Equitas is a unique company by anyone's standard. Formed from the largest ever series of reinsurance transactions, and responsible, at inception, for £14bn of liabilities and £15bn in assets derived from over 300 syndicates managed by over 70 separate businesses – the 1992 and prior business of the Lloyd's non-life syndicates. The reinsurance asset consists of over 250,000 separate reinsurance contracts placed with 3,000 reinsurers and 2,000 underwriting pools. Just over one-third of the reinsurance asset inherited from the syndicates was due from insolvent companies or companies in run-off.
It is this last statistic which has coloured our view of impaired or at risk companies. Unlike many on-going operations, Equitas does not have the luxury of simply writing off the bad debt. As margins become squeezed and companies grapple to show modest surpluses or reduced losses, so the importance of debts from such companies will become even more prominent in balance sheets of live companies.
A Sigma/Swiss Re study published in 1998 looked at what was termed the “run-off phenomenon”. One of the headline numbers to emerge was the value of the worldwide run-off market. Swiss Re estimated that US$230bn of liabilities resided within run-off portfolios and that the market was extremely concentrated – 85% of the total was in five countries: the US, UK, Japan, Germany and France. In addition, Swiss Re indicated that the run-off market was set to grow at 10% per annum with internal run-off portfolios growing at 15% owing to deregulation in continental Europe. It is within this context that Equitas has had to adopt a proactive approach to realising the reinsurance asset reported on its balance sheet.
It is essential for every creditor to monitor the state of its asset. The reinsurance asset is not likely to appreciate in value the same way as investments. For one thing, reinsurance proceeds are generated only as a direct result of a claim settlement on the inwards book. At best, reinsurance mitigates the loss; it rarely cancels out the loss and never puts more than the loss back into the balance sheet. Secondly, over time the reinsurance asset is exposed to the possibility that the reinsurer will fail. Add to these the delays in realising cash from reinsurers and the inefficiencies of the collection process, and it becomes clear that the long-term management of the reinsurance asset may become a significant burden.
Consider a simple example. A company has liabilities of $10m, a reinsurance asset that reflects recoveries of about 50%, cash/investments of $6m and a solvency margin of $1m. A 20% deterioration in liabilities will wipe out the solvency margin. Similarly, a failure of 20% of its reinsurance asset will have the same effect. In a climate of uncertainty these two scenarios are not actually independent but inevitably and inextricably linked. A general deterioration in reserves industry-wide is likely to lead to reinsurers being tipped into insolvency. However, in each case, the reinsurance fails to prevent the insolvency of the company.
A number of factors may signal a company facing difficulties:
Each factor alone may not signal the collapse of a company. However, the combination, the frequency and the materiality of the indicators in the context of the company's balance sheet will usually provide clear signals of impending failure. To be effective, the creditor needs to be alert to the changes in the market and to monitor, assess and prioritise the risk associated with the debt due from counterparties. A commutation undertaken with weak security is likely to yield more than picking over the corpse of a dead reinsurer.
The practical effect of a reinsurer going into provisional liquidation, whether by default or design, is a cessation of processing and an uncoupling from traditional information flows. The failed company is similar to an ailing patient who rapidly becomes comatose and dies. Brokers, with whom the patient had a relationship but who now see themselves written out of the will, distance themselves. Life support mechanisms are switched off. The doctors, from accountancy firms' corporate recovery units, called in too late to save the patient, disrobe to reveal that they provide a mean undertaking and burial service as well. Preparation begins for the funeral march that will, in many cases, last longer than the life the (now) dead company enjoyed.
Creditors continue to raise recoveries, but with little expectation of response from either the broker or the dead company. The perception within the creditor company is that the debt is lost. A prudent provision is posted in the accounts and little time is wasted on pursuing the estate. Efforts are redirected to areas where cash can be more easily realised. This is a mistake. Creditor apathy can unnecessarily delay the realisation of any dividend.
An appointment as provisional liquidator virtually guarantees the successful candidate a substantial income stream over the ‘lifetime' of the estate. Provisional liquidators are court-sanctioned appointees, and once established the court would require compelling reasons for their removal. When the process has matured to a scheme of arrangement, creditors have the direct power to dismiss scheme administrators, but this power is difficult to apply in practice. The potential costs of transfer and the disruption it would cause mean that the administrators are virtually immovable. Thus, the most cost-effective way of creditors getting the control and management of choice is to ensure the appointment of the right people at the outset. Yet this is an opportunity that few creditors, if any, get. A notable, but rare, example was the conflict between Price Waterhouse and Coopers & Lybrand over the management of the KWELM estate.
Likewise, the once the liquidator-appointed run-off manager is established, it is virtually guaranteed the same longevity. The recent tendering process for the management of the Orion estate is a rare example of run-off managers facing removal. As the recent experience of the UK National Lottery illustrated, however, the incumbent has a substantial (and perhaps inevitable) advantage over the alternative candidates.
Creditors do have some influence because of the stake they hold in the estate and through participation in creditors' committees. When opportunities arise, the main points to be made forcefully to liquidators and scheme administrators are:
i) creditors can do more with their cash investments than can be achieved by retaining the cash within an estate. Early distribution is essential;
ii) determining offset with principal-to-principal ledgers is a fundamental cornerstone of estate management. Without it, reinsuring creditors cannot be paid and the assessment of ‘at risk' reinsurance cannot be made. It also indicates that a significant milestone in the development of the estate has been achieved. Put it in place as quickly as possible;
iii) creditors are not homogeneous. Greater flexibility and choice are required to meet individual circumstances, yet not be disadvantageous to the rest of the estate. Options include accelerated payment facilities and commuting admitted debt; and
iv) regular assessment and reappraisal of asset-realising opportunities is an essential part of dynamic run-off management – particularly in the case of an insolvency. Reliance on the approach adopted when the company was live is not appropriate.
Quite often, the costs of running the estate are compared to annual investment income generated by the estate. It is argued that if the cost of the management is less than the investment income, the run-off is being carried out for free. This is, of course, a specious argument. The costs of management should be compared against progress and achievement. Value for money is the key measure. The insolvency practitioner should put in place strict service level agreements with the run-off manager to ensure that the costs incurred have tangible, measurable benefits. How many other businesses tolerate ‘cost-plus' contracts without measuring efficiency and effectiveness?
Likewise, the insolvency practitioner's costs and contribution need similar attention. Run-off schemes of arrangement under which many UK insurance insolvencies operate must not become a ‘run-on' arrangement. The failure to establish principal-to-principal ledgers within a ‘reasonable' time of insolvency should be regarded as a serious failure of management. What is ‘reasonable' depends on the issues inherited at insolvency, but estates should aim for this to be achieved, or substantially under way with a timetable to completion, within two years of insolvency.
Creditors should consider also the insolvency practitioners' handling of the run-off managers and the efficiency with which they operate; the development of a clear strategy and implementation of a detailed and measurable action plan; and the transparency of reporting. These give creditors confidence that the money they have invested in the estate is being dealt with efficiently and effectively.
We must remember that compared to other jurisdictions, the UK is blessed with a framework which, given the right management, supports an earlier return of dividend to creditors. However, there is still room for improvement and there are still innovative solutions to be found. But if creditors don't push for them, what guarantee is there that they will ever be realised? The biggest sin in the present environment is creditor apathy and disinterestedness.
Rhydian Williams is Head of Security, Insolvency & Support, Equitas Ltd.