The Holy Grail for run-off companies is a solution that will cut the burden of costs and achieve complete finality. Tony McMahon and Darryl Ashbourne look at the prospects for this Arthurian quest.
Every year, more companies and lines of business are put into run-off. The present size of this sector is estimated at some $250 million globally, growing at the rate of 10% per annum; that means it will roughly double over the next seven years.
In addition to the cost, there is uncertainty. Many of these run-offs contain exposures to horrors such as pollution and asbestos with the prospect of claims coming in over future decades. Reserving for these liabilities is notoriously difficult and there can be no guarantee that the reserves will not deteriorate.Alternatives solutions include: sale of the business or company, a commutation programme, reinsurance, and portfolio transfer. The mechanics of each are very different, just as the results can be.
Selling the business or company provides shareholders with finality with regard to the exposures written unless, of course, there are guarantees still in place provided by the shareholders or other related parties. Similarly, providing warranties to the purchaser may delay finality until these warranties expire. In addition, purchasers are not normally naive and any risk being assumed may mean a greatly reduced price. Often the discount for risk is a deal-breaker. In other cases, there may be no common ground that can be reached on price due to the potentially unquantifiable nature of the risks.
A commutation programme can provide finality if all contracts are commuted. This is, however, difficult to achieve as there is no way usually that policyholders and cedants can be compelled to commute their policies. In practice, although commutation can be achieved with potentially large numbers of policyholders and cedants, especially those with larger claims, apathy often rules and there is little incentive or inclination for a counterparty to make the effort to commute. This is a major problem if the amounts involved are small and there is no or little downside for the counterparty if they do nothing. Accordingly, not all contracts are likely to be commuted, so true finality will not be achieved.
Reinsurance may provide practical finality if the reinsurer remains solvent, does not dispute the terms of the reinsurance contract, undertakes all the work of the run-off and its cost, is responsible for collection of third party reinsurance collections and assumes any bad debt through irrecoverability, and deals with all legal claims made against the company. Given these conditions (and the list above is not comprehensive), there is ample opportunity for this practical finality solution to become somewhat less than final.
A portfolio transfer in accordance with Schedule 2C of the Insurance Companies Act 1982 can provide finality for the transferring company in relation to liabilities arising on policies subject to the transfer. This assumes that a willing transferee can be found which raises similar problems to that of selling the business.In addition, there are a number of difficulties and problems associated with statutory portfolio transfers. The Schedule 2C transfer will only transfer inwards policies, it does not include reinsurance policies taken out by the transferring company to protect this business. Other arrangements will need to be made in relation to these reinsurance policies such as novation. The transfer will also need to be approved by the regulator and to be advertised and notified to affected parties so that they have the opportunity to object if they wish. This process will take a minimum of six months and, at the end, there is no guarantee that it will be approved. There are added problems if affected policyholders are located overseas where the Schedule 2C may not be recognised.
Solvent scheme of arrangement
With the potential pitfalls of these possible solutions, it may be worth considering an alternative - a solvent scheme of arrangement. In brief, this is a proposal put to creditors. If they approve it by the appropriate majorities (50% by number and 75% by value), and it is subsequently sanctioned by the court, it becomes binding on all creditors regardless whether they voted in favour of the proposals or not, or, indeed, whether they received notification of the proposals. This powerful procedure has obvious attractions for companies that wish to finalise their run-off because it enables them to put a value on inwards claims and stipulate a bar date for submission.
There have been few schemes of arrangement for solvent companies so far, although they are now accepted practice for dealing with insolvent insurance companies. Those that have occurred have tended to be small companies whose affairs are straightforward. Inevitably, the use of these schemes will increase and they will be applied to larger and more complex businesses.
In order to get in shape for a solvent scheme, companies need to tackle some practical issues.
• The issue of systems and databases lies at the heart of closing down an insurer's affairs, be it solvent or insolvent. The configuration and data that are appropriate for processing in the normal course of business are not sufficient for cutting off the books of business, because most business is conducted on a broker net accounting basis. What is needed is a “principal to principal” ledger that establishes, in so far as the data allows, the net position of each and every creditor and debtor of the insurer. The data must be updated as many counterparties will have undergone reconstructions and name-changes over a period of many years.
• UK insurers fall within the regulatory orbit of the Insurance Directorate under the overall control of the Financial Services Authority. Regulators require to be kept informed. In the case of solvent companies seeking finality, their main concern is with private policyholders, such as householders or motorists. The downside risks of adverse publicity or potential political embarrassment weigh heavily in their thinking.
• Protected policyholders are those to whom the Policyholders' Protection Act applies. This protection covers compulsory insurance policies and certain private policies and comes into effect if the insurer is unable to pay, as in the case of a winding-up. The cover is either 100% (in the case of compulsory insurance) or 90% of the claim in other cases.
Provided the insurer remains solvent, this is not an issue that need concern the policyholder. If the insurer wishes to commute with such protected policyholders or enforce a valuation methodology through the agency of a solvent scheme, then the view taken by the protected policyholders is important. They have no incentive to allow a cut-off of claims as they will be paid in full (or nearly) whatever happens and they will be taking the risk of under-valuing the claim. The insurer may have only a few of such claims or they may be immaterial in value, but it needs to determine the position and formulate an appropriate strategy.
• It is important to monitor an insurer's financial position in some detail, especially where solvency is marginal. Financial models are important, showing the varying results produced by different assumption sets. The availability of sensitivity analyses is likely to be particularly crucial if the insurer's solvency becomes very marginal as it will assist the directors in determining the appropriate course of action. The sensitivities available should typically include those relating to changes in discount rates, interest rates, levels of bad debt, gross loss reserve (by at least major class) and appropriate impact on reinsurance recoveries and levels of run-off expenses.
• A full, independent actuarial review will probably be required in order to provide comfort to the directors on the level of solvency. In addition, actuaries may be asked to assist in the valuation of individual creditor claims and in the levels of recoveries due from reinsurers. This may involve the allocation of incurred but not reported loss (IBNR) across creditors.
• A scheme of arrangement is only binding on creditors - not reinsurers who are net debtors. It is vital that reinsurers support any scheme proposals to remove the risk that they may not respond to claims arising from valuations of inwards outstanding and IBNR claims.
• A London market company often has a large part of its liabilities emanating from the United States. Successfully accelerating an insurer's run-off necessitates ensuring sufficient support from US policyholders.
Cutting off the inwards business from the US is fundamental and a commutation programme will probably need to be put in place before promoting a scheme. The move from agreed commutations to enforced valuations under a scheme can be achieved by obtaining a permanent injunction under Section 304 of the US Bankruptcy Code. This gives effect to the provisions of the scheme throughout the US. Without it, the scheme will not bind US creditors and, given their importance, would effectively render the scheme a dead letter.
• A proportion of an insurer's liabilities may derive from business written through involvement in underwriting pools. The insurer may have written business in the pool on a co-insurance basis with other pool participants, on a fronting basis on behalf of itself and other participants or on a fronted basis where it reinsured another participant. There may be extensive contractual relationships with other pool participants and the support and agreement of the other participants (certainly the major ones) is likely to be crucial to the success of any accelerated run-off proposals.
There is a growing body of practical experience of solvent schemes. Below are two examples where KPMG devised and implemented successful schemes.• Osiris Insurance Limited (formerly Orion Insurance (General) Limited)
The principal driver for the solvent scheme for Osiris was the release of surplus capital. Prior to entering into a scheme. it had total assets of some £21 million and liabilities including provisions for run-off costs of some £3 million. Accordingly, its solvency margin was some six times its liabilities. Nevertheless, the regulator was reluctant to authorise a reduction in capital.
A solvent scheme was a potential solution in order to allow for the release back to the parent of this surplus capital. However, there were a number of problems.There were a number of private policyholders who might be less enthusiastic about taking cash now, equating to the estimated value of their claim, rather than waiting until the claim crystallised and receiving its actual value. There was also the risk that new private policyholders' claims might still arise in the future but the policyholder would receive no payment under the scheme. The regulator was particularly anxious to ensure that the scheme did not disadvantage any private policyholder.
Undertaking a thorough investigation of the business identified the currently outstanding private policyholder claims and the policies under which claims could still arise. This was followed by negotiation of generous settlements with each relevant creditor.
There were a large number of US creditors, as well as substantial assets located in the US. The scheme had to be binding in the US to prevent these creditors seeking to enforce their claims outside it, prejudicing the orderly termination and payment of claims through the scheme. To avoid this problem, we obtained S304 relief under US federal Bankruptcy Code, giving effect to the scheme in the US - the first instance in which a solvent foreign insurer obtained such relief in the US.
The Osiris reinsurance programme was, in part, a joint reinsurance programme with Orion Insurance Co. Termination of the Osiris element in isolation would have been difficult, if not impossible, certainly leaving the Orion element of reinsurance difficult to manage. To minimise these difficulties, we negotiated with both the reinsurers and the scheme administrators of Orion to achieve joint commutations of the reinsurance contracts.
The scheme is now virtually complete, with all scheme claims being agreed without reference to the scheme adjudicator. Further, the surplus of Osiris has increased as it was able to release excessive and redundant loss reserves and provisions for future run-off costs.
• Crombie Insurance Company (UK) Limited
Crombie did not have excess capital; in fact its solvency was marginal. Its overseas parent company had, over the years, substantially written down its investment in Crombie. The jurisdiction in which the parent operated (in common with a number of other jurisdictions) only allowed capital losses if the subsidiary were to all intents and purposes liquidated. The parent, therefore, now wished to crystallise for tax purposes the capital loss it had suffered on its depleted investment. Achieving this meant addressing various problems.
The company's solvency was marginal. Until all claims were received, it was impossible to say that it would remain solvent. To cater for this, the scheme contained insolvency provisions to ensure that it would continue and the affairs of the company be finalised even if Crombie became insolvent and creditors were unable to be paid in full.
Crombie had been a participant in several pools managed by the English & American Group. Many of the arrangements were complex and were also affected by the insolvency of English & American Insurance Company. We investigated the arrangements to ascertain and evaluate the risks in order to draft the scheme appropriately.
Crombie, like many London market companies, did not maintain records that readily permitted the identification of its true creditors and debtors. Records were maintained on a broker net account basis without, perhaps, the ideal extent of reconciliation and agreement of balances. Extensive recreation of records and agreement of balances were needed before implementing the scheme. A number of commutations were also negotiated which not only simplified the book but also enhanced solvency.
In conclusion, schemes need to be tailored to the specific circumstances of a company. Some can be implemented and completed very swiftly, others may take several years. Schemes and the work needed to put them in place cost money. The bottom line is that, given the advantages that schemes can bestow, they are well worth the cost, time and effort of preparing and putting into effect.
Tony McMahon is a partner and Darryl Ashbourne is a director in KPMG's insurance solution team based in London.