Welcome to our insurance updater. We will highlight key legislative and regulatory developments. We will also review court judgments and insurance market publications that are likely to be of interest to you.
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Financial sector resolution: broadening the regime
HM Treasury has published a consultation document entitled Financial sector resolution: broadening the regime. The paper sets out proposals for enhancing the mechanisms available for dealing with the failure of systemically important ‘non-banks’. In addition to the insurance sector, the consultation also covers investment firms and parent undertakings, central counterparties and non-central counterparties financial market infrastructures.
Reasons for broader regulation
Global reform of the financial sector has been ongoing since 2008. Although the issue of systemically important non-banks is being addressed internationally, the Treasury considers the threat of failure a significant risk and is committed to an accelerated timetable to address this issue. In its June 2012 white paper, the government considered the gaps in regulatory reform in relation to non-bank financial institutions. According to the government, the disorderly collapse of non-banks, including insurers, can pose a risk to financial stability and taxpayer support may be required to prevent the failure of such institutions.
In times of market stress, traditional insurers are generally considered to have a stabilising effect. Consequently, plans for a systemic designation process in the insurance sector have been met with resistance from industry groups. Many have criticised the reasoning behind the proposals, suggesting that insurers could suffer unintended consequences. Whilst the government considers insurers to have the potential to be systemically important, it acknowledges that only some, or perhaps none at all, will actually be so.
The International Association of Insurance Supervisors (IAIS) is currently in the process of developing a methodology to identify global systemically important insurers. The government is in broad agreement with the IAIS’ view that insurers engaged in traditional insurance activities are unlikely to threaten financial stability. Those firms that deviate from traditional insurance business, however, are “more likely to amplify, or contribute to, systemic risk”. Non-traditional insurance activities, such as derivatives trading, financial guarantees, variable annuities and short-term funding business are considered to carry greater risks.
The government considers that the systemic potential of insurers is likely to increase with: the complexity of the business model, particularly where interconnected with banking models; dependencies and inter-linkages with other financial institutions; the size of the institution; and the size of market share in products required for the functioning of economic activity. The government’s consultation identifies some potential impacts in the event of an insurers’ failure. These include the direct impact on the capital and liquidity positions of insureds, the indirect impact on financial markets particularly where failure would affect the availability of funding for banks, and the impact on consumer confidence and policyholders who may find they are no longer adequately protected.
The Government’s overarching objectives for responding to insurer failure are that:
- any insurer should be able to exit the market without disorderly impact; and
- an appropriate degree of policyholder protection should be achieved, including, where appropriate, through continuity of cover.
In order to achieve these objectives, the government believes it is appropriate to review the existing framework for dealing with insurer failure. Current UK insolvency proceedings for insurers do not differ significantly from other companies and so there is limited scope for ensuring policyholder protection. Under existing administration and liquidation regimes, compulsory obligations apply in respect of long-term business. An administrator of an insolvent insurer is required to carry out the insurer’s long-term business, but may choose to carry out those contracts that are not long-term. Similarly, a liquidator has a duty to continue to receive premiums and pay claims for long-term business. Both regimes require administrators and liquidators to fulfil their obligations with a view to either restoring the viability of the insurance contracts or transferring them to another insurer. With other creditors to consider, the protection of policyholders in the event of an insurer’s insolvency is a particular challenge. In light of this, the government is seeking views on how existing insolvency mechanisms can be strengthened to achieve effective protection for policyholders, and prevent an adverse impact on financial stability.
The Financial Services Compensation Scheme (FSCS) provides compensation to policyholders in the event that a Financial Services Authority (FSA) authorised insurer is unable, or is likely to be unable, to meet its contractual obligations. Having identified certain challenges in respect of continuity of cover and compensation payout, the FSA is currently consulting on potential solutions and considering what action to take. Specific issues addressed in the consultation include: the possibility of increasing FSCS protection from 90 per cent to 100 per cent of the contractual benefits for life insurance; and proposals to address the current risk that, in the event of failure, payments to policyholders may cease while the failed insurer’s systems are changed.
Next, the government considers whether the UK should introduce “a resolution regime for insurance firms that includes a set of stabilisation powers to permit the orderly resolution of any insurance firms that could be systemically significant if it fails”. Some countries, including Australia and the Netherlands, have already implemented resolution tools to cover the failure of insurance firms. Respondents are asked to consider whether a resolution regime is the most appropriate means of addressing the systemic risk posed by a failed insurer. In adopting such a regime, the government would assess the “likely systemic consequences of failure” and consider whether the public interest condition would justify exercising certain stabilisation tools.
Finally, the government proposes a “preventative supervisory tool” which would allow the FSA to direct the transfer of a failing insurer’s liabilities to another insurer under Part VII of the Financial Services and Markets Act. This tool could be used to transfer a portfolio prior to insolvency, therefore, ensuring continuity of cover. In some situations, the government believes, this would provide the best protection for policyholders.
The government invites responses to proposals set out in the consultation by 24 September 2012. The consultation indicates that in order to achieve their overriding objectives the government will, at a minimum, review the current insolvency framework. In terms of the other proposals, the government does not have a firm view and, therefore, seeks feedback on these issues.
The IAIS is in the process of finalised its methodology and is expected to announce the first list of global systemically important insurers in the first half of 2013. The list is expected to focus on those firms carrying out non-traditional insurance business.
For further information: Financial sector resolution: broadening the regime
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Germany: Landmark decisions in the mis-selling of unit-linked life insurance policies
In a series of landmark decisions, the German Federal Court (BGH) held for the first time that unit-linked life assurance policies often qualify as investment products, and are therefore retroactively subject to much more stringent case law rules developed by German courts over recent years.
As a result, a large life insurer is likely to be liable for hundreds of millions of euros not only in mis-selling charges, but also on the basis of “guaranteed payments” set out in the policy schedule, irrespective of a general reference to the standard terms and conditions where such payments were qualified as partial surrender benefits based on a corresponding reduction of the fund units allocated to the policy.
It appears that, in reaching its decision, the court considered the following:
- The policy schedule itself (not just the standard terms and conditions or the customer information leaflet) should have contained a specific explanation that the regular payment of benefits were meant as a partial surrender triggering a cancellation of fund units (as opposed to payments promised by the insurer irrespective of any capital gains in the unit holding).
- The insurer should have drafted its standard terms and conditions in a way that does not require the policyholder to make the connection between several clauses in different places in order to understand certain issues.
- Where the standard terms and conditions provide for the insurer’s discretionary right to unilaterally change the relevant value of units (e.g. in connection with a partial surrender), they should have stated why certain unpredictable developments might reasonably require such a change, together with the specific reasons, parameters and maximum scope for the change.
- With regard to the extensive risk catalogue contained in the prospectus for the underlying fund, which even included the risk of total loss, the insurer should have clearly incorporated the prospectus disclosures into its own information and advice, instead of declining responsibility for the content of the prospectus and specifically excluding it from the relevant contract documentation.
- The insurer should have provided information and advice to the policyholders regardless of the fact that the policies were mediated by independent financial advisers selected by, and obliged to act in the interest of, the policyholder.
- The insurer’s information and advice should have specifically addressed the inherent risks of the product, including for example:
- the particular risks in the underlying funds and/or the amount of fees and charges and their effect on returns which could reasonably be expected, without any overstatement in “non-binding” sample calculations;
- discretionary rights of the insurer to use capital gains in smoothing returns not just for the portfolio, but also for other with-profit pools operated by the life insurer; and
- discretionary rights of the insurer to stop surrender payments in case of an adverse development of the value of the underlying fund.
The life insurer had distributed the unit-linked policies to German customers through networks of independent financial advisers. With or without the knowledge of the life insurer, the financial advisors had persuaded their clients to take out loans to finance the single premium contributions. Clients had expected to be able to finance repayments on the loan with the benefits obtained under the policy. Sample calculations showing capital gains of 8.5 per cent per annum were used as marketing material, whilst only the small print alerted the customer to the insurer’s own assessment of 6.0 per cent per annum.
In the opinion of the court, the life insurer should have taken into account that German customers were mostly used to the traditional participating life assurance policies offered by German insurers. These policies provide for a combination of (conservatively calculated) guaranteed benefits and additional discretionary benefits which are derived from the overall profits of the insurer across its entire business. On the other hand, the combination of the unit-linked policies with the loans used to finance the premium contributions was not a decisive factor.
The court held that none of the following aspects were sufficient to exclude or mitigate the insurer’s liability:
- German insurance contract law and previous case law clearly states that the insurer is not subject to any duties of information and advice where the product is mediated by an independent financial adviser selected by, and obliged to act in the interest of, the customer; these provisions are, however, superseded by the qualification of the policy as an investment product.
- The policy schedule and the marketing material contained numerous general references to the standard terms and conditions.
- The standard terms and conditions contained a clause explaining that there was a risk of “very little capital gains”, which were, however, toned down by reports on the satisfactory investment experience of the life insurer's customers in the past.
- The customers had been orally informed during the sales process that the regular payment of benefits would normally be lower than the interest owed on the financing loan.
The only defence available to the life insurer is that - in the respective case - the customer and the intermediary had in fact arrived at a different common understanding of the product features than could have been inferred from the standard documentation, for example with regard to the qualification of the regular payments set out in the policy schedule as partial surrender benefits. This will have to be re-examined by the lower courts on the merits of each case, together with the respective amount of compensation and damages payable by the insurer.
The generality of the approach and the qualification of unit-linked policies as investment products are unprecedented in German jurisprudence. Also, the decisions do not attach any significance to the fact that unit-linked policies (without guaranteed benefits or participation rights) have been known and widely sold in the German market for a long time. In any case, the outcome clearly favours policyholders with a higher risk appetite at the expense of buyers of more conservative products.
The decisions were made in five test cases. While about 35 more cases are pending with the German Federal Court, many more cases are expected to follow.
For further information, please contact Andreas Börner in Munich
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Italy: ISVAP addresses insurers on discrimination against disabled people
On 23 July 2012, the Italian Insurance Regulator (ISVAP) issued a communication in relation to the UN Convention on the rights of disabled people (the UN Convention). In particular, the communication addressed the illegitimacy of policy clauses that prevent disabled people from obtaining insurance cover.
The Communication marks the final step of a technical workplan, organised by ISVAP in participation with the Italian Association of Insurance Companies and other industry groups, implementing section 25(e) of the UN Convention which states that any signatory must prohibit discrimination against persons with disabilities. During this process, ISVAP has identified a number of issues and is calling for health insurance policies to be amended. In particular, ISVAP has stated that insurers should remove all detrimental provisions placing disabled persons among “non-insurable subjects” from the general conditions of policies, and ensure that people with learning difficulties and/or mental health problems can access cover.
Furthermore, ISVAP also expects insurance companies to take a proactive approach to insuring people with disabilities in the accident sector. By the end of 2012, it is hoped that insurers will be able to offer appropriate cover for people with learning difficulties and/or mental health problems.
Whilst both the technical plan and the communication have considerably improved the current position regarding the implementation of the UN Convention, much of its provisions remain unexecuted in Italian law and, therefore, their application is still uncertain. ISVAP’s communication aims to address this uncertainty in the market and encourage insurers to eliminate any form of discrimination from their policies.
For further information, please contact Nicolò Juvara in Milan
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The following case summaries have been written by Professor Rob Merkin who is a consultant to the insurance and reinsurance and international arbitration teams.
Links have been provided to copies of the judgments on Bailii wherever possible.
Parker and Parker v National Farmers Union Mutual Insurance Society Ltd  EWHC 2156
Misrepresentation and non-disclosure - fraud - joint and composite policies - ICOBS
The first claimant (C1) was the owner of a house, which was insured in her name by The National Farmers Union Mutual Insurance Society Limited (NFU), the insurers, under a policy dated 6 July 2009. On 22 July 2009 the second claimant (C2), who was by then living with C1, was added as an assured. The house was damaged by fire on 6 December 2009, and a claim was made by C1. The insurers denied liability on a number of grounds: there was non-disclosure of a fraudulent claim by C2 in 2002 in respect of a stolen watch; there was non-disclosure of a fraudulent claim by both C1 and C2 in 2007 in respect of two stolen watches; C2 had deliberately set the fire in 2009; false documents relating to the lease of the property had been submitted in support of the claim; and there was breach of a policy condition which required documents. NFU counterclaimed for repayment of the sums paid for the earlier claims, for the cost of investigating the fraud and for a declaration that any sums payable to C1 could be recovered by way of subrogation from C2. Teare J held as follows.
- NFU did not have a non-disclosure defence against C1. (a) The 2002 claim by C2 had been fraudulent. (b) The 2007 claim by C2 had been fraudulent, but C1 had not been involved in the fraud. (c) The policy was composite and not joint. C1 and C2 had different interests in the property. C1 was the owner, and if C2 had any interest at all it was either some form of equitable interest or possibly in the rent payable under a lease to C1 and C2. Given that the rights of C1 and C2 were different, the policy could not be avoided against C1.
- The fire had been deliberately set by C2. However, C1 was not involved in the fraud and the fact that the policy was composite meant that she was not prevented from recovering.
- False documents were not submitted in respect of the fire, so on the facts there was no argument that C2 had submitted false documents as agent for C1 so that C1’s claim would be lost.
- The insurers could rely upon the defence of breach of condition. (a) The general condition “To qualify for benefit you …. must keep to the terms and conditions of the policy” rendered the claims conditions a condition precedent to liability, and that applied to the obligation on C1 “to provide all the written details and documents that [the insurers] ask for”. (b) C1 was in breach of that condition, by refusing the insurers’ request to provide bank statements to evidence the availability of funds to rebuild the property. (c) The condition was not void under the Unfair Terms in Consumer Contracts Regulations 1999. The term did not cause a significant imbalance in the parties’ rights under the contract to the detriment of C1: the insurers were entitled to ask for documents which were in C1’s possession as long as they acted reasonably; under ICOBS 8.1 the insurers could not reject a claim unreasonably; and the general condition was expressed in plain, intelligible language.
- ICOBS 8.1.1R, which prevents an insurer from unreasonably rejecting a clam, did not take effect as an implied term in the policy, although they were legally binding. In the present case the breach of condition was connected to the loss, and reliance on the condition was not unreasonable in that C1 had been informed of the consequences of no-compliance.
- Had it been necessary to decide the point, the insurers would have had a subrogation claim against C2. C2 faced liability for damaging C1’s property, and the insurers would have been entitled to exercise subrogation rights against C2.
- The insurers’ counterclaim would be upheld. (a) The insurers were entitled to repayment of the sums paid in respect of the earlier fraudulent claims, with compound interest. (b) The insurers were entitled to damages representing the costs of investigating the fraudulent claim, with simple interest.
- If the insurers were liable, the diminution in the value of the house after the fire was some £425,000. As that was less than the agreed costs of reconstruction, that was the sum that would have been payable.
For further information: Parker and Parker v National Farmers Union Mutual Insurance Society Ltd  EWHC 2156
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