June 29, 2005
Equitas Financial Reports – 2005 Version
As part of the Reconstruction and Renewal of Lloyd’s in 1996, several Equitas entities were created to serve as the final reinsurer-to-close and to manage the run-off of underwriter liabilities for non-life 1992 and earlier business.
On June 7, 2005, Equitas issued a press release on its annual results and more recently made available its Report & Accounts for the year ended 31 March 2005.
Equitas reported that its accumulated surplus increased immaterially and now totals £476 million; its solvency margin increased over last year by nearly 25 percent to 12.2 percent.
Equitas further hiked its asbestos reserves by £167 million, a figure notable in part given the obvious tactical advantage to Equitas in not raising its reserves at all, in view of the possibility that its reserves will be used as a benchmark for determining its contribution to the US asbestos trust fund, were it ever enacted.
Equitas continues to proclaim that it will be able to make payment of claims in full and emphasized that its board never has considered invoking “proportionate cover,” a power purportedly vested in Equitas to undergo a private bankruptcy in which it pays only a percentage of what it believes it owes on claims. See Report, Chairman’s Statement.
Equitas, however, continues to tout credit risk as a principal reason for policyholders to liquidate and settle their rights to coverage. See Report, Directors’ Report (“The principal risk remains that the Group may not be able to settle its liabilities in full.”).
The press release tries to stimulate further policyholder settlements, saying: “When many companies, including some of the world’s best known businesses, are agreeing settlements with Equitas, the directors of other policyholders will properly question why they should not do the same.” (Commentary at 6). What may have prompted Equitas to make this particular comment was the contrary view of Equitas settlements reported recently in London’s Financial Times, see Steven Fiedler, Will Equitas Come Back to Haunt the Big Companies? Financial Times (Nov. 8, 2004), at 15 (I confess that the FT article quotes me).
But Equitas’s justification of its own settlements confirms these may be one-sided deals. The Press Release explains that “[t]he value of claims from certain policyholders is susceptible to material change depending on the outcome of litigation or variation in claim trends. The liability for such policyholders are . . . the most dangerous. . . . Of the 28 major direct asbestos exposures we have settled since April 2001, 20 were among the most unpredictable that we faced. . . . Their resolution offers Equitas (and the policyholder) protection against wide swings in the value of these cases.” (Commentary at 6). No doubt a policyholder faces risk that there can be materially adverse developments in insurance-coverage law, but it is unlikely that Equitas is settling claims based on unusually policyholder-favorable interpretations of coverage; the wide swings in values to which Equitas refers are unlikely to result from insurance-law developments. Rather, holding aside such developments as a swing factor in the valuation of a settlement, the drivers of settlement values are predictions of the dollar cost of the asbestos claims and the claim flow.
For example, if the expectation is that the claim stream will total $150 in total over the next ten years, settling today for, say, $100 is the economic equivalent (assuming the discount rate used is right and full coverage). However, if the settlement is for $100 and the claim stream ends up costing $200 over the ten-year period, the policyholder has undersold its coverage, and Equitas has done a good deal. Equitas’s comments about the swings in values reveals that it is only the policyholder that is at risk, especially assuming that asbestos claim values unforeseeably escalate (which has happened in the past – several times). In other words, the “wide swing” that Equitas is protecting itself against is more likely than not to be a swing upwards in the value of claims – in which event the policyholder will have liquidated its coverage today without getting full value.
Only if the settlement is cast against the expectation that the value of the claim stream will (unaccountably) go down is there any swing favoring the policyholder in these deals (and potentially a windfall to the policyholder in receiving more payment for its coverage than the economic value of the amounts to which it otherwise would be entitled in the ordinary course). The likelihood of such a downdraft in asbestos claim values seems remote in the extreme. (The possible impact of federal asbestos-liability reform is taken into account in settlements separately, see below.)
Furthermore, given that the Lloyd’s policies that Equitas manages usually are excess policies, Equitas is not typically controlling the defense and settlement of the underlying asbestos liabilities. Accordingly, it is telling when Equitas says that “claims management strategies adopted by the group will reduce claims payments below the level that they would otherwise have been” (Report at Note 2). Equitas is not managing the claims to reduce the payouts to asbestos plaintiffs or to defense lawyers; Equitas is managing the claims to reduce payments to policyholders.
When one sprinkles into the mix a discount being provided by the policyholder for Equitas’s credit risk – which Equitas touts on the one hand and pooh-poohs on the other – then it is clear that Equitas continues its successful practice of inducing policyholders to settle for less than economic value.
In fact, Equitas annually monetizes the amounts it estimates it has saved by doing deals with policyholders at amounts below the reserve for the particular policyholder’s claim stream (note that Equitas discounts its reserves, so the reserve number and a present-value buyout should be equivalent). For the 2004-2005 fiscal year, Equitas says that “claims and commutation activities” produced £95 million of profit, that is, that through its claims settlements Equitas was able to take £95 million into income by settling for less than the reserved value of the claims. See Release, Commentary at 9. (Although the £95 million takes into account reinsurance settlements, given that in excess of 85 percent of Equitas’s outwards reinsurance already had been liquidated before the fiscal year began and assuming that Equitas had not seriously underestimated the value of its reinsurance recoverable, one can reasonably infer that the overwhelming bulk of the settlement “profit” came at the expense of policyholders that settle for amounts below the reserved level.) In fact, more than 70 percent of Equitas’ surplus is accountable to the impact of these Equitas-favorable settlements over the past three years alone (2005, £95 million; 2004, £97 million; 2003, £142 million).
The £95 million in settlement profit in 2004-05 – more than 25 percent of Equitas’s current reported surplus – in fact may represent an even larger amount considering that Equitas does not retroactively adjust its books when it later increases its asbestos reserves. In other words, if Equitas next year increases its reserves by, e.g., £150 million for asbestos liabilities (and in 2004 it increased asbestos reserves by £296 million), the settlement profit for year 2004-05 in truth will be greater than the £95 million (because the reserve for that policyholder should have been higher); but according to Equitas’s accounting practices, “any consequential adjustments to amounts previously reported will be reflected in the results of the year in which they are identified.” (Report at Note 2).
Finally, Equitas rectified an omission in last year’s report by discussing the impact of the “out” clauses it has included in recent major settlements of asbestos liabilities, in which the settlement with the policyholder is altered or vitiated in the event that, e.g., federal asbestos-liability reform legislation is enacted vel non. Equitas reports that a total of £370 million may be returned to it based on various contingencies, principally regarding federal asbestos legislation, but that contingent asset presumably will need be offset against the reinstatement of some policyholder claims.
(Note: As of 31 March 2005, £1 GBP = ~ $1.88 US.)
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June 25, 2004
Equitas Financial Reports – 2004 Version
As is well known, Equitas Ltd. manages the run off of liabilities under non-life insurance policies issued by underwriters at Lloyd’s, London, prior to 1993, and these policies are exposed to paying for liabilities of US companies for certain asbestos, environmental, and other “health hazard” claims of injury or damage that occurred in the period of their coverage. Each year, Equitas publishes its financial results as of 31 March (for 2004, its Reports and Accounts were released in late June but were dated 3 June 2004) and provides additional commentary via an accompanying press release (dated 8 June 2004).
Equitas’s press release confirms that the accumulated surplus of Equitas has been reduced to ₤460 million, down ₤67 million the year before.
Equitas has liquidated approximately 85% of its total reinsurance receivable.
Equitas notes that its gross undiscounted asbestos reserves have increased to ₤4.0 billion (increased by ₤296 million).
According to its figures Equitas’s solvency margin improved to 9.8% from 8.7%.
Of particular note are the following:
- Equitas’s Chief Executive Officer, Scott Moser, candidly acknowledged that, when assureds agree to policy buyouts (whereby they liquidate and extinguish all rights to coverage under policies issued by Lloyd’s underwriters prior to 1993), one key factor driving the pricing for those assured is “eliminating credit risk” (Release p.2; Report p. 5) – that is the credit risk of Equitas’s being unable to pay claims. Nevertheless, in a typical example of Equitas double-talk, footnote 1 to Equitas’s financial statements proclaims, “The Directors believe that the assets should be sufficient to meet all liabilities in full” (Report p. 33) (emphasis added). While Equitas represents to policyholders that there is substantial credit risk, to their auditors Equitas represents the opposite.
- Equitas acknowledged that its claims settlements with policyholders were for an amount nearly ₤100 million less than the book value of the claims. (Release p.8) In other words, Equitas paid ₤97 million less to its assureds than the amounts Equitas reserved for their future stream of claim payments. As we have seen upwards adjustments annually to Equitas’s asbestos reserves for the past several years, if one were to assume that next year Equitas again “strengthens” its reserves, the underpayment to its assureds in fact will turn out to be greater than the ₤100 million in savings Equitas acknowledged this year. (Last year (2003), Equitas acknowledged freeing ₤142 million through settlements with its assureds for less than the reserved values, but its current release does not indicate the appropriate upward adjustment of the “savings” from the prior year’s settlements, given that, even considering those policy buyouts, Equitas was constrained to increase its asbestos reserves again.)
- Equitas’s analysis of the proposed US asbestos-reform legislation showed that its passage would have resulted in Equitas’s risking becoming insolvent. That Equitas views the legislation’s passage as risking its own solvency calls into the question its ability to meet the asbestos-coverage claims of its US assureds.
- Equitas’s major asbestos deals this past year vest in it the right to a refund, or reduction in its future payout obligation, of ₤400 million, in the event federal asbestos-liability reform legislation passes. Equitas does not explain whether it takes this contingent asset into account in its financial statement or in its analysis that passage of the legislation may result in its insolvency.
- Equitas has commuted (liquidated) more than 85 percent of its potential reinsurance recoverables. (Report p. 6) As a result, Equitas is unable to justify its oft-invoked statements to policyholders that unless they demonstrate syndicate information on their Lloyd’s coverage Equitas is unable to make any payment; though this position had some equitable force when Equitas needed such information to facilitate its own outward reinsurance recoveries, that those recoveries have been received already via commutations means that Equitas’s need for this information has correspondingly diminished. Given that Equitas was itself able to achieve commutations without knowing each particular assured’s allocation of liabilities to particular policies, Equitas cannot equitably contend that it should pay nothing with respect to a policy that is known to cover a certain dollar amount but as to which syndicate-participation information is lacking.
- Equitas balances the candid admission of its underpaying its own assureds with the exhortation to its policyholders to settle their claims with Equitas: “If you are being told that you cannot do a fair deal with Equitas, you need new advisers.” (Release p.3; Report p.11) Equitas plainly believes that “fair” deals are at less than its reserve levels for the claims released and are priced against the threat of Equitas’s insolvency.
- The impact of an Equitas insolvency, however, must be offset against the financial structures undergirding the original sale in the US of policies through Lloyd’s. There are US based trust funds, as well as the “old” and “new” Central Funds and possibly the full capital resources of Lloyd’s current membership, that are part of the “chain of security” backing Lloyd’s underwriters’ policies. For example, according to the 2004 Report, there is in excess of ₤2.5 billion in US and Canadian trust funds “for the settlement of claims relating to those jurisdictions.” (Report p.40). A policyholder’s right of recourse to these monies, however, is released in policy settlements with Equitas.
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