It is much easier to know when and why run-offs begin than when and where they will end. Adrian Leonard explains.
People who have been in the insurance industry for a decade will remember well the situation which led to the run-off boom: the underwriting cycle, the spiral, the long tail liabilities. In London alone, about 80 companies ceased writing business in the early 1990s, many of them failing miserably.
But when do run-offs end? The answer is much fuzzier. To date the solvent run-off of a London market reinsurer has yet to be concluded. "I have been on one run off for 14 years," says Pamela McGowan of McGowan Associates Ltd, with more than a hint of exasperation.
"The first and most obvious choice with any run-off is to carry on, and continue the run-off until each and every liability is fully finalised," she explains, "but that may not be particularly satisfactory. You do not know how many years it will take, or what the administrative costs will be. Each run-off has to be tailored to meet the individual circumstances of the ceased company."
What, then, aside from carrying on and on, are the choices? An obvious option is to attempt to commute everything and, thus, bring the exercise to an end. Unfortunately, numerous obstacles usually block that route, unless ridiculous concessions are made. Even if all parties can reach an agreeable deal, the run-off will almost certainly suffer serious cash flow problems, due to wildly accelerated payments and slow recoveries. "You have got to justify to the reinsurers why they should pay," Ms McGowan says, "and they may not want their payments accelerated."
Thus commutation is generally difficult to achieve. "Excess of loss reinsurers do not like it," says Richard Whatton, managing director of Whittington Group Ltd. Very often they would prefer to take their chances and see how things develop. A commutation must be supported by sensible statistics which the reinsurer will accept, he comments, adding: "The availability of technical people will help."
Ray McCrindle, corporate development director at Bridgeway Management Ltd, says that in contrast to direct business, reinsurance run-offs offer greater scope for commutations, global deals or negotiated block deals, though he adds: "The complications of set-off with these deals, as with most aspects of insolvent run-off, are ever present."
The third option is to reinsure, familiar to Lloyd's syndicate managers with their annual reinsurance to close. The premium payable is your asset, and the major drawback is the possible demise of the reinsurer. If it fails, the liabilities will come back to the ceased company, or those who controlled it: businesses or individuals that may have been sitting comfortably for years in the belief that their underwriting operation had long since gone away. In Lloyd's presentation of the plan for Equitas to Names, there was plenty of talk about finality, but buried well inside was a paragraph which explains that, should claims against the company exceed its assets, liability would fall back to the original Names.
The great challenge of the reinsurance option is, of course, finding someone to reinsure the book. If it is financially worthwhile, it is probably worth doing yourself. If it is not, no one else is likely to want it for a reasonable price. Yet most insurers and reinsurers will, at some point, be faced with the question of how to run off lines of business which are no longer core to them, knowing that the executive time required to do so often fails to diminish proportionally with the book of business.
"In such cases, financial reinsurance can be of value," according to Steve Ryland of Participant Run Off, who says there are innovative products, from loss portfolio transfer to adverse loss development reinsurance and even securitisation to the financial markets available through access to its parent company, Swiss Re. "If your corporate objective is to exit problematic lines of business while maintaining a good reputation, this exit route can be the answer."
Such solutions can work extremely well, but they are not often described as inexpensive. "They do not come cheap," one run-off manager comments.
Sadly, too, the costs of running off an insolvent company are likely to be higher than a solvent one. Says Mr McCrindle: "Insolvent run-offs require a far greater degree of information and transaction data to support them and the accompanying need for greater resources to generate the flow of information from the various parties to the transactions (brokers and principals). Direct creditors have additional requirements and the needs of the Policy Holders' Protection Board must also be met."
Another option is a statutory novation, under which the liabilities of the run-off are transferred into another company, which is obliged to retain them. This method is popular with large insurers and reinsurers, who see an advantage in splitting a portfolio - often one which has been acquired - by retaining "good" business in a sister company, and letting a new, arm's-length company quietly fade away. Cigna is still embroiled in legal action in the US over such an adventure; European companies have been more successful with the gambit in recent years. After all, when five years have passed and the company goes bust, those who may have hoped for a little money from it have a tendency to say: "Oh, well. We expected that," and to forget the run-off theoretically had the backing of a multinational giant.
With all the options presenting a mixed set of prospects, many insurers and reinsurers are choosing to retain their run-offs. "The past two or three years have seen very little movement in run-offs, except the developments at the Willis Corroon business Sovereign," says Mr Whatton. "Shareholders are concerned about the parent company's reputation, and it is much easier to control that if the run-off is kept in-house." Indeed, a single off-the-cuff comment about the need to increase reserves from a third-party run-off manager can be very damaging to a share price.
If an insurer or reinsurer chooses to get rid of a problem business by selling it, there is likely to be a large cost up front. In the UK, the supervisory authority has historically been very stringent and demanded actuarial studies and often significant reserve increases before a company can be cut loose. Outsourcing run-off expertise is a possible middle ground, where the business can be retained, as can control of issues of reputation.
"Cash flow has become the key," Mr Whatton says. "It was not an issue in the 1980s, because run-off was just administration. Since then we have had asbestos and pollution and the spiral. That led to aggressiveness, arbitrations and litigation. Now the run-off manager is seeing his name in the press, reserve levels may be uncertain - it is a whole different ball game."
Solvent schemes of arrangement
He believes the solvent scheme of arrangement, recently used in the UK for the first time in the run off of an insurer, may be the way forward. (For a discussion of schemes of arrangement, see page 124.) Finalisation is not an issue, because the process is inherently final. Whether for solvent or insolvent companies, schemes of arrangement usually have the additional advantage of a built in procedure for disputed claims.
"If the company is truly solvent or if the parent is willing to top it up as needed, the solvent scheme will work," Mr Whatton says, adding: "It does pose one problem: a full actuarial study will have to be undertaken, which will probably push the reserves up." Record-building can also be costly.
Other limitations of the solvent scheme are ones of application. The company in run-off has to be wholesale, because only commercial insureds can take a long term view. Excess of loss reinsurance will almost certainly have to have been exhausted or reinsurers are likely to muddy the process. Quota share reinsurances, on the other hand, do not present a problem to the solvent scheme, Mr Whatton says. "A single class of business could be put into a solvent scheme. If the book is right, a solvent scheme is the way."
Ms McGowan agrees. "A scheme of arrangement is a nice clean way of doing it. It is happening more and more often. There is one which I had some claims in. It has been paying out quite nicely, and it is now almost finished," she says.
Finalisation and, indeed, ongoing run-off can often be frustrated by the inherent lack of leverage that a ceased company has with both brokers and insureds. Ms McGowan recalls: "I have had several cases where my clients have been asked to pay claims in a regular manner. I have gone to the broker and the cedant to say the administrative costs of such regular payments are excessive and, therefore, asked about finalisation. It is quite amazing, but in one case, a year later I still have not had a reply."
Why? "Because you do not have an ongoing interest, it can be difficult to get brokers to co-operate," Ms McGowan explains. Yet they can be essential to the process, especially for Lloyd's business, because of the records they hold. A run-off manager may need broker co-operation due to offset, for example. When the insured's account will not reconcile with that of the insurer or reinsurer, the money is often somewhere with the broker, says Ms McGowan. "At Lloyd's, especially with old year business, we really need brokers. Syndicates' records can be very poor, because they have always relied on their brokers to do some of the amount of work required."
No matter what method is chosen, finalisation will not come quickly or cheaply. As Participant Run Off's Steve Ryland admits: "Most run-off companies get criticised for extending run-offs." Whittington's Richard Whatton concurs. "A company that does nothing but run-off has no interest in finalising. If run-off is just a by-product, they are far more interested in closing the operation."
Although according to estimates by the UK Treasury, the current value of the world's run-off companies is now about $23 billion, many of the London market's approximately 180 run-offs are winding down. The withdrawal of companies in run-off from the London Processing Centre (LPC) illustrates the trend: as the number of payments and recoveries passing through the bureau's electronic clearing house decreases, a point comes when it is no longer cost effective to use the service. About half a dozen pulled out this year.
But just as old run-offs are dwindling, new ones are inevitable. Many predict that current international market practice will eventually lead to failures. As Graham Dimmock of Partner Re and SAFR commented in a recent interview: "We have the sad situation where the only corrective mechanism in our industry is bankruptcy."
Continuing consolidation is also bound to create run-off work. "So many companies are being bought," Mr Whatton explains. "Look at the enlarged Axa Group - a lot of the companies it now owns had exposure to the same risks." Run-off, he believes, is the natural consequence. He expects that most of the resulting cases will be handled in house, at least indirectly, and the expertise will be drawn increasingly from consultants.
An example is the run-off of Turegum Insurance, predecessor company of Zurich Re (London), which was put in run off in 1989 when Zurich Re was formed. When the latter decided to dispose of the business, it went to IRISC, another group company.
As a possible new era of run-offs begins, it will be important for run-off managers to consider the roads to finalisation, because thus far the harsh reality of run-off completion has been grim. "I have never seen a run-off that got better, and have seen hundreds of them," Mr Whatton says. "History shows that sooner or later they go bust."
However, Bridgeway's Ray McCrindle expects that the proportion of solvent to insolvent run-offs will increase, thanks to the greater and earlier involvement of the regulatory authority, the UK Treasury, on the principle of help and intervention before the event. He says: "There will always be a substantial level of run-off because companies will always look to change core underwriting activities in response to perceived opportunities, market fluctuations and merger and acquisition activity."
Adrian Leonard is a London based insurance writer and regular contributor to Global Reinsurance.