Helping clients fulfill their capital needs
Legacy transactions help insurers strengthen their capital positions and avoid adverse loss reserve development, all while helping fulfill rating agency and regulatory requirements. In this episode, Ed Hochberg, Head of Global Risk Solutions, and Ronnie Carroll, Managing Director, Global Risk Solutions, discuss how these structured solutions work and how they enable an insurer to redeploy capital from its back book to future underwriting activities.
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Eric Stenson: I'm Eric Stenson from Guy Carpenter. Welcome to this episode of Fo[RE]sight, a Guy Carpenter podcast series bringing you unmatched insights on trending challenges and our solutions, delivered by Guy Carpenter experts on the vanguard of thought leadership within the reinsurance industry.
Today, Guy Carpenter’s Ed Hochberg, Head of Global Risk Solutions, and Ronnie Carroll, Managing Director, Global Risk Solutions, discuss various types of legacy transactions, how they help insurers strengthen their capital positions, and how legacy transactions are useful even for insurers that are confident in their reserve establishing.
Guy Carpenter’s Global Risk Solutions team has the technical expertise to deliver unique, structured solutions—and the sophistication to optimize their value to your enterprise. Please welcome Ed and Ronnie as they share their insights into the world of legacy transactions.
Ronnie Carroll: Thank you, Eric. Ed and I are very pleased to be here today to talk about legacy transactions. We plan to offer our listeners insights on:
- What legacy transactions are
- Why would a company be interested in them?
- How a legacy transaction can help a carrier improve its capital position
- Why companies who are confident in their reserves can still benefit from a legacy transaction when they redeploy capital to future underwriting activities?
Ed Hochberg: Thanks, Ronnie. And, we’ll be covering a lot more, including rating and regulatory credit, the role in helping M&A deals, claims administration versus capital-oriented transactions and new entrants.
Eric Stenson: We have read a lot in the trade press about legacy transactions. What are these transactions and why should a company be interested in them?
Ed Hochberg: Fundamentally, these transactions are retroactive or retrospective in nature; that is, they cover past insurable events, and therefore, they really transfer reserving risk as opposed to prospective underwriting risk.
Ronnie Carroll: You can further split these transactions into some major categories:
- Full legal transfer, such as a reinsurance to close at Lloyds, a Part VII transfer, or a full novation of underlying policies
- Reinsurance, such as Loss Portfolio Transfers (or LPTs) and Adverse Development Covers (or ADCs), with the key distinction being whether the coverage attaches at dollar one (LPT) or excess of a retention (ADC).
Ed Hochberg: There are many reasons that an insurer would want to enter into a legacy transaction, but the key element underpinning nearly all cases is capital.
Ronnie Carroll: Yes, a carrier might do a deal to exit a business, financially, operationally, and in some cases, legally. They might enter into a legacy transaction as part of a larger M&A transaction, but typically, the objective is to improve capital position in one form or another.
Eric Stenson: You say that capital is an over-arching theme, but how does a legacy transaction help a carrier with its capital position?
Ed Hochberg: If you are in the insurance business, then you have capital tied up by business you’ve underwritten in the past. This was always something that was known intuitively—a carrier runs the risk of adverse loss reserve development. Over the last 15-20 years, both regulatory and rating agency capital models have evolved to the point where you can pretty much quantify exactly how much capital is being consumed by prior-year liabilities.
Ronnie Carroll: Ed, in fact if you look back through time, what’s been the number-one reason for a carrier going insolvent or having serious financial difficulties?
Ed Hochberg: Adverse loss reserve development.
Ronnie Carroll: Which is why rating agencies and regulators make carriers hold capital against their loss reserve provisions—depending on the line of business and the capital regime, the amount of undiversified capital required can range from 30% to 50% (or more) of the carried loss reserves.
Ed Hochberg: So, a well-designed legacy transaction can have an immediate impact on a company’s required capital, and it can often be done at an attractive cost of such capital.
Eric Stenson: Specifically, how do rating agencies give credit for legacy transactions? How about regulators?
Ed Hochberg: The major rating agencies have become well-versed in legacy transactions. They have pretty prescriptive formulas for how to reflect them in their capital adequacy models. Again, because of that, we can come very, very close to estimating the exact capital relief in a rating agency model.
Ronnie Carroll: For regulators, it very much depends on the primary regulatory regime for the carrier. And then when you get into Solvency 2 types of regimes, it also depends on whether or not the company utilizes a standard formula or an internal model; it’s pretty easy to estimate the capital relief on a standard formula, but it can be a bit more difficult with an internal model.
Eric Stenson: Do you get the question often: “if I’m not concerned about my reserves, why would I consider a legacy transaction?”
Ronnie Carroll: Yeah, we get that a lot.
Ed Hochberg: Yeah, that’s one of the biggest misconceptions—“I’m confident in my reserves, so there’s no value in a legacy transaction.”
Look, it’s a natural question to ask. If someone doesn’t perceive a lot of risk of adverse loss reserve development, it certainly can be counter-intuitive to think that a legacy transaction can be accretive. But the thing is, even if reserves are considered adequate or even redundant, under rating agency and regulatory capital regimes those reserves still consume capital. So, a legacy transaction could still improve a company’s capital position. It enables a company to redeploy capital from its back book to future underwriting activities.
Ronnie Carroll: In fact, if reserves are in good shape, it makes a transaction much easier.
Ed Hochberg: Sure. The most common hurdle in any deal is overcoming the “bid/ask spread” between what the respective counterparties think the reserves are worth. So, if the reserves are in good shape, that often narrows that gap and makes a transaction easier.
Eric Stenson: So, are you saying that if reserves are potentially volatile, it's difficult to do a deal? That would also seem kind of counterintuitive.
Ronnie Carroll: Yeah, that would be counterintuitive. No, that's not what we're saying. But it's certainly easier if reserves are perceived as adequate and not that volatile. On the other hand, we get paid to find solutions in all sorts of situations. That includes instances where there's a lot of potential volatility.
Ed Hochberg: Right. Every solution is different, and every situation is different. The deals that we have done definitely run the gamut in terms of how much real volatility exists in the underlying reserves.
Eric Stenson: You mentioned M&A or mergers and acquisitions before. How do legacy transactions help M&A deals?
Ed Hochberg: Well, when you buy another company, you buy its balance sheet, which generally includes liabilities for just about everything that it's ever written.
Ronnie Carroll: It is usually one of the major valuation sticking points. The valuation of the liabilities, and/or the perceived impact of the potential volatility of the estimates.
Ed Hochberg: Right, so if you could take that element out of the equation, an M&A deal can go that much more smoothly.
Ronnie Carroll: Yeah. So, all things being equal, a buyer should be willing to pay more with that uncertainty off the table. Done well, the uplift in potential purchase price more than exceeds the net cost of any legacy transaction.
Ed Hochberg: Some of the major transactions that our group has undertaken over the past few years has involved creating certainty for the buyer in an acquisition.
Ronnie Carroll: In these deals, the combination of reduced uncertainty as well as reducing required capital really helped these transactions in getting over the line.
Eric Stenson: What can you say about the counterparties for legacy transactions?
Ed Hochberg: Broadly speaking, you can break the market down into professional reinsurers, for lack of a better term. Those would include the likes of Swiss Re, Munich Re, Hannover, etc., and then legacy acquirers, such as NSTAR, Riverstone, etc.
Ronnie Carroll: It used to be that the reinsurers focused on the reinsurance transactions where the ceding enterprise held on to claims administration. The legacy acquirers would then focus more on disposition types of transactions where claim servicing is transferred. Those lines have definitely become more blurred in the past few years.
Ed Hochberg: Yeah, what we really saw, is that the professional reinsurers are quite full up on long-term liabilities from their prospective books, and so they really seem to take a step back from retroactive coverages. Legacy acquirers, on the other hand, then stepped into the breach. They started considering deals that didn't require the transfer of claims administration and more capital-oriented transactions. So that's still really the current state of play.
Eric Stenson: Is it fair to say that some of the legacy players have wobbled in recent years?
Ronnie Carroll: Sure, you will have seen some of that in the trade press. The thing is, that this is a market with different players who take different types of risks. So, some will do well, and some may not.
Ed Hochberg: Yeah, I think that's to be expected.
Ronnie Carroll: Importantly for cedents, the obligations are nearly always collateralized. So that affords them a fair amount of protection against credit risk, even in the worst-case scenario.
Eric Stenson: And there have been new entrants in the space over the last few years, right?
Ed Hochberg: Capital has definitely flowed into the space, both for new entrants as well as for existing participants. And that's good because legacy business is clearly a capital-intensive one.
Ronnie Carroll: But I wouldn't say it's over capitalized at all. The fact is that there have been some players who have left the space over the last few years, and that has clearly been offset by new capital devoted to legacy.
Ed Hochberg: Clearly, you don't have the hallmarks of too much capital. We definitely don't see players acting irresponsibly. Mostly, I'd say the market is pretty orderly.
Eric Stenson: What about the trend toward very large transactions? Is that likely to persist?
Ronnie Carroll: There have been some headline transactions of a very, very large couple in excess of 1 billion dollars of ceded reserves. But I'm not sure whether a few transactions is indicative of a trend.
Ed Hochberg: No, I'm not sure either. Look, there can be value to a transferrer, of getting large blocks of reserves off their books in one fell swoop. Now, on the other hand, the size and complexity of these types of transactions means that you really limit the market to a couple of players that have the capacity to do deals of that size.
Ronnie Carroll: Yeah, for that reason, we mostly see deals in the 200 million dollar to 500 million dollar sort of range. That's the sweet spot, I think. Big enough to get even the bigger players interested, but not so big that you limit the market.
Eric Stenson: When would a company want to transfer claim servicing? And when would they probably not?
Ronnie Carroll: As ever, it's going to come down to the key objectives of the transaction. Clearly, if it's an exit or legal finality, it's going to make sense to transfer the claim servicing.
Ed Hochberg: Yeah, beyond that, it comes down to the balance of cost-benefit in a particular transaction. Generally, legacy consolidators prefer to have claims servicing. They have extensive claims servicing operations and any savings they perceive can influence their views of the relative attractiveness of a deal, meaning better execution for the transfer.
Ronnie Carroll: On the other hand, there are many situations where transferring servicing obligations doesn't make sense. This will often be the case or subject portfolios where the transferer is still actively writing the business so it isn't comfortable transferring the servicing.
Eric Stenson: What should a company think about if it's considering a legacy transaction?
Ed Hochberg: Well, every deal and every transaction is different. You know, we often get the question, “how much does an LPT cost?”
Ronnie Carroll: Right, that's probably second only to, “how long does it take to do an LPT?”
Ed Hochberg: Of course. But the fact is, that cost is a very difficult question to answer, because every specific situation is so different, and most transactions are very tailored.
Ronnie Carroll: And, quite often, the perceived cost is a function of the extent to which the markets buy into the cedent’s last reserve picks.
Ed Hochberg: And once we get through that, the headline cost will be influenced by things like whether or not the transaction is profit sharing, whether or not the claim servicing is transferred, funds transferred versus funds withheld, among other things.
Ronnie Carroll: And… how long does it take?
Ed Hochberg: Well, a legacy transaction is really a hybrid of reinsurance and M&A. So, it generally takes longer than a more usual reinsurance deal. I don't know, what do we usually say: something like a median time of 6 months? But, many times it's a function of how quickly and efficiently the transferring carrier can address data and due diligence questions.
Ronnie Carroll: We always recommend appointing a project manager, particularly one who knows where and how to get the appropriate data to answer market questions. It can be much harder when the process competes too much with somebody's day job.
Ed Hochberg: Absolutely right. The other thing that can make things run more smoothly is very close management of the contracting phase. Hiring the right law firm, but then managing that law firm in such a way that they're fully versed in what the client believes is important and what isn't. That can just save a lot of time and drama in getting a deal closed.
Ronnie Carroll: Well, Ed, we've covered a lot of ground. We've talked about how there are many reasons that an insurer would want to enter into a legacy transaction. But the key element underpinning nearly all cases is capital. A carrier might do a deal to exit a business financially, operationally and in some cases legally. They might enter into a legacy transaction as part of a larger M&A transaction, but typically, the objective is to improve capital position in one form or another to create profitable growth.
Ed Hochberg: A key takeaway for our listeners is that a well-designed legacy transaction can have an immediate impact on a company's required capital, and it could often be done at an attractive cost of such capital. Guy Carpenter has extensive experience in helping companies understand and manage the complexities of reserved risk and its capital implications. We work with clients to create tailored solutions that match insurers’ capital and risk levels for maximum efficiency.
These solutions offer greater certainty in financial results, capital efficiency, and therefore greater opportunities for profitable growth. Our experienced team has collectively executed on transactions covering in excess of $25 billion of reserves over the past several years, in every major jurisdiction. With vast actuarial accounting, financial underwriting and market experience, the team delivers results to insurers large and small around the world.
Eric Stenson: I’m Eric Stenson and thank you to Guy Carpenter’s Ed Hochberg and Ronnie Carroll for sharing their insights on legacy transactions, how they help insurers improve their capital position, and how companies benefit from legacy transactions when they look to redeploy capital to underwriting activities. Anyone wanting to learn more, or who would like to engage with a Guy Carpenter expert directly should visit guycarp.com and click on Explore Solutions.
Please look for the next episodes in our series, as we address additional themes connected with the reinsurance environment. And thank you to our audience for sharing this time with us and listening to Fo[RE]sight, a Guy Carpenter Podcast Series.