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Benchmarking & Restructuring Claims Services

Speech by Peggy Berton,
President of CNA Global Resource Managers
presented at a conference sponsored by
Global Business Research Ltd.

The concept behind the term "Good Bank Bad Bank" harks all the way back to depression days. In the 1930's, as bank after bank began to fail in the wake of stock market crash of 1929, the US government rode in on a white horse and acquired the failing bank's devalued assets. This allowed the still viable part of the bank to go forward with those of its assets which still retained their value, and with fresh funds. It then was able to satisfy its depositors, while shedding its underperforming portion, like a snake shedding its skin. With the government left literally holding the almost empty bag.

This concept became even further refined during the savings and loan crisis of the 1980's. Once again, with government assistance and approval, savings institutions were allowed to extricate themselves from the consequences of their own poor business judgment and some bad breaks in the economy. The rationale and driving force behind the governments providing a safety net to banks was twofold: first, to protect the depositors and second, to help break what could be a catastrophic death spiral in the US economy.

In recent years, a concept has arisen in the insurance industry which purports to mirror the good bank/bad bank model. There are significant differences, however, in the driving forces behind the model, in the methods by which it is accomplished, and in the true beneficiaries of the model. These differences argue that the current wave of liability based restructurings in the insurance industry cannot be considered true good bank/bad bank transactions.

The purpose of my chat with you today will be to explore the concept of liability based restructurings in the P&C industry from the following 5 perspectives:

  1. My first point is that the "good bank/bad bank" model is too simple to describe what is happening in our industry. At best, "good bank/bad bank" is a handy nickname for LBR. More important than the nickname we give it, however, are the trends that cause it.
  2. The trends leading up to the industry shake out, (the Darwinian concept that only the strongest survive) are the same trends that force some carriers into restructurings.
  3. Each major restructuring and its beneficiaries has been unique.
  4. As interesting as the LBRs themselves is the industry reaction to them (the mainstream perspective on the concept of LBR and the ethical debate among carriers.)
  5. Finally, is there an efficient and responsible way for a carrier to ring fence and run down the books of business it chooses not to renew? Is there a role for the runoff specialist in restructurings?

Let's examine the good bank/bad bank model for a moment. We said it originally consisted of the government assisting in preventing financial institutions from going under in order to benefit depositors and the economy. As William Latza, Esq. recently observed in The Int'l Insurance Monitor there are significant differences between a bank restructuring and an insurance restructuring. In the insurance arena, while government certainly regulates the industry, it is not obligated directly to policyholders. Instead, the industry guarantees itself via insolvency funds. In the good bank/bad bank scenario, bank auditors can go in and assess the bank's situation concretely. They can, in effect, take a snapshot at a point in time which will tell to the penny how badly the bank's assets are underperforming. The assessment of the depth of the problem is finite. Auditors can determine pretty closely how much money to set aside to fix the problem. For an insurer, unfortunately as we all know, the liabilities are in the future. They are assessable only via actuarial projection and it is never known with comfort or certainty whether the funds made available will truly pay the last claim before the lights are turned out.

It is ironic but true that in some situations the most severely troubled carriers have the most difficult future liabilities to assess, consisting of heavy asbestos pollution and health hazard exposures. So even if there were one single entity, like the government which could come in to save a troubled carrier, the determination of the financial requirement could be very uncertain. The final difference between banks and insurers is that no established model exists for severing off the "bad bank" portion of an insurance company. Each liability based restructuring is a new ballgame with new rules, new players, and a different set of umpires! Therein lies the problem in CNAs view. I'll touch on this later in my remarks.

Let's take a moment to look at the activity that has occurred in recent years.

According to AM Best, over only a 2 year period from 1991 - 1993 the number of P&C carriers in the US decreased by 14%. In 1996 alone an astounding $21 billion changed hands in the form of outright purchase of one company by another or the issuance of notes, IPOs and stock offerings to fund acquisitions. Almost 40% of this included the reinsurance segment, for a long time perceived to be of the more stable segments of our industry.

What are the trends which fuel this activity and what are the current predictions for the future?

First, let's face it. Return on equity in the property casualty segment of the insurance industry has consistently been lower than those of other businesses. The 10 year average for ROE for the P&C industry from 1986-1995 is 9.6% on a stat basis and 10.5% on a gap basis. Compare that to 15.1% for diversified financial, 13.2% for banks, 11.8% for utilities and 12.9% for fortune five hundred companies. A desperate struggle within the P&C industry has ensured, in an attempt to overcome the historically low profitability of the segment.

Second, there is nothing new under the sun, even though we in the industry continue to believe that our new twist on a commodity product will sell like proverbial hotcakes. Industry segments are overcrowded and undifferentiated. Price cutting and the struggle for market share have led to drastically underpriced lines and have left carriers expense ratios dangerously high and cruelly exposed to slashing. Unfortunately the "cut the fat" mentality can lead to a cutting of muscle and bone. When that happens, carriers cannot recover enough to bounce back even if the market ever turns hard. And, once they have weakened themselves, their customers who have been so price sensitive as to drive them into this condition in the first place, are now engaging in a flight to quality and insisting on dealing only with insurers who are well capitalized. Third, globalization (especially in the reinsurance industry but in the P&C industry as well) creates both a sometimes false sense of new horizons and a false sense of urgency. As the world gets smaller, and as domestic markets become more competitive, globalization is seen by some carriers as a way to grow, especially in overseas markets that are as yet unsullied by the outrageous liability and APH tort explosion we have seen in the US. As more and more carriers move into this unfamiliar environment, more and more carriers will be forced to do the same to compete. Unfortunately, to create a world class non domestic operation requires three things which are in short supply in our industry; 1) true international expertise, 2) the wherewithal to withstand slow and steady growth (the new kid on the block often doesn't get the most preferable business until he proves himself) and 3) enough money to fund number 1 and 2 above.

The fourth trend that we see is plain bad luck. The past several years have brought higher than usual catastrophe frequency. For some carriers this has been worsened by their own unfortunate choice of territorial concentration.

The fifth trend, as mentioned earlier, is that claims costs and transaction costs are ballooning. The tort explosion especially in the area of product law and the introduction of junk science into the courtroom have created an upward pressure on average settlement figures for most carriers for bodily injury claims. Even in a line as simple as auto physical damage, studies have shown that a new car can be purchased for about $20,000 while to rebuild that same car from parts could cost upwards of $50,000. We've all had the experience of the fender dent that looks like $100 but turns out to be $1000. A subspecies but perhaps the most serious of the claims cost/transactional cost problems is APH claims. For the reinsurance industry the APH component is a single biggest black hole that exists, because the tremendous "bulge" in costs potentially caused by APH is only now entering the reinsurance system. In addition, transaction costs for claims have continued to grow over the past several years. Many carriers have organized themselves to combat this trend by increasing the scrutiny on outside legal expenses as well as other vendor expenses. However, the trend continues apace.

These are just a few of the trends that have contributed both to the industry consolidations and equally to the decision of some companies to engage in liability based restructuring.

What are the advantages to a carrier to engage in a liability based restructuring or to a purchaser to use a liability based restructuring to buy the choicest parts of an acquired company and partially shield itself from responsibility for the less choice parts.

First, the insurer differentiates the "bad bank" or "bad company" component of its liabilities - usually APH in nature. It is able to estimate these, acknowledge the financial hit once and for all, and reserve a set amount of funds to pay the claims arising from this segment. Second, as I said earlier, the insurer having come out of the closet, so to speak, about its bad bank component, is able to manage the runoff in a specialized way which maximizes cash and preserves capital. Third, separating out the clean, go forward, " good bank" component improves the earnings and competitiveness of this segment. Higher quality business and more investors are likely to be attracted.

It has been said that an effective liability based restructuring is not just a survival move, but is in fact designed for multiple beneficiaries. First, through proper assessment of liabilities and creative and adequate funding, it preserves the business for the shareholders and employees benefit. Second, if properly done, it secures the rights of past and current policyholders, claimants and creditors.

If liability based restructuring is in fact an improvement move for a carrier and not just a survival move, what has caused the controversy and discussion and difference of opinion within the ranks of P&C carriers with regard to this concept? First, some peer carriers have expressed a concern that creating separate and discrete pools of assets, namely the good company and bad company concept, will create a stronger "good" company but a much weaker "bad" company. This concept certainly provides advantages to the shareholders of the company which restructures, but it is questionable in the minds of some peer companies whether the benefit to the policyholders is equally good. There is also a concern within the industry, that the trend towards liability based restructuring will force all carriers into this mode in order to be competitive. In addition, I believe there is some lingering concern on the part of some carriers that if the bad company portion of a liability based restructuring happens to fail, the guarantee funds which draw on all carriers will be required to come in and pick up the slack. The primary difference between the acceptability and unacceptability of a liability based restructuring seems to be in the opinion of most carriers, regulators, and the trade press, the question as to whether the parent company of the runoff carrier will be willing to step in and guarantee payment of all claims including asbestos pollution and health hazard claims. Such a guarantee will preclude the possibility the "good company" portion of the restructuring walking away from its responsibilities and leaving the policyholders and rest of the industry holding the bag. The position of my company, CNA, on this matter is that of our chairman. Dennis Chookaszian has called upon the NAIC to study this matter, and to come up with a set of standards and regulatory guidelines to govern this type of transaction. We are far from convinced that LBR is the way to go for the industry. But we are particularly concerned that in the absence of widely accepted standards, LBR will be carried out under a patchwork quilt of regulation, with these transactions migrating to the most favorable regulatory environment.

Let us take a quick look of the most well known liability based restructurings of the past several years and examine the similarities and differences.

Close the doors on Friday with problems, re-open them on Monday with a clean slate - does it get any better than this? Well, it may not turn out to be as easy at that for the Cigna Corporation.

In an attempt to satisfy its long-term goals, the Cigna Corporation has vividly illustrated "good company/bad company". As stated earlier, in the world of finance, this is not a new ploy. With a little stretch of the imagination, the same has been happening in the insurance and reinsurance industry for some time. Transactions involving offshore entities in the Cayman Islands, Turks and Caicos and Bermuda were the "mother" of this type of transaction.

In 1995, the Cigna Corporation announced the creation of the Brandywine operation which is thought to be the largest transaction of its kind in the U.S. insurance/reinsurance industry. The motivation appears to be Cigna's desire to recognize its growing and significant environmental and asbestos exposures and to obtain an "A" rating from the A.M. Best Company.

Under this plan, Cigna took advantage of a law, unique to Pennsylvania, which it believes will allow it to separate the Insurance Company of North America, the old INA into two parts. The bad part, the one containing the APH exposures, was then merged into Century Indemnity Company (Century was to be the primary entity in the runoff operation). The transaction was backed by increased reserves, capital contributions and various reinsurance arrangements. The good business, the non APH part was to remain with Cigna.

This deal has not yet received full regulatory approval. Cigna is facing stiff opposition. In order to get the required regulatory approval, Cigna will have to prove that it has adequately funded the runoff liability. This will be no easy task and the process has already come under fire by leading industry players such as AIG's Maurice Greenberg and others who have gone on record with the opinion that the deal is unfair and, in the long run, does not protect policyholders.

As we understand the plan, should the funds supporting the Brandywine operation prove insufficient, the recourse for policyholders and cedants will be back through the Cigna Corporation which, under the Pennsylvania law, limits the amount that the Cigna active operation may be liable for. Opponents to the plan look for Cigna to take a more significant, if not total role, in any insolvency.

Dependent upon the outcome of the various litigations on the subject, the real advantage, should one exist, is that Cigna is striving to obtain and maintain its Bests Rating. This rating is crucial to Cigna in that its current "A-" rating is the minimum which Cigna can maintain and still attract quality Property and Casualty business.

While the Cigna transaction is still being played out, it will, most likely, be the benchmark upon which future deals are handled. However, there are several others which have either passed muster or are in the process of doing so.

Some would say that the Talegen deal was the first out of the blocks while others may not deem this to be a pure "good bank/bad bank" example. However, as we see it, the restructuring of the former Crum & Forster Companies by Xerox Financial contains several of the hallmark's of a good/bad scenario. Between January 1993 and December 1995, the entities were reformed into four independent operating groups consisting of 17 subsidiaries. The restructuring included reserve strengthening, capital infusion and an additional $1.5bn in excess of loss reinsurance to protect the various books of business.

Industry sources feel that Xerox Financial's motive for the re-structuring was to enable it to divest itself of the operations using the concept that the sale of the parts will be greater than the whole. Prior to the sale of Coregis, it had been assumed that the investment firm of Kohlberg, Kravis Roberts & Co. ("KKR") would buy the Talegen group for an estimated $2bn. This deal fell through in mid-1996. It is anticipated that Xerox Financial still intends to sell the group or its components in the future.

To an extent this concept has worked, witnessed by XEROX's sale of Constitution Re to the Exor Group in 1994 and the sale of the Coregis Group in 1996.

Still, the re-structuring saw the creation of The Resolution Group ("TRG") which is designed to be an In-house runoff manager today and a third-party runoff manager tomorrow. The speed at which TRG turns to third-party business many depend upon the success of Xerox in selling the components of the Talegen operation.

Also to be considered is the 1995 deal involving Trygg-Hansa and Zurich surrounding The Home Insurance Company. In this deal, Zurich led a group of investors which were interested in the good renewal business but not in the vast amount of APH runoff claims it would leave behind in The Home. In order to give regulators comfort the deal resulted in some $440 million being added to The Home's reserves before the restructuring to pay future claims. Also, as part of the deal, Zurich arranged for approximately $1.3bn of reinsurance over and above the base deal in order to provide that extra cushion needed to satisfy the regulators.

Unfortunately, the best laid plans don't always build the best structures. In March of this year, The Home was placed in Supervision by the New Hampshire Department when its reserves had fallen to approximately $250 million and it became clear that its reinsurance would be substantially exhausted before the proverbial lights were turned out on the last claim.

While the Cigna, Talegen and Home situations were designed for a particular reason (ratings/divestiture), others exist which need to be explored. This would be in the area of solvency. There are cases, which we have seen, where the runoff generated by past business is holding a company hostage. The company's solvency, as a result of the runoff liabilities, is in question. The ongoing business of the company is profitable but, due to market conditions, will be insufficient to "write" their way out of the hole created by the past sins of the company.

A possible solution would be for the company to enter into a Good Company/Bad Company transaction whereby the good ongoing book of business either remains with the company or is sold to another entity while the bad business (the runoff liabilities) is sold off to either the company assuming the ongoing business or to a third party runoff manager which, if properly funded, can aggressively runoff the liabilities for a profit. This is precisely what Lloyds has done with the establishment of Equitas.

Much has transpired in the past 309 years during which Lloyd's took its place as the world's leading insurance market. The phrase "Insured at Lloyd's of London" became a household word associated with celebrities and sports figures insuring their virtues with Lloyd's. Yet very few knew what Lloyd's really meant or that it consisted of Underwriting Managers, Syndicates, Names and most notably, unlimited liability. Once, to a select group, being a "Name" at Lloyd's was synonymous with royalty. In the recent past, the same term conjures up thoughts of communicable diseases.

As regards reinsurance, the security of Lloyd's was once the "bar" to which all comparisons were made. But by 1992, questions were starting to be raised regarding the solvency of Lloyd's. What caused the downfall of this once great institution? While there are undoubtedly many factors, several come to mind such as Piper Alpha, Exxon Valdez, U.S. Hurricanes Hugo and Andrew, the San Francisco Earthquakes and Winter Storms in Europe, the U.K. and the U.S. These catastrophes brought on a five year period of Underwriting Losses.

The effects of the LMX spiral were also brought into play. The spiral is a unique phenomenon to Lloyd's and, in theory, is caused by Syndicates reinsuring Syndicates in a complex retrocessional matrix. In reality, it caused a domino effect which took on a life of its own.

The failure of several major Syndicates spread doubt as to the "forever" nature of Lloyd's. The failure of these major players created a great threat for the Lloyd's Central Fund (the backbone of the operation which used member funds to pay for names who would not or could not respond to claims presented and approved for payment). Lloyd's 'promise to pay' meant that if a Lloyd's Syndicate were to become insolvent, any claims would be settled on it's behalf from the Lloyd's Underwriting Fund, which is contributed to by Lloyd's Syndicates and within which a constant reserve fund is maintained. With unlimited liability a precondition of Lloyd's membership, the Names behind every Syndicate were consequently pledged to cover all losses, and in particular the cost of the recent heavy Lloyd's losses. These were eligible to be paid for entirely by the affected Names, from their own declared funds.

The advent of the age of Asbestos, Environmental and other Mass Tort claims was beginning to be felt in the early 1990's. The stress this would bring to the already shaky infrastructure of Lloyd's had to be recognized and dealt with.

What then was Lloyd's to do? In order for Lloyd's to maintain its image as the leader of the insurance/reinsurance marketplace and in order to prevent the catastrophic effect of a Lloyds failure on the UK economy, something drastic had to be done to save this drowning giant.

In a business plan published in April 1993, Lloyd's Chairman David Rowland announced the formation of the NEWCO reconstruction project which was advertised as a ring fence of 1985 and prior policies. Under this plan, the liabilities of the "old" years were to be estimated to ultimate, discounted for the creditability of outwards reinsurance as well as the time value of money and charged to the names as a one-time premium (estimated at £15bn or $23bn) in exchange for certainty if not finality.

To accomplish this task, Lloyd's conducted the largest actuarial analysis ever contemplated in the industry. As can be imagined, the challenge of amassing the kinds of data necessary to come up with one single number per name which would be sufficient to fund what was to become the ultimate "Good Bank/Bad Bank" scheme ever envisioned was enormous.

Politically, the road faced by Lloyds was much tougher than that faced by Talegen, The Home or Cigna. When the reconstruction plan was announced, action groups of which up to 40 were identified, consisting of names, regulators and other debtors of Lloyd's, were formed and litigations commenced against both Syndicate Underwriting managers and other Lloyd's names to prevent the plan from being successful. Finally, in the spring of 1996, a plan was approved and, on September 4, 1996 was taken to a vote with the membership of Lloyd's. The plan, which ultimately passed, included the following provisions:

  • First, a reinsurance and runoff facility named Equitas was established.
  • Members would receive credits totaling £3.2bn which would be offset from their estimated Equitas Premium.
  • Lloyd's three-year accounting rules would be suspended allowing existing names to recognize profits of approximately £2bn or $3bn to use as an offset to their Equitas reinsurance premium.
  • Members could resign from the Society of Lloyd's.

This last item, means that names would be free from the control of Lloyd's. This is of critical importance to policyholders and cedants since, if Equitas were to fail, recourse would fall back to the names, who would not be under the central control of Lloyd's. It would become the debtors responsibility to identify, find and collect any shortfall resulting from a failure of Equitas.

All, in all, I think that it is safe to say that Lloyds and Equitas have created the largest

In addition to the Good Company/Bad Company scenario we have seen other creative ways of restructuring emerge over the past few years. One of these products in the Novation. A Novation legally transfers liability from one party to another. This may seem like a rather simple transaction. In practice, a Novation comes under a significant amount of scrutiny, either by regulators protecting the rights of policyholders or cedants, protecting their security. The consolidation of the Crum & Forster Companies into the group known as Talegen was done via a Novation. In order to understand the draw of such a remedy, it is important to see where the prospects come from.

Many companies seeking Novation are survivors of the reinsurance debacle of the late 1970's and early-to-mid 1980's which saw depressed pricing, lack of underwriting control and subsequent litigation in the areas of latent concerns giving rise to coverage which was never anticipated when the reinsurance was arranged. This was a period of diversification where off-shoots were created to "take advantage of" the capacity crunch and reap the benefits of high premiums and higher interest rates.

Many of these entities have either stopped writing business or have decided to pursue other segments of the market and are now encumbered with the handling and administration of these older books of business which, in many cases, hinder the operation from moving forward profitably. In most of the cases that we have seen, these entities are adequately reserved for the purpose of our discussion. These companies are seeking solutions years after the last contract or certificate expired.

In a Novation, a company would legally assign the liabilities and the handling of its assumed book of Reinsurance (whole or in-part) to another entity for a premium equal to the amount of the agreed case reserves and the assuming Reinsurer's view of the IBNR as well as a factor for the time value of money and the estimated cost for the run-off and administration of the claims.

The Novation has the effect of removing the liabilities emanating from Assumed Reinsurance from the company's balance sheet. It also has the benefit of removing the administrative burden from the company's staff. While the financial effects associated with this type of transaction are generally more costly than other methods available, the company, in effect, walks away from the book permanently. We believe that this scenario is preferable to a company since, at the end of the day, the company would have no liability, contingent or otherwise, derived from the Novated book of business.

In some cases the size of the portfolio makes it necessary to carve the book into sections that can be absorbed by an assuming market. If it is necessary to perform this type of exercise, the plan used to segregate the book should be well thought out and consistent in such a way as to make the resulting sections attractive to potential buyers. If, for example, the book were to be divided into three possible packages with two containing a better selection of the business, the third portion may prove to be the victim of adverse selection and therefore not readily salable in the marketplace. We believe that once the regulatory obstacles are overcome that the transfer of liabilities via Novation will become more widespread in our industry.

Some industry players believe that many runoff books, if managed properly, can actually yield some profit arising from hidden assets embedded within them.

CNA's purchase of CIC in 1995 did not create a good company/bad company split. CNA purchased CIC whole and entire and stands behind all liabilities whether the books of business are ongoing or discontinued. CNA did choose, however, to establish a business unit to manage CICs discontinued liabilities bringing to bear the specialized skills of runoff management.

Since I am responsible for the runoff of all CNAs discontinued liabilities arising from the CIC purchase, I'd like to examine for a minute the role of the runoff specialist in handling the discontinued liabilities of an insurance carrier.

Whether a company actually restructures or merely places special emphasis on the stewardship of discontinued lines of business, there is an advantage to setting up a force of professionals dedicated to the management of the asset known as runoff liability. A professional runoff manager can perform a number of integral tasks to protect this asset. One of these is to investigate, manage and settle claims in a prompt, efficient manner. One of the first tasks of successful runoff management is to build credibility with its policyholders, cedants and reinsurers. The ramifications on its success as a runoff manager can be significant should the runoff manager not "get out of the box" on the right track.

The importance of professional runoff service can not be over-emphasized, whether employed to service a restructured company or employed to service a unit of discontinued business wholly backed by the parent company as in CNA's case.

A few critical activities of the Runoff Manager are:

  1. To commute where the result benefits the estate. While performing commutations on a global basis can maximize efficiency as well as reduce the administrative workload, this may not be as easy or as practical as it seems. Faced with the possibility of various books of business, bringing it all together in a commutation package may be a monumental task considering that the original liabilities and reserve analysis was never reconciled to cedants records and outwards reinsurance will require broker assistance. At the end of the day, the work involved will be worthwhile in considering a quicker and more efficient final runoff.
  2. To learn how to do a professional audit on cedants and use this technique to resolve disputes.
  3. To maximize reinsurance recoverables and collections. A dedicated collections unit with special emphasis on Aged Recoverables and special incentive should be established.
  4. To maximize investment returns. The management of cash is the primary way to self-fund a runoff.
  5. To develop a three to five year plan to consolidate the accounting and claim procedures. The cost for maintaining these services in the long-run is prohibitive and will ultimately prove inefficient. Control consolidation via a specific plan to both maximize productivity and minimize negative.
  6. Finally, to pay attention to the human resources issues. Staff should be recruited and motivated with the approach that runoff management is a professional career discipline in itself. As long as there are fallible human beings writing insurance risks, there will be runoff specialists needed.

These tasks are not easily accomplished. The resources of the professional runoff manager will be hard pressed to meet this challenge. But paying attention to these critical facets of runoff management is the only way to turn a runoff liability into an asset.

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