European run-off report - The lie of the land

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Dan Schwarzmann and Andrew Ward of PricewaterhouseCoopers explain how the views of the market gathered for its Third Survey of Discontinued Insurance Business in Europe support their opinion that times might be tough, but opportunities abound.

The financial sector is as vulnerable as any other to the challenges that the global financial crisis has brought in recent months. With businesses around the world having to tighten their belts, and consider capital efficiency and cost reduction strategies just to survive, it is inevitable that the run-off sector will begin to receive even greater attention from senior management.

This is not only in the context of operational efficiency improvements, but also, given the capital costs of run-off, a wish to unlock the value currently trapped in run-off business. These economic imperatives have coincided with a time of unprecedented opportunities in terms of the range of techniques and strategies available to extract value and this convergence makes for a stimulating time in the run-off market.

In the third edition of the Pricewater-houseCoopers' Survey of Discontinued Insurance Business in Europe, we looked at a cross-section of insurance professionals from discontinued and live insurers in both Europe and the UK to gain a greater understanding of the challenges and opportunities facing owners of discontinued insurance business.

The results illustrate the depth of penetration the financial crisis is having on the wider insurance industry. Almost 60% of those surveyed identified the financial crisis as one of the top three issues facing the insurance industry in Europe for both live and discontinued operations.

We believe that the strength of this view is based on the current perceptions of the market stemming from the financial crisis. This is focused around concerns about asset risk, as investment asset values decline, as well as litigation risk flowing from Directors & Officers and Errors & Omissions claims brought on by the financial crisis, for example the Madoff case.

Deteriorating asset values may be of particular concern to businesses in run-off due to the reliance on investment returns as a source of income in the absence of ongoing premium receipts.

Key issues

Solvency II was a further issue that attracted attention, with over half of respondents ranking it in the top three challenges to European insurers. This forthcoming European Commission Directive has the objective of fully-embedding risk awareness into the governance frameworks used by organisations to manage their businesses.

This is an ambitious Directive, and not without its practical and political challenges. While there is some degree of certainty that Solvency II will come into force, it is possible that it will take a different form to the current draft.

It will enforce change for all but a few insurance organisations, and there are signs from policymakers in Europe that the previous understanding that businesses in run-off prior to 10 December 2007 would be exempt, may not now necessarily be the case.

Indeed, notwithstanding any changes to current exemption requirements, there is a lack of clarity as to how run-off will be considered under the Solvency II framework, for example when it has been subject to a sale and moves from an "exempt" business to a "non-exempt" business.

The third challenge facing European insurers identified by respondents to the survey was pricing/rates, with almost a third of participants ranking it in the top three challenges. In today's tough economic climate, consumers of insurance are seeking to ensure maximum value for money from their coverage.

Making accurate assessments of risk has never been more challenging for businesses, with strains of the failure of high profile financial institutions and widespread instability in the financial services sector alongside frequent natural catastrophes.

Appropriately, evaluating these risks is essential to the survival of the insurance industry. This will require ensuring that pricing models are sensitive and regularly updated to accommodate changes. We envisage that a side effect of these pricing pressures will be that businesses will also focus on other opportunities to make savings and reduce costs in other areas or consider more innovative value extraction strategies.

Focusing now on the issues pertinent to business in run-off, we asked respondents to consider the major challenges facing European insurers with run-off business.

It was unsurprising that the two key areas identified, tied-up capital and operational costs, were consistent with the previous survey and remain closely connected to the pressures being placed on insurance business by the demands of the financial crisis.

As organisations are being squeezed in every direction, there will be greater scrutiny of those parts of the business that are more expensive from a capital perspective relative to the profit that they generate.

As Mark Batten of PricewaterhouseCoopers notes in the survey, Solvency II also has a role to play in exacerbating these pressures. "Feedback from prominent European businesses suggests that they expect Solvency II will be more costly for run-off business from both a capital and profit and loss perspective," he says.

Given that over 50% of respondents expect their run-off business to take at least 10 years to reach natural expiry, the capital costs associated with holding this business, as well as the administration costs could be significant. The convergence of the financial crisis alongside the preparations for Solvency II, may lead to more European insurance businesses looking to exit run-off portfolios as a means of both unlocking value and reaping the dual benefits of freeing up capital and reducing the costs associated with the administration of running off the business.

The results of the survey indicate a greater convergence of views from respondents from both Europe and the UK in terms of the definition and management of run-off business, with 85% of respondents now defining run-off as "lines of business that are no longer written" and almost 70% of respondents managing their run-off business as a separate business unit or in a distinct run-off entity.

One area where views of UK and European respondents appear quite different was in response to the question of what is the single most important issue influencing your ability to gain finality for your run-off liabilities.

A total of 34% of European respondents considered that long-tail claims are a barrier to this, compared to only 15% of UK respondents. As identified in our previous survey, a "typical" European insurance organisation is more likely to have written mainly domestic risks with some exposure to other International risks.

By comparison, UK insurance organisations, through the London Market's position as a main centre of underwriting for major global insurance and reinsurance business, including APH business, might be considered to on average have a longer run-off tail than Continental European businesses.

Consequently, one might expect the long tail barrier to have been felt more keenly by UK organisations. However, it is likely that the familiarity of UK respondents with long-tail claims and applicable exit mechanisms such as via solvent schemes has resulted in UK respondents being less concerned about long-tail liabilities.

As these exit techniques, which include comprehensive methodologies to evaluate long-tail claims, become more widely understood and used it may be that the perceptions of European insurers of long-tail claims representing a barrier to exit begin to reduce.

In addition, 61% of European respondents and 44% of UK respondents consider that the United States will be the location from which major claims exposures for European insurers will emanate from over the next five years. This perception may also be impacting on views as to long-tail claims representing a barrier to exit.

Types of claims

We also asked respondents what they think the major claims exposures will be for European insurers over the next five years, which yielded some interesting results, especially when considered in the context of the experiences of the run-off market.

The survey found that the current issues of the financial crisis and climate-related claims (e.g. floods and hurricanes) are the most pressing claim concerns - 30% of respondents cite climate related claims, and 28% and 16% view the financial crisis and D&O claims respectively as the chief source of claims over the next five years. This compares to 19% of respondents who considered asbestos-related exposures to be the main source of claims.

These types of latent exposures should not be overshadowed or ignored relative to live market issues and shorter tail claims by the many European organisations that have both live and discontinued portfolios under management. Balancing current and legacy issues is a core challenge to management and dealing effectively with long-tail legacy claims is a critical element of any run-off strategy.

The survey indicated that a significant proportion of respondents have a strategic run-off plan in place for their discontinued business. This is encouraging news - but plans need to be challenged to ensure that they embrace the full range of options available for dealing with run-off business and maximising the value associated with it.

Frequently plans revolve around a strategic commutation programme which, while achieving finality on a piecemeal basis, will not deliver an overall end game for exit.

As organisations strive to manage the complex challenges presented by current economic conditions and begin to consider in detail the capital implications of Solvency II, run-off business represents a potential area of value.

Those businesses that recognise this potential are seeing the benefits of formulating sophisticated exit strategies that enable them to extract value, redeploy capital to core business activities and reduce administration costs.

- A full copy of the survey summarised in this article, is available at www.pwc.co.uk/eng/publications/unlocking_value_in_run_off_2009.html.

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