In the first of two articles, Fred Duncan, Helen Wilkinson, Andrew Stoker, and Philippe Guijarro provide an overview of Part VII transfers, why insurers use them, and some of the issues to be dealt with when using them.
Part VII transfers recently gained a higher profile with announcements by XL and Equitas of plans to employ them in widely differing contexts, and a Treasury consultation paper on proposed legislative changes. They take their name from Part VII of the Financial Services & Markets Act 2000. They are also known as insurance business transfer schemes.
Part VII enables a book of insurance policies to be moved from one legal entity to another. For some purposes reinsurance will suffice, but if you want to separate the policies permanently from the transferor, reinsurance doesn't quite cut it. If you have only a few policies to move you might novate each one, but most portfolios comprise too many policies for novation to be practical. Instead the transfer is effected by obtaining a court order, and policyholders' rights are safeguarded via the court process.
All sorts of insurers have used Part VII transfers: life and non-life, direct insurers, and reinsurers, active writers and those in run-off, those insuring individuals, and those insuring companies even a Lloyd's syndicate.
The diversity of uses to which they are put is interesting. We consider some of these below.
Mergers and acquisitions
Part VII can be used to acquire portfolios instead of purchasing the company writing the business. The advantage is flexibility: you can transfer just one part of the business (or even business from several companies at once).
More commonly, insurers use Part VII in conjunction with, rather than instead of, the normal merger route: either beforehand, separating or repackaging liabilities into the entity ready for sale, or after the merger is agreed, to combine duplicate subsidiaries that have similar business, thereby improving efficiency and maximising the benefits of consolidation.
The desire for efficiency is prompting Part VIIs in other situations too. Insurers are always under pressure to trim expenses and improve return on capital.
Many insurance groups, large and small, find themselves with more subsidiaries than they need an increasingly heavy burden given the pressures on management time from regulatory and financial reporting requirements. The Part VII mechanism allows a group to combine the insurance business of multiple subsidiaries, after which the surplus companies can be deregulated and wound up. Imagine a world in which your group has only one regulated insurer: only one set of FSA returns to prepare, only one ICAS process to go through, only one set of insurance company accounts
On top of savings in management time, the group gains more freedom in allocating capital and perhaps even cuts the number of overseas trust funds it needs to maintain.
The two situations above apply equally to closed books: a transfer can be used as the mechanism by which a third party acquires discontinued business, or multiple subsidiaries within a group can be combined to achieve cost and capital savings.
Transfers are powerful used alongside other processes too. They can be used before or after a solvent scheme of arrangement, for example, to remove employers' liability business or other policies that cannot be schemed, or they could be used prior to unitisation of a closed book of life business.
The ability to reorganise insurance liabilities between companies is useful for all sorts of other reasons too: tax efficiency, for example, or preparing for securitisation. Transfers can be used when switching from writing through a branch to a company (or vice versa) to avoid ending up with the run-off liabilities left behind in a parallel entity. A similar process of moving from a UK branch of a non-EU company to a full subsidiary could help to simplify regulatory issues.
Table 1 on the previous page shows a small selection of transfers to illustrate our comments. Regulations on transfers mean that information on these and other transfers is available from public sources.
The main parties involved are the transferor and transferee, their lawyers, the court, policyholders, the FSA, and a person appointed as the independent expert.
The independent expert is usually an actuary (and should be an actuary in the case of life transfers, to satisfy the FSA). He or she writes a report on the terms of the transfer scheme to assist the court in understanding its likely effects on policyholders. The report is also provided to the FSA and is available to policyholders.
The process is focused around two court hearings. We set out a summary of the process in figure 1. The reasons for each task become clear if the process is described by working backwards from the date on which the transfer is to become effective:
- Final court hearing A few days or more before the desired effective date, a court hearing is held at which the court is asked to approve the transfer.
- Period for publicity and objections Policyholders and others who believe they may be affected by the scheme have a right to have their views heard by the court. To give policyholders sufficient time to consider the plans, they should be notified at least six weeks beforehand. If overseas policyholders are involved, the relevant regulators must be notified three months before the hearing.
- Preliminary court hearing The legislation requires that all policyholders of the transferor and transferee are notified individually, and that notices are published in appropriate newspapers. In practice, however, insurers often ask the court for waivers from having to write to some groups of policyholders. The insurers' plans for notifying policyholders are considered at a court hearing known as the hearing for directions.
- Preparation Most of the hard work comes before the two court hearings: the transfer scheme must be designed and the companies must satisfy themselves that projected solvency levels after the transfer are satisfactory. Many documents must be drafted, including the scheme document, witness statements from company directors, newspaper notices and information for policyholders. Extracting the names and addresses of policyholders who will be notified is no small task. Meanwhile, the independent expert must assess the effect of the scheme on policyholders and describe the assessment in a report. The FSA is involved at appropriate points in these processes, including commenting on draft documents and approving the form of the independent expert's report. The FSA is entitled to be heard at court and its view of the proposed transfer and of whether suitable information is being provided to policyholders is important.
- Planning Good planning and project management are essential. There are many challenges to be tackled in pursuing a Part VII transfer; in our experience early contemplation of potential obstacles makes all the difference. Dialogue with stakeholders is important too, both internal and external.
The time taken to complete these steps varies from under six months (ambitious, but achievable where there are few complications) to more than two years (unusual, but can occur on complex transfers, particularly where third parties are involved or where there are interdependent events). Typically a transfer will take between 6 and 12 months.
Focus on non-life
Now that insurers perform regular individual capital assessments (ICAs) and an increasing number have received individual capital guidance (ICG) from the FSA there are additional considerations when undertaking a transfer. We focus on non-life transfers below but many of our comments apply equally to life business.
When designing the transfer scheme, the transferor and transferee may be in a better position now than they would have been in the past to identify their capital needs post-transfer. Likewise, there is more information available to the independent expert to help assess the transfer's effect on policyholder security.
In both cases, the existence of ICAs means that a more sophisticated assessment of the proposed transfer is possible. It does of course mean that more work may be required. The level of analysis needed varies greatly depending on the particular transfer and whether or not policyholder security issues are clear-cut.
The availability of ICAs gives greater prominence to the question of whether a reduction in policyholder security is acceptable. Some may think that a transfer should not proceed if any policyholder is disadvantaged but would a reduction in the theoretical level of confidence from 99.8% to 99.7% constitute a real disadvantage to policyholders in practice, bearing in mind the limitations in the precision of the modelling and parameterisation process? In any case, reductions in policyholder security are not automatically unacceptable it depends very much on the circumstances. A few years ago, when considering a proposed transfer, Mr Justice Hoffman commented that the court 'is concerned in the first place with whether a policyholder, employee or other person would be 'adversely affected'... it does not however follow that any scheme which leaves someone adversely affected must be rejected'; he also noted that the court must 'give due recognition to the commercial judgement entrusted by the company's constitution to its board'.
An interesting issue is the potential tension between the public nature of the independent expert's report and the sensitivity of insurers and the FSA to public discussion of the insurer's ICA or ICG. The independent expert must also tackle the challenge of explaining the analysis in this area in language that will be meaningful to policyholders.