APH liabilities have lain dormant on balance sheets since the 1980s, but Solvency II should prompt companies to look at them anew as a potential source of profit
Despite the delay in its implementation until January 2013, there can be few insurance and reinsurance senior executives who do not have Solvency II at the top of their worry list. Costly, administratively burdensome and negatively impacting capital positions, the EU directive can be seen as just one big headache for the insurance industry.
This should, however, be tempered by the fact that the imposition of Solvency II is leading many insurers to take a positive review of their business practices. A key area that they should urgently revisit is their exposure to old US asbestos, pollution and health hazard (APH) liabilities.
Twenty years ago, APH presented insurers with an enormous challenge that led to a complete overhaul of much of the way in which insurance business was transacted. Many of the industry’s newest senior managers will have missed this shift and for them APH may simply represent a historic cost of business carried about on the balance sheet and unable to be removed.
The cost of holding on to these liabilities is, however, substantial. In a recent research project, Ruxley Ventures estimated that major European insurers and reinsurers are currently holding APH liabilities on their balance sheets that total in excess of $11.5bn. Our figures suggest that the implementation of Solvency II will see a further regulatory capital requirement under the standard formula against these liabilities of more than $5bn, taking the total balance sheet strain to $16.5bn.
Clearly, some insurers will be able to mitigate this drain on capital with the use of an effective internal model, but nevertheless Solvency II will highlight the capital requirement. Even without the impact of Solvency II, these sometimes ancient APH liabilities are placing an unnecessary drag on the profitability of European insurers.
When the magnitude and timeframe involved in the APH problem erupted in the late 1980s, the industry engaged in a flurry of activity to deal with the problem, closing legal loopholes to new underwriting and replacing the under-reserving of liabilities with over-reserving. Today, given the development of APH claims, this makes many of the reserves look excessive, particularly among European companies, which Ruxley’s research suggests have larger over-reserving positions than their US counterparts.
However, these larger reserves offer even greater opportunities to release capital and realise value and profits from old APH liabilities.
At its most basic, there is a significant cost attached to the administration of these complex and open-ended claims that require expensive legal counsel to resolve.
So by highlighting the costs involved in holding on to old APH liabilities, and reminding the insurance industry of this long-dormant issue, Solvency II is perhaps doing the insurance industry a favour.
Perhaps another way for insurers to focus on this issue is to consider the profit that can be generated when capital is released through an APH transfer. Recently, a number of APH liability transfers have resulted in a profit for the insurer as liabilities are transferred for less than the value for which they were historically reserved. These successes are encouraging insurers to better understand the value of their APH liabilities and reserves, given the real possibility of realising an ‘instant’ profit through a transfer.
The ongoing market orthodoxy that APH is a low-level problem slowly resolving itself, with manageable cost implications, is denying insurers the opportunity to maximise this potential source of capital release and the cost savings achievable. However, as the costs have largely been absorbed and accepted for many years, APH simply represents background noise. A closer look at the recent claims history will demonstrate, however, that while levels of activity may be significantly reduced, those that remain represent the challenging last battles that require the knowledge, experience and resources available to successfully conclude.
Solvency II should have a galvanising effect on insurers with APH liabilities – the additional reserve requirements that the directive adds to long-tail, casualty and old years’ liabilities should ensure that APH comes back on the agenda as a key issue. By focusing on APH again, both active and run-off players will be able to achieve a profit, while simultaneously reducing their expenses, releasing capital, achieving finality and most importantly, focusing on future business development. GR
John Winter is chief executive of run-off purchasing firm Ruxley Ventures