Bryan Joseph looks at some of the problems associated with run-offs and discusses the need for alternative mechanisms to liberate capital and enhance shareholder value.

The theory behind insurance is essentially simple. The insurer borrows money from its policyholders and pays it back to those who have a claim. Effectively, the insured uses the insurer's capital to provide it with support when losses occur. The mechanism used by insurers to smooth this transaction is the capital provided by their shareholders (or owners in the case of a mutual).

Following an occurrence, the insurer pledges part of its capital to pay future claims, using the policyholders' premiums to establish the reserves and meeting any excess over the policyholders' premiums plus the capital required to meet any fluctuations in future investment income or variability in the loss reserves out of its own shareholders' funds. Ideally, the contribution required from these shareholders' funds should be as low as possible, to maximise their return. However, since many companies hold undiscounted claims provisions, the amount of capital provided in this way is substantial.

Consider, for example, a company accepting reinsurance business where the expected future average term of the payout pattern extends for eight years. If this pattern were to be discounted at 5% a year, then roughly 12% of reserves would represent the shareholders' capital. This will not be distributable to the shareholders or available to support new business until the business has been completely run-off. Applying these figures to the $80 billion of reserves identified by PricewaterhouseCoopers in UK companies in run-off suggests that the shareholders will have roughly $5-10 billion of capital, excluding dedicated share capital, tied up in these run-off funds.

On a global basis, using the estimate of industry size of $350 billion in Swiss Re's 1998 report The run-off phenomenon, extracting value from discounted business, the global locked in capital in the non-life insurance industry can be estimated at between $20-45 billion. If this is added to the capital and surplus of companies in run-off, the total could well range from $40-90 billion. Accessing this capital and turning it to more productive use should be the Holy Grail of management teams who own or control part of these run-off funds.

The insurance industry has responded to these challenges in a number of ways which, in effect, retain the liabilities within the industry and continue the retention of the hidden capital described above. Strategies often involve the passing of liabilities from one group of shareholders to others within the industry for what is hoped will ultimately turn out to be a fair price. They include the following.

• The “do nothing” strategy that assumes that the problem is temporary and that the reserves have been soundly established. In many run-off funds, the situation where the reserves are unchanged from year to year, regardless of annual claims payments, is quite common. However, the run-off of liabilities to expiry can take years and costs rarely fall as anticipated in the business plan prepared for the run-off (assuming that management has prepared a business plan). An example is the St Helen's Insurance Company which went into run-off in 1965 and finally closed, in liquidation via a scheme of arrangement, in 1997.

• The reinsurance strategy, where management buys a liability cap from a third party reinsurer. This is intelligent use of capital, making the cost of the run-off more explicit and recognisable. However, it merely caps the volatility by transfer to a third party. It ignores the possibility that the reinsurer may not be able to carry out its obligations over the long future period of the run-off, nor does it prevent market wide deterioration in the liability position arising from legislative or social changes, such as the US Comprehensive Environmental Response, Compensation and Liability Act (Superfund) and the UK introduction of the Ogden tables in personal injury cases. This is only a partial solution, as illustrated by the near unravelling of the reinsurance to close concept at Lloyd's prior to the formation of Equitas.

• An aggressive run-off strategy, where a combination of commutations and market activity leads to a slow down of the transfer of funds back to policyholders. This is best described as a legal but not reputation enhancing strategy that could ultimately invite regulatory sanction.

• Selling the business to another party, which moves the problem elsewhere. This is perfectly acceptable, subject to finding a buyer, no requirement for future guarantees from existing shareholders and agreeing an acceptable price.

• Using existing regulations to ensure a complete exit. In the United States, these include conservation, rehabilitation and Chapter 11 strategies while, in the United Kingdom, companies can use schemes of arrangement.

Putting all or part of the business into run-off is rarely planned so management teams tend to adopt strategies by default. Instead, formulating a clearly defined business plan and strategy for the management of the run-off portfolio should be the first step for management teams faced with the run-off decision. This is now a requirement of UK regulators for companies withdrawing from the market.

The business plan should include an actuarial report, identifying the liabilities of the fund on both a discounted and an undiscounted basis, gross and net of outwards protections, and the expected future cash run-off of the portfolio. It should give realistic estimates for future run-off costs and for reinsurance bad debt, also including narrative on available strategies and recommendation, with reasons, of the one that the company should adopt.

By concentrating on costs and benefits, the business plan will allow management to identify the shareholder value locked in the run-off and the strategy to adopt to unlock that shareholder value, while it is still positive. Solutions will necessarily involve some type of compromise agreement with policyholders and regulators. They may also require significant market co-operation where a negotiated solution applies to all participants and retrocessionaires.

The ideal solution will provide early termination of the liabilities concerned. This has several advantages, including
• avoiding deterioration caused by adverse events that were not anticipated in the premium basis
• reducing future run-off costs to release shareholder value
• reducing elements of uncertainty such as interest rate volatility, reinsurance bad debt and normal claims volatility
• releasing the unproductive capital for refocusing on new business or earlier return to shareholders

There are many techniques that can be borrowed from the global capital markets to help companies to achieve the optimum solution although the mechanisms for developing these are in their infancy. They are likely to involve a combination of options and other more exotic derivative structures, accounting and taxation arbitrage, taking advantage of the differences in the accounting and taxation regulations governing derivatives and also of the tax differences between territories to establish value, and policy buy-outs between insureds and their insurers. They will also require sharing the benefit of early termination between the counterparties involved in the transaction, ie insureds and (re)insurers.

These type of mechanisms could well affect the initial inwards contract design leading to fundamental changes in the nature of contracts within the insurance industry. For example, consider the ABC insurance company that has a potential liability to the XYZ corporation with an expected value of $500 million at the gross level.

If ABC wished to terminate this contract early, it should pay XYZ the present value of the $500 million loss times the probability that the loss will be identified as an insured loss times a discount factor for the time value of money between the current date and the date that the loss is expected to be settled. XYZ should accept this amount less the legal and other costs associated with the establishment of the value of its claim that are not covered by its contract. A deal can be struck if the two parties achieve agreement.

Doing this deal may not be attractive to either party as establishing the level of discount or the level of loss may not be possible based on current information; the reinsurers of ABC may prefer to wait until the loss is crystalised. If XYZ were to offer ABC zero dividend redeemable preference shares to the level of the expected value of the loss, then they could create an option where the payment of the preference share values is offset against future claims payment. XYZ receives its cash early and ABC does not overpay as only preference shares to the actual value of the loss will be offset, plus it does not jeopardise its reinsurance recoveries. Provided that XYZ is quoted or that its preference shares have a rating, they can be sold in the open market to support the transaction.

This is a simple example of how alternative structures can be used to settle losses and to terminate some of the larger claims on the portfolio. These structures can be extended to the portfolio as a whole if a capital markets provider can be persuaded to provide replacement capital to support the transaction.

The run-off market represents an inefficient use of the capital within the insurance industry. Companies need to discover alternative mechanisms to liberate the capital and to add shareholder value. Those that fail in this will suffer from share price drag and may be taken over. Those that plan and effectively manage their run-off portfolio to achieve early termination will ultimately be the winners.

Bryan Joseph is a partner of PricewaterhouseCoopers, London.