A long-rumoured transaction between Equitas and Warren Buffett’s Berkshire Hathaway has been announced. This will be a two-step transaction whereby (1) Equitas will be absorbed into a National Indemnity Company subsidiary in exchange for a cash payment and a promise of providing additional reinsurance and (2) a channeling injunction will be obtained cutting off the exposure of Equitas, Lloyd’s, names, and Berkshire beyond the money in the new vehicle. If consummated, the deal will achieve the long-sought finality for names (the individual investors on the responsible pre-1992 syndicate years of account) and for the current Lloyd’s enterprise.
Under the deal, National Indemnity will reinsure all of Equitas’s liabilities and provide a further $7 billion of reinsurance coverage for Equitas. Equitas has reserves presently of $8.7 billion (as of March 31, 2006) and National Indemnity will commit an additional $5.7 billion of reinsurance capacity; Equitas will retain £172 million. National Indemnity gets all of Equitas’s assets, plus £72 million from the Corporation of Lloyd’s.
In Phase II of the deal, National Indemnity will be paid an additional £40 million (£18 million from the Corporation of Lloyd’s), which is to be paid on 31 December 2009. As part of this phase, National Indemnity will commit an additional $1.3 billion of reinsurance cover, for a total of $7 billion of additional reinsurance coverage. The Phase II commitment from National Indemnity, however, is contingent upon the English High Court issuing a channeling injunction directing all claims to the new National Indemnity entity and cutting off all rights of recourse that policyholders otherwise have to seek payment from Equitas or Lloyd’s (and presumably the various trust funds).
So what does all this mean?
1. Let’s start with Lloyd’s. As I have often argued, the Lloyd’s enterprise is the source of ultimate recourse for policyholders that are not paid in full on their claims. While we are shunted over to Equitas in the first instance, policyholders retain the right – pre-Phase II – to seek recompense through the various trust funds in the US backing the Lloyd’s policies and arguably against the current Lloyd’s enterprise, that is, to the current Central Fund and in turn through assessments by Lloyd’s upon the current members. Lloyd’s seems to recognize this exposure by agreeing to commit an additional £90 million to stave off future claims arising from an Equitas shortfall. The principal question here is where is that money coming from? Is it coming from Lloyd’s raiding the existing trust funds or will it come from assessments on the current membership of Lloyd’s? I assume if Phase II does happen, then Lloyd’s will close the existing trust funds and swipe that money.
2. As to the “Names” backing the policies under which assureds are seeking or will seek coverage (these are pre-1993 non-life Lloyd’s policies), while today there is contractual privity between the policyholder and the individual Name, the individual Name is at little risk of any policyholder chasing him or her for the small fractionated share of his/her individual obligation of an specific Lloyd’s policy. It is simply not cost effective for a policyholder to pursue this, nor is there any legal obligation on behalf of policyholders to chase the individual Name in a collection action as opposed to presenting a claim to the “cash window” at Lloyd’s and requiring Lloyd’s then to deal with the accounting/funding through the funds-at-Lloyd’s of the Name and the name’s individual assets more generally (down to the last cufflink, as the saying goes). But if Phase II of this deal goes through, it would appear that the rights of policyholders will be extinguished and a forced novation ordered channeling all claims to the new National Indemnity entity. Moreover, the Names can look forward to a return premium based on roughly the remaining £150 million pounds that will be in Equitas after the deal is done. It seems unlikely that the Names will object to this structure in favor of any of the alternative ways this could possibly play out. Presumably some constituencies will raise a stink in hopes of increasing the size of the return premium, but it is quite difficult to imagine the Names getting together in a fashion to crater this bailout from the nice people in Omaha.
3. The important question is what’s in this for Berkshire Hathaway, and the answer is straightforward: this is just a money bet. To see how the deal works, let start with the money that is presently in Equitas, which as of 31 March 2006 showed a retained surplus of £458 million. The deal in part shows that that “surplus” does not exist (as many of us have long argued), for otherwise why would Equitas and Lloyd’s need to buy an additional $7 billion of assets. If the retained surplus number were right, there is no economically rational need to purchase $7 billion of additional coverage. But hold that to the side, for the moment, and let’s assume that while the surplus number is significantly understated as compared with the entire stream of claims that can be expected to flow into Equitas, assume that the amount of money in Equitas is enough to pay claims for the next 20 years. (Demographers and actuaries tell us that asbestos claims will continue to be asserted for the next 40 years.)
Assuming that there is enough money in Equitas today to handle the next twenty years, the economics of the deal from Berkshire Hathaway’s perspective becomes clear. National Indemnity is taking the back end of the claim stream twenty years out. It is committing to pay up to $7 billion for that back-end portfolio of claims. In exchange for making that commitment, it is getting £286 million today in surplus (a number I derived from taking the current surplus and subtracting the amount that Equitas will retain from that in the deal), plus £90 million in cash from the Corporation of Lloyd’s, plus another £22 million from Equitas. While it gets that money over a couple of years, let’s simplify things and say that Berkshire Hathaway is receiving £398 million in cash today (approximately $746 million) for its $7 billion reinsurance commitment beginning in 2026.
If National Indemnity earns a return of 5.75 percent on that money annually over this period, National Indemnity breaks even on the deal. In other words, in exchange for the cash payment of $746 million, National Indemnity can grow that money to the $7 billion back-end reinsurance commitment as the asbestos claims wind down. What this means of course is that National Indemnity makes money on this deal if any of the following occur:
a. it gets more than 5.75 percent real rate of return (if the return is 6.25, it will make nominally $1.4 billion (with a $123 million present value))
b. the money in Equitas lasts longer than 20 years, allowing National Indemnity to grow its nest egg further
c. the claim stream becomes less than Equitas is currently projecting.
Pursuant to what Albert Einstein supposedly called the greatest mathematical discovery of all time, the miracle of compound interest, tuppence held over a long enough period turns into something of extraordinary value, and Berkshire Hathaway’s taking the long view allows it to enter into a deal like this that others wouldn’t have the stomach for, even though the numbers work on a straightforward basis.
4. How does this proposed deal affect holders of non-life policies issued by underwriters at Lloyd’s prior to 1993, that is, how does this affect those policyholders that today pursue payment of their claims via Equitas?
Phase I of this deal is of course simply a net positive for policyholders. More assets are being made available to Equitas to pay claims. One wonders how the reinsurance policy will work in the sense whether all policies for which Equitas is responsible are reinsured, but one can reasonably assume they all are. If so, then the retained surplus of Equitas improves significantly from £458 million. This is good news for policyholders and for insurance companies that had purchased reinsurance through Lloyd’s and for which Equitas is now the claims handler.
Phase II of the deal is more complicated. If Phase II goes through, the policyholders are benefited by an additional $1.3 billion (really, 1.26 nominally given the Equitas premium), but the policyholders’ recourse will be confined to the new National Indemnity entity, as is the case in approved “solvent runoffs” in the London market. Perhaps this is enough money ultimately to pay all possible claims arising on Equitas-backed policies, but that in part will be the key question in the Phase II court proceedings. In those expected proceedings in the London High Court, policyholders (direct and cedants) need to be prepared to present their own actuarial analyses of the value of the portfolio of claims. The difficulty here will be that no policyholder has enough information to evaluate the entire portfolio of potential claims from anyone who ever purchased a non-life policy through Lloyd’s before 1993. Given the significant politics involved and the absence of compelling proof of a swindle of policyholders, given the gravitas of National Indemnity and the sheer size of the nominal dollars/pounds involved, it seems highly likely that the High Court will approve the cutoff of claims to other assets and parties other than the new National Indemnity/Equitas vehicle.
The constituency that might be less than thrilled with this news are policyholders that liquidated their coverage with Equitas believing the myth that Equitas was the sole recourse and source of funds and fearing for Equitas’s continued solvency. As I have pointed out, of the reported surplus at 31 March 2006, a full 95 percent of that amount was due to policyholders that sold out their coverage for less than the amounts that Equitas had reserved for the claims (and substantially less than the actuarial value of their claims, since most believe that Equitas has systematically underreserved for a variety of reasons). With each passing year, those deals based on erroneous premises look worse and worse, and the Berkshire Hathaway bailout only underscores this.
Note: This analysis was in part quoted in London’s Financial Times (Oct. 23, 2006) at 12.