Insolvency & Insurance Industry Concerns: An Overview of General Concerns in the International Context

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1 Insolvency & Insurance Industry Concerns: An Overview of General Concerns in the International Context Introduction The question of insolvency arises in the insurance context for individuals and companies that are insured, as well as insurance companies undergoing insolvency, themselves. For individuals and companies, insurance is not a method by which recovery can be made, at least within the guiding legal principle that we should avoid and reduce 'moral hazard.' In other words, neither individuals nor companies can insure themselves against insolvency, although they can create insurance which helps to protect them in case of a large claimworthy event. However, we do see the concept of moral hazard being abused - ie: we see companies taking advantage of their existing insurance net to claim recovery as against an intentionally or negligently caused basis for a claim. A classic example of this would be a Mafia-owned warehouse in Chicago, past its prime, which is torched in order to collect the insured value for the building after the fire, in cash. Individual Insolvency The point at which debt, as it relates to insolvency, is declarable before public authorities, varies by country. Generally, in the U.S., the personal debt of an individual can be erased in an action of bankruptcy, with the exception of student loans. Two general types of bankruptcy filing exist there. Secured creditors will, at the time of the filing, take preference in the repayment of secured debts, to the degree arranged and permitted by the courts and by law. Unsecured creditors will take value for their loans if value remains in the assets of the estate of the debtor. Otherwise, the conclusion of the personal bankruptcy is the wiping away of remaining value that was lost, and a multi-year credit freeze for that individual. In general, an individual in the U.S. who proceeds to become overburdened with debt cannot escape repayment without filing for bankruptcy. In such a case, assets of particular value will be sold for the purpose of getting as much value as possible at the time of the bankruptcy. This can include the person s primary home and car. In this way, as a result, banks, for example, recently sold the homes of homeowners who had defaulted on their mortgage payments, despite the fact that the prices of the real estate had fallen significantly, leaving the banks holding recoupments far below natural-market values. Such losses, when compounded by the virtual disappearance of consumers willing and able to purchase real estate, caused banks capital requirements to be stretched beyond recovery. Banks were forced to stop providing the loans needed to purchase existing real estate, while, at the same time, accepting less than the total amount due on the mortgage, an unattractive insolvency solution. In contrast, as I understand it, in Norway, an individual whose home mortgage could not be paid, might experience the need to sell the home which, if sold for less than the value of the original loan, would result in a remainder due. The remainder due would follow the

2 individual and not be written down or written off, as in the U.S. The individual would continue to remain liable for the remainder difference until it was paid. Similar debts, registered by the banks, would thus remain an active part of the financial picture of the total economy ie. not becoming both value lost and value given up for good. Company Insolvency Insolvency in recent times concerns not only individuals, but companies who were not assetfinanced. Companies with asset-financing, which includes shareholder companies who are financed with assets of their shareholders, are better able to weather the storm of declining profits and currency valuation fluctuations than those that are debt-financed. The debtfinanced company, backed with debt instruments based in, for example, mortgage-based securities, is stressed when the property values upon which the mortgage securities were issued begin to fall beyond the hope of near-term recovery. Many small and medium companies are debt-financed, if only temporarily - ie. cash cycle debt financing. And, of course, many are debt-financed with sound securities. In addition, many large companies are debt-financed, to a large degree, based on either their cashaccounting cycle or, more dangerously, are operating on holding and re-financing of debt rather than re-payment of debt. In the case of a publicly organized company, the company, alone, is usually responsible for its debts and obligations. The directors and shareholders cannot generally be required to pay anything towards the debts of a company, even in the case of the company s insolvency. Both the directors and the shareholders have the benefit of the limited liability that company status provides. However, in the case of shareholders, the shareholders may, under certain circumstances, be required to accept a price for their shares equal to the price they agreed to be paid. Few circumstances permit reaching across the limited liability principle during an insolvency process. However, the exceptions include, for example: undervaluation activity, preferences given to company-connected individuals, fraud on a creditor, or the existence of private loans not registered. Findings of this nature may, under U.K. law, be requested by the liquidator during an insolvency, or winding down. Companies with Shareholder Capital and/or Debt Financing Generally, companies with debt financing have loans, called debentures, for which certain registration requirements apply. In the U.K., where companies have substantial reporting requirements compared to many other nations, the completion of the repayment of a loan is noticed to the Companies House. If a company defaults on repayment, either a fixed charge or a floating charge may attach to the debt. In the case of a floating charge, the creditor s receiver can both attach the assets of the company, as needed, and, in addition, has the power to manage the company, the directors powers being suspended. In this case, the shareholder s capital is not part of the

3 pay-out and is not repaid by the company to creditors, although, from a practical perspective, the shareholder s share value has suffered. Insolvency or Liquidation General U.K. principles Generally, liquidation can be compulsory or voluntary. Compulsory liquidation can be noticed by a petition to the court upon seven grounds, the most commonly used being that the company cannot pay its debts. As soon as a liquidator is appointed, the work of the directors is suspended, and all company correspondence must reflect the fact that the company is in the process of liquidation. A case of voluntary liquidation can be initiated (1) by members of the company, by a company resolution for winding up, or (2) by a creditors action, in which case, the members would pass an extraordinary resolution that it is advisable to wind up. A meeting of the creditors would occur within 14 days, with notice to all creditors 7 days in advance. In the U.S., Germany and France, a procedure for involuntary liquidation can be turned into a restructuring. Property owned by the company becomes manageable by the liquidator, but this will not include any property held in trust or subject to a retention of title. The payout on the insolvency in the U.K. follows a generally-standard order: first to the expenses of the wind up, second to preferred creditors, next to creditors with floating charges, then unsecured creditors and then members. Problems in covering the debts of the company In cases in which the assets of the company cannot cover its debts, the liquidator has an interest in enlarging the value of the assets to the greatest degree possible. In the U.K., the liquidator can therefore disclaim overly burdensome or unprofitable contracts. In addition, the courts will refuse to hear actions seeking special preference to unsecured creditors, and will usually treat all equally in any pay-out scheme with insufficient funds. In the case of bad behavior, the liquidator can, for example, file with the court for a finding of fraudulent trading, as well as wrongful trading which is the case when the director should have known that their actions would increase losses to the company while knowing that insolvency was unavoidable. A director s claim that they did nothing would not be a defense to such a charge. In addition, a liquidator may set aside transactions that created under-valued sales, by application to the court under the U.K. Insolvency Act, s To remove preferences in payout to interested parties, the liquidator can, again, apply to the court to set aside the preference (s. 239).Should it appear that the company attempted to put the assets of the company beyond the reach of creditors before the insolvency, the liquidator can seek to reach the assets despite this (s. 423), and, as well, despite when the action to remove the assets and hide them was taken. Of course, more recent activity of this nature would usually be of greater interest to the creditors and pay-out scheme.

4 Lenders and creditors who are working with subsidiary companies will try to approach the parent company for satisfaction of debts. In general, however, U.K. law does not create any obligation for parent companies to cover the debts of their subsidiaries. In the U.S., this distance is occasionally bridged by the director s duty of loyalty, if that duty is otherwise breached by inattention to the subsidiary s financial health. However, in general, the parent company takes a preference status, along with other creditors, should its subsidiary actually fail. Alternatives to liquidation Alternatives to liquidation exist. In addition to a self- or court-sponsored restructuring plans, one might be able to (1) request to be declared a defunct company in the U.K., or (2) propose a voluntary moratorium on creditor actions. In the case of a defunct company, the request is handled by the Companies House, U.K., which action will be undone by petition of any creditor for an extended period of years. In the case of a voluntary moratorium, the company requests this status, as a request for an Administrative Order from the courts. If such an order is granted, a later-filed request for compulsory liquidation will be defeated by the presence of the order. This permits the company to behave in its own interest, in a sense, with the assistance of an administrator who has powers similar to a liquidator ie. who can review and apply to seek findings of undervaluation, defrauding of creditors, inappropriate preferences, etc. In any case, charges or debts that are unregistered or late registered would be void for want of registration, just as they would be in the hands of a liquidator. If a company is in administrative receivership, an individual creditor, holding a registered debenture or loan, is in a position from which they can hire their own receiver for the collection of their security, ie: loan repayment, through the administrator -ie., rather than be forced to file for the company s compulsory liquidation. An administrator scenario is preferable for many companies, as it gives them a chance to reassess the merits of the business, perhaps save the business, and, at least, create an orderly process for the realization of the greatest value from the company s existing assets. Insurers in the Insolvency Context Insurance companies, themselves, have found, in recent years, difficulty capitalizing operations following extreme claims events. Examples include Hurricane Dennis hitting Pensacola and Hurricane Katrina hitting New Orleans in the Summer of As the density with which nations permit housing development increases, and building projects increase in coastal and mountainous areas, insurers are challenged to review their actuarial formulas to better assess the real risks of specific losses to their insured as well as to protect their own economic viability. The insolvency prospects for non-life insurance companies have been studied recently, utilizing Italian data and a cash flow simulation model. (Ceccarelli, Simone, Insolvency Risk in the Italian Non-life Insurance Companies. An Empirical Analysis Based on a Cash Flow Simulation Model (January 2003). Available at SSRN:

5 In reality, the insolvency of insurance companies, themselves, results in the limited ability of policy holders to achieve full satisfaction of their claims. Despite this, the regulatory structure is designed, at least minimally, to identify and assist insurers in danger of insolvency, in order to prevent the protracted litigation that can accompany such scenarios, in particular, in the U.S. Thus, an insurer with difficulties is addressed at the pre-court administrative stage by regulators and auditors in an effort to avoid the 'showdown' of aggrieved claimants' litigation. Comparative Law Examples Insolvency actions in the EU are governed by the EU Insolvency Regulation 2000, with the exception of Denmark. In addition, the Uncitral Model Law, when adopted, controls certain aspects. Between nations, we also find insolvency treaties, such as, for example, the Nordic Convention of 1933, the Bustamente Code of Private International Law of 1928, and the Montevideo Treaties. Insurance and Insolvency: Recent Thoughts Of course, we can observe that the failure to renew insurance can be an early sign of a company s inability to continue. In this regard, we see the insurance industry and its policies in places such as Australia providing for insurance to be obtained, irregardless. For example, a company obtaining a contract with a supplier, for which insurance has not been covered, gives the supplier the right to obtain the necessary insurance and require payment as against the company s accounts. Additionally, as noted by David Jury in a recent article, While not necessarily intended to remedy the impact of insolvency, insurance offers a potential avenue of recourse in the event of contractor or principal insolvency. If the contractor becomes insolvent, the principal's only right of recourse for defective design or damage to the contract works may be a claim against the relevant insurance policy. Specialist insurance policies may include indemnification for, for example, delayed project completion (such as an 'advance loss of profits cover'). However, premium costs may make this option unattractive. Still, companies are advised to obtain special warranties from their subcontractors and suppliers, warranties which would survive insolvency, since, in general, the principal in a contract would not necessarily have a right, in insolvency, to reach their own subcontractors and suppliers for value for payments in materials or services. Principals may also want to contract to pay subcontractors directly, bypassing general contractors to keep jobs running, although this could be defeated in insolvency if found to be an unfair preference. When insolvency becomes unavoidable, David Jury notes, Infrastructure and construction contracts usually list a number of bases on which a party may terminate the contract. These grounds for termination almost always include 'insolvency events'. The list will usually include administrative actions short of compulsory winding up. The withholding of payments to contractors and subcontractors is then permitted to occur, although the point at which this is permissible is often argued in such cases. ("Australia: Guarding Against Insolvency:

6 Procurement In An Economic Downturn," 18 February 2009, by David Jury, ) Conclusion Insurance concerns have always followed need. I would expect no change in this pattern, given uncertain economic health for companies and individuals. The types of offerings will continue to evolve, and the industry will continue to develop new actuarial modeling formulas both to manage risk coverage and pay legitimate claims. The industry s greatest challenges in the insolvency area are, first, to avoid their own insolvency and, second, to help prevent abuse of the 'moral hazard' principle. Guidance on the structuring of insolvency preferences vis a vis insurance claims might also be an area for future research. The industry's greatest current challenges, I feel, are outside the insolvency debate, and seem to me to be, first, their responsibility to respond timely to legitimate claims; second, their legal 'duty to defend' the insured in a prompt, fair and economical way; third, their responsibility to create more efficient and non-litigous methods for handling shared fault distributions in fault-permitting jurisdictions; and fourth, their need to utilize realistic replacement valuations in replacement policies when specific market price information is both stable and available. June Edvenson Edvenson Consulting Edvenson Legal November, 2009