Michael Fitzgerald traces the origins of the run-off industry and analyses the trends which are shaping the industry's future.
The insurance industry, like any other business segment, is capable of strategic mistakes. The underpricing of products, mistiming the entry into markets, or failure to anticipate the evolution of law, can all contribute to unprofitability. And for (re)insurers, even the investment income generated by premium in the bank will sometimes not smooth out a poor result.
The correct business decision when strategic mistakes occur is often to halt the assembly line, stop selling the product, and dump the inventory as quickly as possible. Unfortunately, insurance products (as we all know from the history of the last dozen years or so) are the “gift that keeps on giving”. Policies written many decades ago in a more trusting and less litigious time, are capable of producing claims today, long after their premium is a memory.
The reasons for the results of poor strategic decisions have been repeatedly analysed in industry literature. In the US, we have seen the legacy of cash-flow underwriting, combined with the “litigation explosion” and courts' expansion of coverage beyond anything anticipated by the underwriters of older policies. Asbestos, pollution and mass tort claims have besmirched the books of every major primary carrier, and now are making their way into the reinsurance spiral. The soft market spurred by overcapacity is even today driving poor underwriting decisions. This, combined with the perceived panacea of “globalisation”, is virtually guaranteeing poor future results.
In the London market, the promise of easy money drove an expansion of Lloyd's syndicates, which led to less sophisticated underwriting decisions, and incestuous reinsurance relationships, often called the London Market Spiral. The Spiral had worldwide effects, and precipitated permanent changes in the character of the traditional reinsurance relationship. Once relying on “gentlemens'' agreements”, hand shakes and trust, the reinsurance world has become a hotbed of legal wrangling arising from broken promises between cedants and their reinsurers. Pure bad luck came into play also, in the form of an unprecedented cluster of catastrophes.
These factors, and others, have led to desperately poor results. In some cases, these results have spelled insolvency or takeover to a number of insurers. And they have forced even relatively healthy insurers to take a hard look at traditional modes of doing business in an effort to isolate and minimise the mistakes of the past.
One of the new and more efficient mechanisms devised by our industry is the concept of run-off management: segregating discontinued and/or underperforming books of business and aggressively focusing on strict claims management and rapid reinsurance collections. Based on the model formed by insolvency regulators to protect policyholders, run-off management for solvent companies shielded stockholders from the effects of poor business decisions.
Insurers who were not insolvent began to embrace the concept of segregating bad business. Part of their motivation came from the recognition that companies cannot (and should not try to) be experts in everything. The flight to core competencies led to outsourcing of ancillary services like IT, payroll and human resources. Similarly, companies began to recognise that internally segregating bad business brought some tax, regulatory and cost benefits, as well as improved performance of the bad books, and as a by-product, allowed them to refocus their efforts on new business.
Birth and growth of the run-off industry
If the run-off industry can be said to have spiritual roots, these can certainly be found in the UK, and arose from the unique phenomenon known as Lloyd's of London. In the 300 plus years since insurance was invented at Lloyd's coffee house on Lombard Street, the phrase “insured at Lloyd's of London” became a household phrase for absolute security. From North Sea oil rigs to Betty Grable's legs, being insured at Lloyd's meant being protected. What few people know was that this protection depended on the personal unlimited liability of the Names - individuals who grouped together in syndicates to provide that security.
Through the 1980s a change occurred at Lloyd's which drove one of the biggest insurance catastrophes in history - a catastrophe which had nothing to do with weather, and everything to do with human folly. Gradually, new syndicates began to be formed, and the participating Names were no longer astute investors and heirs to vast fortunes. Now, it was possible for a larger contingent, including working Names, to become Names with “get rich quick” expectations but little realistic appreciation for the implications of unlimited liability. As fate would have it, this same period saw catastrophes mount to spur a five-year period of deep underwriting losses. As the syndicates grew in number and competed for business, risk quality declined, claims proliferated, and syndicates began to fail.
Lloyd's Central Fund, which backed syndicates who were unwilling or unable to pay, was itself backed by the general membership, so all syndicates were at risk. At the same time, the effects of asbestos, pollution and mass tort claims were appearing and brought an additional stress to bear. In order to prevent Lloyd's failure, and in order to prevent the disastrous effects on the UK economy that would follow, drastic measures had to be taken to save the drowning giant.
In a business plan published in April 1993, Lloyd's chairman, David Rowland announced the formation of a reconstruction project which was advertised as a “ringfence” of 1985 and prior liabilities. Under this plan, the liabilities of the old years were to be estimated to ultimate, discounted for the creditability of outwards reinsurance and the time value of money, and charged to the Names as a one-time premium in exchange for certainty, if not finality. After huge and prolonged actuarial studies, and considerable litigation, the membership of Lloyd's approved the plan, which was secured with a $20 billion premium, the largest reinsurance transaction in history, and which created a facility that became known as Equitas, the largest run-off entity in the world.
At the same time, other smaller run-off entities were thriving in the UK, some handling syndicates, some handling run-off business emanating from non-Lloyd's insurers. A few of the larger run-off companies were subsumed into Equitas, or acted in subcontractor capacities. All of them had a similar approach: strict expense control and asset management, aggressive claims management, and a tough-minded approach to reinsurance collections. Their motto could be stated as “Cash Management is King”. By the early 1990s the run-off industry was well established in the London market, and more recently has formed its own trade association, the Association of Run-off Companies (ARC).
Although the US run-off industry had an earlier start, its emergence has been slower. This is partly owing to the lack of a single, high profile situation such as the disastrous results of Lloyd's, but also to a more conservative regulatory environment, antitrust laws, and a reluctance to admit the presence of “dirty linen”. However, in the early 1990s the run-off concept in the US began to be driven by the notion that insurance carriers might be able to separate their bad, environmentally-tainted business, capitalise it and gain regulatory approval for it to stand alone. This concept was modelled after the “good bank/bad bank” structure, which emerged from the US banking crisis in the 1980s.
In 1985, Continental Insurance Company formed Continental Reinsurance Management Inc. (CRMI) to look after certain aspects of their discontinued liabilities. IRISC was formed in the mid 1980s as a true international third-party run-off manager. IRISC was a joint venture between AON and Zurich with offices in the US and London. Subsequently in 1998 IRISC changed its name to REM International.
The breakup of the Crum and Forster operations in the mid 1980s resulted in the formation of The Resolution Group, which was arguably the first major attempt by an insurance carrier at a true segregation of run-off business. This was followed by Zurich's purchase of the Home and their creation of a quasi stand-alone entity to house their run-off business.
In the early 1990s Cigna's attempt to create Brandywine as a stand-alone repository for its discontinued business, backed by limited liability met scrutiny from regulators and industry leaders.
Other carriers quietly created discontinued operation units which were designed in some cases to service books of business carried below the line on their balance sheets, to minimise the effect on stock price. Carriers such as Allstate, the Hartford, and others established specialised units whose mission was, if possible, to “make a silk purse out of a sow's ear”. In other words, manage the run-off as aggressively as possible, in hopes of extracting any hidden value from the books, while nursing the dedicated reserves to a conclusion. In some cases, the units were expected to also manage the environmental exposures and control the associated high defence costs.
The concept was a good one, but the reality sometimes fell short of expectations. For in-house run-off units, the saying “out of sight, out of mind” sometimes came true, and resources became scarce for these non-premium-producing entities. The special challenges inherent in run-off books (diminished cash assets, difficult collections, antiquated IT systems, scanty historical information, and staff perception that they are working themselves out of a job) had the potential to overwhelm the units assigned to them.
The best of these units, however, were able to bring home significant returns to the surplus of their parent companies, and gradually, run-off skills began to be recognised as valuable and unique. A number of these in-house units have capitalised on their franchise by creating separate service businesses in the run-off field.
Simultaneously, the insurance industry in the US, driven by the lash of the soft market and high combined ratios, began to come out of the closet about their need for run-off services, and began to admit that outsourcing these books to professional run-off managers might be a good idea. Carriers, having discovered the labour intensive nature of run-off management, are deciding to call in the experts. Over the past five years, a network of run-off service providers has arisen in the US, along with associated services like auditing, collections, commutations and consulting. This network has been met with a market demand, and the outsourcing of run-off books to specialist providers has become a reality.
The special skills inherent in professional run-off management are different in kind and quality from those used in “live” claims management. In addition to claims expertise in multiple lines and jurisdictions, the most successful run-off managers are experts at operational cost controls, unearthing and preservation of historical information, actuarial science, commutations, specialised collections, dispute resolution, maximisation of cash assets, and even regulatory and tax issues. The final essential skill is the ability to motivate and keep staff, in an environment where people are not sure where “their next claim is coming from”.Carriers who use professional run-off services, whether in-house or outsourced, have achieved the benefits of improved expense control, improved indemnity costs, and rapid collections of reinsurance.
The run-off market of 2000 and beyond
In their monograph, Run-Off; A Solvable Problem, Drs. Wolfgang Eiler and Hubertus W. Labes, comment on the rapid growth of discontinued/run-off business since the late 1970s. At the time of their study, they estimated that the total amount of business in run-off including a portion of the Lloyd's syndicates was 12 billion BPS. They further speculated that the available pool of run-off business worldwide was 220 billion BPS, with anticipated growth of 10% per year.A private study done by McCoy Scott Consultants in 1996 of seven US and international run-off companies showed a variety of administrative models but a common agreement that run-off management is aggressively different from those used in ongoing operations. Estimates of the future market for run-off services stood at 10% of industry reserves. A 1997 study by Mercer Management Consulting expanded this estimate to a market size of over $360 billion by the year 2000.
The questions in the mind of run-off management companies as we approach the millennium are three-fold.
• Will the market for run-off services continue?
• What changes in market demand will drive it?
• What will run-off services look like in 10 years' time? The answer to question number one seems to be a resounding yes. Despite a common belief that “the environmental problem is behind us due to changes in policy language”, new phenomena are occurring which will guarantee a steady stream of run-off prospects. The market consolidations, globalisations, and price competition we have seen in our industry over the past eight to 10 years, coupled with the continual emergence of mass torts, will drive the market for run-off services. In Europe the removal of barriers to doing business through the agency of the European Union is resulting in many carriers taking on business in unfamiliar territories. Despite the turmoil in Asia, there is a concentrated effort by many carriers to move into these developing areas. In the US, most major carriers have recognised the need to expand internationally, yet the question remains if they will have the intestinal fortitude to stay the course in markets where patience and money are key to gaining a foothold. The legendary appetites of US companies for quick profits may cause some of them to abandon their international strategies before they can yield positive results.
The trends noted above will, in the opinion of many, lead to mistakes and unprofitable business. Over time many of these segments will be placed into run-off. Combined with most insurers having embraced the notion of “core competencies”, the trend toward outsourcing, or at least segregating, run-off accounts will continue.
Not quite as obvious, but more engaging are the answers to questions two and three. What new products and services run-off customers will demand and how will that drive changes in the run-off provider profile? An examination of the trends which are already appearing indicate the following new demands.Customers in the future will demand more finality for their run-off accounts. Run-off managers who have the ability to acquire portfolios or who have access to secure reinsurance vehicles will capitalise on this demand. Due to regulatory complexities, this type of mechanism may become more common in reinsurance than in direct run-off. Excellent investment and portfolio management skills will become very important in the run-off industry.
The convergence of the insurance and capital markets will re-emphasise the role of finite or retrospective reinsurance vehicles. On the investor side, “insurance futures” in the form of extracted residual value from acquired portfolios may play a part.
Run-off cost will continue to be a big factor. Run-off providers with lower cost bases combined with a demonstrated ability to return dollars to customer surplus will have a huge market advantage. Ability to price on a flexible basis, using gain and loss sharing incentives will be increasingly important.Customers will demand systems-driven service. Run-off providers who have internet-based capabilities and excellent IT systems with some form of decision support will thrive.
One-stop shopping may become a market need. Insurers, among other businesses, are beginning to recognise the value of partnering with relatively few vendors. Run-off providers who can also offer some ancillary services, such as IT solutions, consulting and actuarial services, as well as litigation management services, will both smooth their business cycles and attract and hold more customers. Unlike the traditional consulting firms, however, this will need to be done with great cost-consciousness and efficiency.
As a result of these trends and others, the new millennium will produce a run-off industry which offers more financial solutions and a greater variety of services to its customers. We may also see more consolidation within run-off providers themselves, as well as some carriers forming or acquiring run-off companies. Run-off companies which offer international scope and have the critical mass to price their services competitively, as well as those who have the vision and foresight to create virtual networks of systems based claims, collections and litigation management will thrive in the new environment.
In 2000 and beyond, the run-off industry, like many, will evolve to meet customer demand. However, unique run-off strategies involving the basic skills of cash flow management, cost efficient operation, preservation of historical information, IT skills, collections, claims and litigation management will continue to be paramount. In the final analysis the companies who will be industry leaders beyond 2000 will be those who can keep talented staff, constantly upgrade skills, and anticipate new ways of doing business.
Michael Fitzgerald is executive vice president, chief operating officer and chief financial officer of CNA Global Runoff Managers. A bibliography is available on request.