With so many adolescent players, Bermuda is not an obvious centre for discontinued business. But Katrina provided some highly-visible run-off activity, which illustrates the market’s growing sophistication, explains Charles Thresh

The run-off market in Bermuda has become increasingly sophisticated in recent years. Some of the most recent run-off activity on the island came following the catastrophic storms of 2005 – Katrina, Rita and Wilma (KRW) – where some significant players ceased or dramatically curtailed writing new business, notably Quanta, Alea, Rosemont Re and PXRE.

Each of these entities has been the focus of great merger and acquisition (M&A) interest, with Quanta offering itself for sale (and deciding for the time being to pursue a “self-managed run-off”); Rosemont Re’s parent pursuing a rights issue to repay debt and provide working capital to fund a value-added work-out; Alea’s announced sale to Fortress Investment Group as its platform to enter the run-off market; and PXRE merging with Argonaut to be recapitalised and commence underwriting again (not unique, but surely a rare occurrence).

Proactive approach to run-off

In the relatively well-developed and highly competitive UK run-off market, the almost exponential growth of new players has forced buyers interested in run-off to explore alternative markets, including Lloyd’s, Bermuda, the US and Europe. This has affected Bermuda in a number of ways.

In Bermuda, the Bermuda Monetary Authority, like the UK Financial Services Authority, has proved receptive to a proactive approach to run-off, promoting accelerated closure to reduce the risk of insolvency, and thereby seeking to balance the interests of cedants with other stakeholders. This has helped to make Bermuda an attractive jurisdiction to pursue run-off opportunities.

In the past two years there has been an almost constant stream of London Market run-off specialists doing the rounds in Hamilton, usually with a private equity or hedge fund capital provider in tow. A number have taken the view that a permanent presence on the island greatly enhances the chances of early access to deals, and so have obtained the necessary regulatory approvals to operate in Bermuda, in anticipation of staffing up when a deal (or management contract) is reached.

It is only in recent years that Lloyd’s has allowed syndicates in run-off to explore reinsurance-to-close (RITC) arrangements with non-Lloyd’s vehicles. In the developing US run-off market, the absence of a tried and tested “finality” solution such as the scheme of arrangement has also pushed investors towards reinsurance as an exit solution for run-off. And it should come as no surprise that many run-off specialists focusing on Lloyd’s RITCs and US portfolios have chosen to establish their risk-bearing entities in Bermuda.

There has been much recent commentary in the industry press and on conference platforms about “passporting” European companies or portfolios to the UK, to benefit from the specialist skills and established legal mechanisms to exit run-off. While passporting may become the method of choice to address the relatively undeveloped European run-off market, at least one run-off specialist has opted for a Bermuda-based reinsurance solution for its European run-offs.

Another recent phenomenon that has uncertain implications for the run-off scene in Bermuda is the emergence of the sidecar (a quota-share vehicle capitalised by third party investors to reinsure a single portfolio or cedant) to facilitate capital market participation in property-catastrophe risks. So far, exit routes have been confined to commutation of the quota share arrangement or sale to the cedant company. If neither option looks likely, it is possible that a financial player may be prepared to take a punt on the long-term underwriting results, although the potential conflict of interest between the newly-independent sidecar and its quota-share cedant would require delicate handling.

Future trends

There is also the much less visible ebb and flow of captive insurance companies. Formation, run-off and dissolution of captives occurs in a continuous cycle and it is the captive market that may be the next focus of run-off M&A, rather than purely third-party underwriting companies (not least because the number of potential targets is so much greater in the captive market). In the case of captives, the challenge for buyers is to get access to sufficient information on the target to formulate a compelling proposition and then to access the potential vendor at the right level, particularly as the vendor will likely be the largest policyholder of the captive.

“In the past two years there has been an almost constant stream of London Market run-off specialists doing the rounds in Hamilton, usually with a private equity or hedge fund capital provider in tow

Aside from captives, Bermuda remains predominately a property catastrophe market and 2006 was a bumper year, with largely benign weather and seismic activity across the globe. But Bermudian reinsurers know only too well that the good times can’t last. Mother Nature may have spared the industry in 2006 by “going on vacation”, as Berkshire Hathaway CEO Warren Buffett so aptly put it, but few are expecting such an easy ride in 2007. Time will tell whether the property-cat writers can still make money in a softening market when the wind blows and/or the earth moves, through shrewd underwriting. If KRW-sized losses are experienced again in coming years, the question is: what will happen?

According to a number of market commentators, many developed economies are coming to the end of a period of unprecedented growth and stability. Rates of insolvency in other industry sectors in the US and UK are already increasing. Further tightening of credit is predicted and that is likely to have knock-on affects on private equity and hedge fund investment strategies, which rely heavily on leverage. So what are the implications for the insurance and reinsurance markets, particularly in Bermuda?

In an environment where there are fewer investment dollars (or more attractive alternative market sectors), obtaining capital to restore impaired balance sheets may be much more difficult than in the recent past. Where impairment is caused by losses suffered across the whole market, like KRW, it is the players that have the strongest franchise that will be first choice for investors. The weaker players will become the next generation of run-offs in Bermuda.

For the time being, however, rescue capital is clearly there for the right deal, as evidenced by the recent recapitalisation of Scottish Re via an injection of $600m of new capital from Cerberus and MassMutual Partners. The deal was the life reinsurer’s last chance to avoid insolvency, as CEO Paul Goldean so candidly accepted. Urging shareholders to vote in favour of the deal ahead of an extraordinary general meeting held in Hamilton on 5 March, he said: “If the MassMutual/

Cerebrus transaction or a similar transaction is not completed in the very near term the company will have no alternative but to seek protection under applicable bankruptcy and insolvency laws almost immediately.”

Will there be insolvencies?

Insolvency has been a rarity in recent years. It has been said that every insolvent run-off starts with a solvent one. However, it does not hold true that every solvent run-off ends in insolvency, even where the run-off is not part of a larger group prepared to support it.

Asbestos, pollution and health remains “the elephant in the room” for many reinsurance players globally, including some of the largest companies in Bermuda. However, the vast majority of Bermudian capacity has only been exposed to 1992 and post events and is not therefore exposed to latent claims (at least ones that we know about).

It is interesting to note that there were no insolvencies arising from KRW. “Failure” in this context was being forced into run-off, not insolvency. This is a facet of the very significant capitalisation of these entities when the events leading to run-off occurred. This in turn resulted from market conditions that continue to prevail today – regulatory, counterparty, analyst and rating agency pressure to maintain a strong capital base. While these market conditions prevail, those companies not disproportionately exposed due to effective underwriting controls are likely to be resilient enough to avoid insolvency, in all but the most cataclysmic circumstances.

Run-off, in the 21st Century, is part of the global reinsurance market lexicon. Rather than being a phrase uttered in hushed and disapproving tones, run-off is now seen as an essential facet of a vibrant and healthy market.

Charles Thresh is managing director at KPMG Advisory Limited, Bermuda.