Commutation is gaining popularity in Europe as a way of ending uncertainty in portfolios, but it has yet to take off in Asia. Jim Moran explains the basics.
Commutations have become commonplace in Europe over the past ten years or so, helping risk carriers to close down exposures to claims, risks or even whole relationships. Some US companies also make use of commutations as part of their overall business strategy, and in Australia proactive run-off is very much the flavour of the moment. Why then has commutation not become common in Asia? On the face of it, all the same reasons for wanting to commute apply to Asian companies as they do to those in the other major markets of the world.
Poor security among reinsurers threatens not just the profits of Asian companies, but potentially, in some cases, their very solvency. Taking money from an insecure reinsurer in the form of a commuted settlement might create a slight loss in any revenue year (because the payment would be discounted for the time value of money), but it removes the security risk and brings the reinsurance asset under the cedant's control. The World Trade Center loss was predicted to cause havoc with the solvency of the world's weaker reinsurers. It might well still do so once the major parts of the claim begin to settle, and mere estimates are no longer relevant. If the failure of one significant market player affects the solvency of another, a domino effect follows, which can easily cascade through to a number of other risk carriers.
Reducing inwards exposures is an obvious reason for promoting commutation, although persuading cedants to commute with you is often easier if you represent one of the weaker reinsurers described above. The uncertainty inherent in a book of reinsurance ties up capital and carries with it a risk of underwriting losses and even financial ruin for a risk carrier. Cutting off those liabilities in a commutation brings a greater level of predictability to an account, protecting the remaining assets and perhaps even persuading shareholders to provide support in the future, eased by the knowledge that even if results are still not looking favourable, at least the level of uncertainty has been reduced.
Setting up a strategy to reduce inwards exposures must be properly considered before starting. In certain circumstances the risk carrier might be relying on reinsurers to support claim payments made to cedants under commutation, and that support is by no means automatic. Where possible reinsurers should be involved in the whole process, although in practical terms there will often be too many reinsurers, too thinly spread for this to be feasible. Furthermore, there are many reinsurers which refuse to support such a strategy, because it accelerates their own cash flow and, even though it would reduce the uncertainty in the risk they have underwritten, they prefer not to take a proactive stance. In such circumstances it might be advisable to try to commute the outwards arrangements first, before approaching cedants. The same reinsurers who would not support a partial commutation are more likely to be willing to close down a whole relationship.
An increasing number of companies are realising that commutation is an effective and efficient method of closing down old reinsurance protections and retrocessions that still have reserves on them, but on which no great deterioration is expected, and on which periodic accounts would not recover significant sums of money. Most reinsurers will agree to pay a single discounted amount now, especially if no incurred but not reported (IBNR) claims are involved, rather than continue to account small sums in future accounts. In closing down the outwards arrangement the cedant not only reduces its administrative burden, but also avoids a security risk on the reinsurance asset.
While all these issues are as relevant to Asian insurers and reinsurers as to any others, the same willingness to develop a strategy and see it through has not developed in Asia. Although there are significant exceptions to this statement, there is no doubt that Asian companies in general have preferred to be reactive in the commutation arena, rather than promoting cut-offs of liability. Perhaps Asian companies would be more inclined to consider commutation if training and support were more readily available. In London in particular, there have been many seminars over the last ten years clarifying the process and suggesting best practice for commutations (and any Asian companies interested in attending seminars on commutation should contact the editor), but there are still very few text books that cover the subject.
Although many active underwriting companies have now embraced the benefits of commutation, the word is still most strongly associated with the run-off industry. In fact the Association of Run-Off Companies, a non-profit organisation based in London with the aim of improving communication between risk carriers in run-off, has produced a commutations manual to help its members perform commutations more effectively. It contains contributions from practitioners, lawyers, accountants and actuaries, together with checklists and details of how to join a database of commutation contacts (see www.aroc.org.uk).
Being originally centred on run-off companies, commutation has perhaps gained an unfair reputation for being a tool for those companies wishing to avoid liability at all costs. It is possible Asian companies have feared damage to their professional reputations in promoting the idea. In practice, however, commutation is often the most effective means of recovering money from recalcitrant reinsurers, or for reducing an administrative burden, and as such is a valuable tool for all insurers and reinsurers, live or in run-off, if used appropriately.
As a new and developing part of the industry, anything written has risked being quickly out-dated as new ideas come to the fore, but there are a few technical processes that are accepted as standards:
For any completed commutations, risk carriers should keep an up-to-date register of details , because auditors and potential buyers must be able to quantify the change to the company's profile brought about by commutation activity.
There is no doubt that commutation becomes much easier once you can identify the right person to approach, and the wider your range of contacts the more likely you are to succeed in a commutation strategy. In Europe we have organised an annual event each June since 1997 to promote commutation, and bring practitioners together to make contact and facilitate negotiation. The Commutations Rendez-Vous is now used by many delegates as the focus of their working year, as they can be confident that many of their counterparties will also attend.
We have always welcomed over 300 delegates to the Rendez-Vous in Norwich, England, but when we tried the idea in Asia for the first time in March 2002, only 75 delegates came to Singapore to take part. At our next Asian Rendez-Vous we hope to see a lot more interest taken by the local markets, even if it is simply to make contact and discuss the principle of commutation, rather than to negotiate final settlements. Meeting one's counterparties face to face is an invaluable part of the process, whether at formal meetings or at one of the many networking opportunities set up around the event. The venue chosen will have booths set up as private offices, but will also provide communal areas for cocktail parties, and will have a range of restaurants within walking distance.
Building a range of contacts takes time even with events such as the Rendez-Vous, so if the benefits are to be fully realised it is essential to have continuity. Changing the staff in the commutation team every two or three years will be counter-productive. A good example of the value of good contacts is seen in the larger operations created through mergers and acquisitions, or in the service providers which handle a number of risk carriers. In these companies the same individuals might come together many times over a period of years to discuss commutation between a number of different risk units. As someone who works for third party clients as well as for our full-time clients, I have found myself meeting certain contacts in the market over and over again on behalf of different clients. At the same time, those contacts might themselves have been representing a number of different risk carriers.
Negotiation is always more straightforward with people you have dealt with in the past. With a new contact it might be necessary to assure them you have followed all the necessary steps in the process, that you understand the issues involved and that your company's data can be trusted. Once over those hurdles, they need not be repeated at the next negotiation.
The technique of negotiation itself is a subject worthy of a book, rather than just a few lines in an article, but it is always worth bearing in mind the unlikelihood that your counterparty would have agreed to meet you at all if he did not want to at least discuss commutation. If you are in the proactive position of trying to persuade the other side to commute, you will have to suggest reasonable terms to reach an agreement, but this is easier if you know the counterparty's business drivers, what he wants (or needs) to get out of the negotiation. This is the sort of information regular contact will help you to build up, perhaps at the next Rendez-Vous in Asia.