October 12th, 2010

Continental European Legislative and Judicial Trends: Run-Off Portfolio Transfer by Means of a Captive Under Swiss Law

Posted at 1:00 AM ET

2010_legislative_thumb-2David Lewin, Managing Director
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An insurer that discontinues the underwriting of new business is said to be in run-off. Irrespective of the reasons for discontinuing the underwriting activity, the run-off of a business gives rise to obligations with regard to the administration of the existing portfolio. In theory, the run-off business continues until all insurance contracts are terminated. The problems arising from a long-lasting passive run-off give a strong incentive to insurers to shorten the run-off period. However, run-off scenarios affect in particular the casualty insurance industry, as the run-off business volume in casualty insurance (including motor liability insurance) is even higher than in other insurance lines of business. (1)

The implementation of Solvency II in the European Union and the Swiss equivalent, the Swiss Solvency Test (SST), are expected to intensify the situation, as they require insurers to maintain and demonstrate adequate capital resources and to maintain appropriate risk management structures that impact run-off portfolios in particular. (2)

This article scrutinizes the question as to the extent Swiss primary insurance portfolios can be shifted to a UK-based captive by means of a portfolio transfer. The article outlines the reasons for a practical need for such a portfolio transfer by presenting the instrument of the Solvent Scheme of Arrangement (”Solvent Scheme”) in run-off scenarios. An attempt will be made to give a short overview of the relevant Swiss regulations concerning portfolio transfers in order to extrapolate the characteristics in law.

Need to Shorten Run-Off

The rationale for run-off might be related to the entire insurance company or only concern a line of insurance or merely one insurance tariff. In many cases, run-off scenarios are chosen solely because of a lack of profitability of an insurance line.

A “passive” run-off, for example, where an insurer ceases its underwriting while letting its remaining contracts expire by reaching their term, might last decades. What is more, during this entire period the insurer is obliged to bear the administrative costs and liabilities arising from the run-off business. In many cases, the loss ratio of such run-off portfolios is very high. This is due to the fact that the ongoing downsizing of the risks on grounds of expiry, cancellation or settlement brings a decreasing spread of risks.

On the other hand, the premium net income of run-off portfolios is very low, which gives a strong incentive to the insurer to foreclose these inactive portfolios and to attend to its active business instead. To sum up, the problems arising from a long-lasting passive run-off are well-known to insurers and give rise to their eagerness to considerably shorten the run-off period.

Instruments to Shorten the Run-Off

The closing of the portfolio can be achieved by different means, such as commutation, portfolio transfer, debt collection or retrospective reinsurance.

These instruments - notwithstanding portfolio transfer (3) - suffer from the flaw that they can be applied only if accepted by the insured. If but one insured person fails to agree, another solution has to be found at least for the person in question.

Only by implementing a Solvent Scheme is it possible to achieve the shutting-down of the portfolio in its entirety with binding effect on all insured parties, notwithstanding their individual disapproval.

Solvent Scheme under British Law

Pursuant to the British Company Act 2006 Part 26, a Solvent Scheme is used for a so-called “solvent liquidation” by way of a mandatory arrangement.

To summarize briefly: For the scheme to be approved, a majority of creditors (50 percent in number and 75 percent by value of those voting) must vote in favor of the scheme. In addition, the arrangement has to be approved by a competent British High Court. If the scheme is sanctioned by that court, the order of the court must be registered at the Office of the Registrar of Companies.

As a result, the Solvent Scheme brings about a ommutation with all policyholders and allows a final distribution to be made to creditors. In addition, it compels policyholders to accept a one-time payment in return for excluding all future claims that might still arise from past policies.

For a solvent scheme to be implemented, the British Company Act 2006 further requires that either the portfolio or a subsidiary company be located in the United Kingdom or that there be a substantial link to the United Kingdom. (4)

For the insurer, this procedure has an advantage in that the entire portfolio of active insurance contracts or the whole line of business in question is terminated. This might have a positive effect even for creditors, as they obtain direct payments. Furthermore, they are released from the risk that the insurer might become insolvent in the future.

However, the applicability of solvent schemes for Swiss portfolios is unclear. In the following, an attempt will be made to give a succinct answer to the question of whether the mere formation of a captive company or the utilization of an already existing captive might constitute a substantial link to the United Kingdom which would allow an active run-off by implementing a solvent scheme.

Further clarification is needed as to whether the termination of insurance contracts resulting from the implementation of a British solvent scheme would be recognized under Swiss law.

Substantial Link to the United Kingdom by the Formation of a Captive

The formation of a captive by a Swiss insurer in the United Kingdom could create a substantial link which would allow the transfer of the portfolio to said captive in order to run it off by a Solvent Scheme.

Requirements for the Portfolio Transfer

In Switzerland, the transfer of portfolios is subject to the authority of the Insurance Supervisory Authority and is regulated specifically by the Swiss Insurance Supervisory Act (Versicherungsaufsichtsgestz - VAG).

Pursuant to Article 62 para. 1 VAG, which is the applicable regulation for primary insurance portfolio transfers, the supervisory authority only gives approval to portfolio transfers insofar as the interests of the insured are safeguarded collectively. Furthermore, the Swiss regulation strengthens the nfluence of the supervisory authority, which is entitled to specify the conditions of the transfer by specifying volume and content via its approval.

If the portfolio transfer brings a different contractual partner (instead of the assignor) the policyholders have to be advised of the transfer. In such cases each policyholder has the right to cancel the contract within three months (Article 62 para. 3 VAG).

However, according to Article 35 VAG, the regulation of Article 62 VAG explicitly does not apply to reinsurance portfolios. As a result, acceptance of all the reinsured is needed to grant reinsurance portfolios transfers. This would be a challenging endeavor.

Portfolio Transfer to UK-Based Captives

As far as portfolio transfers to a UK-based captive are concerned, two questions seem particularly worthy of being highlighted:

- Are the interests of the insured with regard to such a transfer still being adequately safeguarded?

- Is a captive formed for the sole purpose of facilitating a run-off by way of a Solvent Scheme still an insurance company within the meaning of the Insurance Supervisory Act (VAG)?

Safeguarding the Interests of the Insured

The interests of the insured, according to Article 62 VAG, could be at risk if the portfolio transfer to a UK-based captive is not made on the grounds of continuing the insurance business, but exclusively in order to terminate the whole portfolio by way of a solvent scheme. In this case, it seems questionable as to whether the interests of the insured are still sufficiently safeguarded, as the solvent scheme could even be executed against or without the will of the minority.

In contrast to that, the legislator did not (explicitly) prohibit a portfolio transfer by way of a solvent scheme. It should be noted that the regulation could also facilitate the restructuring and the closing of special lines of business for all insurance entities. In addition, the supervisory authority has discretionary power with regard to the volume and content of the approval and to impose conditions for its approval, as it is regulated explicitly in Article 62 VAG.

To summarize, the interests of the insured do not per se give rise to the assumption that a portfolio transfer to a UK-based captive with the intent to implement a Solvent Scheme is not permissible.

Captive as Insurance Company

Article 62 VAG requires the entity to which the portfolio is to be transferred to be an insurance company. In general, even a captive could be such an insurance company. However, this could be disputed if the captive is formed for the sole purpose of liquidating the portfolio, but not to conduct any active business.

For Switzerland, according to Article 11 para. 1 VAG, it is crucial that there be a causal link (unmittelbarer Zusammenhang) between the normal insurance business and the intended run-off business. That is the case only if “running-off” portfolios are considered to be directly linked with normal insurance business. A captive whose sole purpose is such could be considered an insurer. At this point it has not been decided if this link is still given in a sufficient way when the portfolio transfer goes to a UK-based captive and whether such a solvent scheme which is governed by British law is even accepted under Swiss law.

Summary

Although criticism has been expressed by some, a solvent scheme can be an appropriateinstrument for a rapid and comprehensive liquidation of a Swiss primary insurance portfolio or line of insurance business.

However, the founding of a captive in the UK just for that purpose might not be appropriate, as such a captive would risk not being regarded as an insurance company. The Swiss supervisory authority will in all likelihood distinguish between such cases where the portfolio transfer is made to an already existing captive, which serves different purposes (with the latter more likely being regarded as an insurer and thus as an admissible assignee for the transferred portfolio).

For Swiss primary insurers, as far as the question of portfolio transfers is concerned, it remains doubtful if the competent supervisory authority will agree that the interests of the insured are sufficiently safeguarded when confronted with a solvent scheme scenario. Even if the supervisory authority were to accept such a portfolio transfer, it would hold additional discretionary power with regard to the volume and content of the approval and it might impose conditions before granting its approval.

Notes: 

1 Cf. Speck Schweizer Versicherung of May 28, 2010, p. 22 et seq.
2 Ibid.
3 See infra Chapter IV. 1. in detail.
4 Cf. Labes [2008] ZfV 698 (699).

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