Run-offs, their timing, their scope and the tools employed to execute them involve the most important judgements that insurance and reinsurance companies ever make. Yet many leave them to chance. Steve Mathews of EMB discusses the merits of a pro-active run-off.
‘Run-off’ is still a dirty word in many quarters. Although there has been a noticeable improvement in attitude in the last few years, too many people regard an exit strategy as an admission of failure. This stigma discourages firms from adopting the proactive approach towards run-off needed to guarantee and maximise profitability.
Of course, insurers and reinsurers are sometimes forced to stop writing business after getting it hopelessly wrong. Equally, a well-timed, well-ordered exit strategy is a sign of a professionally managed re/insurer.
Conversely, when executive egos cause delays in difficult yet unavoidable decisions, they almost invariably cost shareholders and creditors many millions of dollars as good money is poured into doomed activities. The interests of a well-run, well-timed run-off demand that it be approached in a positive and honest manner.
This article will discuss the actuarial features of the main options and how to determine which is best for a particular company or portfolio. It will also consider how financial modelling can help optimise the outcome.
There are five main routes available to companies wishing to go into run-off, though it is possible to vary each one, sometimes through the creation of hybrids:
• Solvent run-off;
• Commutation;
• Solvent schemes of arrangement;
• Portfolio Transfer;
• Stop loss.
Solvent run-off
Solvent run-off is a continuation of the old operation without the underwriting. It takes the guesswork out of assessing your liabilities by enabling you to wait for them to crystallise. Solvent run-off can, however, encourage an ad hoc mentality, leading to ineffective use of capital. Of all the options, it takes longest to establish finality and can, therefore, be the most expensive to administer.
Commutations
The great advantage of commutation is that it provides true finality, but it can be time-consuming, as Equitas has experienced. It requires deals to be made on an individual basis and, of course, both sides must be willing to compromise.
Reinsurers must also agree to set aside their right to avoid claims on case reserves and settled IBNR. Getting their agreement can involve intense negotiations, sometimes amounting to a game of bluff and counter-bluff. The number of reinsurers involved may be so large that it is just not practical to approach them prior to the commutation.
Solvent schemes of arrangement
This relatively new approach, recently applied by ING in exiting some of its run-off operations, is gaining acceptance. Provided you have the consent of at least 50% of claimants, amounting to at least 75% by value, you can commute your entire portfolio. You thereby gain finality without having to approach every single one of your creditors.
You have the same potential problems with outward reinsurers as with commutations, however, and policyholders will require compensation for the risk you are passing back to them.
Portfolio transfer
A particularly powerful tool, which binds reinsurers as well as policyholders. The disposing company pays a sum to cover the expected liabilities on a portfolio plus administration costs in return for finality. CNA’s disposal of CNA Re to run-off specialist Tawa (now CXRE) was a high profile example.
Negotiation can, however, be complex as the entity taking on your liabilities needs to be confident of making a profit. It can also be expensive, as you must satisfy the FSA and an actuary or other insurance expert that policyholders will not be disadvantaged.
Stop Loss
Stop Loss policies involve purchasing reinsurance. This device was used by CGNU to withdraw from marine underwriting at Lloyd’s via the Marlborough syndicate. Quick and simple to construct, it has a creditable track record. Your reinsurer, though, will want a sizeable profit margin. You will still be liable if you exhaust your reinsurance layer or your reinsurer defaults, and you may still need to administer claims.
Choosing the optimum strategy
Assuming the decision has been taken to go into run-off, which is the best route? 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.
The overriding factor, however, will be the inherent uncertainty about the ultimate liability of the portfolio. In any accelerated exit strategy this uncertainty will be translated into a risk load, which is in effect the premium you are paying to mitigate the risk of the portfolio deteriorating further.
The size of the risk load may seem prohibitive; it may even be more than the company can afford. In this case the company should go for the run-off option, using proactive commutation where possible to crystallise uncertainties.
This article appeared in JTW News in January 2005
