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30 March 2017Analysis

Creating value from captives in runoff

Randall & Quilter (R&Q) has been very active in the runoff market for a number of years.

It has signed over 45 transactions since 2009, with 24 of these involving captives, 15 of which being acquisitions. Other transactions were either novations, reinsurances or transfers where the owner did not want to sell, but wanted to remove legacy liabilities.

In December 2014, R&Q acquired two Bermuda captives in runoff from Unilever. It then announced the acquisition of IC Insurance, a UK runoff captive in May 2015, completing the transaction in September 2015.

In March 2016, R&Q acquired the Rank Group captive in Guernsey. The company obtained pre-approval for change of control from the GFSC. The entity was merged into Capstan, R&Q’s Guernsey runoff consolidator.

And in March 2017, R&Q announced the purchase of the captive ICDC (US, VT) from Cummins, an American Fortune 500 company, as well as the acquisition of Linco, a Bermuda captive insurer of Ameripride Services and Alsco.

R&Q’s business model works due to its ability to create value for both sellers of captive insurance companies in runoff as well as for R&Q from the positive arbitrage from the sale, according to M&A analyst Tom Dixon.

The idiom of “Don’t just do something; stand there!” does not apply to captives in runoff.

Dixon tells Captive International that by selling a captive in runoff, the owner frees up trapped capital and management time, which enables them to focus on their core business.

“As well as the capital drag and time cost, discontinued captives are often loss-making before we buy them, so there are several key reasons to sell,” says Dixon.

“The rationale for R&Q wanting to buy these companies comes, in turn, from the value we are able to create for ourselves. R&Q generates its returns by focussing on both the assets and liabilities of the captive and applying the experience and expertise of our staff. As the liabilities run off, surplus capital is distributed and redeployed into new acquisitions.”

With risk carriers within key jurisdictions of the US, Bermuda, the UK and Europe, R&Q post-acquisition will re-domicile the newly acquired captive and merge it into one of these consolidation vehicles.

If this is not achievable – such is the case in the UK – then R&Q will transfer the policies out of the captive into another R&Q company before dissolving it. The obligations to the policyholders are transferred as part of the process and we continue to settle claims as before.

If the captive is in a new jurisdiction where R&Q sees more opportunities rising, it will retain the captive as a standalone entity.

No longer fit for purpose

A captive insurance company can end up in runoff for a variety of reasons, especially as there are captives that were set up a decade or so ago when insurance rates were much higher.

The low rates available in the market may have meant the captive was no longer economical or worth the effort, especially when a third party will underwrite and administer the policies at a more attractive price, says Dixon.

Furthermore, Dixon suggests that a captive could have been orphaned after M&A activity or intragroup restructuring, resulting in more captives than are needed.

Not only this, but against a backdrop of increased regulatory and tax scrutiny, Dixon says that making and running a captive is becoming a more onerous undertaking.

“The governance and reporting requirements, while demonstrating the captive is a genuine risk carrier to manage the lower layers of a group’s insurance exposure is seen by several captive owners as no longer worthwhile,” says Dixon. “Capital charges for legacy liabilities under Solvency II are materially more punitive than under the previous regime.”

Dixon says that while the pros and cons of establishing a captive or putting it into runoff will vary by company, these are the common themes seen at R&Q.

He stresses the need to continually monitor and evaluate captives and a company’s insurance programme in general.

When a captive is ignored and no decision about its future is made, Dixon says he often sees very seasoned run off captives where costs have eroded the capital base requiring (often repeated) capital injections to ensure solvency requirements are met.

“These situations are entirely avoidable. If runoff is the answer, then the sooner the runoff market is engaged, the more value we can offer. The idiom of ‘Don’t just do something; stand there!’ does not apply to captives in runoff,” says Dixon.

The value of runoff

When examining the value that a captive insurance company has in runoff, Dixon identifies three areas where R&Q are able to take on a loss-making captive in runoff and turn it into a profitable opportunity.

Firstly on costs, Dixon suggests that standalone captives in runoff typically lacks scale, which prevents it from being operated in a cost efficient way.

“As a run-off consolidator, our risk carriers can take on additional insurance liabilities using existing resources at little additional operating cost.”

Secondly, passively-managed discontinued captives tend to take longer to runoff than R&Q can achieve as there is no active claims management strategy in place, according to Dixon.

The claims management for a captive in runoff is often outsourced to a third party supplier of captive manager who pays claims as notified with little loss adjusting taking place and are often remunerated on a time plus cost basis, with little to no incentive to settle claims quickly.

Dixon suggests that proactively commuting liabilities and focusing on loss allocated expenses enables R&Q to generate value from the loss reserves, while continuing to pay all valid claims.

“Ensuring policyholders are looked after post-acquisition is key to our reputation as a legacy partner and a key reason so many corporates have sold their run-off captives to us,” he adds.

Third and finally – in order to preserve capital, but at the expense of investment income – the investments in captives in runoff are often invested in a combination of cash, money markets and gilts, bonds and treasuries.

“We will typically realign the portfolio into investment grade fixed income (where permitted by the fronting carrier) with low volatility, balancing the need to preserve capital and ensuring we have the liquidity needed to settle claims while also generating investment income,” he says.

Prior to the acquisition, Dixon says that due diligence is key to ensure R&Q can deliver its objectives both for sellers on for themselves. Post-acquisition, R&A focuses on costs, claims management and investment management.

More on this story

21 April 2017   Randall & Quilter, a specialist non-life insurance investor, has almost tripled its profits in 2016, which can be attributed to the 15 legacy transactions completed during the period, as well as further net reserve releases from insurance companies in run-off.

More on this story

21 April 2017   Randall & Quilter, a specialist non-life insurance investor, has almost tripled its profits in 2016, which can be attributed to the 15 legacy transactions completed during the period, as well as further net reserve releases from insurance companies in run-off.