All things come to an end, even for insurance policies. While insurers are in business to pool risks and sell policies, what happens when portfolios are no longer profitable enough or ill-suited for the times? One answer is the run-off—the sale or discontinuance of insurance portfolios or entire companies. In Europe, some run-off markets have a long history, such as the life market in the U.K. and most property/casualty (P/C) markets in Europe. Some markets are just starting to become more active, such as the German life insurance market. The reasons insurance companies put a business in run-off are diverse. On the one hand, it can be an effective risk management tool and help streamline and achieve corporate targets. But it also can present significant risks to reputation and balance sheet strength.

Increasing Focus On Technical Profitability And Core Lines Are Feeding Steady Growth In P/C Run-Off

In P/C insurance and reinsurance in Europe, we're seeing continued deal flow of run-off as part of the insurance lifecycle, especially in lines of business such as motor, health & accident (bodily injury), liability, and workers' compensation. P/C transactions are generally more frequent but smaller compared to life deals, driven by an increasing emphasis on technical profitability and focus on core business. Although P&C run-off activities are spread across Europe, Germany and Switzerland are dominant markets in total size of liabilities in run-off (see table 6 in the appendix). The activity in these markets mainly incorporates claims run-off, especially through the reinsurance of U.S., U.K., and German exposures. Another large run-off market is the U.K., especially for large financial lines.

The main reasons P/C insurers pursue run-off in Europe are capital optimization, a focus on the core business, and underwriting results. Other reasons are to reduce volatility on the balance sheet and to build scale, which are increasingly influenced by the regulatory landscape (mainly since the implementation of Solvency II), digitalization, and general cost cutting. We expect these drivers to be further catalysts for run-off deals in the years to come, in particular for the larger P/C markets in Europe such as the U.K. and Germany.

Chart 1

The largest run-off deals in P/C over the past three years have occurred in the U.K., Germany, and, to a smaller extent, in Norway, Belgium, and Italy (see table 6 in the appendix). The main lines of business were motor third-party liability and liability, but also some specialty business lines such as aviation, energy risks, marine, and U.S. asbestos. Complexity and third-party liability cover are common characteristics of almost all of these lines of business.

As opposed to property insurance lines that often settle claims in a relatively short period, third-party liability claims generally take a long time (and sometimes several decades) before settlement. That's because settlement may result from lengthy court proceedings with volatile outcomes. It could take several decades between a claimant's exposure to asbestos and an asbestos claim notification to the insurer, for example.

We expect 1%-2% average annual growth in the run-off P/C market in the next few years, about the same on average as over the past five years. There are three reasons. First, we assume interest rates to only moderately rise in the next three years, with limited scope for investment returns to offset underwriting losses, which means that insurers are aggressively pruning less profitable lines. Second, increasingly enhanced strategic risk management is pushing companies to concentrate on lines of business that meet their risk/return targets and close those that don't. Third, regulatory requirements and other related developments in Europe such as Solvency II, the Swiss Solvency Test, and the coming implementation of International Financial Reporting Standard 17 are compelling companies to allocate capital and other resources to lines of business that they manage best.

Chart 2

Another trend that could result in somewhat larger single transactions in coming years is increased knowledge and work with run-off platforms. In our view, the current run-off platforms will continue to be the main beneficiaries of external run-offs and sales of portfolios because of their expertise and appetite for run-off acquisitions to build scale and maintain current solvency levels.

Table 1

Life: A Varying Market With Differentiated Potential

In Europe in the life insurance run-off market, we have observed increasing transaction volume in the larger markets such as Germany, particularly during the preparation phase and implementation of Solvency II in 2016. Because of the regime, insurers have adopted an increasingly economic view of capital requirements where certain businesses no longer appeared favorable in terms of the risk-/return profile. Certainly, the low interest rate environment has increased product risk in most life insurance markets over the past few years and has accelerated the development of an active run-off market, with many insurers shifting to more capital-light products (see "European Life Insurers Are Playing The Long Game With Product Shifts," published on Feb. 22, 2018).

In life insurance, the management option to put larger back books into external run-off and potentially sell to a third party has become more commonplace in Germany, where the first external transfers of run-off business, those of Heidelberger Leben and Skandia Leben, were transferred to Viridium, a dedicated run-off platform, in 2014. This was followed by further transactions in 2017 and 2018 (see table 5 in the appendix).

Chart 3

Table 2

U.K.

Consolidation in the U.K., which boasts the largest life insurance market by gross written premiums in Europe, began in the 80s. We nevertheless expect further scope for run-offs, in particular in the annuity and with-profit sector because of:

• The increased focus on risk and asset-liability management since the introduction of Solvency II;
• Low interest rates, which led Aegon to sell its U.K. annuity portfolio and L&G to sell its Mature Savings business to Swiss Re;
• Changed business strategy, at, for example, Standard Life and others focused on building asset management capabilities; and,
• Brexit uncertainties.

We expect the number of companies willing to take on management of complex types of business like annuities and with profits will decrease leading to continued consolidation in this sector.

France

In Europe's second-largest life insurance market, the large bancassurance sector dominates business. We have seen only a few insurers placing their business in run-off. In recent years, only one midsize mutual insurer called Matmut decided to close its life savings business to new premiums. Bancassurers offer a comprehensive set of products to their customers and have long-term relationships with their clients, with the average duration of life policies 11 years. As the sector is strongly capitalized and life and saving products remain an important pillar of new business, we see relatively low scope for larger transactions, also because the regulatory environment appears less favorable to external investment. This also reflects the low average minimum guaranteed bonus rate (0.44% at year-end 2017) which does not require an extremely high level of capital under Solvency II. Lastly, there is a reasonably high level of cross-selling between life and P/C products as most French insurers offer both product types to their customer base. As such, insurers would be somewhat reluctant to discontinue part of their business relationships with their existing customers.

Italy

In Italy, we have seen a small number of run-offs in recent years. That's because of the consistent decline in the average guaranteed interest rate on traditional policies to about 1% in 2017, driven by both a higher surrender rate than the European average and a shorter duration for life liabilities of six-seven years than the European average, has reduced the attractiveness for run-off. The Italian life market is concentrated despite a large number of entities, as the insurance subsidiaries of the largest banks and the post office have taken over 60% of premiums distribution, leveraging on economies of scale and wide networks. Despite forecast healthy 4% annual growth in premium, competitive pressure from the largest players could push some smaller insurers to opt for a run-off. However, taking into account the current market structure and development we see relatively low attractiveness for run-off in the Italian life insurance market.

Germany

The German life insurance market has entered a phase of restructuring in product design and back book management, in our view mainly because of the long-lasting low interest environment and Solvency II. The market is shifting to capital-light products in new business with fewer or no guarantees. However, this transition has been slow in our view, moving to an average liability duration of about 12-14 years, down from 16-17 years in 2012, according to our data. Therefore, life insurers are considering various options to manage the back book, including placing parts of the portfolio in an internal or external run-off. While we observed a general shift in product strategy and back book management attention in the market, the options chosen can vary significantly.

We nevertheless expect further consolidation in the market, which will reduce the number of legal entities in the market, which has already resulted in a decline to 84 in 2017 from 95 in 2010.

Meanwhile, three consolidators could establish a reasonable market position in the German life market, which are Viridium Group, Athora Group, and Frankfurter Leben. Run-off platforms typically benefit from economies of scale, synergies, and in-depth expertise. While run-off is not new to the market, the emergence of dedicated business models backed by various investors for run-off is relatively new to the German life market, bringing a new dynamic.

Table 3

Germany has been the most active market for external run-off transactions in the past three years (see table 5). In April 2019, the largest external run-off transaction so far in Germany was approved by the regulator, with Generali Leben contracts being transferred to consolidator Viridium Group. We expect this market to grow further in the coming years, though not at the same pace. On the one hand, consolidators will seek further opportunities to increase economies of scale and optimize the capital held within closed businesses. But on the other hand, rather than going into run-off, life insurers could relieve pressure on their business by shifting to more capital-light products. Additionally, the ongoing stable performance of the groups' P/C subsidiaries and to some extent recalibrating the calculation of additional reserve requirements (see "Proposed Reform Makes ZZR A Less Bitter Pill For German Life Insurers," Oct. 8, 2018) reduces the need for run-off transactions.

Capital Management Versus Customer Orientation

The management of back books is an increasingly important part of the strategic toolbox for restructuring business models and focus on core business in selected markets. Capital management is on the agenda of every management board, and the pressure is there to use capital efficient and focus on profitable business lines.

We expect run-off solutions to provide insurance companies with more flexibility to improve capital positions, improve risk/return profiles, free-up capacity for more profitable business segments and for future challenges, such as digitalization and product innovation.

Table 4

In our view, selling a life business to an external party could have also varying effects on an insurer's financial risk profile, depending on its underlying capitalization as well as embedded technical risk. In our capital model, total adjusted capital (TAC) would decline in the case of a disposal of a business segment in life insurance. The amount of the decline is dependent on the capital base and the underlying value of the business since a run-off could release some TAC components (like shareholders equity, present value of future profits and policyholder bonus reserves).

On the other hand, participating life insurance business carries high risk charges plus the charges for longevity risk. Hence a realization of guaranteed and/or annuity business could lead to a relief within the risk capital.

In P/C, capital relief is also dependent on overall capitalization as well as the reserve surplus and the risk profile within the respective line of business.

Therefore, certain transactions, both in life and P/C insurance, could lead to an improvement but also deterioration of S&P Global Ratings' overall capital adequacy assessment--notwithstanding diversification effects across business segments and lines of business. A well-managed and fairly priced external run-off can be a win-win for the trio of policyholder, seller, and acquirer if synergies in scale and know-how can be sufficiently leveraged. Nevertheless, insurers have to balance negative consequences as reputational risks, scale effects, and cross-selling, which could affect overall business performance and top-line growth.

We expect the P/C run-off market to grow further, which will lead to the restructuring of the portfolios of insurers and reinsurers and will gradually strengthen their risk-return position. However, we expect no material change in creditworthiness for our rated companies because we assume deals will generally be nontransformative, with usually limited impact on solvency and capitalization.

For the life insurance run-off market, in our base-case scenario, we expect continued activity, especially in the U.K. and Germany, but we don't expect further single large transactions of the size of Generali's Germany business. The impact on insurer financial strength has to be assessed individually, but we do not expect any rating change followed by a run-off transaction in the next two years.

Appendix

Table 5

Table 6