Even by the sorry standards of state insurance departments, the OneBeacon transaction in 2014 was the most abject failure of insurance regulation I have ever seen.  With their 2018 statutory financial statements before me, it is interesting to see how the run-off entities have fared over the years since the transaction was approved.  The quick answer is “not well”.

In the summer of 2014, I testified before the Pennsylvania Insurance Department on behalf of a group of policyholders in opposition to the proposed sale by OneBeacon Insurance Group of its subsidiaries in which all of their long-tail liabilities had been concentrated. The proposed purchaser was Armour Group Holdings, a so-called “run-off specialist”, based in Bermuda and of questionable reputation which made only the sketchiest of financial disclosures in the record.

Despite vociferous opposition from all policyholders who submitted commentary, the transaction was approved on December 23, 2014.  I wrote about this decision in January 2015 in a blog post titled “If This Isn’t Wrong, Nothing is Wrong”.

Justifications given for the transaction by the CFO for OneBeacon Group (who testified that “it is reasonable to conclude that the policyholders … are better off after the proposed sale than before it”) include:

1. Managing the run-off of legacy liabilities is a management distraction from the specialty insurance business of OneBeacon Group.
2. It would be better that the run-off of legacy liabilities be handled by a specialist run-off company.
3. By separating the legacy liabilities and dedicating identified assets to them, policyholders will be insulated from the risks associated with OneBeacon Group’s ongoing underwriting activities.
4. OneBeacon Group management have no legal requirement or intention of infusing any more capital into the run-off entities in the future.

As cynical and hollow as these justifications manifestly were, I was not surprised at the OneBeacon CFO advancing them on behalf of the stockholders who would benefit from the transactions. My shocking disbelief, still acute five years later, is in the rationales advanced by the Pennsylvania Insurance Department in accepting these justifications.  They included:

1. Reliance on the Towers Watson actuarial study, in particular their stochastic modeling of 10,000 scenarios, concluding that there was a 93.6% projected likelihood that the run-off entities would be able to fully meet policyholder claims for the next 30 years.
2. Notwithstanding the tremendous upstreaming of capital from the run-off entities to the parent company in the years before the transaction, that the parent would contribute moderate capital back to the run-off entities (up to $150 million).
3. That the financial condition of the acquirer, Amour Group Holdings, and its owners, Messrs. Huntington and Williams, would not jeopardize the financial stability of the run-off companies or prejudice their policyholders. (The run-off companies were being jettisoned by a mighty and profitable insurance group to be acquired by a privately held company the sketchy financial disclosures of which revealed the most limited of capitalization. How any insurance commissioner could conclude this with a straight face is beyond me.)
4. The Department rejected the well supported notion that the reputational risk associated with the insolvency of a subsidiary would cause OneBeacon Group to contribute capital to the run-off entities if they remained a part of the Group.
5. The department did buy into the notion that “efficiencies” would be gained by the transaction which would provide benefits to policyholders.

Each of these specious arguments was previewed at the public hearing held on July 23, 2014 by Deputy Commissioner Stephen Johnson and the proponents of the transaction. Many policyholders argued forcefully against the transaction and submitted expert reports, including two from me. In the context of a blog, I do not have the space to rebut every one of the arguments in favor, but the cumulative log is still up on the website of the Pennsylvania Insurance Department here for those who want to delve in further.

But for a sample of the sort of nonsense advanced in support of the transaction, look no further than the testimony of Towers Watson at the public hearing: “we note that the asbestos litigation environment has been improving for the past eight to nine years”. I would be very hard pressed to find a single person involved in asbestos litigation to agree with this preposterous statement either in 2014 or now. Even Towers Watson’s own research papers were sharply at odds with their testimony (“we believe the forces that have driven insurers’ asbestos reserves upwards in recent years are likely to continue for a number of years.”).

But policyholders were never going to get a fair hearing.  The Insurance Commissioner for the Commonwealth of Pennsylvania who approved the transactions, Michael F Consedine, had been a Partner and Vice Chair of the Insurance Practice Group of the law firm Saul Ewing LLP up until 2011 when he became the Insurance Commissioner. And very cozily, it was the very same law firm, Saul Ewing, that represented OneBeacon in the sale. The particular Saul Ewing partner who represented OneBeacon, Constance Foster, had herself been the Pennsylvania Insurance Commissioner earlier in her career. Nothing like keeping it in the family.  Michael Consedine is now the CEO of the National Association of Insurance Commissioners!

Let’s have a look at the financial statements of the run-off companies at the time of the approval of the transaction, December 2014, and at the end of 2018. Policyholders essentially have two sources of security in the event that the insurance reserves of the run-off entities prove too low.  These are the unexhausted limits of retroactive reinsurance arrangements with Berkshire Hathaway, and the statutory surplus of the run-off companies.

The run-off entities had two retroactive reinsurance arrangements at the time of the transaction, one with National Indemnity Company (NICO) for a face value of $2.5 billion, and another with General Re  Corporation (Gen Re) for a face value of $0.57 billion (both are insurance companies owned by Berkshire Hathaway). The following table compares the remaining limits of these two covers on an “incurred basis” which is insurance company jargon for their best estimate of future liability.

The other source of policyholder protection is statutory surplus (a regulatory accounting term analogous to stockholder’s equity). The following tables compares the statutory surplus of the two run-off entities.

Adding these changes together, policyholders have experienced a reduction of $228 million in available resources between December 2014 and December 2018. If this rate of deterioration continues, the companies will be insolvent in the next two years or so and the Pennsylvania Insurance Department will have a royal mess on its hands.

In the meantime, with the imminent exhaustion of the Berkshire Hathaway coverage, policyholders should prepare for a change of claims administration, from Resolute, another Berkshire Hathaway company, that administers run-off liabilities from the massive book of retroactive reinsurance that Berkshire has assembled over recent decades, to Armour Group, the new owner of the run-off companies after the 2014 transaction.  Could this be a case of the devil you know versus the angel you don’t?!

I took the time to review the statutory financial statements for each of the individual years 2014 to 2018.  It is not hard to see where the financial buffer available to policyholders has gone.  Notwithstanding the protestations of the Department and Towers Watson, the run-off entities needed to increase reserves for losses and related expenses almost immediately after the transaction was approved,  for a total of $209 million over the four-year period, which accounts of the exhaustion of the retroactive reinsurance arrangements with Berkshire Hathaway.  But more alarming even than that, over the same four-year period, the run-off entities paid out $292 million in losses and $313 million in related expenses.  While, as a simple accounting matter, the cash drain should not be important if there are adequate reserves, given the history of under-reserving by OneBeacon and the high handed conduct of the Department in ramming through this transaction, I take it as a further worrying sign that the end is near.

The Towers Watson consulting actuaries ran 10,000 scenarios through their stochastic model, which means they made a number of highly judgmental assumptions, then introduced random variables, and came to a conclusion that there was a 93.6% likelihood that the run-off entities would be able to pay policyholder claims for at least 30 years.  One is reminded of the old axiom “lies, damn lies, and statistics”.  A second consulting actuarial firm signed off on the Towers Watson approach and the Department drank the Kool-Aid.  Policyholders will pay the price for this regulatory failure to protect their interests.

I will therefore add on to the title of my earlier post “If This Isn’t Wrong, Nothing Is Wrong” the conclusion of this blog “We Told You So.”