According to AM Best’s market segment report on A&E liabilities, the insurance industry observed a 9% increase in asbestos payments (i.e., $1.8 billion) in 2022.1 At the same time, asbestos reserves decreased modestly,2 while the number of divestiture transactions showed an uptick. In addition, we have observed a notable increase in the number of merger and acquisition deals involving legacy risks. The reasons are complex, but the timing of these transactions does seem to correspond to a few key themes. This article explores underlying drivers of the increase in legacy risk M&A transactions, along with the unique challenges and opportunities resulting from leveraging the current market environment.
Drivers of transactional activity on asbestos claims
High yield rates
First, the risk-free yield is at one of the highest levels in recent memory, correlated with the Federal Reserve’s steady hike of interest rates and favorable bond yields (see Figure 1). It is unclear how long these favorable yields will be sustained, so buyers and sellers have been moving with urgency to take advantage of this environment.
Investment capital
Perhaps even more impactful, investors are viewing long duration liabilities as financial instruments, as they may provide a stable cash flow and reliable yield with potentially less market risk than equities or real estate. Investors are considering liabilities that range from asbestos to workers’ compensation and can even include federal black lung and per- and polyfluoroalkyl substances (PFAS). This shift in perception has unlocked new advantages for insurers and corporate entities:
- The number of run-off liability purchasers has expanded considerably over the past decade to include buyers backed by private equity firms, investment banks, and hedge funds.
- Deal structures are more innovative and go beyond traditional reinsurance.
- The amount of capital available for these transactions goes well beyond what is available in the insurance industry, mirroring the growth seen in the catastrophe bond market in 2005-20074 or more recently with legacy health and life blocks.5
Alternative strategies prove difficult
In some cases, corporates with large pending litigation related to asbestos or other legacy liabilities have attempted to pursue bankruptcy and set up a trust to handle future payments to claimants, often following an approach known as the “Texas Two-Step.”6 This alternative approach has met some legal roadblocks, with Johnson & Johnson failing twice to prove their case for a bankruptcy to handle their talc liabilities7, 8 and Purdue Pharma’s bankruptcy stemming from opioid abuse claims being challenged in front of the U.S. Supreme Court.9 With the bankruptcy strategy becoming legally dubious, corporates could look to get balance sheet relief from the insurance transaction market.
The drivers described above have led to current market conditions that present a unique opportunity for sellers, with many buyers bidding on blocks of legacy liabilities. As a result, more entities are starting to take advantage of this favorable environment, engaging counsel to assist with deal structure and policy discovery, and working with actuaries to prepare a report containing independent estimates of the liabilities along with documentation of the key risks and uncertainties—an essential step before buyers will consider bidding on the book.
Challenges and opportunities
The seller’s considerations
Once a corporate or insurance entity decides to move forward with a transaction for their legacy liabilities, there are a number of considerations. The procedure of separating these liabilities from the existing assets of the divesting entity can be intricate, but there are effective methods for a company to completely remove their long-tailed liabilities from their balance sheet.
Legal counsel should always be relied upon to determine the strategy that best fits the individual entity, but high-level summaries of a few approaches are discussed here for reference. The first approach involves divesting the affected company from the group, with a condition that the parent company or other group members bear no shared responsibilities for the future liabilities. Another option is to establish a new entity, funded by the parent company, which acquires the at-risk operating business on arm’s length terms. Additional funds are infused into the business and are then “sold” to an acquiring entity.
In many instances, the best approach is determined by tax strategies or the corporate structure of the divesting group. As a result, de-mergers, company reorganizations, or even captive formations may emerge as the best path forward, carrying tax and legal implications. While this all adds additional complexity, the company can plan ahead and bring in the proper experts to help alleviate the side effects from a transaction of this nature.
Eliminating legacy asbestos (or other run-off) liabilities adds other benefits for the transferor as well. For publicly traded companies, removing these liabilities – often seen as unpredictable, and therefore riskier, in the long-term – may mitigate investor uncertainty in the market. A transfer provides clarity and reassurance to investors and can ease regulatory pressure, likely leading to a positive impact on stock prices. Additionally, by gaining balance sheet relief, shedding liabilities unlocks cash flows that can be distributed as dividends to shareholders or utilized for other strategic initiatives. Moreover, through the divestment of these liabilities, companies can alleviate concerns regarding their future solvency, further lessening investor apprehension and bolstering the company’s outlook.
The buyer’s considerations
For buyers, assuming corporate (single exposure) or insurance (multiple exposures) legacy liabilities provides additional means to execute investment strategies, leveraging the influx of capital resulting from these transactions. Including assets that back these liabilities presents an attractive opportunity to grow an asset portfolio, potentially leading to lucrative run-off profits. The current interest rate environment adds to the appeal of these acquisitions.
Deal structure
Legacy liabilities can be transacted in a variety of ways, and no one size fits all. The best path forward for each entity is largely dependent on management preferences. Legal advice should be considered when determining the best solution.
It is worth noting that some deals involve noninsured transactions with legacy liabilities, which can often be less costly for the transferor due to the absence of insurance regulatory requirements. In the case of typical insurance policies covering long-tailed liabilities (e.g., loss portfolio transfer (LPT)), balance sheet relief is not achieved since the company must retain the liabilities on their balance sheet. The primary exposure still rests with the transferor under insurance policies, and they assume credit and liquidity risk with the insurance company. However, through a noninsured solution (e.g., legal entity sale), the transferor attains finality, though without the benefits of protection provided through insurance regulation.
In an uninsured arrangement, the divesting group transfers a specified sum of cash and, in some cases, pre-existing insurance benefits to the acquirer. The acquirer typically injects additional funds to maintain a vested interest. As the acquirer gradually resolves liabilities through litigation, settlements, or resistance of claims, they earn a profit, with the expectation that the initial cash and asset, while accruing investment income, will outlast the liabilities. It is essential to highlight that, given the nonregulated nature of the acquisition, the divesting group must carefully iron out an agreement that avoids any potential perceptions that the transference of liabilities was fraudulent. This is commonly accomplished via a legal “true sale” opinion that can be attached to the transaction. To avoid uncertainty around what constitutes a “true sale,” some entities do find an insurance solution, such as establishing a captive, to be more secure given that there will continue to be insurance regulatory oversight of the liabilities.
Conclusion
Current market conditions have yielded an appreciable increase in transactional activity for insurers, corporate entities, and investment and asset managers. Of course, no reward is without risk, and the industry would be well-advised to remain aware of the challenges and uncertainties. Companies seeking to explore their options for asbestos and other legacy liabilities should begin by engaging with legal counsel and actuarial experts to review potential approaches and quantify their legacy exposures, to find long-term solutions for these long-term liabilities.
Special thanks to Christine Fleming J.D., AIC, ACAS, MAAA, Sam Sager, and Kyle Stowe for their significant contributions to this article.
1 Best’s market segment report: A&E reserves decline along with incurred losses. (December 18, 2023). A.M. Best Company, Inc. Available from https://www3.ambest.com/ambv/sales/bwpurchase.aspx?record_code=338922&altsrc=.
3 Figure 1 is generated from the Federal Reserve Bank of St. Louis's FRED Economic Data database, accessed January 17, 2024.
4 Cummins, J.D. CAT bonds and other risk-linked securities: State of the market and recent developments. Risk Management and Insurance Review. (March 2008). Vol. 11, No. 1, p. 23-47. Available from https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6296.2008.00127.x. .
5 Bergerson, M. and Chaudhury, P. Could legacy long-term care (LTC) blocks be the next wave of M&A deals? Milliman. Retrieved on January 23, 2024 from https://www.milliman.com/en/insight/could-legacy-long-term-care-blocks.
6 Kinel, N.N. (2022, February 22). The “Texas Two-Step” firestorm: This is no dance! The National Law Review. Retrieved January 17, 2024, from https://www.natlawreview.com/article/texas-two-step-firestorm-no-dance.
7 Hals, T., Spector, M., & Levine, D. (2023, January 31). U.S. court rejects J&J bankruptcy strategy for thousands of talc lawsuits. Reuters. Retrieved January 17, 2024, from https://www.reuters.com/legal/jjs-ltl-units-bankruptcy-dismissed-by-us-appeals-court-filing-2023-01-30.
8 Knauth, D. (2023, July 31). J&J effort to resolve talc lawsuits in bankruptcy fails a second time. Insurance Journal. Retrieved January 17, 2024, from https://www.insurancejournal.com/news/national/2023/07/31/732718.htm.
9 Totenberg, N. (2023, December 4). Purdue Pharma, Sacklers’ OxyContin settlement lands at the Supreme Court. NPR. Retrieved January 17, 2024, from https://www.npr.org/2023/12/04/1215717223/purdue-sacklers-oxycontin-supreme-court.