Financial services regulators are starting to realize that the run-off sector needs a different set of rules, says Philip Grant.
It may not be glamorous and it's certainly not high profile, but there is an awful lot of it about. Recent estimates suggest that worldwide liabilities attributable to run-off - discontinued lines of insurance and reinsurance - are now in the order of $350bn, a figure that could grow to $500bn by the middle of this decade1.
Not surprisingly, managing those liabilities to extinction has become big business: the run-off sector now has a distinct - and increasingly sophisticated - structure and culture and its own vibrant marketplace. Like all marketplaces, it has attracted a diverse and colourful cast of characters, there to buy, sell or make a turn on others' sales and purchases. And like all marketplaces it needs rules, customs and etiquette, and someone to make sure that they are observed. Until comparatively recently it was assumed that the rules, customs and etiquette of the run-off marketplace were those of the general insurance market, or at least that they could be accommodated within the regulatory framework applicable to the general insurance market.
However, there is a growing recognition both of the pecularities of run-off and of its importance to the health and reputation of the insurance industry. The result will be a sharper regulatory focus on the run-off sector that will have significant consequences for all of its players.
The current solvency test for insurers in the UK and the rest of Europe requires the maintenance of a solvency margin calculated as the higher of a percentage of premiums and a percentage of average paid claims. The problem is that an insurer in run-off has no, or very little, premium income and, particularly where its reserves consist to a large extent of long-tail liability claims (which is often the case for `mature' London market run-offs), annual claims payments are often small compared to the reserves. As a result, the solvency margin required of an insurer in run-off can be very much smaller than that required from a comparable `live' company.
Implementation of recent EU legislation2 will introduce measures to correct this anomaly and will result in a more realistic margin of solvency requirement for insurers in run-off.
The question is, of course, what happens in practice when that margin is eroded below the required level by worsening claims experience? In theory, the UK's Financial Services Authority (FSA) and other European regulators will be able to exercise their power to require an insurer whose financial position causes concern to present a `financial recovery plan'3, showing the steps that will be taken to ensure that the required solvency margin is maintained (or regained). In practice, what should the regulator do when the shareholders refuse to put in more money?
The problem for the regulator is, of course, to know when and how to intervene: too early and too heavily, and it can provoke precisely the crisis of confidence in the insurer's ability to pay claims that its intervention is seeking to avoid. Too little intervention too late, on the other hand, and the regulator is justly the target of public criticism.
Two possible answers suggest themselves. The first is that where no more money is forthcoming, the FSA could take a much more active role in overseeing the affairs of the insurer. This might include a much tighter reporting regime (of which more below) and, possibly, the imposition of a non-executive director with experience of run-off to act as the regulator's eyes and ears on the board. As an alternative, perhaps thought might be given to requiring a financially challenged insurer to take steps to put in place some kind of contingent scheme of arrangement. This is a mechanism available under the UK Companies Act. In that way, should the insurer's position worsen to the point of insolvency, at least there would be a pre-ordained and fair means of distributing what assets remain.
The implication for those who manage run-offs is clear: that the regulators will in future look for much greater professionalism, not just in terms of the day-to-day disposal of claims, but also in the formulation and implementation of a clear and credible strategy for the orderly management of the whole entity, assets and liabilities, to finality. Those who do not match up to the new standards must expect to feel the regulator's breath on their necks.
The FSA is undertaking extensive consultation on the type of information it should in future be gathering from the insurers it supervises. While not limited to insurers in run-off, there is clearly a case to be argued by the run-off community for a distinctive reporting regime.
The arguments are both technical and practical. Technically, the issue concerns the nature of the business. It is, of course, no longer necessary for the regulator to evaluate the balance and prudence of the company's underwriting policy and plans. On the other hand, the way claims are handled in run-off is a matter for regulatory concern, as is the implementation of the techniques developed by the run-off sector to speed up the extinction of liabilities.
Practically, the issue is one of cost and inclination: any reporting regime that requires a major investment in systems and staff is unlikely to find favour with smaller insurers in run-off.
The Association of Run-Off Companies (ARC), the UK trade association for discontinued insurance operations4, has a regulatory working party that is addressing the issue of FSA reporting for companies in run-off. It is a subject that ARC considers important not only as a way of ensuring that the reporting burden on its members is proportionate and bearable but also as a way of ensuring that the FSA has the right information to do its job.
This difficult task of balancing cost and efficacy will clearly have implications for the way run-off is managed. Arguably, those best placed to strike the right balance are the larger outsource providers, whose broad span of clients and financial resources allow them to invest in appropriate information systems capable of recording and processing the timely and relevant information the FSA increasingly needs.
Outsourcing: quality or price?
The first evidence of the development of a distinctive run-off sector was the emergence of specialist run-off service providers. As most of these service providers are not themselves risk carriers, they have not been directly subject to regulatory control, an anomalous situation that is being remedied in the UK by the FSA, using its new powers under the Financial Services and Markets Act. In a consultation paper published last summer5, the FSA promulgated its views on how outsourcing arrangements should be structured and controlled by insurers. While these guidelines apply to all insurers, they are of particular interest to the run-off sector, where outsourcing is widespread and where, arguably, oversight by shareholders of outsourced arrangements is sometimes not as vigilant as it should be.
The main thrust of the guidance can be summarised as follows:
This suggests that the FSA is rightly concerned with the quality rather than the price of the services provided. The problem is that in the run-off sector, stiff competition for the outsource contracts that are put out to tender has driven profit margins - especially on pure claims management contracts - ever lower at the same time as the obligations placed on the successful service providers have become more and more onerous.
If, under the stimulus of the FSA guidelines, we are to see a `flight to quality', there must come a point where proven ability and financial stability - not price - are the main determinants of success in winning business. If not, there is a risk that some service providers will view their obligations and exposure as not worth the reward and will close their doors.
The way forward is surely some form of performance-related reward structure that not only guarantees service providers a `living wage' for standard performance but also offers them an attractive share of the financial benefits flowing from superior performance. Provided that the incentives are consonant not just with the shareholders' ambitions to achieve finality but also with the FSA's interest in ensuring that run-offs are conducted in a way that is fair to policyholders, there is no reason why the best service providers should not be very well rewarded for their work.
Run-offs should run off
Since the assets of most insurers in run-off are to be regarded as a finite pot, from which all liabilities are to be discharged, it follows, if we assume that investment income and claims inflation are roughly equal, that the longer the run-off takes, the more of the pot will be expended on costs and expenses and the less will be available to shareholders as a final surplus.
It is therefore incumbent on the regulator to support effective ways to speed up the run-off process and bring finality to discontinued books of business. In doing so, the regulator must also ensure that the policyholders' interests are looked after: it is not acceptable for finality to be achieved by the application of improper pressure.
A symbiotic relationship has developed in the UK between shareholders, service providers, professional advisers and the FSA.
Some of the impetus for this has come from shareholders, who, reasonably enough, would like to retrieve what is left of the capital they committed to their discontinued ventures. In some cases they have been able to do this by selling their companies, at a discount to net asset value, to one of the increasing number of specialist purchasers of run-off portfolios. Although that achieves finality for the shareholder, it doesn't achieve it for the underlying business. However, it is beneficial in that the new shareholders have the strongest possible incentive to expedite the disposal of liabilities and to extract a return on their investment.
The challenge to the FSA has been to respond positively to this relatively new phenomenon of run-off sales, while ensuring that the new owners use the right tools in the right way to bring about the finality they seek. One way in which they are rising to this challenge is by taking an active interest in the evolution of the most effective of those tools - the scheme of arrangement.
Another example of the FSA's responsiveness is its recent modifications to the mechanism for transferring portfolios of business - another effective tool for `cleaning out' old run-off portfolios.
What will it all mean?
Drawing together all the issues we have considered, what can we foresee as the likely trends in the run-off market? The following summary offers some predictions:
1. Source: The Run-Off Phenomenon, Swiss Re, 1998 (extrapolation).
2. Directive 2002/13/EC of 5 March 2002.
4. Website: www.aroc.org.uk
5. Consultation Paper CP140 - The Interim Prudential Sourcebooks for Insurers and Friendly Societies and the Lloyd's Sourcebook: Guidance on Systems and Controls, FSA, July 2002.
By Philip Grant
Philip Grant is the Treasurer and a Member of the Executive Committee of the Association of Run-off Companies (ARC). He will shortly join Claims Management Group Ltd as Director of the company's London market division.