CAPTIVES AND THE RUN-OFF SECTOR: A GOOD MATCH WITH HUGE GROWTH POTENTIAL

Many captive owners are yet to explore the potential of run-off solutions for their legacy liabilities. Paul Corver of R&Q outlines the development of the captive legacy sector and explores what lies ahead.

To understand the position of captives in the legacy space, it’s worth looking back at the past three decades, during which the legacy sector has gained ground and become a mainstream part of the re/insurance world.

The legacy market began as a way to take portfolios of run-off liabilities away from insurers and reinsurers that had no interest in managing them or wanted to protect against volatility. A lot of the early deals focused on distressed portfolios—predominantly asbestos-related, pollution and other torts that were coming out of the US market at the time.

By the 1990s, run-off specialists were on the rise, especially in the UK, but also in the US where a number of large insurance companies were going into run-off because of the burden of those liabilities, and a number were in insolvency proceedings.

“There was a lot of activity and specialist requirement to manage those entities,” says Paul Corver, group head of legacy M&A at R&Q. “As that developed through the 1990s and into the 2000s, companies started to look at the solutions that were being used for these distressed run-off situations, and to use them for their own run-off capabilities and portfolios. As a result there was the growth of acquirers such as R&Q, Enstar, Catalina and Compre.”

The introduction of Solvency II in Europe in 2016 fueled the sector’s growth, ushering in a much more risk-based approach to capital, with a focus on the characteristics of the classes of business being written and the investments used to protect them.

“It was possible to analyze and determine how much capital was being used by the company to support portfolios of business that were no longer active and were not part of the company’s ongoing underwriting strategy, so more companies then started to realize that if they could get rid of those portfolios, they would free the capital to redeploy or to pay back to the parent, or whatever else they wanted to do,” says Corver.

As a result, the run-off market in the general re/insurance community has grown to encompass billion-dollar deals. Run-off is now a key tool used by the main insurance market for capital efficiency, pruning dead wood and general tidying up. These developments paved the way for the growth of the sector into the captive insurance market.

The run-off market takes on captives

R&Q started addressing run-off for captives in 2008. At the time, it was building a captive management business predominantly based in Bermuda and it recognized a need for legacy solutions in the captives sector.

“It became clear that there was a whole sector of insurance companies and liability carriers that had no real knowledge of what was available by way of legacy solutions to help them do what companies in the live market or commercial insurers were achieving,” says Corver.

“We started to go to conferences and to captive events to educate the brokers, advisors, the managers, the captive owners and the risk managers in that regard.”

R&Q’s first captive legacy transaction, in 2009, was the acquisition of the Guernsey-based captive of the Woolworths retail group in the UK, which had gone into liquidation.

“The captive had assets in it which the liquidators wanted, so the only way to get that was selling the captive—which they did,” says Corver. “We acquired it and that became our base in Guernsey. We’ve subsequently done about a dozen deals in Guernsey, usually acquisitions of dormant and run-off captives that are no longer utilized or required; we amalgamate and merge them into the one vehicle, which we retain in Guernsey.”

Over time, R&Q has developed a platform that covers the offshore jurisdictions of Guernsey, the Isle of Man, Bermuda and Cayman, plus onshore US in Vermont, onshore EU in Malta, and, post-Brexit, it has companies in the UK to take in liabilities. In the early days, the transactions were acquisitions of captives that were no longer being used and were purely in run-off, but more recently, it’s swung to include taking over portfolios of unwanted liabilities through reinsurance, novation or transfer, depending on what is available in the jurisdiction.

“The market in the captives space has developed pretty much how we have seen it develop in commercial insurance,” says Corver. “However, it is still only scratching the surface of what is possible. There are suggestions from some of the big advisory firms that around about 20 or 25 percent of captives are not being used and are effectively in run-off.

“When you think there are 6,500 captives, you’re looking at potentially 1,500 that are in run-off.”

The leading edge

R&Q has remained at the forefront of the captive run-off sector because it entered it with a pre-existing captive management business that provided a contacts and distribution advantage.

“Prior to us coming in, there were run-off transactions and exit solutions by captives but predominantly the captive utilized a front company, and would pay a premium to the front company for it to take the exposure back,” says Corver.

“We found early on that we were being approached by captives that wanted an exit but had not had a satisfactory response from the front company because not all front companies want to take that risk back on their books; they may have written it in the first place only on the basis they knew they were laying off a certain element of the risk.”

In these situations, R&Q is able to offer a run-off solution that satisfies both the captive and the front company.

“We’ve built very good relationships with some of the front companies and have established cells in our segregated account companies structured in Bermuda that are front company-facing,” he explains.

“We have cells that have aggregated together the exposures we’ve taken on that face companies such as Travelers, AIG or Zurich. It gives the front companies an advantage because they are no longer facing multiple counterparts for which they will be doing annual collateral and credit risk reviews.

“Those front companies who are not happy or willing to take the risk back themselves are happy to sit in front of us and have it on a much more streamlined and efficient basis for them.”

Key considerations

In the captive insurance sector, as in the wider re/insurance industry, solutions and approaches change and develop driven by innovation and by external factors that impact the desirability of running a captive—for example, changes in regulatory oversight or taxes.

“All sorts of things impact captive owners’ decisions as to how long they might run a captive for and where they might run it,” says Corver. “Similarly, factors such as M&A at corporate level, where two large companies combine, may mean they end up with more captives than they need, so rationalization is needed.”

The key to success in the sector is to fully understand any process you enter into and carry out the necessary due diligence.

“The party that’s taking over that business needs to thoroughly understand the exposures and the risks,” says Corver. “We always do claims assessments and due diligence to make sure the claims are being appropriately handled and reserved. You need to understand any ongoing relationship and how that would work.

“If it’s an acquisition that’s being undertaken, then it’s a full finality and the captive owner is out of the picture completely.

“If it’s just a reinsurance transaction because the captive wants to protect a certain part of its business but wants to carry on writing (something we see more frequently) then we as the reinsurer will be in a long relationship with that captive, so there has to be comfort with the reputation of the reinsurer, the capabilities it has, its track record and its execution risk.

“Having started in the sector back in 2009 we now have relationships and platforms in a lot of captive jurisdictions and we have very good relationships with regulators, so that puts us in a strong position compared to some of the newer startups in those territories.”

The impact of COVID-19

In the main commercial re/insurance space, COVID-19 had a significant impact early on due to the crash in the investment environment, which impacted balance sheets and capital. As a result, a number of companies came to market seeking to raise new equity or sub debt to support their balance sheets or to talk to the run-off acquirers about taking on liabilities, which would then free up capital, or asking for an adverse development cover to take out the top layer of risk to alleviate capital.

“We have now seen some similar activity in that regard in the captives space,” says Corver. “But the main impact has been that a lot of companies that perhaps might have been looking to transact have been significantly distracted elsewhere, just running their businesses. The disposal or restructuring of capital through legacy solutions is probably not as high a priority as maintaining distribution channels, keeping factories churning over and keeping product in the stream of business in such turbulent times.

“So, although we have been active in the captive insurance space, there has been a hiatus in activity and some transactions have taken longer than they would otherwise.”

Corver expects that more opportunities will come out of the current situation.

“There’s an uptick in general mergers and acquisitions (M&A) activity in the corporate world, so there could be some activity where companies have sold their operational business, but they’re left with a captive, or where groups combine and they’ve got more captives than they want and need to do some strategic reorganization and disposal. It will come back to how it was before, if not busier, which is what we’ve seen in the main commercial insurance space,” he says.

The future

Corver believes there is growing acknowledgement and understanding of what the legacy acquirers offer in the captives space, and that its growth in this sector will mirror what has happened in the commercial insurance space. As more people recognize the potential of legacy solutions for captives, the market is becoming more competitive—but this does not necessarily worry him.

“The more traders there are in the marketplace, the more people come to trade—and it helps if another party is out there educating them; that education is still worthwhile, whether it’s coming from us or one of our peer group.

“It just means that you will have to be a bit smarter on some of the transactions; we’ll be making sure that we are ahead of the pack when it comes to the competition. The important thing is that the reputation of the sector remains strong: we don’t want entities coming in playing fast and loose and destroying the very hard-won reputation for the whole sector,” he says.

For the captives sector, parts of which are yet to explore run-off options, Corver has the following advice:

“Understanding what exposures and legacy liabilities you have on your balance sheet is a key part of managing and running the business. It’s perfectly acceptable for companies to continue to want to manage those on their balance sheet but also, there are solutions if companies want to dispose of them.

“It’s a good idea to keep an open mind and to ensure those liabilities are assessed and the capital impact—whether it’s actual capital or collateral that is tied up for those liabilities—is reviewed and assessed, because there may be more efficient ways of managing the business by doing a transaction.”

Paul Corver is group head of legacy M&A at R&Q. He can be contacted at: paul.corver@rqih.com