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The Actuary The magazine of the Institute & Faculty of Actuaries
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Achieving closure

In recent years the biggest growth area in non-life insurance has been ‘run-off’ the winding up of defunct portfolios. The trend is set to continue, with an increased focus on the tools for handling the business. The most recent addition to the run-off tool kit is a mechanism to facilitate portfolio transfers known as the ‘Part VII transfer’ method, which is described below.
Businesses in run-off spell trouble to their owners. Rating agencies, stock analysts, and the regulators invariably take a pessimistic view which is a particular problem for the publicly quoted parent companies of run-off subsidiaries. In the UK alone technical reserves of around £30bn are attributable to run-offs. The issue of run-off management, and the tools and techniques available to achieve the efficient closure of such portfolios, has become a matter of great importance to the worldwide financial services sector.

Closure philosophy
In the majority of run-offs the key objective is to terminate liabilities sooner than the ‘business as usual’ timetable. The mantra of the run-off manager is ‘finality’. ‘Finality’ strategies vary considerably, depending on the profile of the portfolio and on the overriding objectives of the owners of the business. But whatever approach the run-off manager takes, there are essentially really only two basic philosophies for accelerated closure (two philosophies which are often combined):
– Inwards first Offer settlement deals (paid claims, case reserves, and IBNR) to policyholders and then collect the reinsurance
– Outwards first Commute the reinsurance programmes to maximise the ‘hard’ assets and then offer settlements to policyholders
Assessing the economic impact of settling contingent claims (case reserves and IBNR) is a tricky problem. The response of reinsurers to deals done by the run-off entity can significantly alter the financial merits of a commutation deal and recent experience suggests that reinsurers’ attitudes are hardening. The signs are that reinsurers are considering more carefully their strict legal obligations, and are becoming less inclined to share accelerated IBNR costs that would otherwise have come their way in the normal course of events. They may also require additional discounts for contributing towards case reserve settlements. The growing number of closure methods available means that run-off managers are becoming better equipped to deal with such issues.
Closure methods
The six principal methods used to achieve ‘finality’ are:
– Claim settlement
The efficient settlement of an insurer’s legal liabilities to pay claims is the building block of all closure methods. This is the simplest method, but it is frequently overlooked in favour of more esoteric and sophisticated financial models.

– Commutation
An estimation approach to settling claims, this creates difficulties in making consequent reinsurance recoveries. Commutation is a scalable method, applicable from a single section of cover within a policy to closure of relations between the counterparties on a global basis. The approach is normally applied on a one-to-one basis ie between two counterparties.

– Scheme of arrangement
This is an inwards commutation deal by consensus, and is voted upon by a quorum of creditors and subsequently sanctioned through the court. The ability to collect commuted balances from reinsurers is usually impaired and forces a strategy of prior approval with reinsurers, many of whom will avoid claims. Schemes are flexible in that they can be applied to discrete segments of business within a portfolio as well as to entire portfolios. Schemes generally operate on a ‘many-to-one’ basis.

– Sell the business
Subject to warranties or contingent arrangements, this method fixes the financial position of the owners of the legal entity and transfers the problem to the purchaser, and has various regulatory consequences. It applies to an entire legal entity, parts of which may be carved out through portfolio reinsurance arrangements.

– Portfolio reinsurance
This method fixes the liabilities of the run-off but it is likely to be difficult and expensive to place. The portfolio reinsurer may impose certain restrictions on the subsequent management, which would typically result in slowing down the closure timetable. The credit risk of the portfolio reinsurer must be considered.

– Portfolio transfer
Now known as ‘Part VII transfers’, this replaces the schedule 2C transfer and is being used to an increasing degree to transfer liabilities between legal entities. The scope of the Part VII mechanism is more flexible than that of a scheme; it can range from single contracts to an entire portfolio. An application is made to the High Court to sanction the transfer.
With the exception of claim settlement, all the methods involve a transfer of contingent risk (ie case reserves and IBNR) to one or other of the parties involved. Only an outright sale of the business and the Part VII transfer method avoids any impairment of the consequent reinsurance asset.

An examination of the Part VII transfer method
Part VII of the Financial Services and Markets Act (FSMA) 2000 relates to the control of business transfers, including life insurance, general insurance and banking transfers. The Act applies to authorised companies operating in EEA states and requires High Court sanction; since the UK High Court has no jurisdiction beyond EEA boundaries, transfers affecting non-EEA policyholders will involve the local legal system. The rules relating to Part VII transfers came into effect in December 2001 and, for insurance business transfers, replaced the arrangements under schedule 2C of the Insurance Companies Act 1982.
Both the Part VII transfer and its predecessor, the schedule 2C, involves the movement of a group of contracts from one insurer to another ie the legal liability to the policyholders is transferred. Part VIIs, however, have one major advantage over the schedule 2C system the associated reinsurance asset can be transferred along with the liabilities.
There are rigorous disclosure requirements which can be costly, particularly if the companies have to inform every policyholder in each EEA state. This is a problem for many ageing non-life books, as records can be incomplete and often the policyholders are not known.
The procedures and documentation required are well established, central to which is the report of the independent scheme expert. The expert, usually an actuary, must report upon the financial and operational impact of the scheme on in turn the transferring and remaining policyholders in each entity. The expert’s responsibilities are primarily to the court and the expert report is in the public domain. The content of the expert’s report is prescribed in chapter 18 of the FSA supervision manual, (‘Transfer of Business’) but the scope and depth of the analysis required depends on the effect on policyholders, which would usually be expressed in terms of the pre-/post-transfer solvency levels of each of the entities involved, adjusted for any additional financial guarantees provided.
Communication
In many respects the successful conclusion of a transfer is more to do with communication than with sophisticated technical evaluation. There are three main areas of communication.
– The initial groundwork between the principals involved The objectives of each party must be set out clearly, together with any alternative measures considered. The aim is not necessarily ‘finality’ for one of the parties, but a reorganisation, rationalisation, or administrative objective aimed at cost savings. Since the transfer is open to public scrutiny, and to that of an independent expert, there is less of the posturing and horse-trading normally associated with commutations and, to a lesser degree, schemes of arrangement.
– Between the reporting expert and the principals The expert is required to have full access to each of the parties and to take an even-handed view, although the professional fee is usually met by only one of the parties involved.
– Between the expert and the FSA and between the principals and the FSA Run-offs are a hot potato for the regulators in both life and non-life insurance and the FSA’s role in ensuring regulatory adherence and in providing guidance to both the principals and the reporting expert is critical. The FSA’s examination of the transaction can be expected to be applied ‘proportionately’ to the issues involved but, since Part VII is relatively new, it remains to be seen how the FSA’s philosophy will evolve.

Experience so far
To date, the courts have approved six non-life Part VIIs, with roughly 18 more in the pipeline. There have been around half as many life insurance transfers.
The majority of transactions aim at internal rationalisation, or for collapsing underwriters’ involvements in underwriting pools. The method seems to be particularly well suited to tidying up the messy job of handling pools and the approach taken is for junior pool members to transfer their pool participations into the senior pool member. This has no operational effect as far as the policyholders are concerned, but it simplifies decision making and the deployment of closure strategies on behalf of the remaining pool.
An intriguing aspect is the possibility that Part VII transfers can be made of insolvent portfolios into solvent portfolios. The receiving portfolio will ring-fence the transferred business and pay policyholders a reduced proportion of the nominal liabilities.
The Part VII transfer is growing in popularity. It certainly doesn’t solve the issue of an accelerated timetable to closure, but it enables portfolios to simplify some of their messy residual problems, increasing the effectiveness of the other techniques to accelerate ‘finality’.

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