Ways to ensure smooth running

With perhaps $400bn of (re)insurance business in run-off worldwide, the expertise required to manage run-offs successfully is finally being recognised. About time too, says Tony McMahon.

In his book 'Against the Gods', Peter Bernstein writes: "The essence
of risk management lies in maximising the areas where we have some control
over the outcome while minimising the areas where we have absolutely no
control over the outcome and the linkage between effect and cause is
hidden from us."


This observation was never truer than when applied to run-off in the
reinsurance industry.


The global reinsurance market has gone through a tremendous period of
change over the last decade. Nowhere has this been more manifestly
demonstrated than in the London market where, as a result of
consolidation, there are no longer any independent British reinsurers,
apart from Lloyd's.


The number of books of business in run-off is immense and growing. No one
can accurately state what the liabilities in run-off total and reliable
figures for the split between insurance and reinsurance are not
available.


Departures boost totals


The most detailed study was published in 1998 by McKinsey and estimated
that the global run-off industry totalled $230bn. It predicted that this
would grow at 10% a year. Five years on, it would appear that this was
underestimated, as the departure of a number of established players from
the market could not have reasonably been predicted. If the base figure is
broadly correct, then we could be looking at a value in excess of
$400bn.


Reinsurers are faced not only with the challenges of managing their own
discontinued books of business but with collecting debts due from
counterparties that are themselves in run-off.


Much of the thinking that has developed on dealing with the issue of
run-off has come about as a result of the lessons learned in dealing with
insolvent estates. The reasons include:


- Insolvent estates face all the problems of solvent run-offs and more;
the solvent industry can benefit from that experience.


- Given the high cost ratios and reduced levels of payment to creditors,
insolvent estates will normally accelerate the run-off and move to a
closure of the estate earlier than would otherwise be the case.


- Insolvent estates have developed the powerful tool of schemes of
arrangement, which have been successfully adapted to truncate solvent
books of business.


A scheme of arrangement is an agreement between the company proposing it
and its creditors. The arrangement becomes binding on the company and its
creditors if a majority, in number, representing 75% in value of the
creditors that vote at the meetings, approve it. The court authorises the
meetings and the arrangement is subsequently sanctioned by order of the
court. The arrangement binds all creditors, not just those that voted.


Manage the risk


The key risk management issues in a solvent run-off are:


- Cost control Lengthy run-offs can incur huge administrative costs.


A cost-benefit analysis needs to be performed using financial models,
comparing costs to closure in the normal course with an earlier
cut-off.


- Retrocessionaire security Unlike fine wine, this does not mature and
improve over time. Many reinsurers are suffering from security downgrades
and the ability of some reinsurers to meet their liabilities well into the
future must be doubtful.


There is also an increasing tendency to dispute claims and raise issues
that would not previously have been raised. This is particularly so where
there is no continuing live business relationship.


- Liability containment Left to their own devices liabilities have an
unnerving tendency to escalate. Active claims management, an effective
commutation strategy and a plan to effect early closure will help combat
this.


- Inefficient use of capital Run-offs tie up immense amounts of capital
that could be more profitably employed elsewhere in the organisation.


Understand the issues


Run-offs come in all shapes and sizes and can be differentiated by a
number of factors, including, but not limited to:


- How long it has been since any new business was written.


- What sort of risks were underwritten and whether it was pure reinsurance
or mixed with direct.


- The extent and the basis of reinsurance protection.


- Whether the book has been outsourced in whole or in part.


- Where the run-off is physically located and the location of the business
that was written.


- The sort of IT systems used.


- The quality of data integrity.


- The position regarding staff retention and motivation.


- Whether the cost base is appropriate.


It is surprising how common it is for basic information to be
unavailable.


Sometimes this is due to the long periods over which underwriting took
place and often brokers hold the bulk of the documentation.


Minimal care


It has to be said that in the past there seems to have been a tendency to
let run-offs take care of themselves with a minimal amount of senior
management time being spent on the issue unless something catastrophic
pushed it up the agenda. This has changed in recent years. Management is
now far more aware of the dangers inherent in run-off and the need to free
up underperforming capital.


A difficulty often encountered is whether there are adequate resources
within the organisation to deal with run-off. It is essential for
management to formulate a clear strategy for the run-off, based on the
best information that can be assembled. Management also needs to ensure
that sufficient resources are available to carry it out.


Trouble in the UK


As if life was not already difficult enough for reinsurers, on 20 April
this year the Insurers Reorganisation and Winding-up Directive will come
into force in the UK.


Perhaps not one of the most fascinating pieces of legislation, it is,
unfortunately, bad news for reinsurers. The reason is that the
legislation, which is imported from Europe, gives priority to 'direct
policyholders' in the event that an insurance company is wound up.


Under the old rules all creditors, apart from some very minor preferential
creditors, were treated equally. This fundamental principle of pari passu,
which is one of the bedrocks of English insolvency practice, will be swept
away for insurance companies by this new legislation.


The effect could be severe for reinsurers exposed to weak security. Take
for example a company that wrote 50% direct and 50% reinsurance business
and that failed with assets sufficient to cover only 50% of its
liabilities.


Under the old rules the reinsurance creditors would recover 50% of their
debt; under the new rules direct policyholders will get paid in full and
reinsurance creditors will receive nothing.


In the short term it would be wise to ascertain what the exposures are to
counterparties with mixed books of business. In the longer term it will
probably lead to pressure for separate corporate entities to conduct each
type of business.


Take care outsourcing


Awareness is one thing. Having the correct set of tools to do the job is
another. Given the multiple challenges currently facing the industry,
experienced resource is in short supply.


Outsourcing is often looked to as a solution to this problem. While this
is true in part, it still has to be treated with caution. Selecting the
right run-off service provider on the right terms is essential for
ensuring that the strategic objectives are met, risk issues are properly
managed, costs are controlled and any potential reputational damage
minimised.


Careful thought should be given to the tendering process and how an
objective assessment of the relative merits of the contenders can be made.
Tight wording of the outsourcing contract and service level agreement is
also essential if any scope for disagreement is to be avoided.


One legacy of the past is the volume of reinsurance underwriting that was
undertaken through pools. Given the differing levels of solvency of pool
members it would be prudent to review or initiate contingency plans if a
pool member became, or was in danger of becoming, insolvent. The damage to
cash flow or ultimate recovery can be substantial if there is a prolonged
period of disruption.


Analyse options


There is more than one way to deal with the problem of a reinsurance
run-off and the options need to be weighed carefully. Schemes of
arrangement can give absolute finality, but this solution may not always
be possible.


Other options that may be available include sale, reinsurance and
portfolio transfer.


A thorough understanding of what the run-off comprises is essential to be
able to analyse and model the most effective strategies. Complex run-offs
need to be broken down into their constituent parts, as it may be
appropriate for a mixture of approaches to be applied.


Given deteriorating investment returns, the threats of escalating claims
and diminishing recoveries from reinsurers, merely letting the run-off
take its course is an increasingly costly and dangerous option. Any
checklist should include the areas to be covered and actioned that are
listed in the box at the top of the page.


QUESTIONS TO ASK


- What records do I have and in what state?


- Do I really know what all my exposures are?


- Do I have a clear map of my reinsurance programmes?


- Do I have up-to-date actuarial reviews of my gross position?


- Are my systems capable of generating principal to principal
information?


- Am I reliant on legacy systems that may prove fragile or unreliable?


- Do I have a practical and cost-effective plan for recovering delinquent
debts?


- Do I have robust financial models of the run-off that will enable me to
apply appropriate sensitivities to projected outcomes?


- Do I have a strong strategic plan for controlling the direction of the
run-off and do I have the right resources to implement it?


Tony McMahon heads the KPMG corporate recovery insurance solutions
practice in London.
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