Asbestos liability, including the trends and key credit issues.
The recent Chapter 11 filings of Owens-Corning (OWC) and Armstrong (ACK) have heightened concerns over the creditworthiness of companies with significant asbestos liabilities. But there are some key factors that can be helpful in differentiating companies with asbestos exposures.
Despite differentiating factors, it appears that the decision to file for chapter 11 reorganisation may also be the result of a variety of other factors, including bankruptcy as a long-term legal strategy for managing asbestos-related claims.
Asbestos cash outflows trended up in 2000 and are projected by most companies to remain at historically high levels over the next one to two years. This trend, combined with deteriorating operating cash flows at many cyclically sensitive companies, makes liquidity a primary credit concern.
While liquidity is worthy of scrutiny, long-term issues continue to play a critical role in assessing the ability of companies to survive the withering effects of asbestos liability. Key long-term issues include the rate at which new claims are filed, the claims backlog, average claim settlement costs, and insurance receivables position, as well as several other factors. Because of the diversity of circumstances facing individual companies with asbestos liabilities, Fitch evaluates the credit impact on individual companies on a case-by-case basis.
Sources of cash
Fitch's initial focus when analysing liquidity is on the earnings component of cash flow. Because earnings are subject to economic and industry conditions, companies with stable earnings through economic and industry cycles generally have an easier time managing cash needs. On the other hand, companies with volatile earnings will not only find it more difficult to meet cash needs, but may also encounter refinancing problems. For example, Owens Illinois' (OI) and WR Grace's (GRA) businesses provide fairly stable and predictable cash flows, which so far has allowed both companies to meet most cash needs from internally- generated funds. Conversely, more cyclical companies like OWC, ACK and Federal Mogul (FMO), facing declining cash flows as a result of economic softening, are likely to find themselves seeking external funding for operational needs and asbestos settlements. FMO was recently able to refinance and extend its bank debt by pledging assets to banks and demonstrating that cash outflows will be manageable. FMO also has a layer of insurance coverage in place that limits exposure once a threshold cash outflow level has been reached.
While asset sales are a traditional source of liquidity, Fitch does not generally give them much credit in asbestos liability situations. This is because asset sales invite legal problems for both buyers and sellers because of the potential obligations to existing asbestos claimants. In addition, asset sales work to temporarily relieve potential liquidity issues, but over an extended period of time do not address the company's ultimate ability to satisfactorily fund asbestos liabilities. Some assets, monetary or otherwise, are truly available for sale and are factored into liquidity assessments. Other sources of cash beyond the immediate control of management, such as insurance receivables, while important are less predictable and are therefore discounted in liquidity assessments. Heavy reliance on cash flows from these external sources as opposed to operating cash flows, in general, is a negative.
The manner in which a company seeks to settle claims also has a substantial impact on a company's liquidity and financial flexibility. While certain companies have historically settled claims and scheduled corresponding cash outflows on a predetermined basis over several years, other companies have negotiated settlement programs over a relatively short period of time. In particular, GRA and OI have managed claim settlements on an annual basis, in contrast to OWC and FMO which chose to settle a substantial portion of known and potential future cases via an administrative vehicle which metered out settlements according to annual payment caps. Looking back, the more aggressive approach led to a larger backlog, which in an environment where the average settlement cost was rising quickly led to shortfalls in the adequacy of the annual payment caps. Long term, it is not clear whether these settlement strategies will have any impact on the present value of cash outflows, but qualitatively there does appear to be an impact on the case backlog.
Uses of cash
Once the predictability of cash sources has been assessed, the flexibility associated with uses of cash for asbestos settlements, working capital, capital expenditures and strategic acquisitions must be evaluated. Companies, particularly those with substantial debt service requirements which cannot fund a substantial portion of asbestos cash outflows from operating cash flows, will have a more difficult time convincing lenders to extend credit and are subject to heightened refinancing risk. Banks may be less inclined to make additional investments in companies with weak earnings than in companies which seem to have good earnings prospects. In short, banks are worried about ‘throwing good money after bad'. Credit protection measures in relation to credit facility covenants can also play a key role in determining what kind of environment a company is dealing with when seeking to access credit lines or renegotiate financing. Ultimately, the banks decide if they will extend credit, which makes predicting default difficult.
The number of claims made by asbestos plaintiffs is generally disclosed and is useful in evaluating the sufficiency of management liability estimates.
Disclosures vary in the breakdown between existing but unsettled claims, new claims and settled or dismissed claims.
Management's accounting estimate of gross asbestos liability is shown on the balance sheet as nominal future cash outflows. For purposes of comparison with management reserves, an estimate of the present value of existing asbestos claims can be made by discounting future nominal cash flows. However, given the uncertainty involved in such an exercise, simply multiplying the number of claims outstanding by an assumed average cost to settle outstanding claims is advisable.
Cash outflows are claims settled multiplied by the cost to settle those claims. Therefore an increase in the claims filing rate or the average settlement cost will translate into higher future cash outflows and a larger liability. Recently, the rate at which new claims have been filed has increased uniformly at companies with asbestos liabilities (figure 1). The number of claims filed through third quarter 2000 is running slightly higher than historical levels, but is still comparable to previous years. If this acceleration represents a new trend, it is likely that many companies will take significant additional charges to reserve for higher than estimated liabilities. In general, it appears that management reserves contemplate a steady decline in new claims filed, so the current trend has and will likely continue to produce new charges.
Qualitative factors which support a fundamental increase in the rate of asbestos claims filings, rather than a temporary surge, include:
(i) pooling of asbestos lawyers' resources has allowed them to become more effective in the claims generation process;
(ii) the value of claims is rising, making the filing of claims a more attractive proposition;
(iii) the internet as a communication medium has allowed lawyers to attract more claimants; and
(iv) more people are being tested for asbestos-related diseases, resulting in more claims being filed.
Alternatively, qualitative factors which point to a temporary surge in claims filings might include:
(i) the recent Chapter 11 filings by OWC and ACK have caused claims that might have been filed in the future to be filed today; and
(ii) the surge in filings is statistically insignificant (i.e. is consistent with the historical ebb and flow of claims filings).
Settlement costs faced at different companies vary significantly (figure 2). Here are some qualitative factors which are likely to impact settlement costs:
(i) how recently and for how long did the company sell asbestos-containing products?;
(ii) what is the mix of mesothelioma, asbestosis and non-impaired claims?;
(iii) what is the perception of a company's ability to pay?; and
(iv) how aggressive was the company in settling cases in the past?
Again, the lack of transparency in assessing these factors makes fine distinctions impossible, but does allow some basic differences to be highlighted.
Estimates of current asbestos settlement costs have varied significantly in recent years, even decreasing in some years, but the most recent figures suggest higher costs. Higher than normal cash outflows, combined with a near constant rate of claims settlement at most asbestos liability companies, confirms the recent trend toward higher settlement costs.
The impact of rising settlement costs should be examined in the context of the claims backlog to determine an individual company's sensitivity. For companies with large backlogs of unsettled claims, a sustained increase in the cost to settle claims is cause for alarm. A larger backlog implies a greater sensitivity to the average settlement cost. OWC, for example, took a tougher approach by limiting average settlement costs paid out through the National Settlement Program (NSP). Arguably, these cases could have been settled more quickly if higher settlements were paid. So when these settlement values started to increase, the number of non-NSP claims started to balloon, resulting in additional charges.
The amount and nature of insurance coverage for asbestos liability varies from company to company. Generally, booked insurance receivables are the result of settlements made with primary insurance carriers and excess insurance carriers. If insurance receivables are booked before a settlement has been reached, they should be discounted because of the uncertainty in size and timing of eventual payments. Many companies continue to seek settlement with insurance carriers which did not join settlement agreements. These funds from impending insurance settlements are likely to benefit many companies, but the timing of these funds may not match cash outflows for settlements. Another type of insurance held by certain companies involves coverage that is not triggered until cash outflows from the company exceed certain predetermined levels. This insurance coverage can help to limit exposure but is still subject to uncertainty given that litigation may be required to gain a favourable settlement.
It is difficult to predict shifts in trends that impact the key factors outlined in this report (number of claims filed, average settlement costs and a wide variety of other issues). There are, however, several variables which can be tracked based on public information and company disclosures, which while not quite sufficient to anticipate a chapter 11 filing, will certainly be useful in identifying companies which may be on a slippery slope.