverage too cheaply, one can fairly say that the only thing keeping Equitas afloat is policyholders’ settling for too little (even from Equitas’s perspective).

* In this light, and perhaps in response to my constant harping on this issue (a theme I don’t see elsewhere), the CEO of Equitas offers the following defense of its claims-settlement practices:

“When we settle claims, whether those coming into us, or those we make on reinsurance policies, sometimes we pay or receive more than we had reserved, and other times less. . . . [S]ome deals were ‘winners’ (producing a contribution to surplus) while others were ‘losers’, but in the aggregate we achieved a win.” (p.4).

* I would challenge even the verity of the statement that some were ‘losers’ (for the reasons above) but at all events in the aggregate it is indisputable that Equitas’s effectiveness in snookering policyholders into settling for less than the reserve is Equitas’s margin.

* Given the tremendous success that Equitas has had in extinguishing major liabilities with its reinsureds’ direct policyholders (it has settled with all 10 of the largest direct asbestos policyholders identified in 2001 (p.2)), Equitas has now turned its attention to its “inwards” reinsurance with US insurance companies. (p. 10) Since the time of the annual report, Equitas has achieved a major settlement with The Hartford (and which resulted in Hartford’s realizing less than its booked reinsurance receivable). So perhaps policyholders can take solace that they are in good company.

Notes: My commentary is available for Equitas Financials 2005 and 2004.

On March 31, 2006, 1 pound equaled $1.74.

Posted by Marc Mayerson at 2:16 PM | Comments (0) | TrackBack

May 17, 2006

Taming the Lion(cover): Lioncover, Lloyd's, Equitas, and the Central Fund(s)

W. Mark Felt or Hal Holbrook playing him said to "follow the money," which has proven difficult in the instance of Lloyd's of London, and a task made all the more important as asbestos and environmental liabilities continue to fall upon corporate policyholders in the US that purchased broad insurance in the 1950s, 60s and 70s through the London market. While lawyers and policyholders may be familiar with Equitas, the reinsurance runoff and claims-handling vehicles set up in the late 1990s to deal with liabilities arising under historical Lloyd's policies, I have long believed that a key for litigators is something called Lioncover, a reinsurance vehicle originally set up to bailout important players at Lloyd's who were involved in Peter Cameron Webb "managed" syndicate years of account. Lioncover, which I understand to be a wholly owned subsidiary of the Corporation of Lloyd's and which houses the PCW business, initially was not reinsured into Equitas when Equitas was set up as part of the "Reconstruction and Renewal" of the Lloyd's operation. It was later poured into the Equitas structure but also is explicitly backed by the Lloyd's enterprise itself. Lioncover is a lever one can use to uncover the financial vehicles backing old Lloyd's policies (which contra to popular myth are not backed solely by the assets of Equitas or by the trust funds in the US). Lloyd's annual report for 2005 contains a few interesting crumbs worthy of note for Lloyd's/Equitas watchers.

First, Lioncover's liability payments in 2005 total slightly more than 525 million pounds or roughly $1 billion (US). These principally were attributable to asbestos, environmental, and health-hazard claims. (p. 114; note 14)

Second, this amount is not reflected on Lloyd's net balance sheet because the directors of Lioncover conclude that, because Equitas says it will pay the claims, it can take that reinsurance recoverable as an offset on its balance sheet. (p. 120) As Lloyd's annual report states:

At present, ERL [Equitas Reinsurance Ltd.] and its subsidiary undertaking, Equitas Limited, which is responsible for the run-off of the reinsured business, continue to pay claims in full and the directors of ERL have stated that they believe that the assets should be sufficient to meet all liabilities in full. Accordingly, the directors of Lioncover have considered it appropriate to recognise the amounts recoverable from ERL in full. Should ERL ever cease to meet in full its obligations in respect of the PCW syndicates, Lioncover would be responsible to its policyholders for meeting any amounts remaining unpaid.

The establishment of Lioncover and its reinsurance into Equitas does not cutoff the policyholder's right to make claim under the policy as against the Lloyd's enterprise. (This is consistent with what I have been counseling that one should not look at Equitas' assets alone when evaluating whether to include a credit-risk discount in a deal done with Equitas.)

Third, in the event Equitas does fail to perform, then Lioncover may seek to obtain payment from the "Central Fund," which helps back the policies issued through Lloyd's. As part of the Reconstruction and Renewal process, there is an "old" Central Fund and a "new" Central Fund, and Lioncover can claim under both, though the Council of Lloyd's purports to have discretion not to pay under the new fund unless the current membership agrees. As the report explains:

Following the implementation of ‘Reconstruction and Renewal’, Names underwriting in respect of 1992 and prior years, Lioncover and Centrewrite were reinsured into Equitas. If Equitas were unable to discharge in full the liabilities which it has reinsured, any resulting shortfall in respect of Lioncover or Centrewrite could be met out of both the ‘Old’ Central Fund and the New Central Fund under the terms of their respective Lloyd’s bond. Both the ‘Old’ Central Fund and the New Central Fund would also be available to meet the claims of policyholders of Names who are party to hardship agreements executed before 4 September 1996, to the extent that such an event resulted in a shortfall. However, unless the members of the Society resolve in a general meeting to make the New Central Fund available, only the ‘Old’ Central Fund would be available to meet the claims of policyholders of Names who are not party to hardship agreements executed before 4 September 1996. The Council has determined that any losses resulting from such indemnities will be met by the Lloyd’s Central Fund. (p. 132, note 29)

There certainly is an open question whether there really is discretion not to pay under the new Central Fund, but the reason we care about this is that it is the current membership of Lloyd's that would be responsible for topping up the fund in the event of a shortfall (and that there would be a shortfall is a likely result if the new fund were tapped).

Note that simultaneously Lioncover's liabilities would need to be shown on Lloyd's balance sheet and the capital of the members would be hit, thus doubly impairing the financial ratings of the Lloyd's enterprise.

Fourth, my sense continues to be that, if Equitas stops making payments or determines that it has more mouths to feed than money (or owns up to that reality), following what happened with Lioncover and how it has been intermingled with "new" Lloyd's will be a key focus for discovery and trial when policyholders seek payment on their old Lloyd's policies and are shunted off to the admittedly penurious Equitas. The story of insiders being bailed out through Lioncover and new Lloyd's assumption of those liabilities and seeming manipulation of its own financial statements (by taking the reinsurance recoverable as a full, undiscounted offset while Equitas otherwise is proclaiming its own credit risk) will be the stuff of trial. The promises Lloyd's makes when selling policies are supposed to be backed up by the vaunted "chain of security," which means the assets of the current membership of the Lloyd's enterprise. Compare Industrial Guarantee Corp. v Lloyd's(1924) 19 Lloyd's List Law Reports 78 (Bailhache J).

The Lloyd's enterprise's efforts to "ringfence" the historic liabilities and to protect the current corporate members may yet prove successful -- at least to the extent that policyholderscooperate in obtaining less than the full value of their insurance; the chain of security will back the policies US companies purchased only once those companies bring litigation to force the Lloyd's enterprise to honor the promises made in the broad insurance policies sold to American companies (or in the unlikely event that regulators step in). Certainly, the halcyon days of Cuthbert Heath saying "pay all our policyholders in full" are long, long gone.

A somewhat expanded version of this commentary appears in 17 Mealey's Litigation Reports: Reinsurance (June 15, 2006).

Posted by Marc Mayerson at 12:54 PM | Comments (1) | TrackBack

December 11, 2005

A Slip ‘Twixt the Cup and the Lip: Captive Insurers and Reinsurance Recovery

The price of an insurance policy naturally includes a projection of future payouts under the policy plus a profit margin for the insurer. Rather than giving profit to an insurance company, sometimes corporate policyholders will elect to try to capture that profit by creating a “captive” insurance company. In this way, when the premium is paid to the captive insurance company, the “profit” component is retained on the corporation’s overall balance sheet. There are other reasons to establish a captive: a sense of greater control over the loss-adjustment process; greater certainty of performance; and opportunities for certain tax advantages (not so much from the deductibility of premium expenses as compared to the accrual of reserves but rather from obtaining investment income in a tax-advantaged manner on assets held by (or stuffed into) foreign-domiciled captives).

It is uncommon to find that a company only has a captive program: typically, there is commercial insurance market involvement through excess-layer insurance above the captive or through reinsurance of the captive. (Sometimes the reinsurance relationship is the converse where the insured has commercial insurance that is reinsured into the captive.) When a corporation taps reinsurance markets, what it wants most assuredly is the seamless flow of loss and coverage through the captive to the reinsurer once the retention is exceeded. In this regard, a recent High Court decision in London is important to note, because the decision creates a gap in this flow stemming from of all things a difference in “choice of law” as between the captive-issued policy and the reinsurance policy backing it.

In CGU Int’l Ins. PLC v. AstraZeneca Ins. Co. Ltd., [2005] EWHC 2755 (Dec. 1, 2005), Mr. Justice Cresswell held that a captive insurer might not obtain recovery due to a disjunction between the interpretation of the identical words between English and US state law. In CGU, the captive faced a loss from an affiliate; that affiliate submitted a claim for coverage that the captive evaluated at arms’ length and paid. The reinsurers had been apprised of the claim and the possibility of settlement in advance, and they did not dispute that all procedural duties pertaining to the perfecting of the reinsurance claim had been satisfied by the captive/cedent.

It was common ground as between the captive and its reinsurers that, had the claim not been paid, the affiliate would have sued the captive for coverage in state court in the US and that the US court, properly applying its own choice-of-law rules, would have applied US state law to the loss in question. Faced with that inevitability, the captive paid the claim guided by that state’s law and turned to its reinsurers for indemnification.

The reinsurers denied recovery for most of the claim by advancing the curious argument that assuming ex hypothesi that the captive’s payment was validly compelled with respect to the US state law the scope of coverage under English law for the same loss was narrower. In other words, the reinsurers argued that one must take the identical words and identical loss and run them through English law, even though the underlying loss would have been litigated and resolved under US law.

The CGU court construed the placing slip – providing coverage “as original” – to mean, as a practical matter, that one takes the words from the original contract being reinsured and retypes them into a new document containing the identical words. Instead of confirming an intention that there be no gap between the terms afforded under the original policy and the reinsurance, “as original” in fact will create a disjunction to the extent the original policy will be construed under a different set of laws from those applying to the retyped policy. As the court states: “Where the reinsurance incorporates the terms of the underlying, the coverage terms of the underlying insurance are treated as incorporated in a contract which is expressly governed by English law. That incorporation took place at the outset, and the coverage terms bore, from the outset, the meaning attached to them applying English rules of construction.” Id. at [126].

In CGU, therefore, the result of the court’s ruling is to put the captive in the following position: having a full obligation to perform vis-à-vis its own insured guided by the applicable US state’s law and having its reinsurance recovery decided by a different jurisdiction’s law with a more parsimonious view of the coverage afforded under the identical words. While recognizing implicitly that the captive’s payment of its insured was compelled (and so was not an ex gratia payment or voluntary), the High Court ruled that unacceptable commercial uncertainty otherwise would result were the reinsurers bound to pay according to the legal obligations of the cedent/captive. Id. at [118], [128].

One lesson of the CGU case is that, when placing reinsurance in the London market for a worldwide program, the company needs to be prepared to incur a substantial additional retention stemming from the disjunction in the coverage afforded under the local law governing a dispute with one of the captive’s insureds and the same words as construed with an English-law gloss. Placing coverage “as original” will not ensure that coverage flows seamlessly – to the contrary, “as original” will create a disjunction in a worldwide policy.

Accordingly, captives placing reinsurance through the London market in particular need to make express the hitherto assumed expectation that the reinsurance will be back-to-back to the captive’s coverage. The captive needs either (i) to issue a policy with the same choice of law (and preferably choice of forum) as that governing its reinsurance or (ii) to craft language in its reinsurance contracts that compels the reinsurers to follow the coverage as it will be construed under the law governing a claim under the captive-issued policy.

Posted by Marc Mayerson at 6:05 PM | Comments (1) | TrackBack

July 26, 2005

Dissolving Solvent Schemes of Arrangement

Bankruptcy is one option for insolvent companies to manage their obligations to creditors and to provide an efficient mechanism to marshall assets for their benefit; an insolvent insurance company similarly may enter a bankruptcy-like process and pay the claims of its creditors – its policyholders – and marshall its assets (typically reinsurance). Over the past few years, however, we have seen increasing numbers of solvent insurance companies seek to ring fence their liabilities – and lock in profits or at least circumscribe losses – by entering into bankruptcy-like processes by which they forcibly commute their obligations to their policyholders. In 2002, Rhode Island established legislation permitting this type of solvent runoff, but most of the action in this area has been in England for London-market insurers that wrote substantial North American (especially US) risks under broad occurrence policy forms and that now wish to extinguish the long-tail liabilities that naturally follow. Because of a new English decision, however, the ability of London market insurance companies to forcibly terminate their obligations to their policyholders is now in substantial doubt.

London market insurance companies enter what are called “schemes of arrangement” – akin to US Chapter 11 proceedings – in which they seek to reorganize their debts (that is, obligations to policyholders). The advantages for the insurance company from such a scheme are obvious: they achieve finality and potentially release capital back to the company or its parent. The process involves formal application with courts and the division of creditors into classes who have meetings and vote on the proposed scheme. Usually, an application will be made in US bankruptcy court for a section 304 injunction (11 USC § 304), which enjoins US litigation against the company, notwithstanding service-of-suit clauses, and funnels all claims to the English reorganization proceeding. Creditors such as policyholders submit claims by a set bar date, which is the basis for a liquidation of their coverage rights.

Claims of policyholders fall into three basic categories: mature, unpaid claims where the amount of loss is known; mature claims where the policyholder’s liability has yet to be established; and incurred-but-not-reported (“IBNR”) claims which involve injury occurring in the period of the carrier’s coverage but which have yet to be asserted against the policyholder. This all echoes Donald Rumsfield’s famous quatrain:

As we know,
There are known knowns.
There are things we know we know.

We also know
There are known unknowns.
That is to say
We know there are some things
We do not know.

But there are also unknown unknowns,
The ones we don't know
We don't know.

(Feb. 12, 2002, Department of Defense news briefing) The Secretary’s trenchant categorization applies with equal force to characterizing the nature of claims against policyholders covered by occurrence coverage and that are unasserted and unliquidated. Guarding against the risk of future of liability of course is the purpose of the policyholder’s purchase of insurance, and one crucial advantage of occurrence-based coverage is that it applies no matter when the claim is eventually asserted against the policyholder, so long as injury or damage occurred in the period of the carrier’s coverage.

Solvent schemes of arrangement seek to cut off the “inconvenience” of the long tail of claims under occurrence policies by forcing the policyholder into a compulsory commutation (buy-back) of its coverage. Therein lies their vice (from the perspective of policyholders), and the High Court of Justice recently invalidated a solvent scheme of arrangement. The case, In the Matter of the British Aviation Insurance Company Ltd., 2005 EWHC 1621 (Ch.), invalidates the scheme on various technical grounds, such how the voting classes were constituted (see paragraphs 83, 92, 93), and thus the court found itself without jurisdiction to uphold the scheme. More significant, however, is its ruling refusing to sanction solvent schemes of arrangement more broadly on the ground that they unfairly force policyholders to liquidate unknown asbestos and other health hazard claims that may or may not come to fruition. (One remains free always to commute policies voluntarily with an insurer for the known-unknowns and the unknown-unknowns; in a solvent scheme, policyholders are forced to liquidate coverage for their IBNR claims.)

In refusing to uphold the scheme essentially on the grounds of fundamental unfairness, Mr. Justice Lewison distinguished the situation of ordinary policyholders from that of insurance companies that may have inwards and outwards reinsurance with British Aviation Insurance Company (BAIC).

“Unlike the direct insureds, the insurers are in the risk business. Given the uncertainties of the extent of potential exposure to asbestos and other long-tail claims, it makes perfect sense for them to be keen to cap their liabilities. If the Company’s liabilities are capped, so are their liabilities as reinsurers. Their mutual liabilities are set off under the scheme. This does not apply to the direct insureds, who remain liable to those who contract asbestos-related diseases.”

(Paragraph 121) The direct insureds, the policyholders, thus face the prospect (were the scheme approved) of facing greater liabilities than were the basis for the claims estimation, yielding a gap in coverage to which they otherwise would have been entitled had the insurer simply continued in its solvent runoff. As the court explains, “So far as policyholders with IBNR claims are concerned, their right in a solvent run-off is to wait and see whether a claim materializes, and if it does, to have full indemnity against the claim. They have already paid their premiums for the insurance cover, so they are at risk of no further expenditure in relation to a valid claim.” (Paragraph 90). There is no risk of the insureds receiving less than that to which they are entitled if the insurance company simply pays claims as they come due.

In contrast, in the proposed solvent scheme of arrangement, in which the policyholders’ rights are cut off and liquidated, the very risk transfer the policyholder sought to achieve may be turned back to the policyholder involuntarily. As Mr. Justice Lewison explains:

“[It is] unfair to require the manufacturers who have bought insurance policies designed to cast the risk of exposure to asbestos claims on insurers to have that risk compulsorily retransferred to them. The Company is in the risk business; and they are not. This is not a case of an insolvent company to which quite different considerations apply. . . .[T]he Company is able to meet its liabilities under such policies as and when they fall due. The purpose of the scheme is to allow surplus funds to be returned to shareholders in preference to satisfying the legitimate claims of creditors. No matter how useable and reasonable [a claims] estimate may be, the very fact that it is an estimate is likely to make it an inaccurate forecast of the actual liabilities of policyholders. If individual policyholders wish to compound the Company’s contingent liabilities to them, and to accept payment in full of an estimate of their claims, there is nothing to stop them doing so. But to compel dissentients to do so would . . . require them to do that which it is unreasonable to require them to do.”

(Paragraph 143) Although the discussion of the fundamental unfairness of solvent schemes technically may be an alternative holding of the court, the breadth and power of the court’s analysis surely casts a pall on their continued popularity. On a going-forward basis, policyholders receiving notice of a solvent scheme of arrangement should arrange to vote in the creditors’ meeting and object on grounds of fundamental unfairness (and consider whether it is appropriate to object to the constitution of the creditor classes). For those solvent schemes that have been approved by a majority, the court retains continuing jurisdiction, and previous objectors presumably may be able to renew their objections. (For a recommended treatise about the English insurance insolvency process, see here.)

A solvent scheme is a mechanism that is too clever by half. Mr. Justice Lewison's decision has become final, and no appeal was taken. Time will tell whether we’ll continue to see this particular form of scheming by solvent companies to cauterize their liabilities under the very broad coverage they sold to US policyholders.

A version of this article was published in 22 Tolley's Insolvency Law & Practice 23(London 2006).

Posted by Marc Mayerson at 5:29 PM | Comments (3) | TrackBack

June 29, 2005

Equitas Financial Reports – 2005 Version

As part of the Reconstruction and Renewal of Lloyd’s in 1996, several Equitas entities were created to serve as the final reinsurer-to-close and to manage the run-off of underwriter liabilities for non-life 1992 and earlier business.

On June 7, 2005, Equitas issued a press release on its annual results and more recently made available its Report & Accounts for the year ended 31 March 2005.

Equitas reported that its accumulated surplus increased immaterially and now totals £476 million; its solvency margin increased over last year by nearly 25 percent to 12.2 percent.

Equitas further hiked its asbestos reserves by £167 million, a figure notable in part given the obvious tactical advantage to Equitas in not raising its reserves at all, in view of the possibility that its reserves will be used as a benchmark for determining its contribution to the US asbestos trust fund, were it ever enacted.

Equitas continues to proclaim that it will be able to make payment of claims in full and emphasized that its board never has considered invoking “proportionate cover,” a power purportedly vested in Equitas to undergo a private bankruptcy in which it pays only a percentage of what it believes it owes on claims. See Report, Chairman’s Statement.
Equitas, however, continues to tout credit risk as a principal reason for policyholders to liquidate and settle their rights to coverage. See Report, Directors’ Report (“The principal risk remains that the Group may not be able to settle its liabilities in full.”).

The press release tries to stimulate further policyholder settlements, saying: “When many companies, including some of the world’s best known businesses, are agreeing settlements with Equitas, the directors of other policyholders will properly question why they should not do the same.” (Commentary at 6). What may have prompted Equitas to make this particular comment was the contrary view of Equitas settlements reported recently in London’s Financial Times, see Steven Fiedler, Will Equitas Come Back to Haunt the Big Companies? Financial Times (Nov. 8, 2004), at 15 (I confess that the FT article quotes me).

But Equitas’s justification of its own settlements confirms these may be one-sided deals. The Press Release explains that “[t]he value of claims from certain policyholders is susceptible to material change depending on the outcome of litigation or variation in claim trends. The liability for such policyholders are . . . the most dangerous. . . . Of the 28 major direct asbestos exposures we have settled since April 2001, 20 were among the most unpredictable that we faced. . . . Their resolution offers Equitas (and the policyholder) protection against wide swings in the value of these cases.” (Commentary at 6). No doubt a policyholder faces risk that there can be materially adverse developments in insurance-coverage law, but it is unlikely that Equitas is settling claims based on unusually policyholder-favorable interpretations of coverage; the wide swings in values to which Equitas refers are unlikely to result from insurance-law developments. Rather, holding aside such developments as a swing factor in the valuation of a settlement, the drivers of settlement values are predictions of the dollar cost of the asbestos claims and the claim flow.

For example, if the expectation is that the claim stream will total $150 in total over the next ten years, settling today for, say, $100 is the economic equivalent (assuming the discount rate used is right and full coverage). However, if the settlement is for $100 and the claim stream ends up costing $200 over the ten-year period, the policyholder has undersold its coverage, and Equitas has done a good deal. Equitas’s comments about the swings in values reveals that it is only the policyholder that is at risk, especially assuming that asbestos claim values unforeseeably escalate (which has happened in the past – several times). In other words, the “wide swing” that Equitas is protecting itself against is more likely than not to be a swing upwards in the value of claims – in which event the policyholder will have liquidated its coverage today without getting full value.

Only if the settlement is cast against the expectation that the value of the claim stream will (unaccountably) go down is there any swing favoring the policyholder in these deals (and potentially a windfall to the policyholder in receiving more payment for its coverage than the economic value of the amounts to which it otherwise would be entitled in the ordinary course). The likelihood of such a downdraft in asbestos claim values seems remote in the extreme. (The possible impact of federal asbestos-liability reform is taken into account in settlements separately, see below.)

Furthermore, given that the Lloyd’s policies that Equitas manages usually are excess policies, Equitas is not typically controlling the defense and settlement of the underlying asbestos liabilities. Accordingly, it is telling when Equitas says that “claims management strategies adopted by the group will reduce claims payments below the level that they would otherwise have been” (Report at Note 2). Equitas is not managing the claims to reduce the payouts to asbestos plaintiffs or to defense lawyers; Equitas is managing the claims to reduce payments to policyholders.

When one sprinkles into the mix a discount being provided by the policyholder for Equitas’s credit risk – which Equitas touts on the one hand and pooh-poohs on the other – then it is clear that Equitas continues its successful practice of inducing policyholders to settle for less than economic value.

In fact, Equitas annually monetizes the amounts it estimates it has saved by doing deals with policyholders at amounts below the reserve for the particular policyholder’s claim stream (note that Equitas discounts its reserves, so the reserve number and a present-value buyout should be equivalent). For the 2004-2005 fiscal year, Equitas says that “claims and commutation activities” produced £95 million of profit, that is, that through its claims settlements Equitas was able to take £95 million into income by settling for less than the reserved value of the claims. See Release, Commentary at 9. (Although the £95 million takes into account reinsurance settlements, given that in excess of 85 percent of Equitas’s outwards reinsurance already had been liquidated before the fiscal year began and assuming that Equitas had not seriously underestimated the value of its reinsurance recoverable, one can reasonably infer that the overwhelming bulk of the settlement “profit” came at the expense of policyholders that settle for amounts below the reserved level.) In fact, more than 70 percent of Equitas’ surplus is accountable to the impact of these Equitas-favorable settlements over the past three years alone (2005, £95 million; 2004, £97 million; 2003, £142 million).

The £95 million in settlement profit in 2004-05 – more than 25 percent of Equitas’s current reported surplus – in fact may represent an even larger amount considering that Equitas does not retroactively adjust its books when it later increases its asbestos reserves. In other words, if Equitas next year increases its reserves by, e.g., £150 million for asbestos liabilities (and in 2004 it increased asbestos reserves by £296 million), the settlement profit for year 2004-05 in truth will be greater than the £95 million (because the reserve for that policyholder should have been higher); but according to Equitas’s accounting practices, “any consequential adjustments to amounts previously reported will be reflected in the results of the year in which they are identified.” (Report at Note 2).

Finally, Equitas rectified an omission in last year’s report by discussing the impact of the “out” clauses it has included in recent major settlements of asbestos liabilities, in which the settlement with the policyholder is altered or vitiated in the event that, e.g., federal asbestos-liability reform legislation is enacted vel non. Equitas reports that a total of £370 million may be returned to it based on various contingencies, principally regarding federal asbestos legislation, but that contingent asset presumably will need be offset against the reinstatement of some policyholder claims.

(Note: As of 31 March 2005, £1 GBP = ~ $1.88 US.)

Posted by Marc Mayerson at 4:40 PM | Comments (0) | TrackBack

June 25, 2004

Equitas Financial Reports – 2004 Version

As is well known, Equitas Ltd. manages the run off of liabilities under non-life insurance policies issued by underwriters at Lloyd’s, London, prior to 1993, and these policies are exposed to paying for liabilities of US companies for certain asbestos, environmental, and other “health hazard” claims of injury or damage that occurred in the period of their coverage. Each year, Equitas publishes its financial results as of 31 March (for 2004, its Reports and Accounts were released in late June but were dated 3 June 2004) and provides additional commentary via an accompanying press release (dated 8 June 2004).

Equitas’s press release confirms that the accumulated surplus of Equitas has been reduced to ₤460 million, down ₤67 million the year before.

Equitas has liquidated approximately 85% of its total reinsurance receivable.

Equitas notes that its gross undiscounted asbestos reserves have increased to ₤4.0 billion (increased by ₤296 million).

According to its figures Equitas’s solvency margin improved to 9.8% from 8.7%.

Of particular note are the following:

Equitas’s Chief Executive Officer, Scott Moser, candidly acknowledged that, when assureds agree to policy buyouts (whereby they liquidate and extinguish all rights to coverage under policies issued by Lloyd’s underwriters prior to 1993), one key factor driving the pricing for those assured is “eliminating credit risk” (Release p.2; Report p. 5) – that is the credit risk of Equitas’s being unable to pay claims. Nevertheless, in a typical example of Equitas double-talk, footnote 1 to Equitas’s financial statements proclaims, “The Directors believe that the assets should be sufficient to meet all liabilities in full” (Report p. 33) (emphasis added). While Equitas represents to policyholders that there is substantial credit risk, to their auditors Equitas represents the opposite.

Equitas acknowledged that its claims settlements with policyholders were for an amount nearly ₤100 million less than the book value of the claims. (Release p.8) In other words, Equitas paid ₤97 million less to its assureds than the amounts Equitas reserved for their future stream of claim payments. As we have seen upwards adjustments annually to Equitas’s asbestos reserves for the past several years, if one were to assume that next year Equitas again “strengthens” its reserves, the underpayment to its assureds in fact will turn out to be greater than the ₤100 million in savings Equitas acknowledged this year. (Last year (2003), Equitas acknowledged freeing ₤142 million through settlements with its assureds for less than the reserved values, but its current release does not indicate the appropriate upward adjustment of the “savings” from the prior year’s settlements, given that, even considering those policy buyouts, Equitas was constrained to increase its asbestos reserves again.)

Equitas’s analysis of the proposed US asbestos-reform legislation showed that its passage would have resulted in Equitas’s risking becoming insolvent. That Equitas views the legislation’s passage as risking its own solvency calls into the question its ability to meet the asbestos-coverage claims of its US assureds.

Equitas’s major asbestos deals this past year vest in it the right to a refund, or reduction in its future payout obligation, of ₤400 million, in the event federal asbestos-liability reform legislation passes. Equitas does not explain whether it takes this contingent asset into account in its financial statement or in its analysis that passage of the legislation may result in its insolvency.

Equitas has commuted (liquidated) more than 85 percent of its potential reinsurance recoverables. (Report p. 6) As a result, Equitas is unable to justify its oft-invoked statements to policyholders that unless they demonstrate syndicate information on their Lloyd’s coverage Equitas is unable to make any payment; though this position had some equitable force when Equitas needed such information to facilitate its own outward reinsurance recoveries, that those recoveries have been received already via commutations means that Equitas’s need for this information has correspondingly diminished. Given that Equitas was itself able to achieve commutations without knowing each particular assured’s allocation of liabilities to particular policies, Equitas cannot equitably contend that it should pay nothing with respect to a policy that is known to cover a certain dollar amount but as to which syndicate-participation information is lacking.

Equitas balances the candid admission of its underpaying its own assureds with the exhortation to its policyholders to settle their claims with Equitas: “If you are being told that you cannot do a fair deal with Equitas, you need new advisers.” (Release p.3; Report p.11) Equitas plainly believes that “fair” deals are at less than its reserve levels for the claims released and are priced against the threat of Equitas’s insolvency.

The impact of an Equitas insolvency, however, must be offset against the financial structures undergirding the original sale in the US of policies through Lloyd’s. There are US based trust funds, as well as the “old” and “new” Central Funds and possibly the full capital resources of Lloyd’s current membership, that are part of the “chain of security” backing Lloyd’s underwriters’ policies. For example, according to the 2004 Report, there is in excess of ₤2.5 billion in US and Canadian trust funds “for the settlement of claims relating to those jurisdictions.” (Report p.40). A policyholder’s right of recourse to these monies, however, is released in policy settlements with Equitas.

Posted by Marc Mayerson at 6:24 PM | Comments (0)