Carolyn Fahey of AIRROC and James Cameron of PwC UK discuss the current state of the run-off market, and how legacy solutions can be utilised to help insurers take advantage of the hardening market
In the current environment of a hardening insurance market, both insurers and reinsurers are exploring how to best benefit from the run-off process by diverting their capital towards emerging profitable areas through legacy solutions. With this heightened interest in the run-off market, legacy business has seen increased activity on both the sell- and buy-side. Going into run-off is one of several resolution options available to insurers (alternative solutions include portfolio transfer, liability structuring, insolvency and liquidation) in which a company is closed to new business so that liabilities will ‘run off’ over time, while continuing to observe existing contracts.
Run-off is advantageous for insurers because it allows more time to attempt to recover viability and solvency. Since viabilities are often long-tail (meaning risks can emerge over time during an extended settlement period), during run-off insurers are able to exit the market over a longer timeline than banks, as well as being less susceptible to fast-burn failure.
It is estimated that global non-life run-off liabilities rose to US$864 billion in 2021, according to PwC’s global insurance run-off survey published in February this year alongside the Insurance and Reinsurance Legacy Association (IRLA) and the Association of Insurance and Reinsurance Run-Off Companies (AIRROC).
Carolyn Fahey, executive director at AIRROC, notes that this marks a 17 per cent increase in global non-life run-off liabilities since 2018.
“Run-off continues to make progress in being recognised as an integral part of the insurance cycle. Insurance companies and captives are looking at the creative and flexible solutions that run-off provides as ways to better manage their portfolios,” she says.
Furthermore, PwC’s survey predicts that the three largest territories (mainland Europe, UK/Ireland and North America) will continue to observe a similar or higher level of activity in legacy deals over the next two years compared to the previous two years, with 77 per cent of North American respondents indicating that they expect a greater increase in activity.
Run-off in the US alone increased by $37 billion, which PwC attributes to growth in motor and property and casualty (P&C) lines of business. Furthermore, the survey finds that the US alone holds reserves of $402 billion, while the UK, Ireland and mainland Europe have combined reserves of $302 billion.
Crucially, the majority of respondents say they believe that the global legacy market is in the growth stage of its evolution, with only 10 per cent stating they believe it has reached maturity.
This current interest in the run-off market is affirmed by James Cameron, senior manager at PwC UK. He says: “The run-off market remains in good health and has not seen any significant adverse reaction from the COVID-19 pandemic. Indeed, deal activity in 2020 was strong and on par with record deal levels in 2019, with a wide variety of sellers and buyers completing deals.”
“In addition to deal activity, legacy management within groups continues to feature as a priority. We continue to see clients seeking to optimise portfolios, obtain capital relief and deal with legacy books, and it is important to note we continue to see a diversification in the types of liabilities being put into run-off and transacted,” Cameron continues.
He also observes a recent “significant influx” of capital across the run-off market following the establishment of several start-ups looking to deploy capital. As well as this, there has been an increase in partnerships between new investors and chartered industry professionals, which Cameron says is “testament to the strength of the market and the returns that have continued to be made”.
“The outsourced execution managed services (EMS) option is rising in popularity, particularly where specific resources and costs are being retained within a captive beyond its useful date. At the other extreme, organisations are also choosing EMS where insufficient resources or specialist skills are not available should significant claims activity be experienced.”
Cameron identifies that as a result of heightened interest in legacy solutions, the run-off market is attracting greater interest from regulatory bodies. For example, the European Insurance and Occupational Pensions Authority, Prudential Regulation Authority and Financial Conduct Authority have all issued consultations in recent months.
“As the market becomes more sophisticated this is to be expected, and we will see players continuing to focus on their operational capabilities and reserving to ensure that policyholders are protected to the satisfaction of regulators,” he adds.
Why run-off?
There are a variety of reasons for which a company may select to enter run-off. It could be strategic, for example, to halt writing business in an underperforming jurisdiction or line of business or distribution channel as part of an evolving group strategy. It could also be financial — to address fiscal issues such as the inability to raise new capital or persistent losses in a specific area.
Alternatively, a firm may go into run-off under an approach of capital management in order to redirect capital to its core businesses to ensure capital optimisation.
Some parent companies are exploring the option of putting portions of their captive structures into run-off. While such transactions were historically perceived in a negative light, they are now generally better understood as a natural progression in the lifecycle of a company. This altered attitude is helped by the advantages of going into run-off, such as freeing up capital to allow companies to adapt and grow their lines of business according to the needs of their policyholders.
Cameron adds that run-off is particularly beneficial when taking advantage of the hard market: “Going into run-off puts an end to the ongoing commitments underwritten in a particular portfolio or entity; with a hard market, many underwriters are increasingly reviewing the classes of business in which they operate to maximise their opportunities from their most profitable lines.”
“Run-off solutions can provide capital relief to allow insurers much greater flexibility to take advantage of market conditions as well as providing a home to unwanted portfolios that may be a drag on the business,” he adds.
In the specific case of the captive insurance industry, run-off strengthens the capital efficiency of the industry as a whole because it allows captives to relieve themselves of business that has failed to keep up with the original purpose of why the captive was formed by the parent company.
Fahey explains the reasoning behind putting a captive insurer into run-off: “When it is more difficult to find affordable insurance for emerging risks in a hard market, corporations might look to their already-formed captives to insure their risks — or look to create a new captive.”
“Exit solutions help free up capital and capacity so that captive owners have the space to take on more risks for their parents. The use of captives has continued to increase as companies look to self-insure risks. In this case, considering an exit solution is a very smart move for captives and a strategic portfolio management tool.”
Specific motivations for putting a captive insurer into run-off include changes to lines of business or geographic operations, or the introduction of new regulation and compliance requirements that diminish the advantages of captive ownership.
In addition, favourable pricing in the commercial insurance market, changes to long-term group captive participants, and duplication of captive services as a result of mergers and acquisitions (M&A) activity are several other reasons why a captive insurer may be put into run-off.
However, it is also important to note that run-off can also be preemptive; a company does not have to be in, or anticipating, financial troubles in order to enter run-off.
Aims of run-off
In terms of the objectives for a company putting a captive entity into run-off, policyholders wish to retain their insurance cover so that claims can continue to be submitted and payments continue to be received. Solvency is also important, to ensure that the system of asset distribution among creditors is fair to both existing and future claimants.
“One of the key features of any exit strategy is that the options are flexible, and the parties involved (the captive owner and a run-off provider) can work out a structure that makes sense for all involved in the scenario. In the end, the key objective is finding a way for the captive to find finality and the solutions that will allow the captive to serve the purpose that it was intended for — to handle the risk for the parent,” comments Fahey.
Cameron identifies that the two fundamental aims of run-off should be to make the most efficient use of capital held by a captive, and to reduce the company’s exposure to risk.
“By entering into run-off, it may be possible to reduce the level of capital required to be held by the captive and obtain a better return on investment with such capital being able to be deployed in more promising business or core activities,” he explains.
“The recent pandemic has led companies to reevaluate their business models and, as a result, we see a greater focus on companies seeking to structure their risks more effectively and streamline their operations. There has been much greater focus on reducing unnecessary expenses, and operational costs of a dormant or unutilised captive is one of these areas.”
Cameron highlights that entering run-off may only be the beginning of a journey. This is as corporations are becoming increasingly aware that there exists an active market for captive disposal which allows them to recover value and avoid the cost of running off a captive insurer over a longer period of time.
Features of captive run-off
Fahey considers the two most important gains for a company putting a captive into run-off to be flexibility and finality. “Exit solutions provide captives the chance to shed old liabilities and focus on new opportunities and the needs of their parent companies. Run-off providers have the expertise needed to assist,” she explains.
Fundamentally, captive run-off benefits firms because it eliminates the capital burden from writing new business, and reduces the costs associated with distribution and onboarding new business. More generally, insurance run-off also prevents new policyholders from being exposed to the firm, and alleviates strains on expenses, as captives intend to reduce their fixed costs and manage their outsource providers.
PwC’s Cameron elaborates: “Poorly managed captives represent a lost opportunity and cost burden. Proactively managing exposures and claims through run-off can provide risk management as well as financial benefits. This may well involve outsourcing of claims but, as outlined above, we are seeing an extremely active market for captives in run-off. This provides an opportunity to release capital through a share sale or reinsurance solution, where claims reserves are transferred to a run-off reinsurer in order to achieve finality.”
Furthermore, Cameron adds that if the sale of a captive in a run-off is not desirable, there exists other solutions, such as releasing the captive from its contractual responsibilities — usually through a novation of the insured risks — which allows the captive owner to close the captive and return any residual assets to the parent company. Alternatively, in place of direct run-off, a captive can utilise a reinsurance solution in which claims reserves are transferred to a run-off reinsurer, or use an outsourcing agreement to streamline claims management and improve cost efficiency within the captive.
It is prudent for captives to bear these alternatives in mind as there are some challenges associated with achieving successful run-off. Prospective issues range from the reputational and market effects of larger companies withdrawing from the market, to having an asset profile with a high proportion of illiquid assets.
There is a potential risk of capital erosion if companies are unable to cover the fixed expenses from their reduced business offering.
Looking specifically at captives in run-off, in the context of the talent crisis it is challenging to attract and retain new staff in passive run-off captive firms.
AIRROC’s Fahey explains: “When captives start to consider pursuing an exit strategy, any number of things can slow down the process. A few worth mentioning are that it can take time for a risk manager to get support from above, as we are all pulled in many directions so other priorities can distract the seller, while regulatory hurdles can be another consideration.”
“In addition, a misunderstanding of the benefits of a run-off could come into play — the owners may not understand insurance well enough to appreciate the benefit of gaining certainty over long-tail exposures,” Fahey adds.
Cameron points out the potential risks relating to the quality of legacy data and systems: “Poor quality data or poor-performing legacy systems can lead to inefficiencies of managing portfolios, increased administrative expenses, incorrectly reserved or capitalised books of businesses, or simply an inability to understand the risks of each book.”
He notes that insurers can best prepare themselves to address the potential risks to achieving successful run-off by having clearly mapped reinsurance arrangements, as well as efficiently handling claims management and reinsurance recoveries to ensure claims are paid and reinsurance proceeds are collected promptly throughout the run-off period.
“Robust reserving for future claims is critical in order to avoid surprises and additional capital needing to be committed to the captive.”
“Good knowledge or access to advisers who know the local claims and litigation environment for each line of business is important to mitigate the risks of nasty surprises in the future,” Cameron advises.
Predictions
Looking forward, Cameron expects the run-off market will continue to grow, and capital will be made available to facilitate this. He notes this expectation is reflected in the responses from PwC’s survey, as well as the completion of two insurance business transfers in Oklahoma which signal growth for the legacy environment.
“Specifically, we expect to see continued focus on legacy in the Lloyd’s market, while distress in the corporate world may identify more captive disposal opportunities and Brexit will continue to see some portfolios earmarked as potential legacy deals,” Cameron says.
“Where historically run-off specialists provided traditional loss portfolio transfers or share sales, there will be an increase in more bespoke adverse development cover solutions, which provide more structural flexibility for insurers and reinsurers who are assessing their capital management strategy, especially given the current market conditions,” he adds.
As the run-off market is expected to continue to flourish as the demand for legacy transactions remains in a pandemic-impacted world, Fahey reflects on the lessons learned from COVID-19: “One of the things that I have learned in the last 18 months is that we all need to be creative and flexible and work together to be successful. These are all elements of run-off that are key and have been in place since the concepts around run-off were formed decades ago!”
“At AIRROC and beyond, I have no doubt that the momentum behind our many years of experience will continue to serve us well as we offer more and more options for captives and the full insurance industry,” Fahey concludes.
