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The Actuary The magazine of the Institute & Faculty of Actuaries
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Solvency II: Running it off

A change in lifestyle happens to all of us over time as we evolve from a working environment into well-deserved retirement, and it often happens to companies at some stage, with insurers being no exception.

At first sight, there is little difference between an insurer writing new and renewal business and an insurer that has ceased such activities and is in run-off. The former would seem to be the latter plus the function of writing new and renewal business. Data quality is the key issue for both but, thereafter, there are significant differences. The emphases of the two types of insurers are different in most aspects of the business.

Effective, efficient and focused capital management is vital to a successful run-off insurer, whereas attributes of new business are the focal point and the most relevant issue for ongoing insurers. Expenses of running off the claims are the most important expense item for run-off insurers, whereas commission and other new business and renewal expenses dominate for ongoing insurers. More importantly, the uncertainty and risk relating to reserves are key for run-off insurers but they are normally of far less relative importance for ongoing insurers, where underwriting risk is usually the main focus. However, for some ongoing insurers — such as those with disproportionately large reserves as compared to current premium income or those writing speciality types of business — reserving risk may be more important than underwriting risk.

Solvency II will significantly increase the amount of insurance business in run-off as insurers seek to utilise their capital more efficiently and position themselves for the new solvency regime, and this will add to the enormous amount of reserves (about €200bn in the EU, of which €50bn is in the UK) currently tied up in the run-off market.

In practice, the supervisors will be involved in major discussions with larger run-off entities regarding their capital requirements, as they will have their capital and reserves in place to the Solvency I standards, but in theory they would have to provide far more capital under Solvency II. It is inevitable that the supervisors will be sympathetic to existing run-off insurers and their managers, but those entering run-off in future will be subject to the new and more stringent capital requirements of Solvency II.

Any insurer with gross premiums over €5m or gross reserves over €25m comes within the remit of Solvency II, and this will include most run-off insurers. Proportionally, Solvency II is likely to affect insurers in run-off far more than those writing new and renewal business. Compliance, return on capital and other costs will change the landscape of the run-off market in the Solvency II world.

What do we mean by this in detail and in practice?
While underwriting risk is normally the major contribution to the overall capital requirements for an insurer, it is not an issue for those in run-off. Hence, the other elements increase in relative importance, and especially reserve and credit risk.

It is important to calculate the reserves, both gross and net of reinsurance, as accurately as possible, and to identify and target the specific areas where potential variability may occur. This process will help to reduce the capital required to run off the claims. The reinsurance asset may be crucial, and especially where lower-rated reinsurers are utilised or where more heavily reinsured property catastrophe claims are involved, hence credit risk would be relevant.

Although operational risk would seem to have less importance than reserve and credit risk, it can have a substantial effect on claims expenses in the event of unexpected and unforeseen events. Whereas these are usually a minor irritation for ongoing insurers, they can be crucial for the financial health of an insurer in run-off, where margins are thin. Cash flow and liquidity risk will be affected and geared up by the lack of inwards premiums, and must be carefully planned and monitored. This process should not normally be a major issue if managed properly. Capital requirements for the remaining types of risk will not normally be an issue, but this will depend on the circumstances.

Run-off insurers may be solvent or insolvent depending on whether they are likely to be able to pay their claims and to meet their other obligations. Those in solvent run-off will be more affected by Solvency II as they are expected to pay off 100% of their liabilities (although the requirements of Solvency II may result in a change for some from solvent to insolvent run-off).

The run-off may be natural, although this may be tempered by an active or passive approach to their liabilities. This approach will largely be affected by their attitude to pursuing commutations, both inwards and outwards. The insurers may mitigate their obligations by minimising their net liabilities by means of portfolio transfers or by the purchase of additional reinsurance. Alternatively, the run-off may be structured, say by the insurer entering a scheme of arrangement. The type of run-off and the effects of Solvency II will also be determined by whether the insured business is part of a company or group, or it is a standalone book of business where there is less scope for flexibility.

The type of organisation involved in those communications is important. Maintaining reinsurance protection with top quality reinsurers is capital-efficient, whereas it is far better to commute that with lesser quality reinsurers. On the inwards side, commuting business with greater potential or actual volatility, such as many types of liability business, is more capital-efficient than parting company with the shorter tail reserves subject to lesser volatility, such as most property business, including property catastrophe business.

Long-tailed (eg. liability) insurance business will continue to have claims notified well into the run-off process, while short-tailed (eg. property) business will have far fewer claims notified and the bulk of the movements will be to claims already on its books. This will be reflected within the Solvency II calculations by the effects on reserve volatility.

Some insurers will be wholly UK domiciled and it will be clear that they come within the remit of the FSA, while others will have overseas operations or come within an overseas group. Hence it may be unclear which legislative jurisdiction is involved, and perhaps it will be one with different attitudes to run-off within Solvency II from the UK.

Some classes of business are compulsory, such as employer’s liability, and the run-off insurer will have to deal with such business differently in that it will not be able to commute or transfer without involvement with, and permission from the supervisor. Similarly, the policyholder protection issues for direct business will affect how these policies are dealt with by a run-off insurer given their obligations and those of the funds underpinning the guarantee.

Diversification is an area that presents benefits, but also difficulties, in the calculation of capital requirements, and this will be important for the reserves of run-off insurers within Solvency II, whether it is diversification for geographical, type of business or other reasons.

Solvency I requires very limited regulatory capital for run-off business as the current requirements are for a percentage of premiums or incurred claims. As such, run-off books of business can now be bought and sold cheaply on a best-estimate basis with little regard for reserve volatility or capital requirements. This will change with Solvency II where the capital is dependent on the probability distribution of net reserves. So for a typical run-off insurer, the Solvency II capital may be five or 10 times of that for Solvency 1.

Further, the more volatile the reserves, the higher the capital requirement. This may well mean that just 15% volatility of reserves could lead to a 50% increase in capital. Hence, the annual return on capital demanded within a run-off insurer will increase dramatically in the future, and perhaps exceed 5% of capital, and so it is likely that management of run-off books of business will change as Solvency II approaches.

Portfolio transfers, proactive management, increased reinsurance, more diversification and other features will become far more prevalent and careful attention will be paid to the possibility of the benefits of synergy. Schemes of arrangement to run off the insurance claims portfolio quickly and equitably will become exceedingly popular.

Run-off insurers will be operating in a new and far more intensive capital environment. The message must be for those contemplating run-off to get their data, portfolios, transfers and schemes sorted sooner rather than later before time catches them up.

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Colin J W Czapiewski is a self-employed consultant, a director of Beaufort Underwriting Agency Ltd at Lloyd’s and an actuarial advisor to Charterhouse Risk Management