Massive claims and company failures are boosting the run-off sector, says Ronald Gift Mullins.
Recent events, particularly in the past six months, have refocused the re/insurance sector. The multi-billion dollar claims from the World Trade Center destruction, coupled with the costly collapse of Enron and Global Crossing, could force many poorly capitalised re/insurers into insolvency, or compel them to drop unprofitable lines. Such misfortune and reorientation will be a boost to the run-off industry.
Within six months of September 11, several sizeable re/insurance companies announced they were putting some or all of their operations into run-off. One such firm was Bermudian reinsurer Overseas Partners Ltd, which decided to shut up shop because even with $1.3bn in capital, it couldn't "compete effectively in today's reinsurance market," it said in a statement.
US re/insurer St Paul said it was restructuring its operations to concentrate on its core businesses and was placing its large book of medical malpractice insurance, domestic as well as international, into run-off. Its reinsurance unit will no longer underwrite aviation reinsurance, bond and credit reinsurance or offer financial risk and capital markets reinsurance products, and it will substantially reduce the North American business it underwrites in London. St Paul at Lloyd's will exit most of its casualty insurance and reinsurance business, US surplus lines and certain non-marine reinsurance lines.
Scandinavian Reinsurance Co Ltd, a Bermuda-based finite risk reinsurer, has ceased new and renewal underwriting after contributing to parent company Sirius International Insurance Corp's $138m loss for 2001.
Japanese insurer Nissan Fire & Marine has hired a run-off manager to handle its participation in the Fortress Re reinsurance pool. Nissan was a member of the pool from 1981 until it withdrew in late November 2001, when Fortress collapsed under the weight of aviation claims.
Even mighty Berkshire Hathaway, reporting a 76% drop in profits for 2001 compared to 2000, announced that it would commence a long-term run-off of its affiliate General Re Securities (GRS), a dealer in derivative contracts. "During the run-off period," Berkshire's 2001 annual report said, "GRS will limit new business to certain risk management transactions and will unwind existing asset and liability positions in an orderly manner. It is expected that the run-off will take several years to complete."
Even before the catastrophes of 2001, the run-off business in the US and the UK was sizeable and expanding by about 10% a year. By the late 1990s, there were sufficient companies and consultants involved in run-off in the London market that they formed the Association of Run-Off Companies (ARC). "Right now, run-off is huge," said Scott Riley, head of the legal department of KMS Insurance Services Ltd (KMSIS). "Everyone wants to get into the run-off business." KMSIS, based in the UK, is a leading run-off firm, responsible for the KWELM run-off, the largest in the world. According to Mr Riley, some of the largest names in the reinsurance sector have highly active run-off operations, including Berkshire Hathaway, Swiss Re, Zurich, Munich Re and CNA.
Two major loss adjusting companies, GAB Robins and Crawford & Co, are actively seeking deals to handle run-off. An executive with Crawford & Co said loss adjusters are ideally placed to manage run-off as "we have a broader spread of business and so are able to better achieve an accurate value for a claim."
Mike Fitzgerald, president and CEO of CNA Global Resource Managers, believed there would be an increase in run-off from the repercussions of the Enron bankruptcy and other companies in trouble. "Whether it will be a hit on reinsurers or retros, it has to affect them or their parent companies and this will force them to put in more capital or close down or use run-off to dispose of unrewarding lines." Also, being hit with losses could force more consolidations within the re/insurance industry. "In the past," he said, "insurance companies thought they needed to be in certain types or lines of business to be considered an all-round reinsurer, and they were reluctant to get out when certain lines turned bad. Now there is not that feeling."
Though no government or private entity maintains accurate records on the size of the run-off business, industry officials estimate worldwide liabilities in run-off at about $200bn, and an estimated 25% of this is covered by reinsurance. Nevertheless, Mr Fitzgerald said there was really no way to determine what the overall liabilities are in run-off. "Companies, for various reasons, keep a lot of it behind closed curtains," he said.
Philip Grant, treasurer of ARC, said: "I think it is pretty clear that a combination of events, including September 11, are going to put a strain on a lot of insurance companies' balance sheets, especially on increasing their reserving levels. It seems to me that this will result in more poorly performing business going into run-off." Mr Grant operates Clay Chimneys Consulting in the UK.
Mr Riley thinks the run-off market will expand in years to come as new markets open for unique financial products. "People are insuring all kinds of things," he said, "with more money-type insurance products, rather than risk-assuming. I think these untried financial products will contribute to the run-off market in the future." Mr Riley foresaw increased regulation for run-off arrangements as more hybrid insurance-finance products develop, fail and go into run-off.
Further fueling the future growth of the run-off industry is the lure of new geographic markets around the world for re/insurers. The slow removal of barriers across Europe is opening up a wider market to eager re/insurers, while in Asia, the glow of China entices re/insurers to move into this vast, highly-regulated market, as well as other developing countries in the region. Recent events have proved that the uncertainty of some South American economies can turn a marginal line into a disaster almost overnight, and highlighted that the promise of profits in these alien and exotic regions requires skill and patience to extract. Too often, the result is increased business for run-off specialists.
The main, and original, purpose for run-off is handling discontinued business of insolvent re/insurance companies. In the US, these failed insurers are taken over by the National Association of Insurance Commissioners (NAIC) and receivers are appointed to oversee the dissolution of the company and manage its rehabilitation or sale. A host of regulations and laws spell out how and when claims are paid. State guarantee funds, responsible for paying mostly personal lines claims, closely monitor the run-off process and surrogate for their payouts.
In the UK, the Financial Services Authority (FSA) oversees run-offs. Currently the government agency is developing further run-off regulations to deal with the various steps in the claims-paying process and achieving finality of solvent and insolvent companies. The Financial Services Compensation Scheme pays personal lines policyholders, and the scheme then becomes a creditor of the insolvent companies in run-off.
Traditionally, US re/insurers have sent lines of underperforming businesses to their own internal run-off sectors, allowing companies to concentrate on core competencies and freeing up additional capital and resources. In addition, segregating bad business brings some tax and regulatory benefits. For example, while these discontinued operations are not removed entirely from the company's balance sheet, the retrospective liability is not included directly in the computation of the re/insurers' combined ratio.
Core business growth
Clint Harris, vice president at US asset management specialist Conning & Co, said that since 1999, it has been evident that insurers are concentrating on and growing their core businesses. "In the early 1990s, insurance companies were looking at expanding markets and trying to bring in additional revenues," he said. "Many of these grand plans did not produce increased profits and companies began selling off or closing down businesses they had bought or created earlier. In many cases, if they couldn't sell them, these went into run-off. A great deal of what is dreamed of today will end up in time as non-performing portions of business dumped into run-off."
Until about five years ago, most re/insurers kept their run-off operations in-house. This arrangement had inherent problems, a major one being that employees were essentially working themselves out of a job as they decreased the liabilities of the business in run-off. Slowly, management began to recognise that the skills the run-off team had acquired could be marketed to handle run-off for other re/insurers. Soon re/insurers began outsourcing their unwanted books to professional run-off managers.
Along with general run-off service providers, there are now auditing, collections, commutations and consulting run-off services. Since the purpose of running-off an unprofitable or discontinued line is to get it off the company's books as quickly as possible, finality is highly important. To accomplish this, the run-off industry has created increasingly sophisticated reinsurance solutions - excess of loss reinsurance coverage, financial reinsurance agreement with timed retrocession, aggregate stop loss reinsurance and others. However, this does not transfer liabilities and could require future adjustments if the exposure increases, as has happened often with asbestos-related claims.
Transferring of insurance and other risks can be achieved by a legal portfolio transfer, sale of the run-off company or investment portfolio, or ending all contractual obligations by offering a discounted settlement to policyholders. This can mean finality for the run-off seller but leaves the buyer the task of achieving a profit while working toward finality for the discontinued business.
Professional run-off companies have become highly experienced in being able to select suitable run-off strategies to close down the run off, yet produce a profit for themselves. Mr Riley of KMSIS noted that managing a run-off account means balancing paying the claims out and collecting from reinsurers who are not eager to pay. "But we need money to pay claims," he said. Creditors usually get 75% of claims payment of a discontinued line, usually less if it is an insolvent company, while his firm collects a fee for managing the run-off for companies. He noted that a run-off firm can sit on the investment income for a while, but commented that it is not that easy as regulators and creditors watch payouts as closely as they can. He admitted, though, that "generally speaking, there is very little regulatory oversight" of the business companies have decided to put in run-off.
Mr Fitzgerald said that 90% of the run-off business his group does is CNA-related, but a few years ago, the group began doing audit consulting work. "We are hired by an insurer, reinsurer or company to look at a treaty going way back to see if there is a chance of collecting on some claims. It is very specialised work, but fascinating and 99% of the time we can recommend a process that will bring some rewards to the client."
With the fall-out from the catastrophes of 2001 and the uncertainty of 2002, the future of run-off looks bright for specialist lines such as directors' and officers' (D&O) and errors and omissions (E&O) coverages. As proof that run-off has profitable promise, Mr Fitzgerald noted that Berkshire Hathaway is steadily buying run-off business. Warren Buffett, CEO of Berkshire Hathaway, has a well-known, demonstrated skill for using `float' to his advantage. By acquiring the investment portfolios of companies or lines in run-off, he augments the billions he uses for investment and with little regulatory oversight.
"The run-off industry will become more professional in the future," Mr Fitzgerald said. "There is too much money at stake now for it to remain a second-hand, back-room operation."
By Ronald Gift Mullins
Ronald Gift Mullins is an insurance journalist based in New York City.