What it means
Many liability policies, such as directors and officers insurance and professional indemnity, are written on a claims-made basis (they respond only if the claim is made while the policy is in force). When the policy ends, a claim that arrives a year later for something that happened earlier would not be covered.
Runoff cover closes that gap. The need arises when a company is acquired, goes out of business or changes insurer.
The new owner may not want to pay for old risks, and the former directors still face possible lawsuits for decisions they made. A runoff policy lets them keep protection for a set number of years, commonly six.
Insurers usually price runoff cover as a multiple of the last annual premium. The multiple depends on the type of risk, how long the cover lasts and how much exposure the business carried.
Negotiations over the cost of cover are often part of the sale agreement, so finance teams need to include it in deal costs. The term is also used in a second sense, where an insurer stops writing new business and simply manages and pays the claims on its existing policies until they are settled.
That is called an insurer in runoff, and the focus is on claims handling and releasing capital as liabilities reduce. For a manager, the key point is timing.
Runoff cover usually has to be arranged before or at the moment the original policy ends, and leaving it late can mean it is unavailable or far more expensive. Brokers advise sellers to raise the topic early because the insurer needs time to assess the risk.
The underwriter will usually ask whether any claims or circumstances that could lead to a claim are already known, and a clean answer on those questions makes cover easier and cheaper to obtain.
In practice
Real-world examples.
Example
A private equity firm buys a software company, and the sale agreement requires the sellers to arrange six years of runoff cover for the old board. The cost is deducted from the sale proceeds, so the sellers see exactly what the protection costs them.
Example
A small architecture practice closes after the founder retires. She buys runoff professional indemnity cover so that a client who finds a design defect years later cannot make a claim against her personally with no insurance behind it.
Example
A specialist insurer decides to stop writing new motor policies. It places the existing book into runoff and focuses on settling the outstanding claims for the next several years.
Formula
Calculation
Runoff premium = Expiring annual premium x Runoff multiple.
Assume a company pays $40,000 a year for directors and officers insurance and is being sold. The insurer offers six years of runoff cover at 200% of the expiring premium, so the cost is $40,000 x 2.00 = $80,000. Spread over the six years, that is about $80,000 / 6 = $13,333 per year for continued protection of the former directors. The multiple varies with the class of insurance and the insurer, so it is worth asking more than one insurer for a quote and comparing the length of cover offered against the price.Case study
Seen in the real world.
Meridian Engineering Services is an entirely fictional consultancy that is acquired by a larger group. Its two founders, in this illustrative story, assume that their liability insurance will carry on after the sale.
Their broker points out that the policy is claims-made and will end on completion. Without runoff cover, a claim in year three about a bridge inspection done in year one would fall on the founders personally.
They negotiate a six-year runoff policy for $90,000, paid by the buyer as part of the price. The illustrative lesson is that the question "who is covered after we sell?" should be asked early in any deal. The founders also made a note in the deal checklist to review runoff terms at the start of any future sale.
Watch out
Common mistakes.
- Assuming that a claims-made policy covers old events forever, when it only responds to claims made while the cover is in force.
- Leaving runoff cover until after the policy has ended, when it often must be bought at or before the end date.
- Ignoring runoff cost in deal modelling, which can leave an unexpected bill in a sale or merger.
Questions
People also ask.
How long does runoff insurance last?
It is often sold for periods such as one to six years, depending on the risk and the terms offered by the insurer.
Who pays for it?
The sale agreement decides, and it may be the buyer, the seller or a shared cost.
Is runoff the same as tail cover?
Yes, the two terms are commonly used for the same arrangement.
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