Last summer in my piece “OneBeacon Five Years On: We Told You So”, I gave readers an update on what I described as the “most abject failure of insurance regulation I have ever seen”.  Now, with the 2019 statutory financial statements before me, I have to say that things are looking even bleaker than last summer.  Insolvency is now almost inevitably on the horizon.

This is going to be a somewhat technical blog, but I will try not to lose you!  First, to set the table, I will remind you of the structure of the four run-off entities that were spat out of the OneBeacon Group at the end of 2014.  These comprise OneBeacon Insurance Company (now renamed Bedivere), its two subsidiaries, OneBeacon American Insurance Company (now renamed Lamorak) and Employers Fire Insurance Company; and Potomac Insurance Company.

In a typical structure used for retroactive reinsurance transactions, Bedivere, Lamorak and Employers Fire insurance companies were reinsured into Potomac Insurance Company, which was the counterparty to two significant retroactive reinsurance policies with the Berkshire Hathaway entities, National Indemnity Company (NICO) and General Re Corporation.  As usual, NICO, through its subsidiary, Resolute, exercised near total control over the handling of the underlying claims through the operation of the retroactive reinsurance.

For the purposes of evaluating the credit risk to holders of insurance policies issued by the run-off entities, Potomac and Berkshire Hathaway are now essentially out of the picture.  Policyholders received letters in July and October 2019 warning that exhaustion of the Berkshire cover was imminent and that claims handling responsibilities would shift from Resolute to the new owners, Armour Group.

Potomac disclosed in its financials that effective November 22, 2019, it commuted both the remaining limits of its NICO cover and its reinsurance agreement with Bedivere related to asbestos, environmental and certain other latent exposures.  The net impact of these, presumably de minimis transactions, was zero to Potomac.  What will happen to Potomac’s statutory surplus of $11.2 million is anyone’s guess, but I will ignore it for the purposes of the remainder of this analysis.  My expectation is that Armour Group is eagerly hoping to get its sticky fingers on it in due course.

It is to the financial statements of Bedivere that policyholders must exclusively now look to assess the credit risk of their counterparty, or what remains of it, after being gutted in the 2014 transactions.

The first place to look for financial security is statutory surplus.  This is analogous to stockholder’s equity.  It is the surplus of assets over liabilities, the margin for safety before insolvency.  Bedivere had a statutory surplus of $24.2 million at December 31, 2019, a precipitous decline from $100.0 million the previous year.  The reason for the decline is the increase in reserves for losses, loss adjustment expense, and underwriting expenses of $92.5 million, booked in 2019. 

To put the surplus level in further context, Bedivere had net reserves for losses and loss adjustment expense of $298.9 million at December 31, 2019.  Statutory surplus is just 8% of that, or, to say it differently, an 8% increase in loss reserves would render the company insolvent.  As referenced above, in 2019 the company increased reserves by $92.5 million.  A further increase of just 26% of that amount would wipe out surplus of $24.2 million.

Looking at the situation through one of the main tools of insurance company regulation, risk-based capital, matters appear extremely serious.  Bedivere reports a risk-based capital requirement of $46.9 million at December 31, 2019, a significant increase from $20.6 million the previous year.  Combining this with the decline in surplus leads to a catastrophic reduction in the risk-based capital ratios, from 484% in 2018 to 52% in 2019.  This is well below that mandatory control level of 70% at which point the insurance regulator is required to step in and place the insurance company under its control.  At some point the Pennsylvania Insurance Department will have to wake up and reckon with the monumental mess it created with its kangaroo court proceedings in 2014.

Another cause of urgent concern is the relatively high percentage of common stocks held in the investment portfolio.  These amount to $72.8 million or 36% of total invested assets.  The significant decline in stock prices since the onset of the coronavirus pandemic makes it entirely possible that statutory surplus has been almost eliminated already.  Insurance regulation discourages insurance companies from holding significant sums in common stocks.  Bedivere’s holdings are just another example of the shocking conduct that characterized every aspect of this transaction.

Before this analysis, I have used the Potomac financial statements for the best indication of the rate at which reserves were being paid out.  This is because of the various intercompany reinsurance agreements which made it very problematic to derive this data from the Bedivere financials.  In the 23 quarters ending September 30, 2019, net loss payment were $458.2 million and net loss adjustment expense payments were $440.5 million.  These combine for an average annual expenditure of $156.3 million for the two categories.  Comparing this average to net reserves of $298.9 million we can derive a “survival ratio” of less than 2, a pitifully low number by industry norms.

Bedivere is clearly already on life support.  It is only a matter of time before the regulator closes down the party and puts the companies into insolvency.  The question is when.  The regulator has the incentive to keep things going to avoid the mess and embarrassment, and the acquiror, Armour Group, also has the incentive so that they can continue to collect management fees.  Sooner rather than later, they will all need to come to their senses.

Policyholders who are seeking to commute their coverage or sell their claims to an investor will have a tricky calculation to appropriately value these many uncertain matters.  I have already undertaken such valuations on behalf of a couple of policyholders.  The various elements of the computation include:

1. A forecast of future liability by year.
2. An allocation of that liability to coverage to derive a cashflow by year.
3. An estimate of the date of Bedivere’s insolvency.
4. An estimate of when the insolvent estate will pay dividends and the percentage of liabilities that will be paid.
5. A risk-adjusted calculation of the present value of those cashflows.

 I, for one, hope that the regulators at the Pennsylvania Insurance Department that presided over this travesty are blushing with shame.