“It's the end of the world as we know it, but I feel fine.”- Pop lyric
“Trends we are seeing today will lead to a vast increase in the incidence of run-off, and, I fear, in the frequency of insolvencies,” declared Paul Jardine, chief actuary for Equitas, at a recent City of London presentation. “It appears that we have almost perfect insolvency conditions.”
Forces driving the trend are many, but they essentially boil down to the state of the reinsurance, insurance, and investment markets. A joint study by the Economist Intelligence Unit and PricewaterhouseCoopers (PwC) states gloomily: “Beleaguered by slumping prices, property and casualty insurers are delivering dismal returns for shareholders, with many destroying shareholder value.”
The collapse of over-enthusiastic antipodean reinsurers and the hardening retro market are pushing the process along significantly. No one was truly surprised at the fate of Australians New Cap Re and GIO, but plenty of real surprises will follow as reinsureds count the costs. “People are looking at their coverages in panic. If you have nice letters of credit you are in clover, but if you have nothing, you have nothing,” one London insolvency practitioner observes.
Worse, he says, the real impact of December 1999 European windstorms, Lothar & Martin, has not yet been seen. “The loss frequency in 1999 will have hurt a number of people, especially in Bavaria. They will be looking to get their ball back, and when you have the likes of the Munich looking to recover its ball, it will lead to tightening in the retro market.” That, he says, will eventually work its way back to the insurers, making it a “tough, tricky year” in the p/c market.
Evidence of a hardening market is mounting. Four major catastrophe programmes renewed between January and March, providing a barometer of reinsurers' willingness to sustain the soft market. CGU, Norwich Union, Farmers and the St Paul each renewed its programme in the first quarter, and in each case the slip was signed in full, reflecting the unwillingness of followers to jump in at the leaders' rates and sign down the contracts. In all four cases, the leaders and their lines remained the same, and each slip saw a marginal rate increase, but the following market clearly would have liked to see greater price hikes. Meanwhile, the Japanese renewal was something of a disappointment, with wind programmes remaining below technical rates. Single-digit rises, from 6-8 %, were common for those treaties unscathed by Typhoon Bart, reflecting an ever-so-slight move to sense, but the protection of proportional treaties by some of the big hitters prevented the substantial and necessary improvement in wind XL rates.
PwC in its recent paper, The managed exits of the future - how to save $50 billion, predicts one possible outcome of the current market pressures. “Certain insurers will adopt a survival strategy... They will enter a war of attrition where the key to success will be the ability to withstand the attrition longer than their competitors.” The potential for multiple collapses is highlighted. “If the reduced level of catastrophes during the past few years is reflected in reserves, then the frequency of failures could rise, with under-capitalised carriers being particularly vulnerable. Indeed, the potential mega-catastrophe may be one of the most serious financial threats to this sector of the industry... It is not a question of if there will be a shake-out across the market - it is just a question of who and when.”
Clearly, PwC feels some insurers will not weather the coming market transition well, and points out that 99% of insurers world-wide are competing for just one third of global business. All in all, PwC predicts more companies in run-off, and suggests that the main problem with insurance-based solutions to run-off challenges is that “liabilities remain within the insurance industry. In other words, if you always do what you always did, you will always get what you always got!”
The firm helpfully lists a set of options for dealing with the troublesome portfolios of ceased operations, beginning with the tempting but impractical choice of ignoring them. The appeal of conventional run-off is limited by the disproportionate way in which costs and liabilities fall, which can be burdensome. Reinsurance caps provide only a bandage and do not alleviate the administrative headaches. Aggressive run-off is impractical for organisations with operations in the live market. PwC also points to non-insurance solutions: sell the company or book, which the consultants admit can be difficult; increase capital, which is usually unattractive to investors, or take a statutory exit route, such as a scheme of arrangement.
Swiss Re has estimated that the global gross liabilities of insurers in run-off could reach $505 billion by 2006, and PwC's calculations show that the related costs and underwriting deterioration could add another $150 billion. There are assets, of course, but the net number is a rather large negative. The accountants argue that traditional run-off is not the solution. The future, PwC claims, lies in the combination of modern insurance skills (specifically liability estimation and commutation), leverage of the capital markets to provide new “financial stakeholders,” mergers and acquisitions and “restructuring skills... to form a new way of handling run-off” which will release trapped shareholder value. PwC suggests that cutting off liabilities early will save shareholders a not-insignificant $50 billion.
The London market has percolating a number of solutions to its multifarious run-offs. One being pursued by the Association of Run-off Companies (ARC), whose membership includes more than 30 companies with portfolios in run-off, is to cut costs by pooling outwards reinsurance collections. Association chairman David McGuigan explained. “Consolidation is the key. The more we can reduce the costs for the companies involved, the better the chance that they will all stay solvent,” he said.
The first planned step is to migrate outwards reinsurance collections from their current brokers to a new service provider who will deal with several members' collections at one time, perhaps negotiating on a principal-to-several-principals basis. A tender is underway to find a service provider that will agree to guarantee certain levels of service. Mr McGuigan said that the chosen provider could be a traditional broker or someone else, and that the job may be divided among multiple providers, perhaps by line of business.
Much uncertainty currently surrounds the UK's new Financial Services and Markets Bill, but it could ultimately introduce court-approved portfolio transfers which do not require the agreement of reinsurers. That, Mr McGuigan said, could fundamentally change the workings of the run-off market. “Live companies could migrate enormous portfolios of lousy business. All the old business in London could move to one place, and the service charges would drop significantly.”
Naturally Mr McGuigan, whose day job is claims, commutations, and reinsurance manager at Scottish Lion, believes in a co-operative and non-profit run-off effort. “The difficulty with the purchase of a portfolio is the due diligence that has to go with it.” Thus the ARC approach is to leave the assets where they lie, centralising only certain processes.
Another group of run-off specialists is taking a commercial approach. It has announced the formation of Markitas Ltd, which has been billed as a company-market version of Equitas but, in fact it has little in common with the Lloyd's run-off vehicle. John Niemiek of Peter Blem Adjusters, a director of Markitas, said the group's plan is to “provide in the world-wide reinsurance markets a solution to the problems that exist related to the management, resources, and expenses involved in looking after long-tail, non-corporate incentive liabilities that have been inherited or assumed.”
Markitas, which Mr Niemiek says counts several recognisable names in the global reinsurance industry among its founding members including six from Europe, plans to assume portfolios of run-off business, along with the related assets, and profit from them by exploiting the economies of scale which could be realised through joint run-off. “It will be done on the basis of a portfolio transfer reinsurance from day one,” he explained. “The eventual goal will be novation. It will be a full and final financing.”
Markitas is gearing up for the growth which it too sees in the sector. “Run-offs are going to become more common,” Mr Niemiek said. “We are seeing a traumatic change in the reinsurance industry, brought on through rates, centralisation and M&A (mergers and acquisitions). We need a vehicle to address that.” The group, which is targeting start-up in January 2001, will be a thoroughly commercial venture. “It comes down to price,” Mr Niemiek explained. “We will assess a portfolio, offer a price for finality and if they will pay the price, we will do the deal.” Thus, unlike ARC, it is assumed founder members will be unable to dump any and all run-off business into the vehicle. Markitas will back its portfolios of assumed business through new, central reinsurance companies in several jurisdictions, and it should be capitalised at £500 million, in part by its founder members and in part with external venture capital.
So what shape is the future? “All the run-off merchants will have more business,” predicts the anonymous insolvency man. He adds a hint of cynicism: “Everybody has the solution for doing it cheaply, but a lot of people have the incentive not to. It is a big industry now, with a lot of people trying to make a buck out of it for themselves.” For them, the end of the world as we know it may be the beginning of something splendid.