National Indemnity’s deal with Equitas has breathed life into the run-off industry and roused interest from a whole new generation of investors. Lindsey Rogerson takes stock.
Run-off, once the embarrassing secret of the reinsurance industry, has been given a glamorous makeover since legendary investor Warren Buffett snapped up Equitas late last year. The $7bn of Equitas liabilities is by no means the only run-off Berkshire Hathaway has been buying up – it also bought $1bn of US liability from Swiss reinsurer Converium last year. So basking in the reflected glow from the Oracle of Omaha, one has to ask: “Is run-off now sexy?”
KMPG certainly seems to think so. It believes run-off is attracting attention from return-hungry investors, frustrated with low or slowing rates of return available from more traditional investments. It said in its UK report that “there are many investors looking to make acquisitions in the global run-off market”. On top of this, Pricewaterhouse- Coopers believes regulatory changes – specifically Solvency II – will force more insurers to consider run-off, thus increasing the opportunities for companies looking to profit from this area of the industry.
Buffett’s purchase has certainly helped to fuel an already simmering investor demand. Such is the “Buffett affect” that simply because he has shown an interest in the sector, others are likely to follow. Indeed, Sean Dalton and Andrew Elliot’s Leinster Syndicate 4882 – set up specifically for reinsurance-to-close business – is arguably attempting to mime the same revenue stream. But with authoritative studies from KPMG and PricewaterhouseCoopers putting the respective size of the UK non-life run-off industry at £38.2bn (see figure 1) and the European run-off market at ?204bn (£140bn) (see figure 2) – it seems there may be plenty more tempted to follow the great man’s lead.
The reason run-off can seem attractive is that companies acquire assets cheaply, paying less than the book value of the reserves for the run-off. Joshua Shanker of Citigroup believes this was the primary attraction for Buffett in buying Equitas and Converium’s US holdings. “In our opinion the primary motivation for the deal is access to ‘float’”, he says. “We think that Berkshire Hathaway feels that it is able to generate a higher return on the asbestos reserves and hence derive more net investment income than Lloyd’s.”
Gambling on long-term liabilities
The big question of course is will they be able to pull it off? What the companies snapping up run-off are gambling on is that they can grow the reserves faster than the liabilities. So a key thing for investors to assess is the investment expertise of the company buying a run-off. Few would argue that Buffett’s track record suggests Berkshire Hathaway will make a success of Equitas – but then there are only a handful of investment managers on the planet who could claim to have his asset-selecting skill. So careful assessment must be made of how a company buying run-off liabilities intends to invest its reserves.
White Mountains also has a track record in managing run-offs. Its subsidiary Folksamerica Re Solutions has been acquiring and managing run-offs since its inception in 2001. Given the surge in run-off in Bermuda in the last few months – KMPG puts it at $5bn in the last 12 months alone – Folksamerica could be sitting pretty.
Another thing to watch is the quality of the run-off itself. As Nick Martin, investment analyst on the £77.6m Hiscox Insurance Portfolio points out, the assessments of liabilities in a run-off book can be notoriously unreliable. “Generally, companies that are in run-off are so because they are a mess, and usually in insurance when there is a mess, it is because there is inadequate reserving. So you have to take a view on whether the reserves you are buying really are enough to cover the liabilities.”
“Buffett’s purchase has certainly helped to fuel an already simmering investor demand
With the accuracy of a run-off’s liabilities being so critical to the eventual profitability to an investor, getting as clear a picture as possible of the level of liabilities is vital. When judging the quality of a run-off, investors and analysts do have a helping hand in the shape of specialist recovery ratings issued by Standard & Poor’s. As part of its wider market work looking into the likelihood that companies which get into financial trouble will successfully come out the other side, S&P has devised the ratings. Peter Hughes, vice president at the group’s corporate and governance division, says they will make it easier for investors to weigh up the relative merits of any individual run-off (see “The value of run-off ratings” on page 26).
A pro at asbestos
Berkshire Hathaway does have one other ace up its sleeve when it comes to making a success of its recent run-off deals – namely its experience of managing asbestos claims. Citigroup believes this is the reason it has moved the Equitas claims staff in-house. Shanker explains: “Berkshire has a track record in the area of asbestos claims. It purchased CIGNA from ACE in 1999 and John Manville in 2001. We continue to believe that Berkshire has a significant amount of data and expertise that it plans to leverage in the settling of Equitas and Converium claims.”
Finally, the flip side of the Buffett/Equitas deal should not be overlooked. Almost overnight Lloyd’s found itself re-rated upwards to “A+” by S&P. Other insurers have likewise breathed a collective sigh of relief when freed of their run-off liabilities, with rating agencies also viewing them in a much more favourable light.
Nick Martin explains: “Usually [selling a run-off] is a positive for a company if they have got a problem somewhere in their underwriting. The fact that Lloyd’s as whole got rid of Equitas is a big plus for them because they got rid of a huge liability. This will inevitably lead to an increase in investors at Lloyd’s, attracted by the ‘cleaner’ company with no skeletons in the closet. It is someone else’s problem now and investors will gain comfort from the fact they have got rid of the tail on their reserving risk.”
Lindsey Rogerson is a freelance journalist.
Investment: Equitas - Timeline to takeover
1980s - 1996 – Lloyd’s slips into devastating losses after years of profitability as natural disasters, catastrophe losses and mounting asbestos liabilities from as far back as the 1930s hit home.
1996 – Equitas is formed to specifically reinsure liabilities that have accumulated in the Lloyd’s syndicates prior to and including 1992. The business is then subsequently reinsured by Equitas Reinsurance. The proposal is accepted by over 30,000 Lloyd’s Names and the scheme starts with approximately £15bn of liabilities with an expected settlement period of 40 years.
2000 – Equitas chairman Hugh Stevenson warns Names that “external factors beyond the control of the company – such as increasing asbestos claims, legal developments, judicial decisions and social trends – could have a profound impact on Equitas’ reserves.”
October 2006 – Equitas and Berkshire Hathaway announce they have reached an agreement in principle on a structure in which National Indemnity, a member of the Berkshire Hathaway group of insurance companies, will reinsure all Equitas’ liabilities, provide up to a further $7bn of reinsurance cover to Equitas, take on the staff and operations of Equitas and conduct the run-off of Equitas’ liabilities.
March 2007 – Equitas announces completion of Phase 1 of the deal with National Indemnity, including a change of name to Resolute Management Services and minor compensation to all reinsured Names. Hugh Stevenson, chairman of Equitas, says: “It is excellent news for reinsured Names that we have now completed the transaction having received all the necessary approvals.”