8 September 2020ArticleAnalysis

Embrace your legacy

The run-off business remains a relatively misunderstood corner of the reinsurance industry. Sometimes characterised as vultures, waiting to feast over the carcasses of other insurance providers, run-off practitioners themselves balk at such imagery.

Run-off is about helping insurers manage their liabilities, say the people working in the business. While it has often been seen as an end point for insurers—a finality solution—it is also increasingly being used as a way to help insurers change strategic direction, by taking legacy liabilities off their hands, freeing up capital to be deployed elsewhere.

“Run-off is about yesterday’s underwriting, which is something all insurance companies have to think about,” says Carolyn Fahey, executive director at the Association of Insurance and Reinsurance Run-off Companies (AIRROC).

Paul Corver, group head of M&A at Randall and Quilter (R&Q), adds: “Run-off is just another form of reinsurance. We offer protection against claims volatility and provide capital relief. The only difference is we cover retrospective risk, rather than prospective risk.”

“I don’t like the word run-off, it is too associated with distress, it sounds like all we do is close portfolios down,” says Dan Linden, deputy chief executive at SOBC DARAG in Bermuda.

“Legacy is a better term for what we do: we take on legacy portfolios and allow our clients to adapt their businesses. We generate a profit from those legacy portfolios. It is all about partnerships.” Run-off—or legacy—has fared relatively well during the COVID-19 pandemic.

Matt Kunish, who leads the actuarial and business development groups in the US at Riverstone, explains: “COVID-19 has had no real impact on the run-off business. You don’t need to be in the office to do run-off transactions, and at Riverstone in particular we had all the infrastructure in place already for remote working.

“We can do most of the work internally—we do not need to rely on external service providers.” As with other parts of the re/insurance industry, the pandemic has forced run-off providers to embrace new technology and new ways of working.

“There is certainly a silver lining to the lockdown in the sense that we have discovered a new way of communicating, which may be a long-term benefit to the industry,” says Kunish.

“When recruiting, for example, we can certainly look to cast a wider net, we can hire people even if they are not based near one of our offices. The more sophisticated players are certainly in a better position to take advantage of these trends.”

Demand had been increasing before the COVID-19 crisis hit, but many expected volume to decline in Q2, as the world went into lockdown. That did not happen.

According to Victor Nelligan, a senior manager at PwC, speaking at the virtual third annual AIRROC and Mayer Brown Run-off Deal Forum in June, 20 public deals had been done in 2020 as at June 10. This involved $2.3 billion of gross liabilities being transferred, and an average deal value of $155 million. These deals involved the transfer of a wide variety of liabilities.

The business is clearly in the ascendency, but it is better established among commercial property and casualty (P&C) insurance carriers than with captives. However, Fahey says, it is increasingly of interest to captives as well.

“Brokers in particular are more aware of the structures that are available for their clients, and they can see that they may be able to earn additional commission on a legacy transaction,” says Corver.

For companies facing bankruptcy, the captive might be the most liquid asset it has on its balance sheet, making a deal with a run-off provider, which is willing to pay cash to take on their liabilities, a potentially attractive option.

Fahey estimates that of the around 6,100 registered single parent captives globally, around 20 percent are dormant, meaning they are not writing new risk coverage.

“Dormant captives continue to cost their parents money, requiring services such as audits to remain compliant with local regulations. They also have existing policies that must still be honoured.

“Captives have been increasingly interested in run-off solutions, especially as a way of managing these dormant captives,” she says.

Run-off is well established in Europe, but when it comes to working with captives the US, where most of the world’s captives are based or where their risks reside, is king. There are many different forms of self-insurance vehicles in the US, also creating many opportunities for run-off providers.

Corver admits it has taken longer for run-off providers to penetrate the captives space than in the P&C space.

“We have been developing it for years, building up relationships and attending and speaking at captive conferences,” he says. R&Q’s reward for that investment of time and attention is that it has done more than 70 deals with captives and other self-insurance vehicles.

Some providers do not appear willing to put in that amount of effort, given that the captives sector throws up fewer transactions, and those it does throw up are often smaller than those in the P&C space.

However, for those who are willing to work on developing these relationships, the business can be profitable.

“We want to do the best we can for our clients, whether they are single parent captives or group captives, because then they will keep coming back as new underwriting years mature,” says Tom Booth, chief executive of DARAG Group.

“That creates a pipeline of business for us. There are one-off deals as well, but we like to produce repeat business where we can.”

As with everything else in the captive insurance industry, building relationships is absolutely vital.

“There is not a huge amount of shopping around going on in the captives space just yet,” says Kunish.

“The captives industry is relatively old-school in that way, it’s about who you have a relationship with and who you’ve had a good experience working with in the past. That works better on small transactions anyway, where there is less scope to compete on price.

“The bigger the deal, the more opportunity there is for providers to compete on price.”

Pricing is determined by competition, but also by who is bringing a deal to the market, Kunish adds.

“If it is being driven by a big reinsurance broker there will likely be more competition for the deal, which will drive down the price. If it is being driven by a law firm, for example, the deal is more likely to be passed to a trusted party the firm has worked with before, which may not be for the most competitive price.”

Corver argues that it will be difficult for new players that are not already versed in the ways of captive insurance to enter the space, without their putting in the same effort in terms of getting to know the people and trends in the industry.

“You need experience of having worked with captives,” Kunish agrees. “It means you may not be working with insurance people, you might be working with doctors, or people from whatever industry the parent company is in.”

Linden, however, plays down the difference between working with captives and commercial insurers, insisting many P&C insurers need an amount of hand-holding similar to their captive peers’.

“P&C insurers may be more familiar with insurance but they don’t necessarily have a legacy mindset,” he explains.

“Captives tend to be just as sophisticated as our other clients when it comes to risk management,” adds Booth.

“They often have very experienced service providers working with them, and we have good relationships with a lot of those institutions.”

Captives are picky about the counterparties they work with, he says.

“The reputation of the counterparty is crucial because captives need to know the claimants will be protected from a disruption in claims handling,” says Booth.

Corver adds: “At R&Q our policy is usually to leave the claims handling function of acquired portfolios with the current incumbent, whether that be a third party administrator, front company or the captive parent. This would be supported by a layer of oversight and authority sign-off from us.”

Linden likens being a legacy provider to being a value investor. “Like a value investor we are looking for opportunities that offer pockets of value,” he says.

Booth elaborates: “It is sometimes said that everything can be done at a price but I don’t believe that. Some things just cannot be priced accurately, at which point it’s about gambling and there is a broad range of possible outcomes.”

As a legacy provider it is difficult to do what an underwriter does, in terms of selecting deals in order to diversify the business by things such as geography and business lines, says Booth.

“You can focus on certain types of business that you like, but it doesn’t make sense to reject a deal because it is too like others you have done before. It is more about pricing the deals you do well,” he explains.

Corver says R&Q looks to transact across different lines of business, but emphasises the importance of being comfortable with the risks being assumed.

“Generally the classes transacted will be medium to long tail in nature,” he says.

“We tend to assume liabilities such as workers’ compensation, general liability, medical malpractice and commercial auto. We also take on professional indemnity, but you don’t get many captives writing that.”

Booth says DARAG sees the opportunities that offer a lot of data as the best ones.

“The more data we have, the easier it is for us to have some certainty about the state of the reserves,” he says.

“More mature underwriting years tend to be less volatile, but that depends very much on the line of business, and smaller retentions also tend to mean less volatility.”

Meanwhile, the hardening market is creating more opportunities. Between increases in rates, and the difficulties businesses face covering such lines as business interruption and trade credit, there is bound to be an increase in self-insurance, says Corver, and by extension more business for legacy and run-off players.

“Captives may need additional capital, but the parent may not want to put up fresh capital,” he explains.

“The alternative is to remove old liabilities from the captive’s balance sheet via a loss portfolio transfer and recycle the capital, or the collateral that was supporting those liabilities.”

Linden adds: “As rates harden across all lines, there can be opportunities with captives that are trapped with a particular partner because all their collateral is tied up with them.

“They might be looking for a way to get out of that arrangement and shop around for a better rate. Legacy can help them shift their business to where they can get a better rate.”

He agrees that the increasing number of captive launches might create new opportunities.

“Two years from now some of those captives owners may be asking themselves why they launched a captive,” says Linden.

“They may be bleeding profits through fees, for their actuaries and their other service providers.

“They might have collateral tied up with their fronting partners, who will hold collateral for as long as they are exposed to the liabilities. They may end up looking for a way out, which can be an opportunity for legacy.”

“Some companies are tapping their captives for liquidity and it is possible that in some cases that could create distressed situations among captives, which could create opportunities for run-off,” adds Kunish.

The first half of 2020 was a particularly busy period for legacy providers, and Linden is not expecting things to slow down much in the second half of the year.

“We are going to see premiums falling and profitability falling, and adverse developments increasing,” he predicts.

“That is going to create opportunities for legacy as insurers look to offload old books of business.”

Meanwhile, on the corporate side there may be companies that have been protected by government programmes which need to find another solution as those programmes come to an end, he says.

“Further out, in 2H 2021 and into 2022 there is going to be an increase in activity resulting from all the distressed situations, which will lead to mergers and acquisitions and companies tapping their most liquid assets: their captives.”

Kunish says: “Business people are currently distracted with COVID-19 so there may be a lull in activity later in the year. It may be that 2020 is characterised by businesses figuring out where they are with their risk exposures, and 2021 being the year we see more interest in run-off solutions in the captives space.”

Riverstone sees opportunities for the distressed and the strategic uses of run-off at the moment, says Kunish.

“Before COVID-19 we were seeing the balance of business shifting towards greater strategic use, but the pandemic is creating a lot of distressed opportunities, so that may tilt the balance back a little, temporarily.

“It is too early to see exactly what impact COVID-19 will have on the market,” he concludes.