The state-by-state regulation of the active insurance industry leads to a variety of scenarios for the management of discontinued operations.
As has been noted in numerous articles, discontinued operations are a growing business in the world, and the US is no exception. By discontinued operations, I mean any insurance or reinsurance book of business not being actively underwritten. This article will address causes of discontinued operations in the US as well as take a look at solutions to the unique challenges presented by discontinued operations.
There are three categories of causes resulting in discontinued operations in the US:
In the US, insurance is regulated primarily at individual state level. This results in a wide range of government involvement, with some states much more actively involved than others. To a large extent this is also impacted by the size of the industry in each state, as well as the budget of the individual state department.
Intervention itself ranges from active seizure of financially impaired insurance entities to promulgation of rules and regulations that are designed to protect consumers but may result in exodus from the market.
In 2001, there were 40 company failures in the US, of which 34 were property and casualty companies. Largest among these were Reliance Group Holdings ($6bn in assets), PHICO Insurance ($727m) and Frontier Insurance ($469m). The states handle their own insolvencies and are a significant participant in the discontinued operations business in the US. The New York Department of Insurance-Liquidation Bureau reports 30 liquidations and two rehabilitations with involvement in an additional 25 liquidations of non-domestic (i.e. not New York-domiciled) companies. The commitment of resources is substantial.
The government's intervention (or sometimes lack thereof) can cause discontinued operations situations to occur in particular lines of business. For example, if a line of business is unprofitable and a carrier wishes to increase prices, this will usually require state approval. State disapproval may well result in the carrier exiting the line of business, resulting a discontinued operation.
An example, of recent interest, is the government's intervention in the area of terrorist insurance cover. Numerous carriers now find themselves unable to purchase reinsurance coverage, which includes terrorist acts, and so are attempting to exclude or restrict such coverage in their underlying policies. The states appeared to be heading toward the approval of such exclusions/restrictions; however, in January California threw a wrench in the works by rejecting the proposed restrictions. In the meantime, the Federal Government has delayed acting on a proposal to create a federal insurance backstop (such as it already does for flood insurance). The impact may well be the need for some carriers to cease underwriting where the net exposure cannot be supported, creating discontinued operations in the affected business lines.
The insurance market in the US is a dynamic and constantly changing place. Markets can undergo enormous changes very quickly, creating situations where carriers have little choice but to exit lines of business or shut down altogether.
There is a constant level of merger and acquisition activity that creates new competitive situations, and may also create discontinued operations situations where business acquired does not fit the new combined organisation. AM Best recently reported the shift in emphasis from carriers merging to brokers acquiring agencies. As the consolidation continues, the carriers favoured by the acquiring broker will receive additional business. This may well be sufficient for some carriers to discontinue some lines of business.
Competition from new businesses such as AXIS Specialty Ltd. and Allied World Assurance Company, both new Bermuda-based companies, could significantly change the market.
Recently, as an example, St Paul Companies announced its exodus from medical malpractice insurance after becoming one of the largest providers of such coverage. Against forecast net premiums of $531m, St Paul estimates its losses at $934m (including a $600m reserve strengthening amount).
Strategic managerial decisions can create discontinued operations scenarios. Given the very open operating environment and wealth of public information on insurance companies created by the regulatory reporting requirements, insurance management is constantly fighting the commoditization of the insurance product. Profitability can only be obtained and maintained through underwriting newer lines of business, which are priced higher than commodity insurance, developing operational efficiencies where costs are lower than competitors, developing non-underwriting fee income (TPA services for example), producing exceptional investment income returns - or all of the above.
Inevitably, some lines of business may prove unsalvageable and merit cessation of underwriting, creating a discontinued operations situation. Management may become enamoured with a newer line of business and capital restrictions may require dropping one line in favour of another.
The last decade has seen some large investors in insurance divest themselves of entire companies. American Express sold Fireman's Fund in an IPO (subsequently resold to Allianz). Xerox exited the insurance business by selling off Crum and Forster. The Xerox divestiture included the setting up of a discontinued operations company - The Resolution Group - which assumed much of Crum & Foster's discontinued lines of business through novation/reinsurance. The Resolution Group's subsidiary, RiverStone Resources, now also handles much of the Fairfax Group's discontinued operations, after Fairfax purchased the Resolution Group.
The insurance market in the US confronts a blizzard of new challenges as a recent article entitled: The top 10 global trends 2002: who pays for insurance? outlines.2
Discontinued operations offer the insurance industry the opportunity to practice what seems to be one of its best managerial approaches - to do nothing! Inevitably, discontinued operations are not viewed as a separate type of challenge and their requirements are often not addressed.
Discontinued operations require substantial resources, expertise, focus and a strategy. In addition, the objectives of discontinued operations include minimal use of resources (and a plan to intelligently reduce resources over time), avoidance of new problems, expedited completion and minimum distraction from ongoing operations.
Achieving this requires maintaining adequate personnel, especially those with historical information, developing measurable goals relating to the new objectives, obtaining and maintaining relevant historical records, and, finally, developing specific policy and procedures unique to run-off.
Key areas of discipline include claims handing, investments and reinsurance recoveries.
In the US discontinued operations have been handled by:
Internally handled discontinued operations are the easiest choice for a variety of reasons, not least because it avoids segregating the problem and fully dealing with it! Leaving the discontinued operations portion of the book entangled in the on-going operations is an easy but potentially dangerous option. The result can be loss of management control, lack of focus, poor cash flow, loss of key personnel and documents and, ultimately, there may be an explosion of new problems.
Purchase of reinsurance cover
The next approach is to do almost nothing other than protect the financials by purchasing reinsurance cover against any ultimate deterioration in reserves. These covers are readily available, though usually at a substantial cost, especially if there is exposure to APH losses. It should be noted that such contracts usually cover the deterioration of reserves on a net basis i.e. after reinsurance, additional cover on a gross basis would add to the cost. If, as noted above, the discontinued operations are handled without adequate controls, especially in the reinsurance recovery area, the bottom line can be seriously exposed.
The next step up is to outsource the functions. This highlights the costs of the discontinued operations and allows for their management, as well as providing a measurement of the financial exposure. It improves focus, provides for expertise and, if appropriately managed, will result in an expedited solution.
A thorough review of the capabilities the contractor brings to the table should be made. Not only should the contractor provide sufficient capital backing to demonstrate its ability to handle discontinued operations to their final stage, but also the contractor should have available the appropriate systems and personnel to support the operations. Key concerns should include meeting the staff who will be running the operations on your behalf.
One alternative would be to outsource the discontinued operations by function, giving the claims handling to one party, the investments function to a second and outsourcing the reinsurance recoveries to a third. This would allow for a selection of experts in each individual area, or a selection of contractors where the company itself has a weakness. Coordinated systems would be essential to streamline administration between the contractors and/or the company in that scenario.
This approach is the holy grail of discontinued operations. Unfortunately it is either extremely complicated, or costly, or both. Sale/assumption presumes the book can be legally segregated, usually contained within an insurance carrier no longer needed, and can be sold for a price acceptable to the holding company. It is the price that usually causes problems. Management may have a very optimistic outlook both on the quality of the reserves and the costs of discontinued operations, which are usually shattered when the offer comes in. Novation is the legal transfer of the policies to a different carrier, and, depending on the state involved, may require policyholder approval. Again, the issue of price and additional costs comes into play, along with issues related to dealing with novation. (Hint: better make sure the policyholder address listing is in good shape.)
Liability-based restructuring (LBR), sometimes referred to as `good bank/bad bank', involves splitting an insurance book into two parts, one of which contains the discontinued business, the other the ongoing book. The key benefit is that the discontinued entity is solely responsible for the liabilities it retains, leaving the ongoing book entity clear of any tail. US examples include Cigna/Brandywine and Zurich/Home Insurance.
For those interested in LBR, the NAIC formed a working group to study the issue and the minutes of its meeting in the summer of 1997 (7 June 1997) provide an excellent description of the process and a proposed pre-approval checklist.3
In conclusion, the occurrence of discontinued operations in the US is a growing trend with a unique set of management issues. The causes, as outlined here, can affect any insurance carrier and many carriers are already facing this situation. Failure to recognise the need for a different approach, when faced with discontinued operations, can lead to poor cash flow, deteriorating results, a less than expedited exit from the book, and distraction of senior management from the ongoing affairs of the company.
With the numerous available options to assist in the handling of discontinued operations, management need not address the issues alone. An expeditious exit can be planned and executed to benefit not only the firm but also the policyholders and reinsurers involved.
By Colin L Gray
Colin L Gray is president of Gray Wolf Group, Inc, a consulting firm dedicated to the recovery of insurance and reinsurance balances