Readers of Risky Business will be well-aware of my strong opposition to insurance regulators allowing healthy insurance groups to spin out their inconvenient legacy liabilities in run-off entities to questionable parties whose interests are misaligned with those of policyholders.

When OneBeacon Insurance Group wanted to do this in 2014, I submitted two expert reports and testified at the regulatory hearing, to no avail. It gave me little satisfaction to be proven right when the run-off entities, now renamed Bedivere Insurance Company, went into liquidation earlier this year. It is the most egregious example of regulatory failure I have ever seen.

Now eyes are cast upon Arrowood Indemnity Inc. The British multi-national insurer Royal and SunAlliance, now trading as RSA Insurance Group, had a long history of underwriting in the U.S. through Royal Indemnity and other insurance entities when it began the process of retreating from the U.S. marketplace back in 2002. A number of its insurance businesses were sold and the remaining companies placed into run-off. In due course, management sought to sell those run-off entities, collectively referred to here as RSAUSA, to a new entity: Arrowpoint Capital Corporation, owned by existing RSAUSA management and some outside directors. Its indirect insurance subsidiary, renamed Arrowood Indemnity Company, comprises the run-off insurance operations.

In 2006, I submitted an expert report and testified during regulatory hearings that preceded the management buyout and formation of Arrowood. The Delaware Insurance Commissioner had the decency to listen to objections and modify the deal to include some extra protections for policyholders. But the stark reality didn’t change: Policyholders who had purchased coverage from the U.S. operations of a prestigious multinational insurance company in the expectation that its name, reputation, and financial resources would stand behind its insurance policies were forever deprived of that security and could only look to the slim financial resources of Arrowpoint for future claims satisfaction.

Nearly 15 years later, Arrowood Indemnity is still in solvent run-off. In fairness, that is a lot longer than I expected and a lot longer than the OneBeacon run-off companies survived. However, Arrowood claims adjusters are gaining a reputation for a “scorched earth” approach to adjusting and litigating claims, and I have been asked by various policyholders with significant Arrowood exposures to review their latest financials and advise on their prospects for survival as a solvent insurer.

And the news is not good. The financial condition of Arrowood has significantly declined to the point that in my professional opinion, for the reasons set out below, Arrowood is at high risk of near-term insolvency.

I am regularly asked to give advice on solvency of insurance companies in run-off and serve as an expert witness on the subject as well. With more than 35 years of financial services experience, a background that crosses accounting, finance, insurance, and banking disciplines, and the experience of working for both insurance companies and policyholders, I have a unique perspective on the credit risk associated with insurance companies in run-off.

This blog post gives some highlights of my recent analysis:

Run-off and the Risk of Insolvency
Insurance companies in run-off status are, by definition, at higher risk of insolvency than those that are actively underwriting. In run-off, an insurance company does not have the benefit of ongoing premium income. Its only sources of income are investment earnings, sales of assets, and gains from commuting direct and reinsurance contracts.

But a run-off insurer is subject to all of the reserve volatility that any insurer faces. The insurer can do the best job in estimating its liabilities for claims for which it has been already notified. What can almost never be reliably reserved are categories of claims that have yet to emerge.

In 2007, proponents of the Arrowood management buyout and their consulting actuaries, with the approval of the Delaware Insurance Department, proclaimed the sophistication of their reserving models and the capital sufficiency of the run-off entities. But they could not have anticipated the material categories of new legacy liabilities that would emerge and cause financial distress to the insurance industry today. These include the sexual molestation of minors by youth, religious, and educational organizations; liability for the manufacture, marketing, distribution, and supply of opioid pain medications; liability for environmental pollution, property damage, and bodily injury from so-called “forever” chemicals like PFAS; and liability for bodily injury from exposure to talc. With a fixed asset base, run-off entities like Arrowood without any parental support have no ability to properly respond to these unwelcome developments.

Financial Analysis
The most recent financial statements available for Arrowood are those in the Statutory Quarterly Statement as of March 31, 2021. A review of the main items of the balance sheet reveals Cash and Invested Assets of $784 million, reserves for Losses and Loss Adjustment Expenses of $664 million, and statutory surplus of $92 million (analogous to stockholders’ equity).

At December 31, 2007, the year-end after the management buyout, Arrowood reported loss reserves of $952 million and Loss Adjustment Expense reserves of $439 million (total $1,391 million). Under statutory accounting rules the loss reserves are presented on the balance sheet net of reinsurance and combine reserves for reported claims, IBNR, and both direct and assumed risks. At December 31, 2020, Arrowood reported loss reserves of $449 million and Loss Adjustment Expense reserves of $243 million (total $692 million).

There is nothing particularly surprising about the reductions in reserves given 13 years of run-off activity, though this observation says nothing about the adequacy of the reserves in either 2007 or 2020. 

However, buried in the arcane disclosures of the statutory fillings is the change in reinsurance protection, which is enormous and surprising. In 2007 gross reserves were $2,889 million netting down to $952 million after accounting for the protection afforded by ceded reinsurance of $1,937 million. In other words, reinsurance represented 67% of gross reserves (1,937/2,889). In 2020, gross reserves were $624 million, netting down to $449 million after accounting for $175 million in ceded reinsurance. At year end 2020, ceded reinsurance represented just 28% of gross reserves (175/624). In 2007 the disclosure indicates that for each dollar increase in reserves, just 33 cents would reduce statutory surplus, whereas in 2020 each dollar increase would reduce statutory surplus by 72 cents.

In my opinion, the most likely explanation for the discrepancy is that Arrowood management have adopted a proactive strategy to commute their ceded reinsurance.

This is a classic tool of run-off strategy. It is often justified on the basis that a run-off insurer may have thousands of individual reinsurance contracts and collecting on them is time consuming and expensive. The reality is that the commutations provide a steady stream of cash to fund operations, pay management fees, and kick off down the road the day when that reinsurance protection will be missed. An insurance company does not have fixed liabilities; its size is dependent upon the claims made on its insurance policies. Likewise, ceded reinsurance is an endlessly flexible asset that will respond to the variability of claims liabilities. But once commuted, that variable protection is lost forever in exchange for a cash payment. Commuting reinsurance raises the risk profile of an insurance company.

I found little encouragement when reviewing the last five years of statutory filings to examine the increases in loss reserves and claims payments. Loss reserves were only increased $30 million over that period, an average of $6 million per year. In two years, Arrowood actually reduced loss reserves. Given the emergence of new categories of risks, including specific disclosures for opioids and sex abuse of minors in the Arrowood financial statements, it is incredible that there should be no adjustment to increase loss reserves over the period in which these classes of liability were emerging.

Equally unbelievable: the extraordinary regularity of the gross claims payments — an average of $94 million per year, with the highest year $104 million and the lowest $82 million. Given the volatility of managing books of legacy liability, it simply beggars belief that they are able to responsibly manage their claims payments with such regularity.

These numbers support the “scorched earth” reputation mentioned above. Loss Adjustment Expense (LAE) reserves, which make provision for the legal and other costs of adjusting claims, have regularly increased over the five-year period, by $158 million in total, an average of $32 million per year, further supporting the sense that Arrowood would prefer to spend its dwindling resources on legal expenses rather than actually pay claims.

Further, a risk-based capital (RBC) analysis provides an early warning system to monitor the financial health of insurance companies and provide a trigger for regulatory intervention. Arrowood’s precipitous drop in statutory surplus since 2016 and especially since 2019 — both in absolute terms and relative to RBC Authorized Control Level — gives considerable cause for concern. At 175% the ratio has triggered the “Company Action Level,” requiring Arrowood to file a plan with the regulator identifying the conditions that contributed to the financial problems and proposals to correct them. The 2020 statutory filing indicates that Arrowood has indeed filed such a plan with the Delaware Insurance Department and that discussions are ongoing.

In short, review of the 2020 Annual Statement raises considerable concerns about the ability of Arrowood to continue in solvent run-off: 

• The company has no significant parentage from which to draw resources.
• Its only material source of income is from its diminishing investment portfolio.
• Its capital position has significantly deteriorated, triggering regulatory action.
• It does not appear to have taken action to reserve for emerging sources of liability.

In my opinion Arrowood is at high risk of near-term insolvency.