A proactive approach to run-off that makes use of modern tools can be worth millions of dollars and mean the difference between loss and profitability, argues Steve Mathews of EMB.
‘Run-off’ is still a dirty word in many quarters, regarded automatically as an admission of failure. This stigma discourages firms from adopting the proactive approach towards run-off needed to guarantee and maximise profitability. However, this is changing and there is a growing recognition that run-off is part of the natural life-cycle of an insurance / reinsurance portfolio.
Of course, insurers and reinsurers are sometimes forced to stop writing business after getting it hopelessly wrong. It is equally true, however, that a well-timed, well-ordered exit strategy can be a sign of a professionally managed re/insurer.
The key lies in the timing. Good, timely decisions can only be made with quality management information and a full appreciation of the exit options available. This article will show why quality information provides a run-off with a competitive advantage, and it looks at the options open to a run-off portfolio and how to choose the optimum strategy.
Run-off operations have grown in size, complexity and sophistication, partly reflecting the huge sums of money involved. In the UK alone reserves of approximately £30bn are in run-off entities, with worldwide estimates in excess of $400 billion.
With such large sums involved, it is not acceptable to blindly run off your account. Those who have only a vague idea of their run-off portfolio will never realise their potential because any high-level strategy will be based largely on guesswork. A soundly based strategic approach towards run-off, on the other hand, can make a difference of many millions of dollars, and mean solvency rather than insolvency.
For these reasons, there is growing appreciation of the value of proactive run-off. This usually involves utilising up-to-date financial modelling techniques, combined with a detailed knowledge of the underlying risks exposing the book. These twin pillars of a successful run-off enable you to analyse the data you need and then apply it down to the level of individual contracts.
The value of proactive tools can be seen in the success of the professional run-off companies that use them. Buying run-offs is a hazardous way to earn a living. To make a healthy profit a company must outperform the assumptions of the original owners and be willing to accept the danger of serious losses if things go wrong. The fact that they succeed illustrates the extent to which they are able to leverage additional value from the funds in their control.
It is tempting when faced with a complex run-off just to assume that, on average, a particular outcome is likely. But, as with the rest of the insurance industry, run-offs need to consider the full range of possible outcomes; to anticipate the unexpected; to understand the true variability of assets and liabilities.
Future claims development, reinsurance collectibles and investment performance are among the variables that need to be assessed. All are subject to considerable margins of error, and the better the information the better you will be able to assess the variability.
Once you have identified the uncertainties, the next step is to create stochastic models. These are models that recreate the financial dynamics of a particular organisation and then allow you to observe the full range of likely outcomes and test its resilience in the face of any number of scenarios.
Such an exercise will not, in itself, provide the answers to all your questions. These will depend ultimately on your overall philosophy and approach, and the trade-off that an organisation is willing to make between risk and reward. For example, what is regarded as an acceptable level of risk that a run-off may be insolvent will vary. However, this type of analysis will tell you whether the course of action you propose is acceptable given your desired risk profile. It can also help in your dealings with regulators.
The chart below shows an example of how a proactive run-off approach can give you the best of all worlds. In this case, a company was able to add substantially to its expected surplus, whilst dramatically reducing the danger of insolvency. Although the company had ceased underwriting altogether, the benefits apply equally to run-offs that are part of on-going concerns.
This kind of model will help you to objectively assess the various options open to you. For example, you could consider embarking on a Loss Portfolio Transfer, or a commutation process to crystallise liabilities at a discount to booked values and to reduce the tail of the run-off, or alternatively adopt a more aggressive investment strategy or even sell the run-off to a third party.
The choice will depend on individual circumstances, such as whether or not the company continues to write business, the inwards reinsurance contracts, the size of run-off, the priorities of shareholders, attitude to risk and financial robustness.
Whatever your decision, your strategy must be based on a reliable, detailed understanding of your portfolio and all the possible scenarios. This will enable you to get the best possible result from the portfolio and to maximise the value of your reinsurance. The old approach of using averages to negotiate your portfolio is, by contrast, wasteful and inefficient. It is no longer sufficient to aggregate your liabilities by, say, class and then use these figures to predict the outcome.
This article appeared in Asia Insurance Review in March 2006
