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      • 2007

July 2007

Introduction

1. In this paper, we explain how we engage with Schemes of Arrangement (Schemes) and, in particular, our process for reviewing Schemes which the firms we regulate propose and the criteria we use in that assessment. Our 11 Principles for Businesses set overall requirements for all financial services firms. As part of principles-based regulation, our aim in this publication is to give you predictability, consistency and certainty on the tests we will use to determine whether a firm has acted appropriately in relation to these principles in promoting a Scheme. This paper will be of interest to anyone involved in the UK insurance run-off market – including the management, advisers and policyholders of firms proposing Schemes, trade associations and market commentators.

Schemes of Arrangement

2. A Scheme of Arrangement is a compromise or arrangement between a company and its creditors (or any class of them) under section 425 of the Companies Act 1985. In the context of insurance companies, Schemes were originally used for insolvent insurers as a more flexible and cost-effective alternative to a liquidation. They have recently been used more extensively by solvent insurers seeking to conclude all or part of their business. This paper covers both solvent and insolvent Schemes.

3. A Scheme can be described as a global statutory commutation requiring both creditor and Court approval. Scheme creditor approval means the approval of a majority in number representing not less than 75% in value of those voting at each Scheme creditors' meeting.

4. The Court is involved at two points in the process. It is first involved when the company seeks permission to call the Scheme creditors' meeting(s). The second occasion is shortly after the Scheme meeting(s). At this point the company should report the results of the Scheme meeting(s) to the Court. Where the required majorities have been achieved, the company will ask the Court for an order sanctioning the Scheme. If the Court grants the order, the company should then deliver it to the Registrar of Companies for registration. The Scheme does not become effective until this has been done.

5. Once a Scheme becomes effective, it becomes legally binding on the company and the Scheme creditors. When the Scheme is announced, creditors are invited to submit claims in relation to their liabilities. These claims are then adjusted, agreed and paid under the terms of the Scheme.

6. Most Schemes impose a deadline, or bar date, of between three and six months after the effective date. After this date no further claims may be taken into account for distribution purposes. Scheme creditors who do not submit a claim by this date may receive nothing under the Scheme.

Regulatory issues

7. Schemes are a Companies Act procedure and are not governed by the Financial Services and Markets Act 2000 (FSMA). However, Principle 11 of our Principles for Businesses states that 'a firm must deal with its regulators in an open and cooperative way, and must disclose to the FSA appropriately anything relating to the firm of which the FSA would reasonably expect notice'. This means that if a firm is proposing to implement a Scheme, it must tell us about it.

8. We recognise that Schemes are available to firms under company law and we are not against them in principle. Even so, Schemes raise regulatory issues. In particular, Principle 6 states that 'a firm must pay due regard to the interests of its customers and treat them fairly' and Principle 7 requires a firm to 'pay due regard to the information needs of its clients, and communicate information to them in a way which is clear, fair and not misleading'. These principles are relevant to how Schemes are constructed and implemented, so are relevant to how we evaluate all Schemes. We review all Schemes to reduce the risk to our objectives of maintaining confidence in the financial system and securing the appropriate degree of protection for consumers.

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Our process for assessing Schemes

Our role versus role of firm

9. We review Schemes to reduce the risk to our objectives, but it is the responsibility of a firm's senior management to run its business and to comply with regulatory obligations, including treating its customers fairly. We do not approve firms' Schemes of Arrangement, but we will object to Schemes that pose a risk to the achievement of our objectives.

10. We are unlikely to object to a Scheme if we are satisfied that the firm's proposed course of action falls within the range of possible reasonable actions the firm might take, depending on what is fair in the circumstances.

Review process

11. Our process for considering Schemes involves the following stages:

• Initial notice of Scheme proposals
  
  The firm should tell both its normal supervisor and the Schemes contact in our Wholesale Insurance Run-Off team that it is planning to implement a Scheme. The larger or more complex the Scheme, the earlier the firm should consult us. This consultation may involve a meeting so the firm can present its Scheme proposals to us.

• Review of Scheme documentation
  
  The firm should send us the Scheme documentation in near-final form for review at least eight weeks before the Court directions hearing. While we consider each case on its own merits, we also try to apply a consistent approach to different cases. We have set up a specialist committee within the FSA (the Schemes of Arrangement Review Committee), to ensure consistency of approach.

• Resolve comments and questions with the firm
  
  As part of our review, we may have questions and comments about the Scheme provisions and will discuss these with the firm. The firm should factor in time for dealing with these queries.

• We send the firm a letter of non-objection, if appropriate
  
  After our review, and when we have received satisfactory responses to our questions and comments, the firm will usually ask for a letter from us just before the directions hearing confirming we have no objection to the Scheme. The Court does not require a firm to have this letter, but our non-objection is usually mentioned in the Scheme documentation; and both the Court and the creditors will almost certainly take this into consideration.

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Factors we take into account

12. A Scheme may be proposed for an entire firm, a branch, a subsidiary or a portfolio of business. Depending on the scope of the Scheme, we will look at the reasons why a firm is proposing a Scheme. For example, the type of firm, the type of policyholder, type of liabilities, intended purpose and shareholder intention, including the firm's current and projected financial position (degree of solvency).

Types of policyholder subject to a scheme

13. Our main considerations with regard to the degree of engagement by the FSA will be the type of policyholder and whether;

1. the proposed Scheme would pose a threat to the achievement of our objectives (including the protection of consumers) if it were implemented; and
2. whether, in promoting a Scheme, the firm has acted appropriately in relation to the Principles for Businesses.

14. In considering the degree of protection that may be appropriate for consumers, we must consider 'the differing degrees of experience and expertise that different consumers may have in relation to different kinds of regulated activity' (section 5 of FSMA). This means greater protection and therefore greater FSA scrutiny is usually needed for direct policyholders, and in particular individual direct policyholders, than is required for policyholders that are also insurance and reinsurance firms.

• Private retail policyholders and small commercial policyholders
  
  Where Schemes are proposed for private retail and small commercial policyholders the FSA will review such Schemes in order to assess whether having regard to our Principles the proposal being put is, in the circumstances, a fair exchange for the rights that private retail and small commercial policyholders are being asked to compromise.
  
  The degree of scrutiny by the FSA will depend on the Scheme purpose together with the intended effect of the Scheme on such policyholders. This is because the FSA recognises the difficulties of consumer understanding and engagement. However the FSA also recognises that Schemes for this policyholder group may be an effective tool in certain circumstances (such as the re-organisation of benefits for Equitable Life policyholders).

• Other direct commercial policyholders
  
  Many of the direct policyholders affected by solvent Schemes are substantial commercial companies, which are usually advised by actuaries and other professional advisers. Some direct commercial policyholders have been objectors to Schemes. Most of their objections have concerned Scheme construction. Nevertheless, the Court in Re British Aviation Insurance Company Ltd [2005] EWHC 1621 (Ch) recognised that fairness considerations remain relevant.

• Insurers/reinsurers
  
  Insurance and reinsurance companies are familiar with the process of entering into commutations. A Scheme effectively brings into force a global commutation between an insurer and its policyholders.
  
  Schemes are generally understood by this group of policyholders and they may even consider implementing a Scheme themselves. Insurance and reinsurance companies are 'in the risk business'.

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Other factors we take into account

In deciding whether or not to object to a Scheme, our decision-making criteria will also take into account the following factors. Dependent on the type of policyholder and how their interests are affected we may consider these on a stand alone basis or one in conjunction with another.

1. Degree of solvency

• Insolvent firms
  
  Schemes of Arrangement are routinely used for insolvent insurers and reinsurers as a flexible and cost effective alternative to liquidation. In the case of insolvency, Schemes are likely to be in the interests of policyholders as a whole.

• Marginally solvent firms
  
  Marginally solvent firms are at risk of being unable to discharge their liabilities to policyholders in full. Schemes offer a flexible and cost-effective alternative to servicing liabilities to extinction or in liquidation and may offer policyholders a better return.
  
  For these purposes we define a firm as marginally solvent if its capital resources are below the lower of its own Internal Capital Assessment (ICA) or FSA Individual Capital Guidance (ICG).

• Substantially solvent firms
  
  A substantially solvent firm is unlikely to Scheme the whole of its business unless it is a subsidiary of a substantially solvent group. It is more likely that it wants to exit from a particular portfolio of business for commercial reasons. A substantially solvent firm is a firm with capital resources at or above ICG. Such a firm should demonstrate that the intended outcome of a Scheme is to place policyholders in no worse a position than in a solvent run-off.

2. Type of business
   
   Employers' liability business cannot be Schemed for statutory reasons.
   
   The classes and type of business to be Schemed can affect the ability to estimate ultimate outcomes at contract level. In particular, this is more difficult where policies are occurrence based and the claim has not yet manifested itself.

3. Age of liability exposures
   
   In a mature run-off, it is likely that the largest and most volatile exposures will have already been commuted. The longer business has been in run-off, the more stable and suitable for Scheming it is likely to become.

4. Pools
   
   Schemes have been implemented for insurance pools. In deciding whether to object to a Scheme, we have regard to the solvency level of the firm. In the case of pool Schemes, the various pool members may have different levels of solvency. We recognise the potential benefits to policyholders of pool members acting together. So we will base our decision on a pool as a whole. Consideration of pool Schemes is likely to be complex.

5. Qualification
   
   Despite the decision-making criteria mentioned above, we may not object to a Scheme if the proposer is able to demonstrate that the Scheme treats policyholders fairly, for example through suitable additional benefits for policyholders and/or safeguards for dissenting policyholders.

6. Policyholder Advocate
   
   The FSA accepts that the interests of policyholders may be protected in a number of ways, depending on the circumstances of the firm and the type of Scheme it is proposing. Where a firm is proposing a Scheme which affects the interests of private retail policyholders or small commercial policyholders or is likely to be complex or controversial we may ask the firm to appoint a Policyholder Advocate. In addition, FSA rules already require the appointment of a Policyholder Advocate in relation to the reattribution of an inherited estate.
   
   The Policyholder Advocate should have the necessary skills and knowledge and be free from any conflict of interest that might or might appear to be detrimental to the interests of policyholders.
   
   The precise role of the Policyholder Advocate will depend on the type of firm and its proposed Scheme. Typically, the Policyholder Advocate will liaise with the firm on behalf of the relevant policyholders, for instance over the individual/aggregate value of the benefits the firm is offering to them in exchange for the interests they are asked to give up. The Policyholder Advocate will also advise policyholders on issues such as the estimation methodology and the criteria used for determining their claims. He will also prepare a report on these issues.

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Next steps

15. This is not a formal consultation exercise, but we welcome your views on the decision criteria set out in this process guide. Please send us your comments in writing to:
    
    Paul Taylor
    Wholesale Firms Division
    The Financial Services Authority
    25 The North Colonnade
    Canary Wharf
    London E14 5HS

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