LOSS PORTFOLIO TRANSFERS: CONCERN FOR THE TAIL [Rough Notes]

Safety National's LPTs provide the means to clean up a balance sheet

Today's uncertain economic climate has required that corporations reconsider many of the financial decisions they may have made years ago. While many of these decisions involving self-insurance or captive formations might have been correct then, the current financial landscape may now demand contemplation of other alternatives. Companies across the country are actively considering such major steps as mergers, divestures, bankruptcy and other similar dramatic actions.

One issue regarding some riskfinancing alternatives that comes up frequently involves open claims and their effect on an organization's balance sheet. At a time when companies could use a viable method of cleaning up their balance sheets, their open claims can be problematic.

Fortunately, a financial tool is available to assist in solving this problem. The tool, Loss Portfolio Transfers (LPT) has actually been around for years although its use has been primarily limited to the insurance industry's insurers and reinsurers. However, LPTs have gained popularity in recent decades among risk managers and chief financial officers.

"In its simplest form," according to Michael Kim, loss portfolio manager for Safety National, "an LPT is the transfer of a book of liabilities from an entity to a carrier or reinsurer." An LPT has no minimum or maximum size, but he points out that the transaction must be both financially reasonable to the transferring entity and also provide adequate financial protection for the carrier to address concerns regarding adverse claim development. Self-insurance has proven to be the most straightforward environment for the application of an LPT, but the positive effects of this type of agreement can be realized in other situations as well.

For example, Kim says, "If an entity is currently insured under a Large Deductible program, the LPT can reduce or eliminate the need for holding reserves for prior policy periods." In addition, any time a merger or acquisition takes place, an LPT can eliminate any existing claims on the acquired entity's books, which can make it easier for such a transaction to take place.

LPT basics

As noted above, LPTs were developed as a type of financial reinsurance, through which primary insurers could transfer liability for specified blocks of reserves for known losses to a reinsurer. This enhanced the ceding company's financial statement without transferring underwriting risk. In today's corporate risk management environment, since financial liability for the losses is transferred to the reinsurer, a captive or selfinsurer does not have to show it as a liability against surplus, thereby providing immediate relief on the parent's balance sheet.

To be sure, there are a number of other advantages available through the use of an LPT. For the transferring entity, these benefits may include:

* Providing and converting a fixed payment for all known and unknown liabilities

* Eliminating the variability and volatility of long-tail liabilities

* Relief for, and potential strengthening of, the entity's balance sheet by removing accumulated historical liability

* Elimination of joint and several liability in a group or association scenario as well as the potential for additional assessment of the group's members

* Administrative cost savings by reducing or eliminating claims administration responsibilities for the entity

In the workers compensation alternative markets such as self-insurance, Kim notes, "The most important benefit of an LPT can be the elimination or reduction of a collateral requirement by the state, or states, where that entity is self-insured. With continuing credit challenges facing some selfinsured organizations, an LPT may allow for the reduction of a state's held collateral by providing for the removal of liabilities from the selfinsured's balance sheet."

There are many stories of entities in the self-insured community using LPTs with great success. "We recently worked with a self-insured employer wishing to dissolve its status as a qualified selfinsured," says Kim. "The transferring entity had $1.4 million in outstanding reserves and, through an LPT, received a return of collateral totaling $6.6 million from the jurisdiction in which that collateral was held. This type of collateral relief is also available to an entity wishing to remain a qualified selfinsured, but still transfer liabilities from a prior occurrence period," he notes.

Time to take stock

In order for an LPT to receive approval, the transaction will need to satisfy three important criteria to most jurisdictions. First, the transfer must include all known and unknown liabilities, defined as not only development on existing claims, but also incurred but not reported (IBNR) liabilities. Second, the transfer cannot be canceled by either the seller or buyer of the transfer. This prevents any of the liability from being returned to the self-insured entity. Third, the policy format must meet the unique requirements of each jurisdiction. For example, Kim points out, "The State of California has its own Special Excess Policy form that is to be used in order to execute an LPT in the state."

Kim explains, "Safety National originally offered the LPT product to our self-insured customers largely as an accommodation for those customers seeking to leave self-insurance; but, over time, the product expanded to additionally provide our customers with an ability to transfer long-standing claims liabilities offof their balance sheet."

The product has now matured such that Safety National offers LPTs in various forms (e.g., policies, assumption agreements, deductible buy-outs, captive commutations, and reinsurance vehicles) to a diverse group of clients such as self-insured employers and groups, captives, deductible insureds, insurance companies and, in certain circumstances, regulatory authorities.

Kim adds, "We have completed LPTs in 33 states, including California, and we've also completed an LPT in Canada."

"Typically a meaningful amount of time and effort will be spent before such a transfer can be executed; however, one of the major advantages to using Safety National is that we provide a free preliminary quote," he says. In that regard, he continues, the items Safety National looks for when preparing a cost estimate include a completed LPT application, current losses for open and closed claims, complete excess coverage history, current and historical actuarial opinions, and most recent audited financial statement relative to the prospective LPT partner.

Safety National considers the items necessary for the estimate to be a framework that may need additional filling in as the process continues. With that being said, "Having a prospective LPT partner that is willing to come to the table with realistic ultimate reserve expectations is frequently the most important part to the early analysis of whether an LPT will be a viable solution," Kim states.

As one would anticipate, sometimes the quote may require substantial time to develop. "The pace of the process to deliver an estimate is largely dependent upon the complexity of the potential transaction and the number of claims subject to the LPT," Kim explains. "We pride ourselves on providing the fastest possible turnaround on the initial cost estimate so that all parties are aware of the starting point for analyzing the potential transaction."

At this point, according to Kim, "Safety National is accepting requests for consideration of LPTs involving auto and general liability claims, in addition to our well-established workers compensation LPT product." He also points out that they are "not, at present, considering an expansion of our LPT product into professional liability for hospitals or other professional lines." They do, however, have some "target classes" for AL/GL and workers compensation lines of coverage that include:

* Public entities including municipalities, schools, counties, and water districts

* Light and medium manufacturing

* Health care, including hospitals and nursing homes

* Hospitality, including hotels and restaurants

* Wholesale distributors

* Technology

* Retail

* Gaming operations/tribal gaming

Interest rates have always been an important consideration when considering any risk-financing alterative. Given the current investment rates that still hover at historic lows, Kim indicates that while "investment rates do not affect Safety National's appetite for an LPT, interest rates do affect pricing of an LPT." As is the case with any long-tail line of business like workers compensation, "investment income is an important consideration when arriving at a final price for an LPT," he says.

Conclusion

Many companies are considering courses of actions that just a few years ago would have been out of the question. The financial crisis has many of them searching for ways to enhance their financial statements. For some, the use of loss portfolio transfers may provide such a solution. Finding a financially strong, admitted and rated carrier or reinsurer with experience executing LPTs is important to streamlining the process and making the transaction efficient and successful. Safety National's proven track record indicates their understanding of this product and ability to provide this cost-effective riskfinancing alternative.

For brokers, the LPT market may provide a great value-added product for clients and prospects alike. As noted previously, Safety National will provide a free cost estimate that should assist in determining the viability of the LPT, and the LPT product is available to any agent or broker, not just Safety National customers.

"If an entity is currently insured under a Large Deductible program, the LPT can reduce or eliminate the need for holding reserves for prior policy periods."

-Michael Kim

Loss Portfolio Manager

Safety National

By Michael J. Moody, MBA, ARM