As shareholders take a closer interest in run-off, Philip Grant asks whether it's time to severely brandish the broom

Sometimes you need a bit of a jolt to get round to doing something that you have been putting off for ages. You know the sort of thing: the spare room has been full of clutter for years and suddenly you need the space. Out go the empty cardboard boxes, old lampshades and piles of magazines.You shed a few sentimental tears, but a certain ruthlessness is required and when the job is done you marvel at the space you have created.An obvious analogy really, but it is amazing just how many cluttered spare rooms there still are in the international insurance industry: old portfolios of business just lying neglected and taking up valuable financial space. The good news is that the jolt has been given and the clear-out is starting, with significant consequences for the burgeoning discontinued business sector.The jolt, of course, was the tragedy of September 11, 2001, which threw a harsh spotlight on the balance sheets of innumerable insurance companies and prompted a dramatic hardening of rates and terms. Customers and ratings agencies have become ever more demanding of financial strength and resilience in risk carriers. Moreover, those insurers that have sought to take advantage of the upturn in rates have found that they have needed to raise capital from markets that expect high returns.The net result is that every pound or dollar of capital in an insurance group has to work harder. Sub-optimisation of capital is no longer an option. Group financial directors look at risk-based capital models such as Standard & Poor's insurer capital adequacy model and ask themselves how they can optimise their rating.One obvious way is to limit the scope and volatility of unprofitable or discontinued business lines. The outcome for a number of major international insurance groups has been a progressive withdrawal from non-core activities and a reappraisal of management and exit strategies for portfolios already in run-off.Many of those portfolios have been pottering along for years, absorbing time and money, quite often managed by the same teams that looked after them as active books of business. The problem - to revert to our earlier analogy of the cluttered spare room - is that portfolios of discontinued insurance business cannot just be thrown away. Nor, for that matter, is it necessarily easy to identify which portfolios should be disposed of and which kept.It is a major concern for the insurance industry: a recent survey1 indicated that, in the UK alone, liabilities relating to business in run-off amount to some £33.3bn2 and that £4.3bn of shareholders funds are tied up in entities in run-off.Shareholders and senior management rightly eye those amounts - especially those relating to tied-up capital - as a huge opportunity cost: imagine what profitable business could be written against such capital were it not earmarked to support the enormous and often volatile discontinued reserves on their balance sheets.What then are the options for an insurance group that wishes to clean out its spare rooms rather than just keeping the door shut and hoping for the best?

Vigorous commutationOne way of achieving the acceleration of a run-off is to undertake a vigorous programme of commutations with policyholders and reinsurers.This strategy is useful up to a point and it can certainly go a long way towards reducing the size and volatility of a portfolio, but it doesn't offer genuine finality, unless you have the good fortune to be able to commute every last contract. Even then, the regulator is likely to be reluctant to permit the repatriation of surplus capital unless you can offer strong proof that no more insurance liabilities can arise. For most portfolios that is simply not possible with the degree of certainty that both the directors and the regulator would require.Portfolio reinsurance is a possibility, whereby a specialist - and financially sound - reinsurer agrees to take responsibility for all future losses up to a level that is well beyond the worst expected deterioration in the insurance liabilities. Provided the reinsurer is financially secure enough to satisfy the regulator, it might permit surplus funds to be repatriated, but it does leave some untidiness, since the gross liabilities remain on the books, even if the net has been reduced to zero. This makes it impossible to wind up the company until the last claim has been paid.Moreover, there is always the possibility, however remote, that the losses might ultimately exceed the cover given - or, indeed, that the reinsurer might fail - forcing the owners to take an unexpected and unwelcome further loss.There are two options, however, that do offer genuine finality to shareholders, with the ability not just to regain and redeploy their surplus capital but also to de-authorise and wind up the company. It is no surprise that they are becoming increasingly popular and that a virtual industry has grown up in the UK to advise upon and execute them.These two options are: sale; and a solvent scheme of arrangement3.Sale of a run-off entity, be it a limited liability company or a portfolio of business (in which case, the mechanism would probably be a Part VII transfer4) is attractive to shareholders because it offers rapid and complete finality, subject to any warranties, which are usually few and not onerous.However, there are drawbacks, not the least of which is price. Specialist buyers of run-off entities will not only expect to buy at a significant discount to net asset value, but will also frequently demand that some additional protection be offered by the buyer against deterioration in the technical reserves.The cost to a shareholder of selling the company could therefore be very high, so this kind of true finality comes at a price. That is why attention is increasingly being focused on the solvent scheme of arrangement as the only other mechanism that offers true accelerated finality to a solvent insurance entity5.There have been numerous articles describing the mechanism and extolling the merits of the solvent scheme, but for present purposes, suffice it to say that its key advantages over sale are that it is likely to be cheaper, as there is no 'risk premium' payable to a buyer and the reputational concerns that can attend a sale to a third party are avoided.Against that, a solvent scheme will generally take longer to achieve than a sale and, indeed, may not be possible to achieve at all if the creditors take the view that they have no concerns about the parent's long-term solvency and thus no interest in voting for a scheme.It should also be noted in relation to schemes that not every insurance entity is suitable for them. First of all, not every line of business is suitable for such a mechanism: personal lines business and compulsory classes such as employer's liability are examples of this. Secondly, the maturity of the book and the relative size of the reinsurance asset are key factors to be considered: too young and volatile or too heavily reinsured and the risk of a scheme would be too great.One thing is certain: run-off is not a passing phase. There will always be portfolios and companies that no longer fit, economically or strategically, within an insurance group's plans for the future. Shareholders that fail to plan for run-off, both in terms of selecting appropriate business units for closure and of having a clear exit strategy, will find themselves at a great disadvantage to their more proactive competitors. We are in an era when clear business focus and capital optimisation are key to competitive advantage, even to corporate survival. Neither is possible without a regular spring cleaning of the group balance sheet and the spare rooms that contain the discontinued business should be first to feel the broom.

References1 The UK Run-Off Survey - ARC/KPMG/Run-Off Business, Autumn 2003.2 Estimated UK run-off market excluding firms regulated by the EU outside the UK and business written in Lloyd's since 1993.3 Under Section 425 of the UK Companies Act 1985.4 A statutory transfer of both inwards liabilities and the corresponding reinsurance asset under the provisions of Part VII of the Financial Services and Markets Act 2000.5 A procedure analogous to the Section 425 Scheme is being promulgated in Rhode Island but to the best of the author's knowledge the procedure has not yet been used.Philip Grant is Treasurer of the Association of Run-Off Companies and Director of the London market division of Claims Management Group Ltd.