LOSS PORTFOLIO TRANSFER: MIDDLE MARKET SOLUTION
Agents and brokers can share this technique with their clients
In today’s capital-rich financial environment, risk managers, corporate CFOs, and others in the C-suite are starting to scrutinize some of their earlier alternative risk transfer (ART) decisions. A number of these decisions surround merger and acquisition activities. These analyses have been occurring with increased frequency over the past dozen or so years.
Many industry experts think these kinds of merger and acquisition (M&A) activities will continue into the foreseeable future. According to The Wall Street Journal, 2015 merger and acquisition activity was the highest ever. Further, although the exact number of events in 2016 has not been finalized, KPMG in its M&A Outlook for 2017 states that it believes the number for 2016 may be as high as that for 2015. Additionally, KPMG indicates that much of this year’s activity will be in the middle market, rather than the mega-deals that typically have made up the majority of M&A activity.
Many organizations have surplus capital and are developing strategies for more efficiently deploying this excess capacity. Although this affects all industries, the technology and healthcare sectors have been engaging in a disproportionate amount of activity. In the healthcare industry, this is in large part a result of changes in rules and regulations after implementation of the Affordable Care Act. A similar situation can happen in the wake of changes to the ACA that the new Congress may make. KPMG indicates that, although the majority of mergers and acquisitions are implemented without fanfare, 36% have major problems that typically end up with a failure to complete the event. The primary reason for failure is disagreement between the parties with respect to valuation.
A solution to this problem is a little-used approach known as loss portfolio transfer (LPT). To date, this approach has been used primarily in financial transactions within the insurance community. Recently, however, use of this approach has started to broaden. In essence, the parties enter into a reinsurance contract that covers the open claims for the primary risk taker. This approach works with claims for uninsured, self-insured or captive risks. The insured incurs a fixed cost for all known and unknown (incurred but not reported) liabilities. This way, the insured can sell off some divisions or product lines, which allows the insured to clean up its balance sheet. The reinsurer assumes the open claims for the insured, self-insured, or captive.
Although no single domicile has carved out a significant portion of this market, several states have specific regulations dealing with LPT. Initially, Rhode Island enacted legislation; it was followed shortly thereafter by Pennsylvania and Vermont. More recently, New York enacted specific rules regarding the use of LPT.
As noted above, this approach has mainly been used by the financial services industry, specifically the insurance industry. In addition to the ability to generate capital cheaply, existing rules and regulations have helped provide a more stable environment for those entities. The LPT market has become a combination of new legislation coupled with innovative uses to assist in designing broader applications of LPT. It has become a viable option for organizations wishing to release capital that otherwise could take years to resolve.
LPT has become a viable option for organizations that wish to release capital that otherwise could take years to resolve.
Regardless of the increased regulation, the challenge of using LPT is finding two parties to consummate the deal. One solution is a structural change to arrive at the appropriate cost for the LPT in the first place. Over the past several years, there has been significant improvement in the actuarial projections, which are a key indicator in the LPT market, through the use of big data.
Recently, non-insurance uses of LPT have been reported. For example, early 2017 saw the LPT approach being used to solve a risk-financing
issue for the Coca-Cola Bottlers Association. The coverage was to finalize several lines of long-tail insurance written between 2002 and 2016. The corporation noted that the use of loss portfolio transfers could help resolve a number of risk-financing issues. In Coke’s case, the transfer was written to cover both known and unknown claims—incurred but not reported (IBNR). For its part, the use of LPT is all about determining the net present value of the transaction. Use of such vehicles speaks to the professionalism of the market participants as well as the sophistication of the company that develops the LPT.
A number of industry observers believe that the use of loss portfolio transfers by non-insurance parents is now just scratching the surface. Recent estimates of the growth of this market segment show that the current value of LPTs in the United States is between $150 billion and $200 billion and could be as high as $500 billion worldwide. The growth of the non-insurance-related market will allow many organizations to resolve retention issues, as well as provide solutions for M&A opportunities.
Generally speaking, today’s risk transfer market is characterized as a diverse array of options and transfer mechanisms. Loss portfolio transfer is one such solution. The LPT is a widely known option that has gained broad acceptance within the insurance sector; its use outside the insurance landscape is much less visible. Among today’s array of technology-driven innovations, LPT is beginning to make headway as a universal solution. The LPT has the greatest appeal to middle market accounts and offers attractive opportunities for mid-market agents and brokers.
Over the past 25 to 30 years, many middle market accounts have been forced to take higher retentions and, in some cases, no coverage at all. In such situations an LPT can be used to arrange a more appropriate retention level. Thus, the LPT can provide a solution tailored to the customer/prospect’s specific needs. Its use in a non-insurance market appears to be set for significant growth. Forward-looking middle market agents and brokers will want to consider the potential advantages for their customers and prospects of using the LPT.
Michael J. Moody, MBA, ARM, is the retired managing director of Strategic Risk Financing, Inc. (SuRF), which provides consulting services to captive and other alternative risk transfer mechanisms. As a regular columnist, he continues to actively promote the benefits of the ART market by providing current, objective information about the market, the structures being used, and the players involved.