In the last decade, both the size and complexity of runoff business has mushroomed exponentially. Runoff managers are expected to deliver more than ever before. Garry Nelson reports.

The term "runoff" has been around for years. It originated in the insurance and reinsurance industries as a means to distinguish between canceling contracts on a cutoff basis (the (re)insurer liability is cut off after policy termination) and canceling contracts on an ongoing or runoff basis. In the latter case, losses are handled by the (re)insurer until the ultimate conclusion of all activity on a particular contract. In the past 15 years, the term has expanded to denote not only the runoff of a particular contract, but also that of an entire book of business or even of the insurance or reinsurance company itself.

Why runoff?

Insurance and reinsurance companies go into runoff for two main reasons:

* Results from a particular line or lines have been unprofitable.

* A need to focus on core business or change the strategic direction of the company has been determined.

Each company's situation is unique, but the options generally available are:

* An outright sale of the company or book.

* A portfolio transfer.

* A run off of liabilities to conclusion.

Traditionally, companies handled runoff business in much the same way as they handled ongoing business. A line of business (or the business itself) was discontinued; the company ceased writing policies; and the ensuing liabilities were run off to conclusion. The emphasis was on processing the business, paying losses, making reinsurance recoveries, and relying on actuarial projections to determine future loss reserve requirements.

Occasionally, executives carved away the runoff function from day to day operations, out-sourcing runoff services to one of the few companies (mainly brokers) that offered such services. These services were substantially the same as those the insurer or reinsurer could perform itself. The focus was usually on performing the day to day claims and accounting functions year after year, with little attention paid to alternative strategies.

Recent developments

In the last decade, both the size and complexity of runoff business has mushroomed exponentially. Not only are known claims expanding beyond reserved amounts, but new claims are emerging at a greater rate than expected at the time operations ceased. The (re)insurance ceo faces an uncertain and open-ended exposure to future loss development. In the areas of mass torts, asbestos, pollution and others, huge losses can rapidly drain financial and human resources, taking cash, time and energy away from the development of new, profitable lines and/or eroding surplus. While it is tempting to simply eliminate the underwriting function and carry on the business of paying and accounting for claims in the traditional manner, several challenges stymie the executive's efforts to control and manage runoff activities:

* Losses continue to emerge and must be handled and paid, for many years into the future. While actuaries have many forecasting techniques, no one really knows how many losses will ultimately be incurred, and worse, how much they will ultimately cost.

* Administrative costs tend to increase as the runoff progresses. It becomes more and more difficult to find and retain qualified staff. Unfortunately, the need for high levels of expertise becomes critical just as the "tail" comes into view, and only the more complex and contentious claims remain.

* In the case of companies with other, active business segments, a constant battle rages between the company's need to focus valuable resources on core, ongoing business and the sometimes dire need to focus attention and contain loss exposure on discontinued operations.

* Relations with (re)insureds often become strained as the runoff continues. It requires a different skill set and business philosophy to effectively manage a runoff. Relationships that normally develop between ongoing business entities seldom develop; no new business prospects exist to foster and promote co-operation; and confrontational issues arise with no apparent commercial solution.

Executives have two main options:

* Traditional runoff. Contain the problem and process the business to its natural conclusion (with or without outside help and sometimes with the use of various forms of finite risk reinsurance).

* Fast track runoff. Take an aggressive approach to extinguishing liabilities at an earlier date through a systematic program of evaluation, audits, commutations and policy buy-backs.

Both strategies have merits and disadvantages, and the appropriate choice is dependent on the company's financial condition, access to required expertise, and management philosophy.

New strategies

More and more (re)insurers are discovering that traditional runoff operations - the administration of liabilities over a long period - simply do not work. Runoff claims have become more sophisticated, too costly, and require too much management attention.

The management of runoff operations has essentially become a task of shooting at a rapidly moving target. Just when one appears to be nearing the target, the bull's eye expands hugely and speeds off into the distance. For example, consulting actuaries currently forecast that it can take as long as 55 years for casualty reinsurance claims with toxic tort exposure to run off to conclusion. Fifteen years ago, it was 35 years.

If a reinsurer's loss reserves and IBNR (incurred but not reported losses) represent a factor of 18 to 20 times (at a 5% discount rate) one year's paid losses, with a 55-year tail from inception, the reinsurer can theoretically pay all of its future claims without the need to add any additional reserves. This is commonly referred to as the survival ratio.

While fine in theory, managers are finding that in practice such equations do little to resolve the ongoing administrative expenses, the possibility of unanticipated and unreserved loss development, the detour of resources and the loss of focus on present core business. Many executives are grappling with strategies for handling huge financial obligations for old business that almost has a life of its own. Today, many of these executives are looking for more than runoff managers have delivered in the past. They recognise a need for experienced specialists in what is more properly termed the business of getting out of business. Executives are looking for:

* A customised approach that recognises each company's unique position, needs and goals.

* Assistance in strategic planning to determine how best to extinguish liabilities in a timely and cost effective manner.

* A runoff strategy that produces measurable financial savings.

* Competent, efficient handling of ongoing losses by experienced staff dedicated to management's goals.

* Assistance in quickly identifying opportunities to define current losses and extinguish future liabilities (such as improving runoff velocity).

* Assistance in planning and executing favorable commutations of reinsured contracts or policy buybacks of insurance policies.

* Prompt, relevant communication, including timely reports on the extent of current and expected ultimate liabilities, and an early warning system for large and/or contentious exposures.

In short, executives are usually seeking:

* Customisation.

* Velocity.

* Improved financial outcomes.

Almost without exception, companies facing a long-term runoff of discontinued business have concluded that the most sound strategy is to accelerate the runoff with a focus on capping or even eliminating open-ended liabilities.

Strategic planning

Once the runoff decision is made, the first step is to develop a strategic plan governing the manner in which the runoff will be conducted. Threshold questions include:

* What is our current financial position? in particular, does the liquidity ratio provide sufficient funds to eliminate future liabilities now, should this become a possibility?

* Do we have internal resources to administer the business?

* Do we have competent, high level claims personnel experienced in commutations and knowledgeable in runoff bench marks?

* Does it make sense to devote management time, personnel and other resources to a business we are no longer in?

The most important thing for management to recognise upon placing a company in runoff is that it is now in a very different business than it was in as an underwriter. It is now in the business of getting out of business. Faced with these questions, executives often opt to outsource the runoff. In the case of runoff business that arises from business mergers or acquisitions, it is vital that runoff experts are consulted during the due diligence phase.

What happens (how the runoff process works)

Several dynamics will affect the runoff. Perception of the company as an entity in runoff will change the manner in which it is viewed by the business community. Previous relationships that assist in the process of amicable resolution of claims and other issues may no longer exist. A number of initial inquiries can be expected concerning the company's commitment to ongoing liabilities and its present and expected future financial condition. It is essential that these inquiries be handled with the utmost skill and diplomacy. For these and other reasons, experts frequently advise that a company continuing to write other business separate itself from the runoff. This is accomplished either by carving the runoff segment out of the ongoing business, or turning it over to an experienced runoff administrator, or both.

If all or part of the runoff is outsourced, a number of administrative tasks will be completed early in the process. These include:

* Transferring of files and other records.

* Transferring or converting the computer system.

* Bringing any backlog current.

* Establishing management and internal controls.

* Designing appropriate communication and reporting guidelines.

A good runoff administrator conducts a complete evaluation of the book and develops a strategic plan for an orderly exit from the business. He should identify those contracts with which further adverse development is likely to occur and should identify opportunities for immediate containment or even elimination of the company's ongoing liabilities. An administrator with sufficient breadth of experience will probably see that the 80/20 rule applies to most runoffs. That is, 80% of the problems usually arise from 20% of the contracts. It is vital that these difficult contracts are identified early so that strategic plans become proactive rather than reactive.

Unless a company's losses are extremely well funded through reserves and IBNR, it is rare that simply "riding it out" until all claims are reported, reserved and paid is a wise strategy for anyone other than an administrator looking for job security. Rather, executives should insist that plans be developed to accelerate the runoff and contain or eliminate liabilities sooner rather than later. The plan should include:

* An intensive evaluation of each contract and claim.

* A review of the reinsurance program.

* A proactive strategy to resolve claims effectively.

* A list of accounts targeted for on-site reviews and audits, where inadequate information is received or problems appear to exist.

* Commutation and policy buyback recommendation, based on the company's objectives and anticipated availability of funds.

Commutations

A systematic and intensive approach to commutations (and policy buybacks) is required to accelerate the time frame that is usually required to run off a book of business. This approach provides significant advantages, including:

* Elimination of uncertainty regarding estimated future losses.

* Elimination of concerns over underwriting or claims handling by the reinsured.

* Resolution of current and future disputes.

* Provision of a firm cap on losses and extinguishment of ongoing liabilities.

Runoff experts frequently use several techniques to discover commutation and buyback opportunities not only for the willing ceding companies and policyholders (the easiest) but also for the most difficult ones. Values should be established in conjunction with audits, actuarial projections (in some cases) and other key indicators of future performance. In our own firm's experience, companies can achieve commutation of 25% of outstanding liabilities in 30 to 36 months if the proper strategy is developed and executed. Technical and negotiating expertise, familiarity with negotiating parties, and knowledge of the vast number of ceding companies are essential to this process. This is a vital step in improving runoff velocity. In selecting runoff administrators, the adage, "results are everything" is an absolute truth.

Communication

Runoff operations are simply too complex and too expensive in terms of ultimate exposures to be ignored by (re)insurance executives. Management reporting is critical. Runoff administrators should report at least quarterly, providing comprehensive information concerning significant activities, losses, operational issues and results. Good communication enhances the executive/administrator relationship and ensures that strategic goals are monitored and met.

Reaching the target

An effective claims handling, commutation and policy buyback programme can ensure that a 55-year runoff becomes a much smaller prospect after perhaps three to five years. At that time, other options may become available such as a substantial reduction in ongoing administrative costs, the sale of a runoff that is now purged of much of its volatility, or finite risk reinsurance for far less cost than originally anticipated.

Companies facing runoff decision must decide whether they are content to simply handle the runoff, plodding along for decades in a business as usual mode, or actually manage the runoff by ensuring that their administrator can:

* Customise a runoff strategy to meet the company's unique needs and resources.

* Produce meaningful savings in measurable financial impact.

* Approach the target (that is exit from the business) sooner by improving velocity.

* Provide consistent quality and results in claims handling, audits, commutations and reporting.

In recap, the key elements in a successful runoff in today's environment are:

* Selection of an administration method.

* Strategic planning.

* Evaluation of current and future liabilities

* Containment and elimination of ongoing liabilities.

* Measurement of effectiveness and cost savings.

* Re-evaluation of strategic plan (at least every three to five years).

Carefully implementing these key elements should ensure that a once-onerous prospect becomes at least a manageable one. Smart planning and execution of an effective runoff strategy will help those in the business of getting out of business reach that goal sooner rather than later - with less impact on the bottom line.

Garry Nelson is president and ceo of Devonshire Group, an independent runoff management company with offices in Santa Ana, California and New York City. The company specialises in runoff solutions for US and international companies with US based exposures. It develops exit strategies and improves financial performance for companies facing the unique challenges of runoff operations. A full range of services is offered, including runoff administration, accounting, claims handling, audits, and commutation negotiations. Devonshire is acknowledged in the industry for expertise in design and implementation of accelerated runoff strategies.

The company was founded by the author, Garry Nelson, 10 years ago. Mr Nelson's thirty years' experience includes claims administration, international and domestic reinsurance management and runoff planning and implementation.

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