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8/29/2022 By Jonathan Terrell

I last wrote about the financial decline and tenuous financial condition of Arrowood Indemnity Company in my March 22, 2022, blog based upon their 2021 Statutory Annual Statement. I now have before me their June 30, 2022, Quarterly Statement. The news is only discouraging.

Statutory surplus declined from $50.3 million at December 31, 2021, to $40.7 million at June 30, 2022. While in absolute terms a decline of $9.6 million may not appear so significant, a 19% decline is significant in relative terms, and especially with respect to the crucial regulatory ratio comparing Risk Based Capital to surplus.

As of December 31, 2021, the ratio of surplus to Authorized Control Level Risk Based Capital (ACLRBC) was 96%. Anything below 200% has regulatory consequences. A ratio below 100% authorizes the regulator (Delaware Insurance Department) to take control of the insurer. A ratio below 70% mandates that the regulator take control.

Simple math demonstrates—based on the December 31, 2021, ACLRBC—that a decline in surplus of just approximately $13.5 million would trigger mandatory control. As stated above, the company experienced a $9.6 million decline in the six months to June 30, 2022. While an updated ACLRBC is not disclosed in the quarterly statements, it is likely that the company is very close to the mandatory control level.

The 2021 decline in RBC ratios was from 175% at December 31, 2020, to 96% at December 31, 2021. This decline required the company to prepare a financial plan to the regulator. The plan is required to make proposals to correct the financial problems, provide financial projections, list key assumptions, and identify its business problems. A December 31, 2021, the Annual Statement indicates that such a plan was under preparation and that there were ongoing discussions with the Department concerning it.

We learn in the 2nd Quarter 2021 Statement that the Department approved the plan as acceptable on May 20, 2021. Very few details are disclosed except that the plan “includes the Company’s continued execution of its operating strategy with a focus on ongoing cost reductions, expense management, reinsurance collections and loss settlements.” Nothing mentioned here is particularly reassuring.  It would be extremely informative to see the plan, but it is doubtful to be forthcoming except in litigation-related discovery.

“Going Concern” is an accounting concept for the assumption that a company has the resources to generate enough income and cash to stay in business for the foreseeable future. It is an important concept that has material consequences as to how assets are valued.

At December 31, 2021, the company discloses its evaluation that there is “no substantial doubt about the Company’s ability to continue as a going concern …”. This statement is watered down in the June 30, 2022, disclosure to state that the Company has “sufficient liquidity … to continue as a going concern.” This tracks closer to the accounting definition and indicates greater caution by management in their prognosis.

What has caused a $9.6 million deterioration in surplus? As to be expected, the answer is a little complicated, but it can be found in the Statement of Income on page 4 of the June 30, 2022 Quarterly Statement, which includes a reconciliation of changes in surplus to net income.

On the positive side there were increases in surplus caused by:

  • Investment income and realized gains              $6.7mm
  • Unrealized investment gains                               $1.7mm

Offsetting these increases were:

  • Increases in loss reserves                                    $1.2mm
  • Increase in loss adjustment reserves                $5.5mm
  • Other underwriting expenses incurred             $7.2mm

There were also a couple of mystery items without discloses:

  • Aggregate write-in …misc. income                    $1.9mm
  • Aggregate write-ins for gains & losses             $(4.9)mm

Loss and loss adjustment expense reserves are established “to ultimate” i.e. to be sufficient to pay all known and unknown claims. In practice insurance companies adjust them regularly based on the latest actuarial reviews. For an active insurer this is an ordinary adjustment to their underwriting income.

For a run-off insurer like Arrowood, clearly under reserved from the start and needing to make provision for emerging claim types such as sex abuse, investment income is their one source of funding reserve increases. It is manifestly inadequate, as seen from their last several years of financial statements—in which increases in loss reserves have significantly exceeded investment income.

Even if the company were, by some miracle, adequately reserved, the situation would still be dire because the run-off does not administer itself. Unlike reserves for losses, the expenses of administering the run-off are not reserved to ultimate but are expensed as incurred in the line item “other underwriting expenses”—rather inappropriately named for a run-off insurer. At $7.2 million for the six months to June 30, 2022, while considerably trimmed from earlier years, these expenses by themselves still exceed investment income.

As mentioned earlier, the RBC plan filed with the Department must make for some fascinating reading. But I do not see how any plan can keep the company out of mandatory control by the Department and insolvency shortly thereafter. It is only a matter of time. Even if the company were adequately reserved—and based on the publicly available evidence it is not—the operating expenses of the runoff still exceed investment income, making insolvency all but inevitable.

The facts have been in plain sight for the Department for years, and it is mystifying why they have allowed Arrowood management to continue with a failing run-off for so long. But the real scandal is that the Department approved the transaction in the first place back in 2007 thereby separating policyholders from a mighty international insurance group and condemning them to an undercapitalized run-off operation and their opportunistic and avaricious management.

Whether it be policyholders of Royal Sun Alliance (Arrowood), OneBeacon (Bedivere), or the Home Insurance Company, insurance regulators have a shameful history of failing in their primary duty: the protection of policyholders.

An earlier post on this topic:

Here We Go Again. Is Arrowood on the Path to Insolvency?

Jonathan Terrell

About Jonathan Terrell

Jonathan Terrell is the Founder and President of KCIC. He has more than 30 years of international financial services experience with a multi-disciplinary background in accounting, finance and insurance. Prior to founding KCIC in 2002, he worked at Zurich Financial Services, JP Morgan, and PriceWaterhouseCoopers.

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