Guy Carpenter: Mitigating exposure to run-off liabilities

Guy Carpenter’s Rob Collins, Jesse Sommer and John West discuss options for captives when they stop writing new business and are left to manage the resultant run-off­ liability

 

In the captive universe, the word ‘run-off’ has been used historically to describe a captive insurance company no longer writing new business.

The remaining function of that captive is to manage the resultant liability. However, that notion has changed dramatically over the past few years.

‘Run-off liability’ is a phrase that actually refers to the obligations of a captive that arise when a portfolio of business has been evaluated, priced and underwritten.

These obligations encompass not only the liabilities arising from known and unknown reserves (outstanding reserves and incurred but not reported (IBNR) values), but also other relevant factors.

For instance, consideration must be given to administrative costs associated with managing these liabilities and the amount of collateral required to safeguard against insolvency, to name a few. Another ‘cost’ created by run-off liability is opportunity cost.

For what other purpose could that captive owner be using the capital committed to supporting these liabilities? While a captive can be in a state of runoff or dormancy, it is also very important to recognise that clients can use a variety of financial strategies to mitigate their exposure to known or future liability without thinking the whole enterprise has to be closed in order to do so.

If an underwriting year(s) produces future loss estimates of at least $1 million, that portfolio can be transferred. Typically, the party considering the transfer (the captive owner) will want to consider how to best mitigate that exposure so they can continue focusing on their live business.

That consideration usually takes place at least three years after the underwriting year has expired. Run-off liability within a captive can be transferred to a third party through three primary mechanisms: novations, loss portfolio transfers and acquisitions.

Novations provide full legal and financial transfer of the liability. Loss portfolio transfers provide financial finality through a reinsurance contract. Stock acquisitions allow for a full divestment not only from the liabilities, but also allow the captive owner potential revenue based on the value of the captive’s intrinsic value.

The client has a truly valuable resource in its reinsurance broker who serves two vital roles: advising and executing. Indeed, a broker must not only have the knowledge of what the relevant markets are to these transactions, but also which of those markets are a good match for the client’s needs.

Furthermore, by acting as a central hub for potential bidders, the broker can leverage its position to encourage competitive pricing from legacy buyers.

The broker plays another crucial role by assembling historical loss data and providing proprietary analysis and loss projections.

These functions are essential for any transaction as they ensure that all parties, at a minimum, have a shared understanding of historical patterns concerning the years being transferred. By establishing a common starting point, the execution risk of the transaction is reduced significantly.

Projections for future loss development encompass a comprehensive examination of macroeconomic trends, such as economic and social inflation, discount rates and other relevant factors specific to the industry.

These factors are carefully weighted alongside the client’s own experience to generate a reliable loss projection. The client then can use this projection to evaluate the reasonableness of the bids received from the market.

Any legacy transaction is going to involve an upfront payment to an acquirer of the liabilities. Clients can work with their broker early on to determine whether such a payment is viable.

Is your letter of credit backed by cash? If so, the transaction might be particularly advantageous.

If not, does your company have the financial strength to proceed with a legacy transfer? Would an alternative structure (selecting older years, adding a ‘rolling’ feature, etc.) be a more effective approach?

Over the years, Guy Carpenter has developed analytical tools and a deep database of information to enable detailed discussions with captive owners and reinsurers.

This work helps safeguard proper understanding and effective communication to reinsurers of exposures and loss projections, ensuring that the best possible terms are delivered. The market of legacy acquirers can range from traditional insurance companies to insurance carriers who only focus on legacy (run-off) transactions.

In total, all of these are referred to as ‘the market’. To keep things simple, these markets are also referred to as ‘the buyer’ when speaking of legacy transactions. The implication is that all of these markets are taking on the risks from the counterparty, or seller (captive owner).

Here are a few examples that illustrate how the three fundamental transaction forms have been successfully employed:

  • Novation: A captive risk advisor identified an opportunity for one of their group captives. The objective was to lock in gains from prior years while eliminating future risk associated with market and inflation uncertainties. The seller decided to carve out three underwriting years and novate them to a counterparty. The group achieved full legal and economic finality through a novation at a discount to booked reserves, thereby locking in prior gains and transferring all future risk to a third party. The undiscounted reserves were $31 million, discounted reserves were $25 million, and the expense load was 10%. Gross premium was $27.5 million and the net capital gain was $3.5 million.
  • Loss portfolio transfer: A client has a large deductible plan and their objective was to eliminate disputes with the carrier around collateral and gain future protection against adverse loss development due to inflation uncertainties. A loss portfolio transfer was transacted, providing not only relief from future economic uncertainty, but the acquiring market worked with the bank to replace the client’s collateral assets with its own balances, freeing up the client’s capital assets. The undiscounted reserves were $6.1 million, discounted reserves were $5.6 million, and the expense load was 10%. Gross premium was $6.15 million and the net capital gain was less than $50,000.
  • Acquisition: a hospital owned a captive domiciled in Barbados. The hospital was in financial distress and was to be absorbed into a larger hospital group. However, one of the contingencies of the deal was that the hospital sell its captive prior to the merger. The hospital administrator did not realise it was possible to sell the captive. After initial discussions with an interested acquirer, an acquisition was made of the captive and the hospital was subsequently merged into the larger group. The deal was valued at $12 million.

In each of the examples given, it was the role of the broker to find a party who was interested, capable and willing to offer a reasonable price.

These objectives highlight another benefit of using a broker – advising the client on how many markets to approach for bids on a single project. In simple terms, the number of bids to solicit depends on the size and complexity of the transaction at hand.

If you picture an inverted pyramid, the point represents the size of the deal value. At the smallest point, it may be prudent and efficient to bring one qualified market to the transaction. As the deal size increases, there is value in having multiple markets bidding.

However, once the deal size is extremely large, it then makes sense to work with only three or four markets, as they are then the only ones who are large enough to transact at that size.

12 August 2024
5-6 November 2025

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