The Equitas deal has thrust run-off into the international limelight and thrown open a door of possibilities. Philip Grant explores how legacy management came of age
As reflected by the buzz at ARC’s annual congress in February, there is no doubt that there is now a sense that the run-off sector – or the “legacy management sector” – is finally coming of age and taking its place in the sun. But what is responsible for this turnaround?
The answer probably lies in the confluence of a number of seemingly separate factors which together suggest we are on the verge of a transformation in the way legacy business is viewed, the importance it is accorded and the way in which it is dealt with. As such, it is important to take a closer look at these factors and to consider what they portend, not just for the legacy management sector, but also for the broader insurance and reinsurance industry.
Perhaps the most important of these factors – and certainly the highest profile – is the sale of Equitas to National Indemnity. On the face of it, although it was notable for its enormous size, the deal was just the straightforward transfer of some old liabilities, of the type that the run-off sector has been managing since the 1980s. However, it is in the motivation for the deal and the reaction of the markets that its true significance lies.
Consider the following statement from Standard and Poor’s (S&P) analyst Rob Jones on the rating agency’s decision to upgrade Lloyd’s financial strength rating from “A” to “A+”: “The upgrade reflects the successful conclusion of Phase 1 of the Equitas group’s transaction with National Indemnity, progress with regard to Phase 2, and the unstoppable momentum behind improving London market business processes.”
Critically, two out of three of the reasons cited relate to the disposal of the Equitas liabilities and its liberating effect on the Lloyd’s market. The fact is that rating agencies are increasingly aware, both in their general approach and in the specific rules they apply in compiling their ratings, that the presence of legacy business on a balance sheet amounts to twin drag anchors on a company’s progress. Not only is there the ever-present risk that the business will deteriorate, so impacting on the company’s results, but also there is the need to allocate capital to support that business – capital that could be better used to back new, profitable business.
Small wonder, then, that S&P viewed the Equitas deal so favourably and that forward-looking insurance groups throughout the world are now looking at their balance sheets and seeking ways to divest themselves of billions of euros, dollars or yen tied up in legacy liabilities.
This increasingly global approach to the issue of prior year liabilities also offers another reason to suggest that the time has come for the legacy management sector.
For most of its life, the run-off management sector has been predominantly a London market phenomenon. That is changing fast. There are now flourishing equivalents to ARC in both the US (AIRROC) and Europe (SEGS). Europe in particular is currently the focus of intense attention from the army of accountants, lawyers, service providers and consultants that now specialise in supporting discontinued business in the London market.
Why this sudden focus? Because European companies are waking up to the balance sheet realities of old year liabilities, a focus which has been given additional stimulus by the impending Solvency II Directive. This will introduce a broadly risk-based approach to the assessment of regulatory capital and thus provide great incentive to clean out legacy business.
What is more, the evidence is growing that disposing of legacy business can bring significant positives, the latest example being SCOR’s successful bid to acquire Converium. Part of Converium’s attraction was undoubtedly the fact that it had successfully divested itself of its troubled US run-off unit, regaining its valuable “A” rating in the process. Similarly, Royal & SunAlliance has benefited from the sale of its US subsidiary with its huge volume of legacy business.
Divestment of legacy portfolios frees up capital, removes risk from the balance sheet and eliminates management distraction. Every insurance group has legacy and soon every insurance group CFO will become familiar with the increasingly sophisticated ways that exist to exit from it.
“We are on the verge of a transformation in the way legacy business is viewed
These factors are driving both the recognition of the importance of legacy business and the rapidly growing impetus to do something about it. These, if you like, are the ‘push’ factors, the creators of demand. All of this would, however, be in vain if there was not also simultaneously a dramatic increase in interest in the supply side of the equation, as imaginative investors and their advisers look to meet that demand. Accordingly, another key factor is the tremendous upsurge of interest amongst the investment community in acquiring legacy portfolios.
For a number of years there has been a small group of highly specialist investors in the distressed end of run-off – such as Castlewood, Ruxley and Randall & Quilter – with the experience, skill and risk appetite to acquire portfolios of asbestos, pollution and health-ridden business and apply their particular skills to robustly closing down such portfolios, often at a significant profit. It is, however, a highly specialised market and has not tended to attract the mainstream investment community.
At the other end of the spectrum, other players, such as the Resolution Group have taken on huge quantities of relatively stable, non-volatile liabilities in the form of books of discontinued with-profits life business. Here, the drivers for sale and acquisition are different from those that motivate the sellers and buyers of distressed books. The margins are thinner, but the risks are fewer and, rather that acting our of fear of dramatic deterioration in underlying books, sellers are making disposals in order to reduce their overall administration and cost burdens.
What is now exciting the investment community is the “space” between these two extremes. This space offers the opportunity to acquire large parcels of liabilities that are under-performing, rather than distressed, but unlike those in the life sector, are still not utterly predictable. Accordingly, such books still offer acquirers the prospect of creating and realising surpluses by active and efficient management whilst affording the seller significant capital release.
The current excitement within the investment community is being further fuelled by two key factors. The first is that tools – such as solvent schemes of arrangement and business transfers – are now beginning to be developed that enable precise, efficient transactions to take place within a reasonable timescale.
The traditional run-off sector has long been accustomed to the solvent scheme of arrangement. While much-maligned in some quarters over the last couple of years, it is still the only way to achieve true finality for a book of business and there is little doubt it will continue to evolve in such a way as to address such criticisms and to extend its utility as a way of equitably accelerating the closure of legacy books.
Of potentially greater significance, however, is the insurance business transfer (known in the UK as the Part VII transfer). This procedure allows the surgical excision of a book of business, including its associated reinsurance asset, from one balance sheet and its transfer to another balance sheet. This can be either within the same group (allowing the efficient re-organisation of group balance sheets) or to an external balance sheet created for the purpose by an acquirer. Similar mechanisms are being rolled out, with some variations, across Europe, so potentially allowing significant cross-border transactions to take place.
This in turn opens the way for major insurance groups to be able to aggregate their legacy exposures and then to transfer them to a willing acquirer, so creating possibilities for the service provision and advisory sectors, as well as for investors in acquisition vehicles.
Perhaps even more notable than the evolution of effective insurance tools, however, is the increasing recognition within the broader financial community – and the capital markets in particular – of the opportunities that may exist to apply sophisticated techniques that have been successfully used elsewhere to insurance balance sheets. Lips are being smacked as we speak in the major finance and investment houses at the possibility of applying cutting-edge asset management practices to large specialist legacy balance sheets – not to mention slicing up insurance and reinsurance risk in the same way that credit card companies slice up and sell on their debt – ie by duration or relative risk rather than by monetary amount.
There is a tremendous opportunity now for the legacy management sector to carve out a future for itself in which it will not just support the active underwriting sector, but will positively enhance its capital efficiency, its flexibility, its dynamism and its operational excellence.
Philip Grant is chairman of the Association of Run-off Companies.