Run-off, and its associated challenges, will be around as long as the business is written. Art Coleman examines the key issues.
Let us start at the end. Much of the talk in run-off circles these days is focused on “finalisation”. There is the “solvent scheme”, “crystallisation scheme” and the “portfolio transfer”. By the time this article goes to press there will probably be three more ideas which propose the same basic resolution which is to “wind-up” the operations of the book or entity. While there are merits to looking in this direction, one must be cautious as to the route taken to get to the final stop. To do this, let us take a look at run-off from the big-picture perspective.
Where are we today?
Thanks to Swiss Re, those of us who have built our careers in the run-off and service areas know that we have made a wise choice! We are a part of the largest growth industry today. With estimated liabilities currently at $300 billion growing to an estimated $505 billion by 2006 the growth of the run-off industry exceeds the growth projected for the industry as a whole.
How did we get here?
Many of our clients are survivors of the insurance/reinsurance debacle of the late 1970s and early-to-mid 1980s. This period saw depressed pricing, lack of underwriting control and administration as well as the subsequent litigation in the areas of latent concerns giving rise to coverage that was never anticipated when the insurance or reinsurance was arranged. This was a period of diversification where off-shoot reinsurers were created to “take advantage” of the capacity crunch and reap the benefits of high premiums and even higher interest rates. In many cases, the end result did not meet the expectations. Enough said about that.
Many of these entities have either stopped writing business or have decided to pursue other segments of the market and now find themselves throttled with the handling and administration of these older books of business.
Most of the businesses we see entering run-off contain a high degree of long tailed liability risks. What this means is that the business is usually somewhere between its infancy and its teen years in its life span. In other words, the most challenging time in the cycle. Having said that, it is during this time that the assets (the reserves in the portfolio as well as outwards reinsurance) can produce some of its greatest yields.
One other point to consider; run-off is inevitable just like death and taxes! Eventually, all new business is cancelled and the policies and claims are put into run-off mode. This premise will not change - that is the nature of the beast!
What are we doing about it?
In order to simplify the complexity of run-off it is critical to have a set of goals for the business. The primary goals for anyone running off a book of business should include:
• Understanding the book of business (its genesis, composition, exposure, assets, etc).
• Stabilising the processing of accounts, claims, reinsurance and cash.
• Analysing the exposure and experience to develop an estimate of the ultimate liabilities.
Although the following tools are not unique to the run-off world, they become critical (from both a financially and time perspective) once a book has been placed into run-off.
A. Technical tools
Creation of a common database
In most of the situations we have seen, the business resides on a single system. However, that is not the rule and those that do not present the greatest challenge to the administrator of the run-off. Concerns in this area are:
• Y2K issues - If this is still a concern, it is getting a bit late in the game to obtain a successful resolution.
• Creditability of the data - A few of the critical points we consider are:
- Is all of the business on the system(s)?
- How good is the data?
- When was the last time it was reconciled?
- How many conversions have been performed on the data in the past?
- Does the system perform all critical tasks?
- Have non-system “work-arounds” been created to massage data?
Eliminate reserve redundancies
Early on in the run-off process we inventory all claims, verify reserves, ensure and verify the cession to available reinsurance (see found reinsurance below). This includes:
• Identifying claims that may have closed without payment.
• Identifying duplicate reserves.
• Identifying claims with stale information (lack of updates).
• Unwinding/commuting internal reinsurance arrangements.
Identify unbilled or “found” reinsurance.
Over the years we have found one area that has paid the highest returns has been a forensic comparison of inception-to-date claims to reinsurance contracts. Maximisation of the reinsurance asset is the key. Some of the reasons that make this analysis so beneficial are:
• Application of all available reinsurance (such as clash or contingency covers).
• Development of aggregates to reach available “un-blown” layers.
• Identification of catastrophe claims (as well as reinstatements).
• Commutations which have not been allocated to reinsurance.
One of the first tasks to be assigned when we receive a book to analyse is to compile data and information from which we create our top exposures database. This is a list which ranks the business in the book by source using inception-to-date paid losses, case reserves and, where available, IBNR as the criteria. From this list we generate a list of audits/inspections which we plan on carrying out in a one-year period. Our audit plan has generated millions in savings in the paid loss as well as commutation areas.
In any operation, an effective collection unit is important. In a run-off operation, it is imperative. Statute and time bar issues may complicate collections and once in run-off there is no premium from which losses can be offset. In addition, in many cases the leverage of being an active writer is lost. There is a general rule of thumb, that the more stale and overdue the balances the higher the level staff needed to collect the funds.
As for commutations, it is important to have a plan for commuting both inwards and outwards business. The key here is to commute only for sound business reasons. In some cases the best plan can be not to commute.
At a minimum, commutation plans should include the following criteria:
• Security analysis of the company's reinsurers (sensitive to the financial security of the reinsurers for the classes of business reinsured).
• Consideration to eliminate the administration of small exposures/risks.
• Top exposure analysis (see audit plan) to possibly cut off large/problematic exposures.
B. Operational tools
Identifying all deposits in all locations and bringing these back into the fold is an important step. This is not always possible due to local security provisions but worth the effort especially if the funds are located in a foreign country and the company no longer has an underwriting commitment in that country.
Human capital administration
This is one area that can make or break the success of a run-off. It is also one of the areas that is most overlooked in managing a business. Human capital is the most significant cost in a run-off (after the liabilities, of course). The cost of managing an insurance/reinsurance business falls within the category of unallocated loss adjustment expense, an area in which we find most companies to be under-reserved.
The challenge is to continually match the workload with the proper staff and not to overpay for that which is not needed. Having said that it is important to have “bench strength” available for new assignments or special projects as they arise (and they have a way of doing so at the most inopportune time) but not so much as it causes a financial burden to the run-off. In many cases, we have allocated and utilised this “bench strength” in areas that return the highest yield to the business (claim redundancies, collections/commutations and audits). In addition to maximising the potential of the asset, opportunities are offered to staff in areas outside of their normal expertise.
Where are we going and how do we get there?
As stated earlier, there are a number of options available for entities to consider as they go down the run-off path. Many of these options consider the estimation of ultimate liabilities and the wind-up of the operation. As an industry we are seeking the panacea, the one step that will make the pain go away forever without any lingering effects. For some companies and certain lines of business this may be readily possible to accomplish. For others, the book of business may have to mature and become stabilised prior to these steps being considered. Others still, may have to run the course and administer the business until the last claim is settled; the last reinsurance balance collected and the lights turned out.
A few of the key issues facing the estimation process are as follows:
• The condition of the book of business - In this area we consider processing backlogs, payment and collection deficiencies, reserve redundancies, and other impediments that can render estimation techniques either inaccurate or impractical.
• Creditability of systems and data - Already discussed in a previous section.
• Legal issues - In the UK the laws would seem to favour estimation techniques while, in the US and other jurisdictions, estimation techniques are still being tested.• Ceded reinsurance issues - To-date there has been no legal precedent set that would bind reinsurers to the effects of an estimation scheme. This results in a reliance on the business sense of the reinsurers in accepting the plan presented.
Whatever the plan, whatever the scheme there is one thing that should remain clear for all to see. Run-off, and its associated challenges, will be around as long as the business is written. So, to our insureds, producers, insurers, brokers and reinsurers - God speed!
Art Coleman is an executive vice president of CNA Global Runoff Managers.