Warren Buffett has started another trend. Run-off is now in vogue with canny investors. Marcus Alcock weighs up the attractions.
The market for investors may not be the most buoyant at the moment in the wake of the US-led subprime mortgage fiasco and the credit squeeze it has created, but sniff around and there are interesting deals to be found. Curiously, one of the areas that has attracted the attentions of the capital markets is a sector that was once seen as the esoteric preserve of all but a few specialists in EC3: run-off. We’re not talking floats or leveraged buyouts here, but discontinued business.
Oracle spots a deal
Of course the first big deal that held everyone’s attention was the incredible contract signed between Warren Buffett’s Berkshire Hathaway Group and Equitas, the company established to reinsure and run-off the pre-1993 liabilities of Lloyd’s Names. Under the deal, agreed last October, Berkshire Hathaway subsidiary National Indemnity signed up to provide £3.7bn of reinsurance cover. Equitas also transferred all reinsured Names’ liabilities to Berkshire Hathaway.
Since the spectacular entry of Warren Buffett, there have been other interesting moves by investors into the run-off market, interesting in part because these are not normally the sorts of investors who would previously have been interested in this sector. In July, run-off specialist Tawa actually floated part of its capital on the Alternative Investment Market, becoming the first non-life consolidator to be listed in London.
Then in September another run-off specialist, Afinia Capital Group, was launched in Bermuda. Headed by former Alea Group Holdings chief financial officer Amanda Atkins, the new company has been funded by a division of Deutsche Bank along with investment fund EOS Credit Opportunities. It aims to provide a range of services for companies involved in the run-off arena. This includes assistance with reinsurance debt purchase, balance transfers, and the establishment of solvent schemes of arrangement.
Run-off cat bonds?
More recently still, investment bank ABN Amro has announced it is launching insurance-linked securities based on the run-off of long-tail casualty business. Possible lines that the product might cover are understood to include public liability, employers’ liability, motor liability, workers’ compensation and medical malpractice amongst others. The transactions are likely to be structured similarly to catastrophe bonds, with the use of a special purpose vehicle.
“The first big deal that held everyone's attention was the incredible contract signed between Warren Buffet's Berkshire Hathaway Group and Equitas
Indeed, such is the new found interest from the capital markets in the once neglected run-off market that rating agency Standard & Poor’s is set to unveil a new ratings index aimed at this very area in the near future. According to Peter Hughes, vice president at the company: “We’re launching a new form of rating for run-off companies which is specific for that market, though for most cases these ratings will probably be confidential. We see these being used in a number of ways, both from the point of view of potential investors and from the point of view of insurers who are looking to divest some part of their business or offer their policyholders another option.” And it’s the new wave of investors who seem to be showing interest, he says: “Since we announced this there’s been a hell of a lot of interest from hedge funds and subsidiaries of insurance companies.”
But hold on, why this new found interest in run-off? Shouldn’t the capital markets be confining themselves to more tried and tested avenues of investment? Sean McDermott, executive director of the Quest Group, feels they should. “There’s more interest now in run-off because there’s more interest from the larger insurance groups to offload their run-off portfolios,” he comments. “It’s become a preferred way to take some of their assets off balance sheet”.
He isn’t convinced that some of the hedge funds that have recently decided to invest in the sector are making the best choice. “A lot of them are naïve, and haven’t really the knowledge that’s required when it comes to this,” he declares, suggesting that their experience is more on the asset management side generally, but not so much on the highly specialised reinsurance run-off sector.
Gilles Erulin, chief executive officer of the recently-floated Tawa, also adds a word of caution. “Profitability is ok, but it’s not going to be immense. Most people believe they can make massive returns, but in reality that’s not the case. We can make some money, but it’s not going to be huge.” Money is not the issue; it’s about finding the right target. “A run-off vehicle is a sum of future risk, which is followed in six or seven years by a potential dividend,” explains Erulin. “It’s an investment programmer that requires some long-term players.”
Indeed, the feeling from some of the old hands in the run-off sector seems to be one that is inherently suspicious of new money and new players. Is such suspicion merely a natural reaction to the threat posed by competitors, or is it based on experience? As one old hand explains, very few of the longer-term players are currently involved in new run-off ventures.
“Mr X or Y has some experience in the run-off field, and he goes and finds a private equity group or a hedge fund and creates a dedicated vehicle for run-off backed by $1m for investment purposes,” he says. “But none of the people who have been traditionally involved in run-off – people like Ken Randall [founding head of run-off acquisition firm Randall & Quilter] and John Winter [Ruxley MD] – have been doing this. It’s always people marginally involved who go for big pots of money and it’s because of a wrong vision of what the market is. Someone might be looking at making a profit margin of 25% per year, but where will you find that sort of money in run-off? I’ve been in the industry for years and it’s just not going to happen.”
“It's always people marginally involved who go for big pots of money and it's because of a wrong vision of what the market is
Whether there is a lack of opportunity remains to be seen. After all, run-off is by its nature a long-term game and some of these recent forays by new investors have hardly had a chance to get up and running. Not every investor has been all that keen on dealing with entities in run-off. Just look at investment specialist KKR, hardly a newcomer to the world of reinsurance. Yet KKR sold Alea at a big discount to its flotation value to Fortress Group earlier this year, demonstrating just how tricky companies in run-off can be viewed by even the biggest investors.
London’s heyday is over
Even though run-off may be viewed as difficult by some, the fact remains that many investors are keen to get involved in the sector. Just as non-traditional investors have entered the scene, so too the centre of gravity for run-off – the London Market, appears to be shifting. According to the findings of the latest KPMG/ARC non-life run-off survey, proactive management of existing run-off portfolios, absence of new run-offs and the weak US dollar combined to bring down total estimated liabilities in the UK non-life run-off market – including Lloyd’s syndicates – by over 14% to £32.7bn at the end of 2006, a reduction of £5.5bn on £38.2bn at the end of 2005.
So is London losing out? “The London Market has always been slightly advanced, but even the BMA [Bermuda Monetary Authority] is creating a special department for run-off, so the market has dramatically changed in terms of awareness,” comments Gilles Erulin. Nonetheless he feels the issue should not be exaggerated: “There’s a significant dollar impact there which is probably understated in the report. The dollar has lost probably 40% of its value in the last three years, so I don’t see London in decline so much. The fact is it’s a stable sector with new run-offs every year and that won’t change. Besides, the origin of run-offs is limited to where the new players are.”
Sean McDermott agrees with this assessment. “I think all that’s happened is that the quantity of businesses in run-off has reduced recently, which is a pretty straightforward explanation for the figures,” he says. “Post-9/11 there was a plethora of entities in run-off, but since then a lot of the liabilities have been settled. Besides, it’s been a very good market in the last couple of years and we haven’t seen as much activity, though that may change with a softening market.”
Will the capital markets continue to focus on run-off in 2008? With the credit crunch still taking effect, it’s difficult to say with any certainty. It is true that any type of insurance investment will continue to be popular in this climate as insurance is – on the whole – uncorrelated to the global equity and debt markets. One thing is certain: run-off is now seen as a bona fide area for investment. Whether this will remain so long term is a more pertinent question. As one insider says, “newcomers are most welcome, but what we don’t want is someone coming in and screwing the market”.
Marcus Alcock is a freelance journalist.