At times, insurance carriers decide that -- for any number of reasons --they need to divest themselves of certain insurance policies, books of premium writings, or lines of business. Certainly, some companies merely shift their focus for the future and wait for the undesirable or unwanted business to lapse and go away by itself. Unfortunately, that option is not always available.
Some policies have "long tails"; i.e., the potential for claims to develop many years after the expiration date of the policy. These would include contracts with exposures for such things as: asbestosis, pollution, medical malpractice, and others. In those cases, to wait could entail years and years of unknown and unanticipated exposure. Under such circumstances, the carrier may indeed want to finalize their involvement and put the coverage behind them.
Letting Go of Long Tails
These long-tail policies are far less prevalent today than they were in the past. Today, most carriers have restricted their occurrence policies to exclude certain types of losses that often generated these claims years past the policy expiration date. In more recent writings for certain types of coverages, the carriers are now issuing "claims-made" policies, which state that not only does the incident giving rise to the claim have to occur during the policy period, but the claim must actually be presented within those coverage dates, as well. Nevertheless, there are still situations that suggest eliminating the coverage completely would be the best course of action for the insured and/or the insurer.
Another reason a carrier may want to divest themselves of certain writings might be the need for strengthening its surplus, to raise cash, or to remove the possibility of being placed in receivership or bankruptcy due to the financial exposure of these long-tail existing policies.
The desire to void certain policies that could continue to have future exposure does not always emanate from the insurer. There are also occasions in which the insured may wish to "cash in" his policy. This involves trading the possible coverage protection provided by the policy for immediate cash, and the "opportunity" to self-administer any claims that arise in the future.
Not only do scenarios arise involving primary carriers and their insureds, but also they apply to reinsurers, as well. A reinsurer may wish to disassociate itself from a ceding carrier, a line of business, or even an individual treaty or facultative agreement. Many of the same reasons that applied to carriers and insureds can also come into play between reinsurers and their ceding companies.
Buying Back
Insurance commutations, also referred to as "policy buybacks," can be useful and mutually advantageous instruments for resolving the specific types of situations mentioned above arising between insured and insurer (or between cedant and reinsurer).
A commutation is the act of the insurer paying the insured a sum of money, and then ceasing all further responsibilities for existing or future claims and obligations under the policy contract. As indicated above, there are a number of reasons an insurer might want to buy back the policy from the insured. There are also certain reasons the insured might want to receive the up-front cash, and no longer deal with the insurer on a particular policy.
Commutations/policy buybacks are seldom considered for policies providing relatively short-term exposure such as automobile, homeowners, and commercial fire. The reason for this is that claims under such policies are generally known to all parties almost immediately. The exposure under such contracts seldom extends much, if any, beyond the expiration date of the policy.
In some instances, the insurer is merely interested in ridding itself of certain policies, types of policies, or classes of business because their underwriting focus has changed. In other instances, the insurer may find itself in the untenable situation of having less money in assets than in anticipated claim liabilities. In either case, the insurer may attempt to buy back the policy (and its related coverage) from the insured. This may have mutual benefit to both parties, but it must be handled properly with an honest, full disclosure of the facts and an earnest attempt to find a mutually acceptable price for the transaction. The payment to be made by the insurer to the insured must be predicated on the fair and logical assessment of the present and anticipated future claims that may arise under the policy.
The insurer would, of course, like this sum to be as little as possible, while the insured would obviously like the sum to be as great as possible. Actually, this is no different than any other type of monetary transaction between parties, and the net result can generally be accomplished through honest and ethical negotiations.
What the insurer has to offer is the payment of a specific sum that the insured can then control, and can spend on existing and possible future claims. The insured can invest the money, thus potentially increasing the amount available for later claim payments. The insured may even be able to ultimately achieve better results than had otherwise been anticipated. The investment income and/or any possible claim-handling proficiency would have the same effect as having received a higher amount than was actually paid for the transaction.
The advantage to the insurer is that they would be rid of the exposure under the policy in question, and would also avoid the related allocated loss adjustment expenses that are associated with all claim operations. Their hope is that the up-front payment will be less than they would have spent had they retained the coverage and settled or defended the losses under the policy.
On the down side for the insurer is that the expenditure will adversely affect their short-term asset picture, and the payment may ultimately be more than they would have spent had they retained the coverage. Conversely, by eliminating the related reserve liabilities, present and future, the payment for the commutation may strengthen their net liability posture.
The advantage to the insured is the ability to gain a substantial sum of money and to have the opportunity to invest that money, thereby increasing it through interest, asset growth, etc. They would also have the opportunity to administer and direct the loss payments that would otherwise be controlled by the insurer, with the hope that they would do a better job, and thus render a further savings.
The payment amount to be passed from insurer to insured is generally based on the current value of money, which is the anticipated amount that the loss payments and related expenses would equal at the time they would be paid (sometime in the future), reduced to current monetary value.
The process entails both sides reviewing all existing and known claims under the policy, and placing a value on them as to ultimate loss payment and related expenses. This is usually accomplished with a claim audit by a knowledgeable individual or group. Once this is accomplished, the first step in the evaluation is done, resulting in the anticipated amount needed to settle/defend all existing and known claims.
But there is more remaining to be accomplished. The assessment of known or existing claims must then be coupled with an actuarial review to determine future loss development of those known claims, based on past experience.
A third step in the process also involves an actuarial consideration to attempt to project the number and severity of future claims -- the IBNR (incurred but not reported) claims and those not yet incurred. Since such predictions of the future can fluctuate substantially between actuaries considering the problem, this ingredient can also have a wide variance as to the ultimate loss value to be added to the figure for existing claims.
The sum of these three figures will comprise the starting point for establishing the projected ultimate loss payment, to which anticipated loss adjustment expenses must be added.
Finding Common Ground
The final estimated amounts derived from the reviews by the insured and insurer may not be in agreement, and, in fact, are generally substantially different. This may be the result of the two sides each having different experience levels, a different focus, and/or possibly a slightly different advantage to be gained from their conclusions. Each side may purposely, or inadvertently, skew their results toward that bias; however, the valuations must nevertheless always be honest and based on true and provable facts.
As noted, although the questions and methodology of arriving at these financial ingredients are basically the same, the net result is often very different for the two sides examining the issues.
It is at this point that negotiations begin, and each side will attempt to bring the other to a figure that is to their own advantage, or to one that will be at least mutually acceptable. As with all negotiations on any issue, the discussions must be conducted within the boundaries of established protocols for fairness, honesty, openness, and in accordance with insurance industry standards.
It is unacceptable -- and potentially fraudulent -- to misstate material facts that are pertinent to the issues or to withhold information of which the other party may not be aware and/or unable to review or otherwise verify. One definite area of subterfuge is for the insurer to misrepresent and dramatically understate its own financial stability and worth in an attempt to engender fear that they will not be around in the future to pay the claims.
Such coercion is an unacceptable practice. It is certainly below the standard of care within the insurance industry, and specifically outside the parameters of good faith and fair dealings by reputable companies and individuals involved in arranging commutations.
When the future financial stability of the carrier is an issue, the insured must do his own investigation to determine that the allegations of pending doom by the insurer are, indeed, factual. If such is truly the case, the insured may want to take less money up-front, and may be more prone to accept any reasonable offer for the commutation. The alternative for the insured in such a situation could be the undesirable outcome of later having to deal with a corporate receiver or bankruptcy judge in order to recoup even a part of their covered payments.
As with all negotiations, the parties must approach the proceedings in good faith. They must make an honest effort to resolve the issues through accurate and straightforward presentations of the facts. Certainly, as noted above, the two sides may have differing positions as to the elements of any possible settlement, but those differences must not grow out of deceitful or dishonest presentation of the facts and issues.
It is possible that after a good-faith attempt on the part of all parties, a commutation/buyback will not come to fruition. Under those circumstances, the relationship between the parties should continue as in the past.
Even though a successful attempt to reach a meeting of the minds might not be initially successful, it is quite possible that a later attempt may prove to bring about an agreement. A commutation at some later date may still be a possibility.
Commuting can be a useful tool for many entities and for many reasons, and remember, "commuting" is no longer just getting to and from the office.
