What have been the key drivers that have seen the UK life run-off market double in size in only five years? Darryl Ashbourne provides his insight

The policyholder liabilities of the UK life run-off market have almost doubled to £135bn over recent years, according to the findings of the KPMG LLP (UK)/ARC life and non-life insurance run-off survey 2005(1), a figure which represents some 14% of the total UK life market. But what factors have contributed to this phenomenal growth and what are the reasons affecting the sector's development?

State of the market

Not only has the sector undergone a period of significant growth in recent years, but it has also seen considerable shifts in the control and operation of life run-off business following consolidation and increased utilisation of outsourcing.

In addition to the life assurers in run-off, the KPMG/ARC survey identified that there are active life assurers that have placed a significant part of their business (for example, their with-profits fund) into run-off.

It reported 24 such UK life assurers in "partial run-off", although information on the value of their run-off portfolios was not available. The survey concluded that it underestimated the true size of the UK life run-off market, potentially by a significant value.

This conclusion is supported by statistics reported by the Financial Services Authority (FSA), which stated in September 2004 that 66 of the total 110 UK with-profits funds were closed to new business and that these closed funds had some £191bn of assets under management(2). This shows that life assurers that remain active in other areas hold significant closed with-profits business.

The growth spurt

The KPMG/ARC survey revealed that the number of life assurers moving into run-off increased to 51 from 18 at the end of 2000. Over the same five-year period policyholder liabilities of life assurers in run-off increased from £71bn to £135bn, a 90% increase, while policyholder liabilities of the entire life market increased from £886bn to £972bn, an increase of only 10%. In 2000, life assurers in run-off accounted for approximately 8% of the total life market (measured by value of policyholder liabilities), but by 2005 this had increased to 14%.

Reasons for growth

A key element in these increases was the move by several large well-known ex-mutuals and with profit companies into run-off. The majority of these assurers closed to new business because their financial solvency position deteriorated to such an extent that it was not possible for them to continue to write new business.

Major underlying reasons for this financial deterioration included the significant stock market falls experienced in the early part of 2000.

Towards the end of the twentieth century, life assurers had invested a large proportion of their assets in equities, although a large proportion of their liabilities were not linked to equity returns or were guaranteed.

This meant that they were severely adversely impacted when stock markets collapsed in 2000 and 2001.

A further factor was the low interest rate environment which resulted in reduced yields on gilts and other fixed interest securities in which life assurers had traditionally invested a majority of their assets. Consequently, life assurers could not rely on fixed interest income to achieve competitive returns, or (subsequently) to offset equity losses.

Mis-selling of liabilities also contributed to the financial deterioration.

Life assurers were found to have mis-sold endowment and pension products in the 1980s and 1990s. This led to significant compensation costs and provisions, additional administration costs to investigate and resolve claims, and the loss of customer confidence in these products.

These reasons and the imposition of additional capital requirements, in the form of realistic balance sheet requirements and individual capital adequacy assessments, by the FSA combined to cause a reduction in the value of policyholder funds and regulatory surplus, and placed a significant capital cost on continuing to write new business.

However, financial weakness is not the only reason for the movement to run-off. Other factors included changes in business strategy due to consolidation activity, group capital being redirected to other businesses, and responses to changes in the economic or regulatory environment. In certain cases, lower new business volumes as a result of a lack of consumer confidence in with-profits led assurers to reassess the profitability of their with-profits funds and to cease actively marketing with-profits business.

Developments in the life run-off market

Individual life assurers have reacted to these implications in different ways, reflecting their individual circumstances and their overall group strategy. A number of trends can be identified as common responses to these run-off issues.

Outsourcing - Outsourcing has shown considerable growth in the UK life run-off market in recent years, which is reflected in the fact that a number of specialist outsourcing companies have developed a particular niche in response to this growing market.

The fact that outsourcing can produce cost savings and reduce diseconomies of scale is often cited as the reason for the widespread adoption of outsourcing arrangements. However, outsourcing has a number of other advantages to life assurers in run-off, notably:

- Transferring operational risks, including at least some of the financial cost of operational failures, to the outsource supplier;

- The removal or reduction of the issue of key staff retention and the benefit of giving staff who transfer to the outsource supplier opportunities for continuous employment and a future career with the outsource company;

- Migrating systems to a proven, unified and fully supported administration platform, which enables better customer service and enables staff to develop skills that are transferable between products and portfolios. Typically life assurers have a number of legacy systems that are difficult and costly to maintain and to enhance; and

- Operating in a more efficient manner by using common processes and central support functions across several outsourced portfolios.

Critics of outsourcing often highlight the loss of control that can accompany outsourcing arrangements, but effective management of the outsourcing relationship can mitigate this risk and ensure that the benefits received outweigh the risk.

Consolidation - The KPMG/ARC survey has reported a large number of M&A transactions in the UK life run-off sector over the past two years. Much of this activity was driven by a few large life fund consolidators, which have been established or have developed their strategy to take advantage of opportunities arising in the UK life run-off market.

Consolidation in life run-off, like outsourcing, addresses the issues of diseconomies of scale, staff retention, inability to invest and related problems that adversely affect individual life assurers in run-off. In a consolidation, ownership benefits and capital risks transfer to the consolidating acquirer and provide finality to the seller (subject to any warranties, guarantees, or retentions that may have been agreed as part of the sale or transfer), while in outsourcing these benefits and risks remain with the life assurer. Consolidation can be combined with outsourcing with several consolidators using outsourcing as an integral part of their business model.

Consolidators seek to profit from the acquisition by developing and exploiting an expertise in life run-off, from the benefits that can accrue from greater scale, by applying different investment strategies and by utilising more cost effective sources of capital. These strategies may not be prudent or cost effective for a smaller life assurer operating in isolation.

The KPMG/ARC survey shows that, although the number of assurers in run-off has increased to 51 following this consolidation activity, all of the UK life assurers in run-off are contained within just 18 groups and the two largest run-off groups in 2004 contain over £60bn of policyholder liabilities.

Group reorganisations - While consolidation is often achieved via direct acquisition of a company's shares, in insurance both acquisitions and group reorganisations can be achieved through a transfer of business under the provisions of Part VII of the Financial Services & Markets Act 2000 (Part VII transfers). Since their introduction, Part VII transfers have been used by some life assureds to transfer parts of books that they do not wish to retain and by a number of groups to reorganise business that is in run-off or partial run-off.

As reported in the KPMG/ARC survey, examples of major group reorganisations involving run-off life business include:

These group reorganisations demonstrate the availability of the Part VII transfer mechanism to move blocks of life business together with related reinsurance between assurers. This allows groups to consolidate previously acquired and legacy business in one place, thus enabling them to de-authorise and liquidate closed companies.

Run-off round-up

Policy holder liabilities of the UK life run-off market have almost doubled to £135bn in recent years. Factors have included lower returns on equities; the low interest rate environment; mis-selling costs; more stringent capital requirements; and the shift by consumers away from with-profits products.

Cost pressures and the desire to maximise shareholder returns have led to outsourcing and consolidation activity.

The dominance of a few large life run-off consolidators and the success of the Part VII transfers will likely provide impetus for further transactions and consolidation in the UK life run-off market and the potential for active life assurers to dispose of their closed life funds. Recent press reports also suggest that similar consolidation activity is likely to begin in the pension and bulk annuity markets.

Darryl Ashbourne is a director of KPMG LLP (UK) Corporate Recovery Insurance Solutions.

The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP (UK).

The information contained is of a general nature and is not intended to address the circumstances of any particular individual or entity.

1 The 2005 edition of the KPMG/ARC UK Run-Off Survey was based on a study of over 130 UK life assurers and friendly societies. This represented over 97% of the total value of UK long-term technical liabilities (policyholder liabilities). The survey reported that, of the 329 entities that were authorised to carry on life assurance business in the UK, 51 were in run-off and write no new business.

2 Financial Services Authority "Closed Funds - The FSA's perspective", speech by David Strachan, 28/09/2004

RUN-OFF FEATURES OF THE LIFE RUN-OFF MARKET

The basic characteristics that are particular to closed life assurers rather than active assurers are:

- No new life insurance contracts are written - However, closed assurers continue to receive regular premiums on in-force business, and still accept increments to existing policies and group contracts in accordance with existing contractual commitments. Depending on their maturity profile, assurers can grow for a number of years after they have closed to new business because of these incremental risks.

- In-force business will decrease over time - The decline is likely to take many years and will depend on numerous factors including the types of policy written, maturity profile and any surrender penalties imposed.

- The range of operations is reduced - For instance, there is no further need for sales or marketing functions.

Many companies in run-off have focused on improving existing business processes and enhanced investment activity to improve the overall performance for the benefit of both policyholders and shareholders.