Jason Woolfe explores some of the reasons why commutation is appearing on many reinsurers' route maps to the future

Insurers have been gripped by the escalating costs of asbestosis for too long.

And there are other latent liabilities out there like time bombs ready to detonate within insurers' balance sheets.

Commutation - a deal by a reinsurer to buy itself out of its commitments to a ceding insurer - is rapidly becoming a popular option for reinsurers.

Lloyd's insurer SVB, having largely pulled itself out of difficulties arising from its directors' & officers' (D&O) book, announced earlier this summer that it was planning to commute a raft of long tail US business.

A flock of other reinsurers is joining the action. For the reinsurers, commutation offers finality, whatever sort of long term liability keeps them awake at night.

Having suffered for years watching asbestos liabilities spiral into figures that would not have been believed ten years ago, the outlook for the industry is not improving.

Indeed, plans in the US to legislate against the escalating crisis are looking unlikely to come to fruition this year. The idea of a multi-billion dollar trust fund will be welcomed by insurers, but they would be unwise to hold their breath waiting.

The 2004 presidential campaign is likely to get in the way of legislation, giving claimant lawyers enough time to send a surge of new cases to courts while they can.

In the meantime, insurers are under huge pressure to reassure shareholders and capital providers that they have no skeletons in their closets. And liability skeletons are known to be expensive.

Mark McCausland, a partner with leading actuariy and consultant Lane Clark & Peacock, argues the uncertain state of global stock markets and the current low interest rate environment are piling on the pressure to commute.

At times of higher investment returns, reinsurers could at least count on significant earnings from their reserves, producing income that could be discounted from the eventual cost of paying claims.

As McCausland points out: "Because the markets are depressed at the moment, the discount factors that have traditionally been applied may in the current market seem to be too high."

Enormous losses
The extent of the escalation was made clear when ratings agency AM Best increased its estimate of ultimate asbestos losses for the US insurance industry to $65bn in May 2001 - a massive rise from the already enormous figure of $40bn estimated just four years earlier in 1997.

McCausland says: "Five or ten years ago commutation wasn't really a consideration. Today it's on the list. The fact that reinsurers have found themselves having to strengthen their reserves with regard to asbestosis has made them think that rather than having to have this drain on their ongoing business, it makes more sense to provide finality by simply withdrawing from the contracts."

The global run-off market has been estimated to be worth at least $300bn, and some put the value of liabilities at closer to $500bn.

Given the size of the sums, many reinsurers are devoting large amounts of time and effort to spotting the next asbestosis.

Tobacco, toxic mould, fatty junk food and alcohol are all targets for legal action.

And while the US is traditionally more litigious than the UK, there's no shortage of people willing to push the boundaries of the law on this side of the Atlantic.

When a group of Scottish alcoholics announced their intention to sue breweries for failing to warn them of the dangers of drink, the story made tabloid headlines.

That case has now fallen by the wayside - due to lack of legal aid - but Glasgow-based litigation specialists Ross Harper who advised the men is now manoeuvring a tobacco case towards a place in the history books.

Margaret McTear hopes to have her day in court in October to sue Imperial Tobacco for £500,000 on behalf of her late husband, Alf.

No warnings
Alf died in 1993 from lung cancer that Margaret will claim was caused by smoking 40 cigarettes a day. Solicitor Cameron Fyfe says: "Our legal argument is strong. Alf began smoking in the early 1960s when there were no warnings [about the risks of smoking]. When the warnings came on in 1971, he tried to stop but it was too late, he was hooked."

Fyfe, who is handling the case on a no-win, no-fee basis, adds: "If we don't win, someone else will win some time."

Fyfe is sceptical that junk foods or alcohol will be the next asbestosis - "We've know since Roman times that alcohol is detrimental to health", as he points out - but insurers are being kept busy worrying about liabilities from mobile phones, GM crops, food preservatives or 101 other common substances.

McCausland says: "The question for the insurers is where will the next asbestosis come from. When people were signing contracts on asbestos it was never imagined that the premiums signed 40 or 50 years ago would cover claims like these being seen under asbestos litigation today. Against this background, commutation makes an awful lot of sense."

It can also add to a reinsurer's competitive edge. McCausland argues: "Capacity is already withdrawing and reinsurers need to demonstrate that legacy issues won't come back to haunt them."

From a cedant's point of view, there are also advantages. Current pressure on reinsurers' financial strength ratings is raising the possibility that some reinsurers may not be around in ten years' time to pay claims. All the better, surely, to take the money now in a commutation settlement.

"That's a major benefit for cedants," McCausland says. "They can obtain cash today, based on their reinsurer's current financial strength rating."

There are risks. Buying yourself out of a contract makes sense only if the price is right, and negotiations may be long and slow.

SVB's chief executive Matthew Fosh says he expects to wait until the end of next year before getting his first commutation win.

Most importantly, the price must be right.

But the cost of an experienced and team crawling all over a contract and its liabilities could pale into insignificance compared to that of waiting and watching claims balloon.