Emphasis: Proactive Management of Asbestos Liabilities

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1 Emphasis, 2008/1 Emphasis: Proactive Management of Asbestos Liabilities By Sandra Santomenno, Steven Lin and Kate O Reilly Asbestos litigation in the U.S. has been characterized by its repeated transformation. Legislation, court rulings, medical research, plaintiff bar activity and other factors have radically altered the litigation landscape in the past and continue to do so today. Traditionally, defendant companies and their insurers found themselves in a reactive role when confronted with asbestos litigation and related developments. But, in the last few years, they have worked to reshape their strategies for managing asbestos liabilities with the help of some novel financial approaches that can mitigate balance sheet risk. THE CLAIMS BOOM Asbestos claimants first achieved compensation in the tort system in the early 1970s. From an initial trickle, the annual number of claimants grew to approximately 5,000 in the early 1980s and 25,000 in the early 1990s. Despite the growth in claims, defendants and insurers mostly viewed asbestos claims as a manageable liability that could be resolved in an orderly fashion. Matrix settlements were negotiated with the leading plaintiff law firms to methodically compensate plaintiffs without the laborious adjudication of individual claims. Claim costs were allocated among many major defendants according to rules established by the Asbestos Claims Facility and then by the Center for Claim Resolution (CCR). This tenuous system was upset in the mid-1990s by a number of legal developments, most importantly the U.S. Supreme Court's rejection of a proposed class-action settlement between the CCR and plaintiff law firms, as well as increasing efforts by certain firms to bring large numbers of unimpaired plaintiffs into litigation. New claim filings exploded, growing to an annual average of approximately 50,000 in the late 1990s and reaching nearly 100,000 in The old settlement strategy became prohibitively costly when applied to the massive number of new claims. A GROWING FINANCIAL BURDEN Asbestos defendants have generally relied on general liability insurance coverage purchased from the 1940s to 1980s for the indemnification of litigation costs. Insurers, in turn, transferred risk to other insurers via reinsurance arrangements. As the cost of litigation grew, defendants found themselves shouldering an increasing financial burden because of depleted or otherwise unavailable coverage and, in some cases, insolvent insurers. Many defendants turned to bankruptcy to resolve their liabilities. These companies utilized a section of the federal bankruptcy code, Section 524(g), that enables a debtor organization to channel all pending and future asbestos claims to a special trust fund while the reorganized company operates free from asbestos litigation. A variation of this strategy is the prepackaged bankruptcy, commonly called a "prepack," where the defendant negotiates a global settlement with its pending asbestos plaintiffs in advance of a bankruptcy petition in order to secure their votes for approval of the reorganization plan. However, 524(g) bankruptcies have proven to be expensive and time-consuming. Transaction costs often exceed $50 million in professional fees alone, and the reorganization process may take two to four years or longer. More recently, the future of the 524(g) structure, in particular prepacks, has been called into question as courts have rejected an increasing number of proposed reorganization plans. The number of new asbestos-related bankruptcies has decreased from a peak of 13 in 2002 to just two in 2007 (see Exhibit 1).

2 SHIFTING LEGAL LANDSCAPE The reduced interest in bankruptcies may also reflect the steep decline in new claim filings since 2003 and the widespread perception among defendants that asbestos litigation has "turned a corner" as a result of favorable developments in litigation in recent years. Many states have enacted asbestos or general tort reform measures, and courts in various jurisdictions have stepped up restraints on asbestos suits. These reforms have created a less frenzied litigation atmosphere that allows defendant companies and insurers to evaluate proactive alternatives for managing their asbestos liabilities. Assessing such liabilities has always been and remains a challenging task because of the large population of workers exposed to asbestos and the long latency period between exposure and disease manifestation. Today, companies must still plan for more than a 40-year horizon for ultimate resolution of their asbestos liabilities, during which they may receive tens of thousands of new claims. Although recent trends seem more favorable to defendants, there are still significant unknowns in how the liabilities will ultimately be resolved. PROMISING OPTION One newly emerging option for defendant companies is to purchase insurance coverage or another risk transfer product designed for the specific purpose of transferring asbestos claim liabilities. Historically, asbestos portfolio products were rare, as a unique or stand-alone risk management tool. General liability insurance policies written through the mid-1980s typically included indemnification for asbestos-related claims but little or no attention was devoted to understanding and pricing asbestos as a specific risk. This began changing in the 1980s, as it became clear to insurers that policyholders, as well as judges and juries, expected these policies to respond to a much wider range and greater magnitude of asbestos claims than the insurers anticipated. The insurers responded by disputing and in many cases litigating the demands made on coverage that had been written. They also added specific asbestos exclusions to wording on new policies to eliminate potential risk of asbestos loss on future policies.

3 Insurers still dealing with legacy asbestos liability were reticent to jump back into the asbestos waters and offer new coverage. In the absence of proactive loss transfer solutions being offered in the marketplace, defendant companies facing asbestos liabilities with exhausted or inadequate insurance coverage had little choice but to keep the problems in-house. MARKETPLACE DEMAND Recently, new players have emerged that are offering to assume the asbestos litigation risks of defendant companies desiring to mitigate the impact of asbestos liabilities on their balance sheets and reduce the volatility in their financial outlook. The goal of these new entrants to the market is to manage asbestos claims and litigation risk more efficiently than their client companies, thus freeing the clients to concentrate on their core operations and ongoing business interests. The beginning of 2008 saw the launch of St. George Re Limited, a Bermuda regulated insurer. St. George Re was created to meet the demand for true risk transfer insurance coverage for companies dealing with asbestos liabilities. For small to midsize transactions, St. George Re will underwrite and issue direct coverage. Additionally, it can underwrite larger limits via an agreement with Berkshire Hathaway, under which Berkshire will coinsure transactions underwritten by St. George Re. St. George Re is willing to provide this new type of risk transfer product because: It believes that fundamental changes in the legal and economic climate now make it more possible to quantify potential asbestos liability with a reasonable degree of confidence. It provides a tailored insurance policy that provides the coverage that a defendant company seeks, without exposing the insurer to risks that it did not intend to accept and did not price. An alternative approach is espoused by the Litigation Resolution Group (LRG), formed in LRG proposes to assume and manage asbestos litigation costs of client companies through corporate indemnification contracts. Much of the marketplace demand for asbestos risk transfer solutions is driven by changes in the broad legal environment. There are also factors specific to a defendant firm that impact its interest in asbestos portfolio products. Generally, a company s interest increases when it is faced with unexpected events that require it to quantify or reassess its contingent asbestos liabilities. Such events may include: Adverse developments in litigation that result in higher claim costs. These can include unfavorable trial verdicts, larger-than-budgeted settlements that make sense for strategic reasons, increases in defense costs to defend against claims or a new type of plaintiff that catches the company by surprise. Potential merger, acquisition or divestiture. Such transactions can be aided by the quantification, and especially capping, of asbestos liabilities. New regulatory or financial reporting requirements. These can require a company to quantify or provide greater disclosure of its contingent asbestos liabilities.

4 DUE DILIGENCE STEPS For asbestos portfolio products and transactions to be successful, effective due diligence should be conducted by both parties to determine the nature of the exposures to be included in the loss transfer portfolio and the potential outcomes of the transaction. The main considerations for the party assuming the liabilities are listed in Exhibit 2. Not all risks will be considered sufficiently stable to be offered a quote. For example, a company newly targeted by litigants or one with inadequate information may be considered too volatile. The defendant company may still be in denial about the size of its problem and unwilling to pay the required premium while, from the viewpoint of the party assuming liabilities, no premium may be sufficient to compensate for the amount of volatility. From the defendant's vantage point, the net present value of retaining the cost of the expected future loss on its balance sheet should be compared with the cost of an equivalent or greater amount of insurance protection (or other indemnification). In addition to direct premium costs, the company should also consider the factors in Exhibit 3. FINANCIAL ADVANTAGES Compared to bankruptcy, a risk transfer product is a less invasive solution. Risk transfer solutions allow a company to restructure the balance sheet and assure stakeholders that the "asbestos monkey" is off its back without resorting to an expensive, time-consuming and potentially ineffective bankruptcy process. Companies may discover that the cost of transferring risk and management of asbestos liability to a third party ends up being cheaper than bankruptcy. While the cost savings are realized over a long time period, there may be up-front benefits if financial analysts, rating agencies, lenders and suppliers no longer have to grapple with attempting to quantify contingent liabilities and are able to remove the "asbestos risk discount" from their assessment of a company.

5 Standard & Poor's (S&P) recently proposed including an enterprise risk management (ERM) component in its scoring process when determining the credit ratings of nonfinancial companies. S&P indicates its "principal interest in evaluating ERM is to implement steps that will limit the frequency and severity of losses that could potentially affect ratings." It has explicitly identified liability lawsuits as a key risk for certain industry sectors. Companies with significant asbestos liabilities will likely be expected to devote a large part of their ERM plan to the diligent management of these liabilities. INSURER TRANSACTIONS While insurance companies with significant asbestos liabilities have been bought and sold since the early 1990s, there has recently been increased interest in acquiring runoff portfolios that include significant asbestos liabilities. One example is the sale by ACE Limited of ACE American Reinsurance Company and two other runoff reinsurance subsidiaries to the investment firm Randall & Quilter in ACE estimates the sale reduced its gross liabilities on asbestos and other legacy claims by $900 million. Also in 2006, Equitas and Berkshire Hathaway Inc. announced that they had reached an agreement in which National Indemnity Company (NICO), a subsidiary of Berkshire Hathaway, would provide reinsurance cover to Equitas of $7.0 billion over and above the March 31, 2006 reserves ($8.7 billion), and take on its staff and runoff operations. It will be interesting to see how the companies fare under these new agreements. ADVANTAGES TO THE BUSINESS As with portfolio transfers involving defendant companies, asbestos portfolio transfers between insurers require due diligence by both buyer and seller to thoroughly assess the potential liabilities. Exposure-based analyses are considered to be industry best practice for the estimation of an insurer s asbestos liabilities. A sound exposure-based model fully incorporates the insurer s underwriting and claim experience in the projection process and can generate, not just a point estimate, but also a stochastic range of estimates that reflects the variability underlying the asbestos claim costs. Such methods support the proper evaluation of proactive solutions to address outstanding asbestos liabilities and are favored by rating agencies. Using proactive planning, supported by sound financial and operational risk analysis, asbestos defendants and insurers can employ portfolio transfers as a way to manage and mitigate their risk and exposure to volatile asbestos litigation. This is an important tool for company decision makers with a desire to not only create and maintain operational efficiency and add economic value, but also develop organizational resilience using ERM