Paul Evans and Philip Singer examine the reasons for the growing interest in claims estimation techniques and their application to the efficient closure of general insurance run-offs
"Tomorrow, and tomorrow, and tomorrow, creeps in this petty pace from day to day, to the last syllable of recorded time; and all our yesterdays have lighted fools the way to dusty death." (Macbeth Act V scene v.)
One of the dominant features of the London market in recent years has been the continuing search for "finality", that elusive Holy Grail which might enable the underwriter, the company director, the Lloyd's Name to sleep at night in the certain knowledge that the worst is over.
The inexorable rise in the claims experience, in particular as regards asbestos, pollution and environmental liabilities, professional indemnity and that fateful string of catastrophes in the late 1980s and early 1990s created the huge cloud of uncertainty over old-year underwriting that led, among other things, to Reconstruction and Renewal (R&R) and the establishment of Equitas at Lloyd's, to the unprecedented number of companies in run-off, to declining levels of solvency and, for some, the curse of insolvency. The market has a problem.
It is clear, too, that this is not just a London market problem. A recent survey by Swiss Re suggested that the liabilities of worldwide companies in run-off in 1996 were estimated at $230 billion. If that is not a frightening enough number, their estimate of such liabilities in 2001 is $350 billion and in 2006 - $505 billion!
In the London market alone, there are 180 authorised companies in run-off, together with perhaps a further 50 subsidiaries of composite insurers and over 50 branches of companies authorised elsewhere within the EU. The liabilities of London companies in run-off have been estimated at between $17 billion and $25 billion, excluding Equitas, and this assumes that balance sheets reflect reasonable actuarial estimates, which is perhaps questionable on occasion. Over 30 of those London companies are now in one form of insolvency proceedings or another.
So, the run-off industry has boomed and the market is faced with years of uncertainty as the long tail unwinds with years of costs in handling it all. The obvious fact that reinsurance simply spreads the burden wider just emphasises that this is not just a problem of the few. Indeed, it is reasonable to suppose that, as regards some liability business, the old-year problem is affecting many parts of the business community beyond the insurance sector.
For (re)insurance companies the old-year problem is a product of the difficulty and uncertainty over the nature, amount and extent of the underlying claims against insureds and the time taken to agree then. Tighter wordings and exclusion clauses obviously help in more recent underwriting years, and there are numerous proposals for getting disputes settled more quickly. There are also stark realities like, for example, the frequent comment that more money is spent in paying lawyers to argue complex coverage and liability issues than on clearing up polluted landscapes.
In the face of all of this, how do we find "finality"?
What is estimation?
"If it were done when 'tis done then 'twere well it were done quickly;" (Macbeth Act I scene vii.)
The rest of this article will examine a technique for helping (re)insurance companies reach a point where, for the whole of their business in run-off or for a particular book of business, they can be entirely content that no more liabilities can possibly accrue. This includes liabilities in respect of those "unknown" causes that have a habit of crawling out of the woodwork when everyone thought it was safe to breathe again. That is what we mean by "finality" - not reinsurance, not alternative risk transfer - but no more liability.
At the heart of any such proposal must be the supposition that a company can by various means place a fair and reasonable estimate on its ultimate liability to a particular policyholder or ceding company. This estimate can then be used to finalise a deal between the parties in a way that brings to an end any prospect of further liability between them. As between cedant and reinsurer (or between parties further down the reinsurance chain) this gives rise to the classic commutation, involving an agreed payment for bilateral finality. For policyholders, too, policy buy-backs are not unknown.
So, parties have been taking commercial decisions for years based on a judgement of the reasonableness of estimated liability. What's the big deal?
What has brought this whole concept into sharper focus recently has been the recognition that estimation techniques, when coupled with a legal envelope such as a scheme of arrangement, can be applied to the whole of a company's book of business as a means (arguably, the only means with no further risk) of bringing to an end a run-off. This need for finality is particularly important in order to finalise a long-running liquidation of a (re)insurance company. It is the basis for dealing with some current insolvencies from the start and is most likely to be needed in order, eventually, to finalise the current crop of "run-off" schemes of arrangement. It will increasingly be seen as a means of managing the exit from the market of solvent companies.
In dealing with insolvent run-offs, the roots of the estimation ideas are based in the Insurance Companies (Winding-up) Rules 1985, which sets out the basis for admitting a creditor's claim in respect of a general business policy. The general rule is that the creditor's claim shall be a just estimate of the value of the policy, except for amounts falling due for payment before the date of the winding-up order. On the basis of this wording, partners in one of the predecessor firms of PricewaterhouseCoopers obtained the English court's approval of an estimation based means of agreeing all claims in the liquidation of Cambridge Reinsurance Company, one of the earliest users of wholesale estimation.
We have also been involved with using estimation techniques in the schemes of arrangement for ICS Reinsurance Company and RMCA Reinsurance Company, in the scheme to bring the liquidation of St Helen's Insurance Company to a close, in the preparation for schemes for Fremont (UK) Insurance Company and Charter Reinsurance Company and, most recently, in the first scheme for a solvent company, Scottish & Commonwealth Insurance Company.
How does it work?
"but that this blow might be the be-all and the end-all here, but here, upon this bank and shoal of time . . ." (Macbeth Act I scene vii.)
The objective is always to agree with each (re)insured a value for the estimated ultimate liability under a policy, less amounts actually paid to the valuation date. Clearly, the focus of the estimation will be on getting values for case reserves and assessing an appropriate level of reserve for claims incurred but not reported (IBNR). This latter amount might be said also to include a reserve for deterioration in known case reserves - IBNE "incurred but not enough".
In the simplest cases, this estimation process might comprise no more than an invitation for insureds to make their own assessment of the valuation and submit it to the insurer or reinsurer for agreement or negotiation. This relatively simple process can achieve agreement quickly, but will only work where the amount and volume of claims outstanding are modest and, even then, will require a third party arbitration system to deal with disputes. Such was the process adopted by Scottish & Commonwealth Insurance Company.
In most cases, actuarial techniques will inevitably be involved, in particular in assessing appropriate levels of IBNR reserve. Here there will be two main thrusts to the exercise: assessing an overall level of reserve on a class of business using traditional techniques and then allocating the overall number among the insureds, including, perhaps, those who have no notified claims but have unutilised coverage under their policy.
The allocation process is necessary because by its nature the assessment of an IBNR reserve for a particular class of business is a statistical exercise that can only be approached by examining the whole class rather than individual policies or treaties. As with the whole of the actuarial estimation, the allocation process must be explained and be seen to be fair and reasonable, recognising that it cannot produce a perfect answer.
In any event, the company must establish early on the base data to which the estimation techniques are to be applied. Accordingly, there will need to be an exchange of information between insurer and insureds, in particular as to the extent of the contracts giving rise to present or future liabilities which will form the agreed basis for the estimation. How easily this can be achieved will depend very much on the quality and completeness of the company's records.
What are the problems?
"Is this a dagger which I see before me, the handle toward my hand?" (Macbeth Act II scene i.)
Actuaries are continuing to hone their techniques in the area of estimation and the successful conclusion of the various schemes referred to earlier will add to the experience, as well as raise market awareness and, hopefully, acceptance of this approach.
Nevertheless, there are areas of difficulty, where innovation and creativity must be brought applied to achieve a pragmatic, and fair, solution. Reinsurance is easier to estimate than direct business - a host of claims against an excess of loss treaty will be more susceptible to the sort of actuarial techniques necessary than a number of individual, and possibly large, direct claims. Liability business involving third parties is also difficult, especially if insureds are concerned about the prospect of future claims from those third parties where they might effectively be self-insured after a commutation based on estimated amounts. Furthermore, if all or part of those liability claims might be protected under a guarantee scheme or covered under arrangements such as those provided by the UK Policyholders Protection Act 1975, then insureds may be less willing to contemplate finality unless the price is right.
We suspect that the biggest issue surrounding estimation, after the fairness of the actuarial technique and the credibility of data, is the impact on the outward reinsurance programme. This is not a new issue, given that commutation has been a tool of run-off for years and reinsurers frequently take part in deals to end contractual relationships on the basis of estimated liability. Furthermore, the number of schemes involving estimation is rising and with that comes greater experience for reinsurers also.
It seems to us that the question for reinsurers is a simple one: is it worth paying a lump sum now, at a discount, to obtain finality? Reinsurers are capable of taking a commercial view and we believe that, in the context of an estimation scheme, they will want three things: information about the process, involvement in the process and some commercial advantage from the process.
The experience of partners in our firm who have been involved in estimation schemes is that, when reinsurers are properly presented with these three things, they will usually pay. The fact that the scheme administrators of ICS Reinsurance Company and RMCA Reinsurance Company are making dividend payments at 75% speaks for itself in terms of the ability of those insolvent companies to collect from reinsurers on the basis of estimated liabilities. What's the big deal?
In the US, these issues have become something of a cause célébre, in particular in the cases of Mission Insurance Company, Integrity Insurance Company and Holland America Insurance Company. In these insolvencies, attempts are being made, not only to impress estimation techniques on creditors with a view to early closure of the estates, but also to bind the reinsurers to accept the estimation involuntarily.
As will be apparent from the earlier discussions, English law provides no opportunity to bind reinsurers within an estimation scheme and reliance must be placed upon commercial common sense and negotiation. We prefer it that way. It seems to us that, if reinsurers in the US were to be offered the same three things, information, involvement and a good deal, then even the Reinsurance Association of America (RAA) would be willing to support estimation. What's the big deal?
Paul Evans and Philip Singer are partners in the London office of PricewaterhouseCoopers. Both have handled corporate recovery work for many years and specialise in reorganisations and insolvencies within the insurance industry. They have been involved in the run-off and schemes of arrangement for a number of substantial London market companies. Tel: +44 (0) 171 939 3000. Fax: +44 (0) 171 403 5265.