Originally published in Captive Review, Guernsey Report, 2009-10, October 2009

Konrad Friedlaender of Carey Olsen's Fiduciary Law Group outlines Guernsey's policyholder protection scheme and the advantages it can bring.

The comfort depositors and other investors have customarily taken, not only from the security ostensibly provided by banks but also from their reliance on the financial strength of large financial institutions generally, has been given a severe jolt by the turmoil in financial markets over the past 18 months. The run on Northern Rock, the failure of Lehman Brothers and the severe difficulties experienced by the world's largest insurer, AIG, has caused investors to re-visit a host of financial instruments, deposits and securities and the protection they provide against financial loss in the event of failure of the institution.

It has become disturbingly clear that even large insurers, despite adhering to capitalisation and solvency margins as well as reinsurance arrangements which appeared until recently to be entirely prudent and adequate, are nevertheless vulnerable when the markets in which they operate are subject to severe financial turmoil.

The same period has seen an increasing investors' interest in a wide variety of long-term insurance products including wrappers or insurance policies with underlying investment portfolios, with or without life cover. Changes in fiscal rules directed at the taxation of settlements and trust arrangements have caused many wealthy individuals to be attracted to invest their money through the use of such insurance products as an alternative to settling their assets into trusts.

Trusts provide a degree of asset protection comfort to settlors as settled assets no longer form part of their own estate and as the trust assets are not available to meet the claims of creditors of the trustee's personal estate. On the other hand, premiums paid on policies become the property of the insurer, not unlike deposits paid to a bank. Both banks and insurers use the monies so received as their own and ply their respective trades by re-lending, investing or otherwise dealing with these assets which are reflected as their own on their balance sheets.

Consequently, these assets are available to meet the claims of the general body of creditors in the event of the insolvency of either the bank or the insurer.

Protection schemes

To address policyholder concerns regarding this risk to their investments and so as to protect the holders of long-term insurance policies, most jurisdictions have imposed protection schemes which are generally based on either state run or privately run (but compulsory) compulsive insurance schemes. Guernsey, which through its well-established and regulated insurance sector attracts a substantial portfolio of long-term insurance policyholders, has not imposed a compulsory insurance scheme to protect policyholders but has instead imposed a simple yet effective policyholder protection scheme.

This is based on each long-term insurer ring-fencing sufficient assets in a trust arrangement to insulate the assets from the claims of the insurers own creditors and to enable the insurer to meet its contractual obligations to its policyholders even if the insurer runs into financial difficulties.

The Guernsey Financial Services Commission (GFSC) under the Insurance Business (Licensing) Regulations 2002 (the "Regulations"), when issuing an insurance licence to a Guernsey long-term insurer, requires that the insurer must have in place satisfactory arrangements to protect the interests of its long-term policyholders. This generally means that the long-term insurer appoints a Guernsey- based trustee to safeguard certain of the insurer's assets. Under such an arrangement, assets representing at least 90% of long-term policyholder liabilities must be held in trust by the trustee although in practice many Guernsey insurers increase the percentage to 100%. To ensure that the trustee arrangement is robust, the following requirements have to be met:

1. The Trustee must be Guernsey based, independent of the insurer and approved by the GFSC. As all Guernsey-based trustees are required to be licensed and are regulated by the GFSC, the trustee would have to meet all regulatory requirements as a licensed Guernsey trustee.

2. The Trustee may hold the assets either directly in its own name or with an appointed nominee or may appoint a custodian to hold the assets. Generally, custodians must be independent of the insurer or its manager and only in exceptional circumstances will the GFSC consent to an associated custodian being appointed. Custodians do not have to be Guernsey based.

3. The Trustee has to report to the GFSC on a quarterly basis and additionally has to report if the insurer instructs that more than 5% of the value of the trust assets are to be paid out within one calendar month.

In establishing the trust arrangement, the insurer's own assets are effectively set aside to enable the insurer, in the event of an insolvency, to meet its obligations to its long-term policyholders and prevents the assets held in the trust arrangement from being used to meet the other obligations of the insurer, such as those of its general creditors, save to the extent that the terms of the policies allow the funds to be used to meet the expenses of the insurer. This protection is expressly entrenched in the winding up provisions of section 54 of the Insurance Business (Bailiwick of Guernsey) Law 2002.

The regulations allow the trustee to make payments from the trust either to the policyholders directly or to the insurer so that it can pay its policyholders but in either event the assets held in the trust can only be applied to pay policyholders' interests. The flexibility of the trust arrangement is also entirely suitable for products where the surrender or maturity value of the policy is linked to the performance of underlying investments which are made at the direction of the policyholder.

A good structure

In establishing a trust-based policyholder protection scheme, Guernsey has achieved an effective and relatively inexpensive structure to give comfort and protection to policyholders of long-term Guernsey insurance policies while at the same time allowing the insurer to conduct its business in the ordinary course with its own assets, including those which are held under the trust arrangement.

The trust arrangement further does not suffer from the risk and uncertainty created by insurance based protection schemes which, unless underwritten by the state, are inherently limited in their ability to meet claims by their level of funding.

While Guernsey law does allow for other arrangements to be put in place, including security interests, insurance or re-insurance and guarantees, the trust arrangement has proved to be effective, cost-efficient and easy to understand, and consequently is widely applied by Guernsey long-term insurers giving comfort to the holders of Guernsey long term policies.

For more information about Guernsey's finance industry please visit www.guernseyfinance.com.

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