The advent of run-off as an investment is driving the service provider market in a new and interesting direction, says Mike Walker, partner and Michael Maccallum, senior manager at KPMG LLP (UK).

New money, new entrants and new ways of doing business are adding a different dimension to an already dynamic UK run-off sector.

Approximately a quarter of all general insurance liabilities are in run-off. The KPMG LLP (UK)/ARC Non Life Run-off Surveys show this trend – at year end 2004, there were £38.4 billion of total liabilities in run-off.

The run-off service industry has grown rapidly around these burgeoning liabilities. However, the advent of run-off as an investment is driving the service provider market in a new and interesting direction.

Interest in the run-off sector has developed significantly over the last decade. More recently, it has attracted the attention of those who have traditionally been outside the run-off arena, particularly private equity providers.

The participation of private equity houses in run-off has allowed for a new source of capital to enter a market which had attracted interest but, until recently, a shortage of deals. In the second half of 2005 alone, a number of players have either entered the UK run-off market or announced transactions with external equity investors.

This interest from private equity has drawn out a broad range of strategies, from those who see their future as a services only business, to those who will be involved in purchase only, and most models in between. What is of interest to market observers is just how these players will try to make their strategies work.

One approach to run-off investment is the business model which advocates purchasing run-off portfolios by third parties.

There are demonstrably more participants in the run-off purchase market than there were five years, or even as recently as last year. Simple economic analysis would dictate that a larger demand pursuing a given quantity of supply must lead to an increase in the price paid for the product being purchased. Of course, it is not that simple with run-off, but the point remains that the increase in the number of participants in the purchase market should see an increase in competition for deals.

The readily available nature of funding is an issue which run-off purchasers may also need to consider carefully. Much like in the underwriting cycle itself, they need to ensure that availability of capital does not lead to them buying unprofitable businesses.

Clearly thorough due diligence is one key factor of a successful acquisition strategy. Whilst the costs associated with this work may not be insignificant; many purchasers may perform due diligence several times before securing a transaction. Third party investors generally expect to be repaid at some predicted time in the future. With private equity houses, that exit time frame may be as short as three to five years. This could pose potential issues for acquirers who may prefer a longer time frame to achieve finality and whose expectations may well be more realistic. When a private equity fund comes to the end of its (usually finite) life, to whom will they sell the investment they acquired years before?

As well as entire businesses of smaller risk carriers which have been easier investment targets, larger insurers may now be looking as solutions other than ordinary course run-off. Therefore, the supply of available run-off to purchase may be getting larger, along with the number of those willing to purchase. As with the availability of capital, the increase in demand for purchasing run-off may itself lead to an increase in the number of portfolios being made available for sale.

Not all run-off purchasers are pursuing the same books of business, nor do they have the same strategies. Some may prefer particular books of business, for example APH, some may structure deals with deferred consideration or risk sharing, others may purchase outright. What the run-off purchasers do with the portfolio to extract value could fill the entirety of this issue.

New products and ways of realising value may present methods for run-off purchasers to extract value in ways that were not attractive before. Much has been written about schemes of arrangement as an exit solution. There is, however, an increasing appetite for the use of Part VII transfers, which allow for specific liabilities, along with the attaching reinsurance, to be transferred. This procedure increases the potential for large, ongoing insurers to effectively isolate and remove their chosen run-off issues in a way not previously available.

Finally, there are of course new geographic markets which are already opening up. The markets in North America, Bermuda, Europe and Asia have attracted the attention of many acquirers in the recent past.

Another approach to run-off investment is the model which centres on run-off servicing only, without the element of risk purchase.

It almost goes without saying that the prospects for run-off servicing depend very heavily upon the market’s appetite for preferring outsourcing to in house run-off and the ability of outsource providers to demonstrate value for their clients. However, an obvious challenge to UK service providers is a possible liability to VAT. The prospect of having the cost of servicing increased by application of VAT on a previously exempt service is one which may require a different approach from providers as to how they create value in delivery. HM Revenue and Customs has chosen not to implement the Andersen decision to impose VAT, pending the review of the European Commission. No change is expected this calendar year, but it is likely to be in the minds of both providers and clients.

There was a time when many run-off outsourcing contracts were operated solely on a cost-plus basis. This basis allowed for run-off operators to set up with limited capital and to establish a low risk business. Conversely, low risk can mean low return. Going forward, providers are likely to use innovative pricing to earn acceptable margins.

Whilst there are challenges for the service providers, there are of course real opportunities for them going forward.

For example, the way in which run-off servicing providers price their services may change, moving away from the costplus basis. With an appetite for assuming risk, pricing which takes advantage of the risk/reward trade off could prove fruitful.

In addition, an emphasis on quality of personnel and service is important to ensure that the right clients get the right skills at the right time particularly if VAT is to have an effect on cost. Offshoring may be one method to lessen any UK VAT burden reducing costs generally, but the market has shown little appetite for such a change in structures to date.

As with the run-off purchasers, the prospects of expanding to foreign shores where the impact of run-off on a company’s results is beginning to draw attention must be inviting.

Run-off purchase and run-off servicing are two of the approaches to market entry by third party investors. There have been many others, including a blend of purchase/servicing, joint ventures, purchase of reinsurance debt and purchase of claims against risk carriers. Whatever investment is made, each has its own bespoke financing structure and tax consequences, which may make any deal more or less attractive to the parties.

There can be little doubt that the market for run-off will continue to expand. There are more policies in run-off every year and there are an increasing variety of ways in which risk carriers can deal with and finalise their exposures.

There are also an increasing number of participants in the market, with clear differences in strategy between them and it is unlikely that things will remain as they were, as the market becomes altogether larger and more competitive.

Fortunately, those involved in the run-off market are a resourceful group; it comes with the territory. Those who are innovative and fast to adapt to new markets, conditions and opportunities should have a clear advantage. It is an open question whether the new money, entrants and ways of doing business will lead to a round of successes, failures or consolidations and whether one strategy will win out over another.

This Feature item appeared in issue 106 of JTW News - June 2006

Author: Mike Walker | Michael Maccallum - KPMG LLP (UK)