There are parallels between Isaac Newton's 17th century view of the world and aspects of the insurance run-off industry today. Daniel Schwarzmann discusses these parallels and outlines a vision of a market-wide solution to exit discontinued insurance business and release billions of dollars of trapped shareholder value.
Our history of the 17th century does not record whether Newton was insured against injury caused by falling apples, apocryphal or otherwise. Nevertheless, Newton went on to define the fundamentals of physics that have helped us understand the world for over 300 years.
Newton's understanding of physics also has something to say in the 21st century to the shareholders and senior management of insurance companies with discontinued business, now in `run-off'. Newton understood the importance of mass. The UK run-off insurance industry as a whole, and a number of its constituent companies, is weighty indeed (see figure 1, on page 49).
The force for change
Newton's First Law of Motion states: `Every body continues in its state of rest or uniform motion in a straight line, unless compelled by some external force to act otherwise.'
Newton described the tendency of a body to continue in the direction it is heading until a force for change is applied. Increasingly, shareholders and senior management of companies with discontinued business are facing a range of issues that were not envisaged when the business was underwritten (see figure 2, on page 49). The risks presented by these issues threaten shareholder value through erosion of equity, diversion of senior management resources, exposure to guarantees and adverse affects on reputation.
The modern business world is characterised by sophisticated investors and well-developed capital markets. Making effective use of capital employed and, consequently, meeting the expectations of shareholders is one of the most significant problems faced by senior management.
Industry commentators believe much of the capital employed in discontinued business is not earning its opportunity cost - the returns available by investing these funds elsewhere. In addition, a significant proportion of this capital employed represents shareholder value that is trapped, awaiting a mechanism to close the run-off.
In the face of these issues, shareholders and senior management of companies in run-off should question and, where necessary, change the strategic direction of their businesses.
Newton's Second Law of Motion states: `When a force acts upon a body, it imparts an acceleration proportional to the force and inversely proportional to the mass of the body and in the direction of the force.'
Inertia in the run-off industry
Newton also predicted the effect of inertia: the greater the mass of an entity, the more difficult it is to change course. The influence of vested interests, the complexity of the underlying issues and the value of discontinued insurance business, can impart undesirable inertia within insurance companies.
This inertia frustrates the attempts of shareholders and senior management to devise and implement optimal strategies for these businesses. As a consequence, the run-off industry, since it emerged as a recognised `business' over 25 years ago, has changed very little, if at all. Now, rather than looking at millions, we find billions of dollars of shareholder value trapped, as the industry has been very slow in responding to changing circumstances and opportunities.
A new approach
As science explored beyond the boundaries of the earth, Newtonian theory was not enough. Resolving problems on such a scale required a new approach. Einstein revolutionised how we perceive the world and formed the basis of our understanding of the wider universe.
Einstein predicted the existence of `black holes', massive bodies having such a gravitational pull that nothing - planets, stars, galaxies, not even light - can escape from them. The shareholders of many insurance companies in run-off are finding this an apt description of their investments' capacity for capital.
PricewaterhouseCoopers has helped to develop a new approach to enable insurance companies to exit discontinued business effectively. Stakeholders working together can share in a proposition which offers flexibility, finality and the potential to share in value creation.
The transfer of a business (or line or class of business) may be an outright sale for cash, or for equity provided by the acquirer, or both. Run-off protocols can be developed and agreed with the current owners, to ensure the vendor is comfortable about the quality of future run-off management. The outsourcing aspect can also provide for a level of continuing involvement in run-off management by the vendor. Alternatively, the vendor can divest complete control of the run-off business.
Reinsurance may also be provided to give financial certainty. High level, whole account stop-loss reinsurance can effectively cap potential claims reserve deterioration and satisfy the requirements of the Financial Services Authority.
Reinsurance can also be linked with release of parental guarantees to third parties. Some parent companies wish to remove even the most remote contingent liability. Even if this is not currently an issue, such a release, obtained when there are few concerns about security, can improve flexibility in any subsequent reorganisation.
The ultimate aim of this proposition is to bring about legal and/or financial finality. Traditional approaches to discontinued business are well established and, as such, may be quick to implement. However, these usually focus on using reinsurance and other methods to redistribute risk. In some cases this approach may be the most appropriate, however in others, traditional reinsurance solutions do not solve the problems, but merely defer them by shifting them to someone else in the market.Using innovative exit routes for discontinued business, which have been pioneered over recent years, it is possible to provide financial finality. Exit routes are tailored to the characteristics of the relevant portfolio, including, for example, provision of a bar date for submission of claims, actuarial assessment of ultimate liabilities, wholesale commutations based on a net present value discount and appropriate payment arrangements.
Finality also gives an opportunity, when it is appropriate to do so, to close the run-off early. Early closure will reduce the overall cost of administering the run-off. Any solution that expedites closure is also likely to reduce the cost of reinsurer default, which tends to increase over time.
Participation in value creation
Using this one-stop shop, vendors may seek outright disposal of their run-off businesses from the outset. If this is the case, the financial outcome for the vendors is determined by the transfer value of the run-off business.
Alternatively, by retaining an interest, the vendor can participate in any value created through the benefits of scale synergies. These benefits may include:
Maximising shareholder value
Given the flexibility available, the vendor is able to select the most appropriate mechanism to cut-off the risk of future deterioration of claims reserves, whilst minimising the risk of reinsurer default, the costs of run-off and exposure to investment earnings' volatility. Shareholder value is therefore maximised, while successfully balancing the interests of other stakeholders and removing an unnecessary distraction for management.
Time to market
Despite the quantum leaps in physics brought about by Einstein and his contemporaries, classical physics remains relevant. Success in pursuing a strategy is a function of how quickly you can make progress from the outset and the rate you can generate change in the time available. As a market-wide solution, participants benefit from the collective effort of all concerned, giving new joiners a head start and the resources to effect change rapidly.
Discontinued business remains a massive issue in the insurance industry. It represents an industry burden which ties up shareholder value, often in a way that is unproductive, generating lower returns than those available elsewhere.
These problems will not be resolved without a fundamental change in the way the industry deals with discontinued business. This concept provides a unique framework for how this change may be effected. Traditional solutions alone do not have the scale required to provide a solution across the market as a whole; this proposition can provide this scale.
The industry is not being held back from solving the problem of discontinued business by technical reasons. The tools to achieve a managed exit and release trapped value exist; it just needs imagination, determination and leadership - qualities that Einstein and the other architects of modern physics had in abundance.
By Daniel Schwarzmann
Daniel Schwarzmann is a partner in the insurance sector in the Corporate Finance and Recovery practice of PricewaterhouseCoopers - Tel: +(44) 20 7804 5067 -