Acquiring runoff business needs proper due diligence

The amount of runoff business continues to grow as a greater amount of liabilities enter this space, but, at the same time, closure of this business occurs at a slower pace.

With the rise of runoff liabilities and interest shown in this segment by both capital markets and companies reinsuring these risks, it is imperative that the cautious industry executive perform the appropriate due diligence or forensic investigations prior to engaging in an acquisition or runoff plan.

Throughout the life of a runoff, understanding stakeholder expectations is critical to ensuring the risk behaves as predicted. Each stakeholder, whether a reinsurance company or hedge fund, should be considered during the planning, promotion and implementation phases of a runoff plan to ensure that all perspectives are considered. It is especially important for the company considering purchasing the runoff to perform the proper due diligence before entering the business.

A typical scenario in which a reinsurance company or hedge fund might engage a forensic accountant or an investigator while involved in a runoff book of business is twofold: The company is either interested in understanding what has taken place in the past, or it is interested in understanding the past and how it may impact future development and business decisions.

Importance of procedures

As a result of the technical nature of runoff plans and the potential for financial and reputation loss, fund investors, reinsurance companies and brokerage houses would be best served if they were to conduct thorough due diligence. Research and investigation into the company and/or the principals of an investment entity should be thoroughly vetted prior to funds being directed to them. With the recent attention being paid by regulators, investment firms need to be more cognizant of potential future regulations, while also taking the high road when it comes to the investment of other people's money.

In the midst of the information world shrinking and the creation of international databases, the process of conducting due diligence is not as cumbersome as it once was.

That is not to say that just anyone can conduct due diligence just because they have access to the Internet and a couple of databases. There is a level of expertise and experience that investigation firms work by and are expected to conform to, in order to analyze and locate potential derogatory information concerning a potential investment. For those situations where information is not available from a database or more detailed information is needed, those firms that have access to international "in-country" contacts will be better situated to locate the necessary information to either move forward with the investment or to alert their client to proceed with caution.

The due diligence process for hedge funds and runoffs is unlike any other due to the lack of regulation, which in turn allows "bad guys" to hide behind the regulatory agency's inability to enforce regulations.

It is important for the forensic accountant and investigator to understand how business conducted by the company entering runoff is intended to be structured and operate. Proper due diligence on a runoff business consists of several smaller investigations, which taken together should either encourage an entity to begin negotiations with a company or run for the hills.

The forensic auditor should be able to ascertain the makeup of the organization and the book of business from the initial and follow-up due diligence. Some of the details uncovered should include corporate business structure, agents involved and the costs of their services as related to the business. In addition, comprehensive due diligence should provide insight into reviews of personnel, compliance, marketing, underwriting, claims, operations, actuarial and information technology.

There are several forensic techniques that can be utilized to uncover bad guys' involvement in a potential runoff scheme. The first step in this process may be a public search for unethical or fraudulent business practices by the company's principals or the company itself. Other techniques a forensic audit might include are an examination of physical evidence and analysis of electronic data.

Forensic accountants and investigators who are familiar with the industry and business models can be an invaluable asset for entities considering entering the runoff business. Employing specialized techniques to investigate troubled business relationships, the forensic accountant's practical approach and the investigator's methodology can provide needed answers to a company's nagging questions and suspicions of trouble.

Frederick J. Kohm (top) is a partner with SMART Business Advisory & Consulting L.L.C. in Philadelphia. Bill News is the director of investigative resources at NFC Global L.L.C. in Horsham, Pa.