Runoff strategies can help captives adjust to post-COVID-19 world: CICA
The COVID-19 pandemic is set to increase the use of runoff solutions, as companies and insurers alike review their risk exposures and adapt their businesses to cope with new economic and social realities.
That was the view of a panel of experts talking on a Captive Insurance Companies Association (CICA) webinar, titled “Runoff and Exit Strategies for Captives”.
“Boards are going to be auditing their risk committees and thinking much more about ‘black swan’ events,” said Steve McElhiney, senior vice president and director of reinsurance at Artex Risk Solutions.
COVID-19 is just one of many emerging risks that companies are increasingly having to factor into their business plans. This will increase demand for new types of coverage, which insurers will be able to provide only by freeing up capital currently deployed in other areas.
Companies use runoff as a way to free up that capital, which can facilitate moves into new lines of coverage, or create space to write more policies for existing lines.
By handing liabilities to a third party, a captive—or any other insurer—frees up the capital held as a reserve against them, which can be deployed somewhere else.
Traditionally seen as a way for companies to offload ailing parts of the business, the emphasis of the runoff business has shifted in recent years, with a greater emphasis now on using it as a tool to increase capital efficiency, said McElhiney.
“Runoff has grown from a cottage industry to being, in 2020, a strategic tool that is part of the arsenal of every insurance company around the world,” he said.
He believes runoff will become increasingly important to insurers of all types, for example in response to a growing number of obesity suits against companies such as fast food chains and snack manufacturers. This may force insurers to reduce their exposures to this risk, in much the same way they did with asbestos claims in the past, with runoff being a way to pass the exposure off to institutions better equipped to manage it.
Captives have traditionally played a leading role in guiding the insurance industry into emerging areas of risk management, in areas such as cyber, cannabis, climate change or pandemics. In order to have the capital on hand to open up those areas, they will need to ensure their capital reserves are managed efficiently. A good way of doing that is by offloading old liabilities via runoff deals.
Carolyn Fahey, executive director at the Association of Insurance and Reinsurance Runoff Companies (AIRROC), estimated that of 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 runoff solutions, especially as a way of managing these dormant captives, said Fahey.
Michael Terelmes, chief financial officer at Sirius Global Solutions, advised captives to think about runoff as early as during the formation process.
“Success is better defined by how you finish something than how you start it,” he said.
“It is important to know your exit strategy right from the beginning, it helps to make the decision-making process more strategic.”
Regulators like to see runoff transactions, added Terelmes. “They want companies to look for alternative ways to use their capital, they like to see capital being used efficiently. Regulators want captives to be successful and they will support you.”
He advised captives thinking about entering a runoff transaction to employ counsel to help guide the process, with legal documents tending to be more complex than standard reinsurance agreements.
As well as being a great business opportunity for captives, it is a profitable business for reinsurers and other runoff service providers, said Terelmes. Institutions dedicated to runoff, or with dedicated runoff businesses operating within them, such as Sirius, may have greater resources than a captive to reserve for an old portfolio of liabilities, which can be profitably managed, he explained.
“Companies buy these old liabilities for the same reason that banks buy old debt, or people buy old baseball cards: because they see value in them,” he said.
Pricing is broadly determined by four factors, said Terelmes: what the expected ultimate reserves of a portfolio will be; the timeline on which those reserves will be paid out; the investment income those reserves can generate before being paid out; and the cost of managing the claims.
“Overall, it is about when and how much money will be coming in and when and how much will be going back out,” he said.