With mounting novel coronavirus (COVID-19) liabilities straining insurers’ and reinsurers’ balance sheets, the pressing need to free the capital tied up in legacy portfolios can no longer be ignored. Sorting out legacy risk would not only relieve reserve pressure, but also release much needed capital to support growth. So, what are the options for tackling the legacy drain proactively, and why is it so important to address these issues now?
In a recent edition of The Voice of Insurance, Guy Carpenter’s Victoria Carter delivered a rigorous assessment of the balance sheet issues facing insurers in the wake of the COVID-19 pandemic and the resulting need to focus on capital relief. Ms. Carter examined insurers’ current concerns about capital management, market, and societal activity. These concerns have heightened insurers’ focus on capital management, and the tools they are considering to manage current and prospective capital requirements.
In June, I outlined criteria for insurers to consider as they navigated the COVID-19 minefield. Capital management was among the topics covered. The effects of the pandemic have highlighted that concern.
Insurers and reinsurers Q2 and H1 results did not make for good reading. Many established insurers reported a sharp rise in combined ratios and reserve deterioration. Without proactive steps to relieve balance sheet pressure, the coming quarters are unlikely to be any better. These results illustrate that now is the time for insurers and reinsurers to consider business transfer and/or accelerated closure in addition to the more commonly used options of sale or reinsurance.
As Ms. Carter’s interview highlighted, customized restructuring solutions consider core balance sheet and exposure issues alongside overall corporate strategy, counterparty concerns, third party capital involvement, regulatory and rating agency criteria, and shareholder demands. Insurers have demonstrated their comfort with traditional third-party reinsurance as a capital solution for the issues Ms. Carter identified. Rather than precluding the use of reinsurance, it is notable that more innovative and novel restructuring and true finality solutions available in various jurisdictions are enhanced by capital or balance sheet support from traditional reinsurance protection.
The market opportunity for an increased focus on restructuring is timely, significant, and expanding. It crosses all lines and levels of business, markets, and geographies, and will require a broad range of coordinated complementary skill sets that may not reside within each insurer.
The COVID-19 and post-COVID-19 world will see increased focus on balance sheet relief and financial finality across a broad spectrum of active and legacy insurance and reinsurance liabilities. Individually and collectively, these current liability sectors represent substantial reserve exposure:
- Historic legacy exposures;
- Recently exited lines of business including delegated authority and MGA/MGU exposures within and outside of the Lloyd’s and London Markets;
- Corporate self-insured and captive obligations;
- Post COVID exits – companies or individual lines of busines; and
- Active underwriting entities looking for reserve relief, improved operating ratios, ratings, or RBC/BCAR levels.
Additionally, insurers are concerned by the impact of what they refer to as “social inflation”, which is defined as the “rising costs of insurance claims resulting from things like increasing litigation, broader definitions of liability, more plaintiff-friendly legal decisions, and larger compensatory jury awards.” These adverse developments are hardly new. Notable past developments include the impact of the asbestos ‘triple trigger’ ruling in Keene v. INA. The impact of today’s adverse claim development characterized as “social inflation” may pale in comparison to the impact on insurance company obligations for asbestos liabilities that have followed the Keene decision and its progeny.
Issues to consider
Each restructuring transaction affecting these current liability sectors will require consideration of numerous factors beyond actuarial loss data and risk-based capital outcomes. Among the criteria will be:
- Balance sheet relief;
- Protection against adverse development;
- Satisfaction of shareholder concerns;
- Operational control – retained or divested;
- Rating agency relief; and
- Regulatory compliance.
Historic and tested (principally UK) portfolio transfer will continue. At the same time, the US should see expanded regulatory and market acceptance of its emerging restructuring mechanisms for live and discontinued business.
- At present seven states have statutory provisions that allow domiciled insurers to divide into two or more entities. Two other states have insurance business transfer regulations like the UK’s Part VII transfer.
- The need for portfolio transfer is substantial. US carriers have roughly $18B in assumed reinsurance reserves for asbestos and pollution liabilities alone. Workers compensation, general liability, construction defect, surety, and financial guaranty are also substantial but not recorded with the same level of detail.
Each of these prospective portfolio transfer transactions should rely on internal or, more likely, third party reinsurance for leverage, regulatory and judicial approval, as well as to satisfy counterparty concerns.
COVID-19 could well be the inflection point for dealing with this legacy burden.
The insurance industry will be tested. As the pandemic continues, we may witness its June 30 financial results replicated at the end of the third quarter and year end 2020. Will participants move proactively, strategically, and remedially to arrest the inevitable balance sheet and capital strain? Will they recognize that these restructuring measures allow them to emerge from the pandemic in a stronger capital position, better able to satisfy the concerns of shareholders, regulators, and policyholders now and into the future?