Insurer Reorganization and Restructuring in the US and UK

1. Insurer Reorganizationand Restructuring in theUS and UK Geoffrey Etherington - Partner, New York Edwards Angell Palmer & Dodge LLP Melissa Oxnam - Associate, London Edwards Angell Palmer & Dodge UK LLP

2. Reasons for Reorganization and Restructuring • Exit lines of business • Exit geographic markets • Rationalize group structure after period of acquisitions • Redeploy capital or improve capital efficiency • Solvency II

3. Primary Tools for Reorganization and Restructuring • Loss portfolio transfers (US & EU) • Assumption reinsurance (US) • Insurance business transfers (EU) • Sale or merger of insurance companies (US) • Solvent schemes of arrangement or sale of insurance companies (UK)

4. Loss Portfolio Transfer (LPT) (US) • Reinsurance; does not eliminate insurer’s liability to insureds. • Transfers to reinsurer the liability for losses already incurred, so always retrospective in nature. • The reinsurance premium reflects a discount from the reserves maintained by the cedent; based upon calculation of the present value of future payments for ultimate net losses. Result is increase in surplus of ceding company. • Principal use in restructuring is to transfer reserves associated with a particular line of business from which the cedent has withdrawn.

5. LPT (US) (continued) • Many states require LPTs to meet specific criteria including: • The LPT must be noncancellable. • The reinsurer must not be able to exercise influence over claims settlement practices of the cedent. • Recoveries under the LPT must be available without delay. • No guarantees of any kind may be made by the cedent to reinsurer. • The consideration must be a stated sum certain. • No subsequent pricing adjustment is allowed except for the cedent’s participation in the ultimate profit, if any.

6. LPT (EU) • Reinsurance for a class or totality of insurer’s business. • 2 common forms: • LPT – ground up, premium equals discounted reserves plus risk premium (margin); and • Adverse Development Cover – attachment point set at reserves plus a margin, premium paid. • Reinsurance is retrospective in nature. • Policies usually contain an aggregate limit on liability. • Insurer’s liability to insureds continues. • ADC more common than LPT.

7. LPT (EU) (continued) • Not an explicit regulatory capital tool therefore not the same capital benefits as the US. For capital purposes LPTs are treated like any other reinsurance with cedants receiving up to 50% credit for reinsurance. • No specific regulatory requirements to meet. • Solvency II will require cedants to carry capital in respect of risk of reinsurer default. • Claims handling may transfer to reinsurer, achieving cost savings (LPT not ADC).

8. Assumption Reinsurance (US) • Contract of novation and assumption: assuming company steps into the shoes of issuer, which is released from all obligations. (Misnamed – not reinsurance at all.) • Provides issuing company with finality – legally off the risk. Allows for a clean exit from lines of business or jurisdictions. Also useful for transfers of business between affiliated companies. • Many states have adopted NAIC Model Assumption Reinsurance Law which requires individual policyholders’ consents to effectuate novation. Other states require consent by case law.

9. Assumption Reinsurance (US) (continued) • Impediments to use: • Assuming company must be licensed in each state in which novated policies were issued. • Obtaining policyholders’ consents can be onerous and time consuming – no guarantee of success. • Problems associated with consents discourage use – often coupled with 100% reinsurance which will automatically pick up policies that are not novated. • As LPTs, may require regulatory approval depending upon size of transaction.

10. Insurance Business Transfers (IBT) (EU) • Statutory regime involving court sanctioned transfer, by operation of law, of a portfolio of business (Part VII FSMA). • Transferee steps into shoes of transferor; transferee legally off risk. • Policyholder consent is not required. Policyholders must be notified and can object. • IBT mandatory where Transferor is EEA authorised and transferring whole or part of a (re)insurance business which will be carried on from establishment in EEA. • IBT mandatory where number/value of novations seen as a transfer of part of the business.

11. IBT (EU) (continued) • FSA approval is prerequisite to court approval. • FSA’s primary concern is impact of scheme on policyholders. • If risks situated in other EEA countries, FSA must notify and obtain consent of such EEA regulators. • Transferee must have authorisation in appropriate jurisdictions. • Regulator of the scheme will need to produce a solvency certificate to the regulator of the transferee. • If a substantial business is being sold/acquired it will constitute a change of business plan requiring FSA approval.

12. IBT (EU) (continued) • VAT - Swiss Re case: • transfer of 195 life reinsurance contracts • deemed supply of services (not goods as no transfer of tangible property) • not an exempt “banking, financial or insurance transaction” • subject to VAT at standard rate • Consequences: • Revisit past transactions for VAT liability. • Ensure transfer is a “transfer of a going concern.” • Implement a reinsurance contract prior to transfer.

13. Merger (US) • Merger between two insurers will result in one of the companies being the surviving entity and the other ceasing to exist. The surviving company must be licensed in each jurisdiction in which the merged company is licensed and has policyholder obligations. In the context of reorganization, we assume the companies being merged are affiliates, so no change of control filing and approvals should be required. • Merging two affiliated insurers can achieve economics of scale through consolidation of administration and business production activity.

14. Merger (US) (continued) • Approval of the domiciliary regulator of both companies is required, involving the following: • Submission of a merger agreement setting forth the terms and conditions of the merger. • A statement of any changes to the articles of incorporation of the surviving company. • Submission of written approval of the directors and shareholder(s) of each company to the merger agreement (typically the same shareholder in a reorganization). • A hearing on the application to merge may be required in each state depending upon the state specific requirements.

15. Merger (US) (continued) • If the company being merged out of existence is not licensed in the surviving company’s domiciliary jurisdiction, the survivor’s domiciliary regulation will require submission of such information as may be required to assure its solvency (N.Y. requires that both companies be licensed as a condition to merger). • After approval of the merger in both jurisdictions, and any requisite filings with Secretaries of State, on the effective date all liabilities and assets of the merged entity will become those of the surviving entity which will become the insurer on all policies that were issued by the merged entity.

16. Sale/Acquisition of Insurer (US) • Sale of an insurer is always subject to state regulatory approval and, depending upon transaction size, may require HSR filings. • Acquiror will need to file for approval with the target’s domiciliary regulator (and possibly another state if the insurer is deemed “commercially domiciled” there). • Typically, purchase price is based upon amount of surplus to policyholders, plus a premium for each state license and good will. • Actuarial analysis of reserves is critical to purchase since inadequate reserves can destroy economics of transaction.

17. Sale/Acquisition of Insurer (US)(continued) • Purchase of an insurer that is actively engaged in business can provide the acquiror with a “turn-key” entry into new geographic areas or lines of business. • Purchase of a “shell company”, one that has little or no business and is in run-off mode can be done for less capital outlay. Typically done to expand into new geographic markets so good standing of licenses are critical. Also legacy business in the shell company must be appropriately reinsured or otherwise reserved for.

18. Sale/Acquisition of Insurer (US)(continued) • Disposition of an insurer is effective for withdrawing from lines of business or geographic areas, downsizing a holding company system, or simply monetizing an asset. But sellers should expect that buyer will want protection from adverse loss development on business in the company. This is often the single most contested aspect of a sale.

19. Solvent Schemes of Arrangement (Solvent Schemes) (UK) • Statutory court approved procedure for compromise arrangement between company and creditors/members (Part 26 Companies Act 2006) if: • at creditors meeting, 50% in number and 75% in value of those who attend and vote, vote in favour; and • court gives its approval. • Benefits: • Flexible - compromise/arrangement of anything which company and all/group of creditors/members may agree. • Binds all creditors: even those who did not receive notice, did not vote or voted against. • Majority for approval may be less than other options (e.g. takeover requires 90%).

20. Solvent Schemes (UK) (continued) • Uses for insurers: • To terminate a solvent run-off by implementing an estimation scheme. • Equitable life used to remove need to pay bonuses. • HAPM used to reduce policy period from 35 years to 20 and thereby improve solvency. • Cape plc used to hive off asbestos claims into a trust. • Re-organisation can bind members of relevant class of creditors/members to any almost any re-organisation.

21. Solvent Schemes (UK) (continued) • Class Issues: • Class “must be confined to those persons whose rights are not so dissimilar as to make it impossible for them to consult together with a view to their common interest.” (Sovereign Life Assurance Co v Dodd) • Important for those who can consult together to do so otherwise majority oppressed by minority. • Separate classes = separate meetings. • Solvent Scheme, IBNR generally a separate class. • IBNR may be in same class if only reinsurers.

22. Sale/Acquisition of Insurer (UK) • Regulatory approvals required: • Target/acquiror needs to file for advance approval of change in control. • New directors carrying out “controlled functions” require approval. • Run-off companies: • Purchaser will need to submit scheme of operations. • Intra-group commutations need to be approved. • Release of intra-group guarantees need to be approved.

23. Sale/Acquisition of Insurer (UK) (continued) • Auctions have been popular in recent years • Seller friendly • improve price • bidders focus on important issues • seller controls documentation • Up-front work (and cost) • Need to appoint an Investment Bank? • Information Memorandum • NDA and Process Letters • Physical/Online Data Room • Sale Agreement

24. Sale/Acquisition of Insurer (UK) (continued) • Acquisition of Lloyd’s entities popular because of: • ability to write business in 79 jurisdictions; • strong brand - reputation for complex and specialist risks; • unique capital structure – “chain of security”; and • excellent financial strength rating (A+ Fitch S&P, A AM Best).

25. Insurer Reorganizationand Restructuring in theUS and UK Geoffrey Etherington - Partner, New York Edwards Angell Palmer & Dodge LLP getherington@eapdlaw.com 212.912.2740 Melissa Oxnam - Associate, London Edwards Angell Palmer & Dodge UK LLP moxnam@eapdlaw.com +44.207.556.4417

26. Shaping the Future of Insurance CoverageSelected Significant US Coverage Litigation Decisions Mary-Pat Cormier - Partner, Boston Edwards Angell Palmer & Dodge LLP

27. Shaping the future of coverage • Recent significant areas of coverage litigation: • Scope of exclusions – esp. IP exclusions • Advancement/reimbursement of defense costs • Allocation among coverages and policy years • Bankruptcy context • Fiduciary bonds • Bad faith, bad faith, bad faith.

28. Shaping the future of coverage • Millennium Partners LP v. Select Insurance Co., 24 Misc. 3d 212, 882 N.Y.S.2d 849 (App. Div. 2009). • Finn v. National Union Fire Ins. Co., 452 Mass. 690, 896 N.E.2d 1272 (2008). • Hartford Insurance Company of the Mid-West v. Steven Koeppel and Yeslow & Koeppel, 629 F. Supp. 2d 1293 (M.D. Fl. 2009).   • Conagra Foods v. Lexington Insurance Company, C.A. No.: 09C-02-170 FSS 2009, 2009 Del. Super. LEXIS 408 (unpublished).

29. Millennium Partners LP v. Select Insurance Co. • Facts: • MF blended D&O/E&O coverage issued to hedge fund insured • NYAG & SEC settlements for MT/LT practices • Extensive findings of fact; assurance of discontinuance; but no admission of liability • $148M regulatory settlement classified as “disgorgement” • $19M Defense Costs incurred in NYAG/SEC investigations • “Loss” = “Defense Costs;” but not matters uninsurable as a matter of law

30. Millennium Partners LP(continued) • Held: • Cited: Vigilant Ins. Co. v. Credit Suisse First Boston Corp., 10 AD3d 528, 529 [1st Dep’t 2004] • “Disgorgement” not “Loss” or “damages” under Policy • Where defense costs are a component of uninsurable loss, a party may not be reimbursed for those costs as defense costs “are only recoverable for covered claims.” • “defense costs in connection with a claim for disgorgement are therefore also not a covered loss[.]”

31. Finn v. National Union Fire Ins. Co. • Facts: • Professional liability policy issued to a records management and document imaging company. • Individual on site of large copying job took sensitive information belonging to DirectTV and posted it to a hackers’ website. • Denial of coverage based on Intellectual Property Exclusion – “arising out of any misappropriation of trade secret . . .”

32. Finn(continued) • Held: • “The phrase ‘arising out of’ must be read expansively, incorporating a greater range of causation than that encompassed by proximate cause under tort law.”  • “Arising out of” plus “any claim” = “unambiguously encompasses claims based on third-party conduct.”  (emphasis added) • “Arising out of”  causation more analogous to ‘but for’ causation. • “Would [there] have been personal injuries, and a basis for the plaintiff’s suit, in the absence of objectionable underlying conduct?”

33. Hartford Insurance Company of the Mid-West v. Steven Koeppel and Yeslow & Koeppel • Facts: • Legal malpractice case filed by carrier against assigned defense counsel. • Settlement of catastrophic automobile accident. • Carrier claimed that as a result of alleged legal malpractice, it was obligated to settle the underlying case for an amount substantially in excess of the policy limits.  • Insured argued that carrier lacked standing: no privity between carrier and defense counsel.

34. Yeslow & Koeppel(continued) • Held: • Majority view: carrier would have standing to sue defense counsel on duty to defend policy if it was found that the lawyer had been retained by the insured only. • Public policy reasons, including: fiduciary obligations and incentive to bring action against defense counsel • Ethical rules governing Fl. Bar • General exceptions to strict privity requirements • Florida precedent

35. Conagra Foods v. Lexington Insurance Company • Facts: • GL Policy issued to peanut butter manufacturer; $5M SIR • Salmonella outbreak caused by contaminated peanut butter • Insured claimed duty to defend on 24,000 claims alleging injuries from its peanut butter • “Lot”/”Batch” provision endorsement to Policy – single or multiple “occurrence(s)?”

36. Conagra Foods(continued) • Held: • Lot/Batch Endorsement requires exhaustion of separate SIRs for each lot or batch of contaminated peanut butter. • Rejected Insured’s argument that "Lot or Batch" provision did not apply, because the peanut butter claims all arose from a single occurrence subject to a single retention. • Insurer had no duty to defend until Insured established that it paid the SIR for each lot or batch of peanut butter that was produced.  • Bad faith claims allowed to proceed, including discovery.

37. Shaping the Future of Insurance CoverageSelected Significant US Coverage Litigation Decisions Mary-Pat Cormier - Partner, Boston Edwards Angell Palmer & Dodge LLP mcormier@eapdlaw.com 617.951.2225

38. Decisions, Decisions . . .A Review of Recent UK Cases Antony Woodhouse - Partner, London Edwards Angell Palmer & Dodge UK LLP

39. The Employers’ Liability Policy‘Trigger’ Litigation • relates to claims of mesothelioma victims • about 60,000 more deaths expected • UK Asbestos Working Party – 2009 ‘re-projection’: • 90% of cost (mainly EL insurance) • about £10billion (range £4.8billion to £30billion) • over 80% in the future

40. The Employers’ Liability Policy‘Trigger’ Litigation – the issue • two EL policy wordings – indemnify for injury ‘caused’ or for injury ‘sustained’ during policy period • long latency period between exposure, development of tumour and ‘diagnosability’ (symptoms) – 40-50 years • ‘caused’ during exposure, but is it also ‘sustained’ during exposure?

41. The Employers’ Liability Policy‘Trigger’ Litigation – the decision • November 2008 – Burton J • ‘…For the purposes of [EL] policies, injury is sustained when it is caused and disease is contracted when it is caused…’ • reflected decades of consistent market practice • EL policies, however they are worded, are triggered by exposure to asbestos (‘exposure basis’)

42. The Employers’ Liability Policy‘Trigger’ Litigation – the appeal • insurers’ appeal – heard November 2009 (no judgment yet)…then Supreme Court? • if decision reversed - chaos • legislation? • increased scrutiny of policy language (insurance and reinsurance)

43. Wasa v Lexington (House of Lords July 2009) • property damage insurance • US policyholder liable for pollution clean-up costs – pollution 1942 to 1986 • Washington Court (applying Pennsylvanian law) found Lexington jointly and severally liable for 44 years of damage • insurance period July 1977 to July 1980 (only three years) • settled for $103m • US Service of Suit clause – no express choice of governing law

44. Wasa v LexingtonReinsurance contract • proportional facultative reinsurance • ‘as original’ with a full reinsurance clause • period clause the same as in insurance – cover for losses occurring during July 1977 to July 1980 • accepted that governed by English law • same provision in insurance and reinsurance, but different laws apply

45. Wasa v LexingtonHouse of Lords • a question of construction of the reinsurance • starting point = proportional facultative reinsurance should be construed as back-to-back with insurance • but in 1977, uncertainty over which foreign (US) law would govern the insurance • so parties must have intended the clear English law construction

46. Wasa v LexingtonHouse of Lords • the period clause was fundamental to the scope of the reinsurance cover • Lexington had been ‘spiked’; but the reinsurers could rely upon the period clause • same decision if Pennsylvanian law had been specified?

47. Equitas v R&Q (November 2009) • LMX spiral • complex intertwining network of mutual X/L reinsurance • the ‘spiral’ had the effect of magnifying a loss many times

48. Equitas v R&QTwo ‘tainted’ catastrophic losses • losses had entered spiral • Exxon Valdez (oil spill in Alaska in 1989) • irrecoverable losses paid by insurers • about 6% tainted • KAC/BA (loss of aircraft and spares during first Gulf War) • losses wrongly aggregated • needed to strip out about 12.5% • market stopped paying – in ‘lockdown’ • “…search by the Court for an acceptable legal and sensible commercial solution in a situation where the market has been unable to devise one…” [Gross J]

49. Equitas v R&QThe position of the parties • the spiral could not be replicated with ‘tainted’ losses stripped out • Equitas (seeking to recover under X/L reinsurance) • prove its recoverable losses to a standard of the balance of probabilities – rely upon actuarial modelling • appropriate discounts strip out the tainted losses • R&Q • Equitas must prove that sums due, contract by contract, from the bottom of the spiral • actuarial modelling (‘estimating and guesswork’) is inadequate • Equitas’s model is flawed

50. Equitas v R&QQuestions for the Court (1) • must prove settlements are within the terms and conditions of the original policies and the reinsurance (double proviso) • Hill v M&G did not require correct re-presentation of the losses upwards through/round the spiral • must only prove the loss was within the cover of the inwards policy • Equitas could decide how to seek to prove its claims • modelling approach was permissible as a matter of law