Is There a Future in Run-off?16 February 2000 Paul Jardine of Equitas Limited Good afternoon Ladies and Gentlemen, I am delighted to have been invited to speak today on the subject of run-off. I am reminded of the cautionary tale of the prima donna who during her after dinner speech was banging on about how her voice was insured, at Lloyd’s of course, for £1m. "Oh really", said a bored member of her unimpressed audience, "and what did you do with the money?". Over the past 5 years there have been many changes in the world of reinsurance, not least the establishment of Equitas as a central part of Lloyd’s Reconstruction & Renewal. This afternoon I would like to spend some time looking at the current reinsurance market and the trends which fuel my belief that run-off, whether solvent or insolvent, will continue to be a significant feature over the coming years. I would then like to explore some of the key issues which need to be dealt with in order to produce successful run-off results, with specific reference to the lessons which we have learnt at Equitas over the past 3 years. It is my belief that the trends we are seeing today will lead directly to a vast increase in the incidence of the run-off phenomenon and, I fear, in the frequency of insolvencies. Either way, the demand for high quality run-off management – whether in-house or outsourced – is set to grow, perhaps exponentially. There are a number of key features of today’s reinsurance market which suggest that many carriers will simply not present a viable long-term business proposition for their capital providers. In terms of reinsurance purchased, there are a number of trends which indicate a potential significant reduction in the size of the cake:
Against the background of a changing demand for reinsurance both in terms of both volume and type, consolidation in the industry will continue. There are very strong business reasons for the consolidation – companies can leverage off the combined capital base and economies of scale. Troubled companies will be acquired as vehicles for expansion in a particular market and their assets stripped. Either way, portfolios of old run-off business will be created. If we look at the reasons why companies go insolvent, we see some interesting trends and of more importance some clear parallels with the current market. A special report produced by A M Best in February of last year posed the question: "Insolvency: will historic trends return?". As you can see from the slide, the number of US insolvencies over the past 25 years has been vast, with the period between 1985 and the early 1990s displaying the greatest frequency. In this latter period the insolvency rate was broadly 2% by number of the companies operating in the market at that time. The Best study identified a number of key reasons why companies fail with the primary causes being reserve deficiency and rapid growth. In many ways these two features go hand in hand – companies undercut their competitors to gain business and this leads to under-reserving. In addition to these features we have some other root causes of insolvency:
If we look to today’s market and the key features, we see an environment of intense competition, extremely soft premiums, volatile bond and equity markets, and some notable troubled companies. Reinsurers’ results have been propped up by reserve releases over the past few years and on the horizon we have further potential natural and man-made catastrophes. Just witness the size of storm-related losses which have been reported over the past couple of months amidst rumours of whole local markets eroding their reinsurance programmes. All in all, it appears that we have almost perfect insolvency conditions.
The second area where a run-off company must focus attention is the way in which its relationships with its counterparties are managed. It is simply not enough to construct a principal ledger and hope that this in itself gets the cash moving. Whilst the ledger enables offset to be used within the relationship, it does nothing to clear old issues nor bring the overall relationship to a conclusion. If the stated aim of the company is to commute its outwards reinsurance asset, then it has to manage the entirety of the interaction with its counterparties, from soup to nuts as the Americans would say. A more fundamental question linked to outwards reinsurance is whether the organisation wants to manage its own risk and investments, or whether it is prepared to delegate these tasks to a third party, i.e. its reinsurers. Notwithstanding the traditional arguments in favour of reinsurance such as capital borrowing, reciprocity and reinsurer expertise, many organisations fail to appreciate the hidden functional cost of reinsurance. For Equitas, the vast scale and complexity of the reinsurance programmes means that the overall processing of reinsurance recoveries is a labour intensive and, hence, expensive exercise. Including internal and external costs, it is likely that 50%-60% of the Equitas cost base relates to reinsurance processing and collection – that is currently in excess of £100m per year. Contrast this with the Equitas investment department where we have five people looking after £6bn of investments. If we were to translate our reinsurance asset of £5bn into cash and invest it, the associated costs would be on the order of 0.1% or £5m, and what’s more, we would earn investment income. Our current reinsurance asset does not earn us anything in the way of a return. As an aside, when you consider that cost estimates in the aggregate for UK run-offs have been put at £750m per year and rising, the loss of investment return and excess cost is potentially massive. Against this background, our strategy has to be to commute as much of the reinsurance asset as possible and to turn it into cash. This strategy will also serve to protect that portion of the asset which rests with reinsurers who are less than secure and will also involve the resolution of the various disputes which we inherited. To give you some idea of the enormity of the task, I have prepared a number of statistics on our outwards reinsurance asset:
Given what I have already said about the outwards reinsurance asset and the need to commute, one key issue remains unresolved within the London market – that old chestnut of the recoverability of IBNR on outwards reinsurance. We could create a lengthy conference on the matter but I will restrict myself to just a few remarks designed to demonstrate the significance of the issue to run-off companies. In general, an inwards commutation will present issues regarding how reinsurers will respond to the deal. These issues will primarily surround the question of whether the IBNR element is recoverable or not but may also extend to other items such as interest, fees and ex gratia payments. What is clear that the market does not usually respond to IBNR as it arises within commutations; indeed in many cases it is debatable whether they actually are prepared to pay crystallised case outstandings. Given that commutations are the lifeblood of the run-off market, it is clear that this issue, to the extent that it prevents deals being done, will have a potentially disastrous effect on the ability of run-offs to manage their exit. Short of getting a marketwide agreement on the issue (and the ABI is working on this issue at present) or obtaining a legal judgement, there are a number of strategies which can help to avoid some of the problems:
As I mentioned earlier, I believe that there are dangers in looking at run-off entities as on-going companies that simply lack an underwriting and marketing function. In order to be successful, management must view the issues as business challenges. Many run-offs fail to deliver their stated objectives because they simply replicate the conditions which caused them in the first place. All too often I am reminded of a summer vacation when to break the boredom of the inevitable lazy day by the pool, I shipped the family off to see the local archaeological site. Gazing with awe at the magnificent ancient temple, I asked the guide, "How old are the ruins?". "2007 years," came the prompt reply. "But how can you be sure of the precise year?" I challenged with typical actuarial aplomb. "Oh," said the guide, "the leader of the team who excavated the ruins told us that they were 2000 years old – and that was 7 years ago". I hope that I have been able to give you some insight into the run-off phenomenon this afternoon and to the particular challenges which this business provides. Thank you and I am happy to take any questions that you may have. |