Based on any market analysis, run-off, whether solvent or insolvent, will continue to be a significant feature over the coming years. Inevitably, demand for high quality run-off management, whether in-house or outsourced, is set to grow. Against this background, Paul Jardine explores some of the key issues in producing successful run-off results specifically with regard to commutations activity.

A Sigma/Swiss Re study, published in 1998, looked at what it termed the “run-off phenomenon”. One of the statistics that emerged from the study was the value of the world-wide run-off market. Swiss Re estimated that $230 billion of liabilities resided within run-off portfolios and that the market was extremely concentrated; 85% of the $230 billion was in five countries - United States, United Kingdom, Japan, Germany and France. In addition, Swiss Re indicated that the run-off market was set to grow at 10% per annum, with the growth rates in internal run-off portfolios at 15% owing to deregulation in continental Europe.Given that run-off is here to stay and will be growing rapidly, what are the critical success factors? Swiss Re identified three central objectives which any run-off entity must deal with:
• cost reduction;
• centralised credit control;
• a proactive commutation strategy.

A significant volume of published material has been produced on the first two of these, both within and outside the (re)insurance industry. However, little has been documented in the area of commutations and the process has received scant attention from market bodies and regulators in the past. This situation is changing, with the establishment of a commutations working party by the Association of British Insurers (ABI), which is seeking to examine the whole commutations process and to provide guidance to the industry.

It is often asked why the Lloyd's run-off company Equitas would even consider commuting outwards reinsurance, given the extreme concentration of risk which has been created and the nature of the potential gross exposures. The fundamental question is whether we want a third party both to manage our risk and invest the reinsurance asset. The reinsurance programmes that we have inherited are not only complex but also, in many aspects, do not respond adequately to the types of claims liabilities which Equitas has reinsured. These individual syndicate reinsurance programmes were never designed to protect the aggregate portfolio which was created when Equitas was formed. Each one was purchased by a disparate set of underwriters to protect their individual syndicate portfolios.

Further, the vast scale and complexity of the reinsurance programmes mean that the overall processing of reinsurance recoveries is labour intensive and therefore expensive. Including internal and external items, between 50% and 60% of the Equitas cost base relates to reinsurance processing and collection, that is in excess of £100 million per year for a reinsurance asset of approximately £5 billion.

If we were to translate this reinsurance asset of £5 billion into cash and invest it, the associated cost of managing this asset would be of the order of 0.1% or £5 million and, what is more, Equitas would also earn investment income. That is a cost differential of £95 million, while the current reinsurance asset does not earn Equitas anything in the way of a return. As an aside, with cost estimates in the aggregate for UK run-offs put at £750 million per year and rising, the loss of return and excess cost is potentially massive.

Against this background, our strategy has to be to commute as much of the reinsurance asset as possible and to turn it into cash. This strategy serves to protect that portion of the asset which rests with reinsurers which are less than secure and also involves the resolution of the various outwards disputes that we inherited. In short, we commute to obtain certainty, make a balance sheet contribution (ie profit) and reduce administrative costs.The following statistics on the Equitas outwards reinsurance asset give some idea of the enormity of the task.

• There are in excess of 250,000 separate reinsurance contracts, placed with 3,000 reinsurers and 2,000 underwriting pools.
• 4% of the reinsurance transactions account for 96% of the value of the reinsurance asset collected.
• The top 10 reinsurers account for over 30% of the reinsurance asset although no one reinsurer accounts for more than 4%.
• The smallest 500 reinsurers owe less than £8 million in aggregate, ie less than £50,000 per reinsurer.

Most of the commutation deals that we have pursued over the past two years have been on a global basis - we have entered into commutation arrangements that have extinguished the entirety of the relationship with the particular counterparty, both for business ceded as well as written. In this way, not only do we crystallise the reinsurance asset but we also achieve further certainty and finality as regards inwards liabilities.

In the early stages of Equitas' existence, we focused our commutation efforts largely on balances due from reinsurers deemed to represent an insolvency risk. In those particular circumstances, the advantage of a global deal is that balances due and owing can be offset, thereby producing 100 cents to the dollar rather than taking any discount for bad or doubtful debt. As time progressed and our understanding of both the reinsurance asset and the syndicates' liabilities increased, we adopted a revised strategy. While still pursuing the weaker security, we have recognised that large global deals, particularly with other London market players, can also solve other issues such as the LMX spiral and the associated enormous volumes of transactional processing.

What has been very clear is that a successful commutation process requires an integrated team approach from both parties to the deal. It is vital that each company has a shared mandate and commitment to closing out the commutation. Inevitably, there will be challenges and entrenched positions to overcome but, if the teams work together effectively, they can achieve positive results for both sides. With the larger global deals, we have found it vital to get the respective teams to meet early in the process. In this way, they establish a common bond, with each side clear as to the respective “going in” positions. Building this rapport makes negotiations more efficient and effective and allows a much wider use of “distance” negotiation methods such as fax and e-mail.

Given the emphasis on the relationship between the parties, there is a clear requirement for appointing a relationship manager with responsibility for all aspects of the company's interface with its counterparty. In this way the overall financial and operational aspects can be managed centrally and consistently. The other key resource requirement is focused and effective project management. Nothing will be achieved without clear deliverables, milestones and time scales, with both sides agreeing to adhere to the project plan.

There are dangers in looking at run-off entities as on-going companies that simply lack an underwriting and marketing function. In order to be successful, run-off must be viewed as a business challenge. Many run-offs fail to deliver their stated objectives because they simply replicate the conditions which caused them in the first place.

Commutations are the lifeblood of the run-off market and offer all concerned the chance to achieve certainty and a speedier resolution of old issues. Equitas welcomes the current market initiatives in this area and is committed to providing support to the ABI and others to achieve their goals.

Paul Jardine is commutations director and chief actuary, Equitas Ltd.