We recently blogged about the late August announcement by Stronghold Insurance Company Limited that it planned to propose a solvent Scheme of Arrangement.  This was a direct result of the Solvency II Directive which went into effect across the European Union on January 1, 2016.  Stronghold failed the new capital requirements in both 2016 and 2017.  In its letter to creditors Stronghold describes how it believes it has no option but to propose the Scheme. 

Stronghold has been a feature of the London Company Market in run-off for a long time – it ceased active underwriting and went into solvent run-off in 1985.  Along with Dominion Insurance Company – not technically related, but with common shareholders – Stronghold is one of the few independently owned run-off entities that had not been swallowed up by Berkshire and had not been “schemed”.  Stronghold was also an extremely active underwriter between the mid-1960s and late-1970s, and many US companies have Stronghold among the Lloyds and Company Market underwriters backing their London insurance policies. 

My own dealings with them on behalf of KCIC clients have been uniformly positive – I have found their claims adjusters to be professional and they were prepared to do buyout deals at reasonable values, given their run-off status. 

But I have also been acutely aware of their run-off status and attendant credit risk.  They are not members of an insurance group that could suffer reputational consequences from their insolvency.  They do not have a strong parent company.  And as they ceased underwriting in 1985, there is no source of additional retained profits to bolster their claims paying ability. 

The balance sheet pretty much tells the whole story: an investment portfolio; liabilities for mainly US-based general liability insurance policies, mainly for asbestos and environmental liabilities; reinsurance policies to mitigate those risks; and a small cushion of equity to absorb the downside risks.  What could go wrong?  Plenty!  Given that almost all insurance companies with asbestos and environmental liabilities have needed to bolster their reserves repeatedly since 1985, I have to pay tribute to Stronghold management’s ability to organize a well-ordered run-off of over 30 years. 

How do solvent run-offs end?  When the last claim on the last policy is adjusted?  When the company runs out of money to pay claims?  Why do they need to end at all?

The nature of occurrence-based general liability corporate insurance policies is that they never expire.  Claims can, in theory, be made against the policy forever.  As a consequence, there is never a point when a solvent run-off insurance company can confidently say they have adjusted every potential claim and can close their books, distribute their surplus and go home.  But it may come to the point that maintaining the status quo is against the interests of policyholders.  The argument for this is that the cost of running the company relative to the size of the claims reserves is disproportionately high and that more money can be paid out to policyholders if a bar date is set and an orderly closure can take place using a device such as a solvent scheme of arrangement.

So much for theory.  What do the financial statements tell us?  I have them for the years 1997, 2007 and 2017, so can do a 20-year comparison.  Here is some of the story the financials tell me. 

1. We would expect an insurance company in solvent run-off to be reducing its liabilities by paying claims, and that is exactly what we see. On December 31, 1997 reserves for claims, gross of reinsurance and gross of present value discount stood at £554 million.  Ten years later, on December 31, 2007, they were down to £240 million, and on December 31, 2017 £65 million, just 12% of where they were 20 years earlier. 

2. Reinsurance reserves tell a similar story. As they should.  The accepted run-off wisdom is that unwinding the reinsurance asset through dispute resolution and commutation is the key to a successful run-off.  Undiscounted reinsurance reserves were at £406 million in 1997, down to £150 million in 2007, and all the way down to £4 million at the end of 2017.  A remarkable achievement. 

3. Shareholder’s funds, (in UK financial accounting, roughly equivalent to Surplus in US Regulatory financials), are a critical measure of solvency. For a run-off company, without resorting to accounting trickery, the only place to go to increase loss reserves is Shareholder Funds.  The amount of Shareholder Funds, both in absolute terms and as a percentage of net reserves, is a significant metric.  Stronghold’s Shareholder funds actually increased from £5 million in 1997, to £7 million in 2007, to £11 million in 2017 – not a result I was expecting.  As a percentage of reserves (net of reinsurance and present value discount) they increased from 4% in 1997, to 9% in 2007 to 22% in 2017.  In other words, in 1997, the company could afford to increase net loss reserves by just 4% and remain solvent, but in 2017 it had room to increase them by 22%. 

4. The main argument for bringing the run-off to a close is that operating expenses will become disproportionate and will eat into funds available to policyholders. The main run-off-related expenses that are disclosed in at least 2007 and 2017 are:  staff costs; directors emoluments; and fees paid to Isis Consulting (a run-off consultancy owned and operated by the directors and owners of Stronghold).  Staff costs were not disclosed in 1997, but in 2007 and 2017 the sum of these three expense categories was about the same, at just under $2 million.  Given that the net liabilities are now greatly reduced, it is true that this is proportionately a bigger expense, though still well less than is generated by investment income. 

So where do I come out?  Is the proposal for a solvent scheme in the interests of remaining policyholders of Stronghold? 

As a general matter, I am against solvent schemes.  While they may be neutral for a policyholder that has incurred the liabilities to exhaust coverage, or one that has a sufficient claims experience to prepare a robust forecast, they are prejudicial to policyholders that are the beginning of a liability, or desire the basic bargain of an insurance contract, to mitigate the effects of a liability that is yet to emerge.  While, on the one hand, Stronghold has been operating smoothly for over 30 years in solvent run-off, a long time for policyholders to become aware of potential liabilities, on the other hand, the landscape is constantly shifting.  In the area of asbestos-related litigation alone, we are seeing companies being named for the very first time, and so called “peripheral” defendants suddenly in the cross hairs.  New classes of long-tail liability continue to be regularly asserted.  These types of policyholder will inevitably suffer from a solvent scheme.  Another objection is that Schemes are expensive and spend large sums on professional fees that would otherwise be available to policyholders. 

The existing management of Stronghold has done an excellent job in collecting reinsurance and reducing policyholder liabilities.  At the same time, they have increased Shareholders Equity, especially as a percentage of net reserves.  The company appears at less risk of insolvency than at any time in the last 20 years.  Finally, run-off-related expenses are increasingly significant as a percentage of reserves, but still manageable and well within investment income. I believe it is in the interest of policyholders to see the status quo maintained for some more years. 

It is not entirely clear to me the powers that the UK regulator has to compel a Solvent Scheme, but this would appear to be a case where they should show restraint, and U.S. policyholders should urge that view upon them.