Out of the Shadows - EMB on Run-Off - 2008-04-29
The birth of run off
The principles of run-off are nearly as old as insurance itself, but only in the late 1980s did it start to take on its modern appearance in response to the disasters that befell the industry. Just as the live market changed almost out of recognition in a few decades, there has been a transformation to the legacy or discontinued business sector, as it is sometimes called.
The London market was at the forefront of it all. Above all, it fell to Lloyd’s to suffer the losses that nearly destroyed it, and then to develop proactive, highly skilled and ultimately very effective run-off techniques. It will come as no consolation to the Names who lost their homes in the carnage, but the episode proved to be a catalyst in developing a whole new approach to dealing with past liabilities.
Anyone who knows the London market will be familiar with the horrendous liabilities that came in waves from the 1980s onwards. Back in the late 1970’s to early 1980’s, asbestos claims from the US had started to arrive. Johns-Manville, then the world’s largest producer of asbestos, filed for bankruptcy in 1982. A battle began between London market claims people and the lawyers of US corporations who were facing increasing asbestos claim filings from aggressive plaintiff lawyers.
At around this time, US pollution emerged as a new liability type. The Superfund regime applied penal, retroactive legislation making US corporations responsible for the clean up of environmental damage, even though their activities had been entirely legal. Meanwhile, the application of Joint and Several Liability meant that some companies were effectively forced to pay for other people’s damage. Inevitably, the bill landed with the insurance industry.
Also around this time health hazards such as injury caused by silicone in breast implants or from lead paint or from chemicals such as Agent Orange started to emerge.
Then, just as all these liabilities were causing material back-year reserve deteriorations, the late 1980s saw the start of a string of more conventional catastrophes like Hurricane Hugo, Lockerbie, Exxon Valdez and Piper Alpha. Together they exposed a spiral of retrocession arrangements within the London Market. Original losses were leveraged up many times over as insurers passed the risk to and from each other round and round in a spiral. The lack of transparency has uncanny resemblances to the credit crunch crisis being faced within the banking sector (and beyond) today.
After suffering minimal loss-making years in its 300-year history, Lloyd’s was on its knees, suffering successive years of multi-billion pound losses. Syndicates could not be closed into the subsequent years because of the huge uncertainty that existed. Simultaneously other London market players stopped writing.
The emergence of the modern run-off industry
Against this desperate background, Equitas was born. Its purpose: to accept and run off all Lloyd’s pre-1992 liabilities, so enabling the live market to function without the burden of old liabilities.
Dubbed Mission Impossible by some observers, Equitas was much more than just another run-off. It was by far the biggest and most complex exercise of its kind ever undertaken, it was central to the whole Lloyd’s Reconstruction and Renewal project and it kick started the modern industry. If Equitas had applied the traditional approach to run-off, basically paying off claims as they appeared until the money ran out, it would almost certainly have failed. And so would Lloyd’s.
Although they now seem relatively standard, the techniques employed by Equitas broke new ground in understanding exposures at an unprecedented level of detail. Their proactive strategy involved a thorough evaluation of the liabilities at each counter-party level, then attempting to buy policies back within those set reserves. Many US corporations chose to do deals and Equitas was able to remove material downside risk and therefore move towards finality. Many such deals were made in parallel with London market companies.
In the late 1990’s, the US asbestos situation deteriorated beyond all but the most pessimistic actuaries’ expectations. Plaintiff lawyers were extracting huge sums of money from US corporations, often grouping together masses of “unimpaired” claimants with a few ill people and striking “inventory settlements”. Cash started to haemorrhage again.
The people at Equitas could see that the fundamental principles of insurance were being violated, and they resisted. Valid claims, where claimants could demonstrate illness and a link to the product of a US corporation, would be paid. Claimants without such proof would not. The cash taps were turned off and this was a catalyst for large numbers of major deals to be made. Simultaneously, much lobbying was done to reform some of the worst “hell-hole” jurisdictions in the US. This tort reform was hugely influential in taming the nightmare of US asbestos.
Last year, when Berkshire Hathaway placed a huge reinsurance contract behind Equitas, it effectively brought finality to the 1992 and prior Lloyd’s years. It was a resounding vote of confidence in the whole project, a tribute to proactive run-off management techniques and the high calibre of its people. They had reduced the downside risk to such a degree that the Equitas portfolio had become sellable – and they had played a central role in the rescue of the world’s best-known insurance market.
Realising the potential of run off
Equitas had succeeded in a large part by creating and executing proactive commutation strategies, but that is by no means the only way to draw a line under legacy liabilities. From the 1990s onwards a whole new industry developed, with London as one of its main hubs, and a new breed of specialist run-off company emerged. Actuarial techniques and software, meanwhile, had evolved almost beyond recognition in the live market and were increasingly being applied to the run off sector, which had once been something of an afterthought.
Today’s insurance company has the choice of a wide range of exit strategies. Indeed, perhaps the most important decision a run-off manager will have to make is the choice of route.
Solvent schemes of arrangement evolved from the schemes used to crystallise insolvencies, and became common in the late 1990’s. They essentially allow a mass commutation with all creditors simultaneously if a sufficient number vote in favour. This facilitates a complete exit, with the owner passing the risk back to the original policyholder in return for a payment in respect of the liabilities, often with a material risk margin.
Part VII transfers have also become a tool of choice, allowing portfolios of insurance or reinsurance business to pass from one owner to another, whilst maintaining the outwards reinsurance protections. This is a court approved process, as opposed to being subject to a vote by policyholders. Part VII transfers have been used to great effect to tidy up old books of business within large live companies, combining them in one place and closing down the previous entity.
Moving to the next level
The industry is alive and well, and ‘run-off’ is no longer a dirty word. New portfolios have emerged following events like Enron, the World Trade Centre and Hurricane Katrina. UK asbestos claims are here in force and other latent claims, such as physical and sexual abuse, are still subject to significant uncertainty, keeping the actuarial and legal professions busy. Large trade bodies such as the Association of Run off Companies (ARC) in the UK and the Association of Insurance and Reinsurance Run Off Companies (AIRROC) in the US are thriving, with many hundreds of members.
We would be kidding ourselves, though, if we thought that was the end of the story. As with the live market, there is a tremendous variation in the quality and sophistication of techniques employed, and part of the challenge is to bring everyone up to the standards of the best.
As the world becomes more focussed on capital and returns on capital, so too the run-off market must embrace a risk-based approach. Even just a couple of years ago, only a tiny fraction of run-off companies would have thought about a capital model. Now they are positively encouraged (and sometimes demanded) by the FSA’s ICAS regime, whilst Solvency II will add to the pressure to move in this direction.
Financial models, and their associated business application, make any insurance operation – live or legacy – likely to be more profitable and resilient. A big challenge for practitioners today is to employ these and the relevant data management techniques to the full.
The run-off industry is a fascinating area. It has attracted and retained some sharp minds and hard-working creative entrepreneurs, but there is still a long way to go.
About the AuthorAuthor: Jonathan Broughton (EMB)
Jonathan Broughton is a director at EMB, the non-life actuaries and management consultants.
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