Eligibility of structured products as units of account for life insurance

On 21 June 2016, the Paris Court of Appeal issued an unprecedented ruling (RG n°15/00317) when it instructed an insurance company (the “Insurer”) to reimburse its client, who had subscribed to a life insurance contract (the “Client”), for all of his losses (amounting to €416,238) caused by the poor performance of a structured product (in this case an EMTN1) used as a unit of account in said contract.

Facts

On 12 December 2006, the Client, holding a life insurance contract with the Insurer, chose to invest his contract’s entire premium in the unit-linked product Optimiz Presto 2, a structured product traded on the Luxembourg Stock Exchange (the “Structured Product”).

The Structured Product did not offer a capital guarantee but had an early repayment mechanism, which would trigger provided that, on a set date, the performance of the reference basket had not crossed below a predetermined threshold, which declined annually. The commercial brochure stated that when the product reached maturity (in this case after 8 years), if the early repayment mechanism had not been triggered, the investor would be unable to request the repayment of his capital and in fact would only receive a fraction of the initially invested amount, which would always be lower than 60%.

In this case, the reference basket of the Structured Product had performed under the triggering threshold of the early repayment mechanism every year, so that when the product reached maturity, the Client was only reimbursed for 39% of the premium invested in his life insurance contract.

The Client then took his insurance broker2 and the Insurer to court in order to obtain the repayment of his loss, notably on the grounds that the Structured Product was ineligible as a unit of account in life insurance contracts.

Regulations

Transferable securities and assets are eligible as units of account in life insurance contracts provided that (i) they offer sufficient protection for the invested savings and if (ii) they are included in a list created by a decree of the Council of State3.

This list4 notably includes bonds5. French law6 defines bonds as “tradable securities that, within a single issue, confer the same creditor's rights for the same par value”.

Analysis by the Paris Court of Appeal

The Paris Court of Appeal adds to the definition given by the French Monetary and Financial Code, stating that the “right to repayment of par value upon maturity” is an “essential characteristic” for a debt security to be labelled as a bond.

However, the description of the Structured Product’s early repayment mechanism, in the commercial brochure, did not clearly state whether the early repayment mechanism included a right to repayment of par value upon maturity. The drafting could be interpreted to mean that only the triggering of the early repayment mechanism, happening before maturity, could allow for an investor to recover his capital.

The judges therefore quoted the following extract from the commercial brochure in their ruling: “if the early maturity mechanism is never triggered, the investor shall receive 100% of the value of the reference basket, as determined upon maturity after 8 years. In such a case, the reimbursed value shall be lower than 60% of par value.”

The judges also noted that the Structured Product did not include a capital guarantee.

In light of the above, the Court of Appeal ruled that, given that the Structured Product necessarily deprived the Client of his right to repayment of par value upon maturity, it could not be labelled as a bond and therefore was not eligible as a unit of account in the Client’s life insurance contract.

The judges deduced that the Insurer had to remedy the damages caused by an investment which the Client should not have been able to make under the law, and sentenced the Insurer to reimburse all of the sustained losses, amounting to €416,238.

Impact of the Paris Court of Appeal’s analysis

It should be noted that the description of the Structured Product’s mechanism is very unusual, in that it could be interpreted to mean that the investor would never be allowed to recover all of his capital upon maturity.

However, the Terms and Conditions of the Structured Product describe a more standard mechanism, which gives a right to repayment of par value upon maturity, provided that the performance of the reference basket is not lower than a predetermined threshold.

Upon examining the ruling, it is not possible to determine which element the Court of Appeal used to decide that there was no right to repayment upon maturity: the lack of a capital guarantee (which would deal a blow to the structured products industry) or the awkward description of the mechanism of repayment upon maturity (which would be less worrying).

Furthermore, the Court of Appeal’s ruling does not justify why the “right to repayment of par value upon maturity” was added as a criteria to the legal definition of bonds.

Some commentators took this ruling as a clear sign that non-capital guaranteed structured would no longer be eligible as units of account in life insurance contracts.

However, it seems more likely that the 21 June 2016 ruling will only impact a few select cases, related to the subscription of hypothetical structured products that forbid the full repayment of the capital upon maturity.

Indeed, it seems that the judges’ decision stems from the awkward writing of a commercial brochure rather than from a lack of capital guarantee.

Supporting this idea is the fact that the ACPR explicitly recognizes non-capital guaranteed structured products as eligible as units of account in life insurance contracts7.

We also note that the Insurer has 2 months to lodge an appeal with the Court of Cassation. The Court of Appeal’s ruling could then be set aside by the judges of the High Court.

1. Euro Medium Term Notes.
2. The legal action taken against the insurance broker does not bring any new elements into the established jurisprudence and thus will not be examined here.
3. Article L.131-1 of the French Insurance Code.
4. As codified by article R.131-1 of the French Monetary and Financial Code.
5. By reference to article R.332-2, 2° of the French Monetary and Financial Code.
6. Article L.213-5 of the French Monetary and Financial Code.
7. ACPR recommendation 2010-R-01 from 15 October 2010, meaning it was made after the Client’s choice of the Structured Product on 12 December 2006.