London's run-off market is an arena of professionalism and innovation, says Philip Grant.
Given its pre-eminence for decades, if not centuries, among international insurance and reinsurance markets, it is not surprising that London has become the commercial and intellectual centre of the world for `discontinued business', as run-off is now euphemistically known.
If that position had been attained simply as a function of the volume of business transacted, the story would not be a very interesting one. In fact, the evolution in London of an increasingly sophisticated marketplace for the extinction and transfer of insurance liabilities offers an insight into the changing attitudes of risk carriers and capital providers over the last ten to 15 years.
At the beginning of that period, when companies stopped underwriting business, it was generally because they were bust, which meant a long and uncertain period under the management of liquidators, whose ability to speed up the distribution of assets to creditors was fatally limited by the insolvency law and practice of the time. Those few companies that voluntarily ceased to accept new business tended to view the run-off of liabilities as an exclusively back-office function, to be parcelled out among the displaced underwriters and claims handlers. It was the era of passive run-off, with little thought given to the possibilities of achieving finality, whether by accelerated settlement or transfer of liabilities: a run-off was for life, not just for Christmas.
The first stirrings of London's legendary flair for innovation came with the establishment of specialist service providers offering an external run-off management service. Initially, this was essentially a bare claims-handling service, relieving the management and shareholders of risk carriers of the administrative burden of their discontinued portfolios and remunerated by fees based on transaction volume. It was not long, however, before the more imaginative of these companies, recognising the limitations of scope and potential income set by the narrowness of the service, were attracting business by offering incentive-based fees linked to the speed of disposal and to the consequent surpluses generated for shareholders.
With companies awakening to the idea that they could actually see an end to their run-off portfolios, and service providers eager to prove their mettle, the basic tools of the run-off trade were created and sharpened: commutation, inspection of records, time bar. Equally importantly, there emerged a discernible run-off attitude towards the handling of claims and the collection of reinsurance. A culture was born that characterises run-off practitioners to this day: hard-nosed, cynical and tight-lipped, asking and giving no quarter.
Professional as these service providers generally were (and are), it gradually became apparent to risk carriers and their shareholders that merely subcontracting the management of liabilities, however cost-efficient that might be, did not give them the finality they sought, at least not quickly enough. The challenge was to find some way of transferring those liabilities to another entity, so enabling the transferor to draw an early line under its financial, regulatory and administrative responsibility for the business.
The answer has been the development over the last few years of a high-stakes version of the traditional children's game of `pass the parcel', and it is this that will make the run-off sector arguably one of the most stimulating and demanding areas of employment for London insurance professionals in the years to come.
The theory of the deal is simple: it operates as a form of swap, with the transferor obtaining finality at the price of surrendering its `up side' on the ultimate outturn of the liabilities and, usually, an enhancement of reserving levels; the transferor on the other hand accepts the uncertainty of that outturn in consideration of the enhanced reserve levels. Finality for the transferor might be in the form of a transfer of shares to, or virtually unlimited stop loss reinsurance granted by, the transferee.
It is a deal that in principle benefits all concerned: the transferor obtains certainty and finality; the transferee gains the possibility of a substantial surplus on conclusion of the run-off; and the regulator is able to ensure that the interests of policyholders are protected by insisting on some added value, for example by way of increased reinsurance protection or the augmentation of free reserves, as a condition of approval of the deal. Last but not least, the whole market gains by the increasing concentration of run-off liabilities in the hands of professionals committed to the expeditious unravelling of the problems of the past.
The classic example of this type of transaction was, of course, the creation of Equitas, but a number of major capital providers now offer similarly structured transactions to the insurance and reinsurance markets, using their financial expertise and balance sheet strength to construct balanced portfolios of run-off liabilities.
Back to the future
None of this, of course, is to suggest that the future will be a joyous canter to the sunlit uplands of finality and repatriated capital. There are still many complex and intractable problems in the run-off market that its very culture of cynicism and secrecy make all the more difficult to resolve. One has only to think of the legal and procedural wrangling over the allocation of the Exxon Valdez loss and the incipient battles over the interpretation of the events of September 11 to recognise that London would often rather labour vainly to untie its Gordian knots than take a sword to them.
There is also still the sad but inevitable progress of solvent run-offs into insolvency. For all that the top legal and accounting practitioners have devised ingeniously procrustean ways to fit insolvency law to the circumstances of insurance businesses (the scheme of arrangement is surely the apotheosis of lateral thinking), insolvency still protracts and complicates the process of run-off.
Nonetheless, London will have a bright future in the field of discontinued business management if it can train and retain talented all-rounders, who offer not just the traditional skills of claims adjustment and administration, but who can also deploy the broad range of financial, investment and regulatory expertise that this increasingly sophisticated market will require. In short, it needs people who can make run-offs run off, and not just run on, as so many have seemed to do.
Those all-rounders must, of course, be placed not only within the commercial sector but also among the gamekeepers - the regulators - for with increasing sophistication comes the need for greater vigilance on the part of those appointed to ensure that the rules are obeyed.
There are encouraging signs that the UK's new financial super-regulator, the Financial Services Authority, will seek to take a more active and informed interest in the markets it regulates, but it will only be as effective in that role as the calibre of the people it employs.
We may venture, then, an optimistic view of the future for the run-off sector in London if it continues to be a breeding ground for innovators and informed risk-takers and if it can maintain and nurture the unique pool of talent that the practitioners and professional advisers who do their business there constitute.
By Philip Grant
Philip Grant is treasurer of the Association of Run-Off Companies.