Session 39 PD, The Advantages of Reinsurance as an Alternative Capital Source. Moderator: Michael L. Kaster, FSA, MAAA

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Session 39 PD, The Advantages of Reinsurance as an Alternative Capital Source 

 

Moderator: 

Michael L. Kaster, FSA, MAAA 

 

Presenters: 

Dale J. Mensik 

Michael David Mulcahy, FSA, MAAA 

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The Advantages of Reinsurance as an

Alternative Capital Source

Michael Mulcahy

VP, Marketing

Canada Life Reinsurance

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Financial Reinsurance as Alternative Capital

Dale Mensik

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Disclaimer

This presentation does not address the investment objectives or financial situation of any particular person or legal entity. Investors should seek independent professional advice and perform their own analysis regarding the appropriateness of investing in any of our securities.

While Hannover Re has endeavoured to include in this presentation information it believes to be reliable, complete and up-to-date, the company does not make any representation or warranty, express or implied, as to the accuracy, completeness or updated status of such information.

Some of the statements in this presentation may be forward-looking statements or statements of future expectations based on currently available information. Such statements naturally are subject to risks and uncertainties. Factors such as the development of general economic conditions, future market conditions, unusual catastrophic loss events, changes in the capital markets and other circumstances may cause the actual events or results to be materially different from those anticipated by such statements.

This presentation serves information purposes only and does not constitute or form part of an offer or solicitation to acquire, subscribe to or dispose of, any of the securities of Hannover Re.

© Hannover Rück SE. All rights reserved.

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Reinsurance For Capital Management

Sources of Capital

Types of Reinsurance for Capital Management

Coinsurance

New Business Financing

Surplus Relief

Redundant Reserve Financing

Capital Relief

Example – Group Life Capital Relief Reinsurance

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Financial Reinsurance Vs. Insurance Lending:

Terminology differences are often distinctions without differences

Financial Reinsurance

Traditional financial reinsurance utilizes traditional reinsurance structures to transfer liabilities to and thus increase surplus or lower capital requirements for a ceding insurer

May impact the asset side of the balance sheet but primarily impacts the liability side of the balance sheet

Insurance Lending

Focuses on providing traditional (i.e. cash, securities) and structured assets

Financial guarantors have still not rebounded to pre-crisis health so the pre-crisis negative basis trade is often not an option

Rating agencies have limited amount of financial and total leverage and have assigned leverage to more instruments

There are economic, regulatory and accounting considerations which make one

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Sources of Capital

Retained Profits

 Takes Time

 Difficult when in Growth Mode

Raise Equity/Capital Contribution

 Expensive (up front costs)/Dillution if external

 Existing Owners may be unwilling

Borrow (Surplus Notes or Debt)

 May be expensive depending on company and market conditions

 Debt Covenants

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Current State of Capital Markets for Insurance Companies

Plenty of traditional capital is available to the insurance market

Traditional Debt Capital Markets and Equity Capital Markets are deep and a reliable

ABS markets have come a long way since the financial crisis but still have less depth

Many investors are willing to consider structured insurance risk to generate incremental yield

But. …

A skeptical market exists for structured life insurance risk after pre-crisis XXX risk securitizations and life settlements underperformed expectations

Financial guarantors have still not rebounded to pre-crisis health so the negative basis trade is often not a reliable option

Rating agencies have further limited financial, operating and total leverage insurance entities can carry and expanded what structures create leverage

Complexity, lack of insurance expertise and small bite size makes executing meaningful transactions difficult in capital markets

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All Financial Reinsurance is really Asset-backed Lending

Financial Reinsurance involves Hannover Re advancing the present value of future

profits of a collateral block of life insurance, health insurance or annuities

Can involve an asset transfer (e.g. cash ceding commission)

Can involve a reduction of liability (e.g. transfer less assets than liability)

May impact GAAP, IFRS or only statutory accounting

Can advance full value (i.e. equity-like cost) or a small fraction (less than debt financing cost).

Cost of a Financial Reinsurance solution is a function of

Loan-to-value ratio of collateral block

Cost of liquidity or collateral required

Variability of future profits (i.e. risk that value drops below the value of the loan)

Correlation to reinsurer’s portfolio of risk (i.e. diversifying risks attract less economic capital than core risks)

Typically, ceding company credit spread is a secondary or tertiary consideration on price

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Pricing is a Function of Risk and Reward

But, risk to whom and how do you calculate reward?

Retu

rn

Investment Grade Bonds

Cash

Hi-Yield Bonds

Real Estate

Public Equity

Private Equity

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Financial Reinsurance Pricing Relative to Alternatives…

- Financing Expense +

Debt-levels

Equity-levels

Pricing levels can be inside of Debt-levels to

wider than Equity-levels and anywhere based

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Uses of Financial Reinsurance

• NAIC RBC and other capital ratios are often a limiting factor for insurance

companies which constrain insurance companies with rating agencies, regulators and capital

• Most are some variation of Surplus divided by Required Capital

• May be highly prescribed (i.e. RBC or most rating agency frameworks)

• May be more principles based (i.e. Solvency II and MCCSR)

• Both can make sense at a high level but can make very little sense for a given product, company or situation.

• RBC Ratio = __Total Adjusted Surplus__ = Modified Surplus Company Action Level RBC Required Capital

• Most folks focus on increasing surplus in the numerator, but lowering the denominator is often easier and has a levered impact

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Surplus Relief

Goal: Improve Ceding Company Surplus

Structure:

 Typically Coinsurance and Modified Coinsurance

 Expense Allowance paid by reinsurer may be cash or non-cash.

 Non-cash allowance acts to reduce the reserve held by the ceding company

 Profits in excess of the risk charge are returned to the ceding company through an experience refund.

 Typically on inforce business. If on new business, allowance improves income as well as surplus.

Advantages to conventional financing:

 Often much cheaper than surplus notes or other capital sources

 No leverage created

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Reducing Required Capital

Sell Less Business/Limit Sales

 Reduces Profits

 Upset Sales Force

Take Advantage of Covariance

 Limited impact

 Difficult to control and grow

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Reinsurance To Control Sales Volume

Advantages

 Can reduce capital/strain without restricting sales

 Can exit business without selling a company

 Potential cost savings from reduced administration

 Exit business that is no longer strategic

 May unlock future profits

Disadvantages

 Portion of future profits passed to reinsurer

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New Business Financing

Goal: Raise funds to cover expense of issuing new business

Structure:

 Typically Coinsurance

 Expense Allowance paid by reinsurer to cover a portion of the new business strain

 Reinsurer charges a risk charge as a portion of the outstanding allowance.

 Charge may be fixed or related to some index

 Profits in excess of the risk charge are returned to the ceding company through an experience refund

 Experience refund typically expires when allowance is repaid, and reinsurance is typically recaptured

Advantages to conventional financing:

 May be only option

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Redundant Reserve Financing

Goal: Finance Reserves Considered to Be Redundant More

Efficiently than Conventional Methods

Structure:

 Often use of captives involved

 Reserves financed over fixed period of time

 Alternative assets used to fund the reserves considered redundant

 Reinsurer takes the risk that conventional assets won’t be sufficient to pay claims

Advantages to conventional financing:

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Capital Relief Reinsurance

Structure:

 Varies depending on business covered

 Cover moves required capital from the ceding company to the reinsurer

 Unlike surplus relief reinsurance, typically no allowance is paid above normal expenses

 Reinsurer charges a risk fee, and returns the remainder of profits to the ceding company through an experience refund

 Experience refund usually expires after a set time to encourage recapture

Advantages to conventional financing:

 Low Cost

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RBC Relief and A/XXX Facility

to Facilitate an Acquisition

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Options to Optimize a Target's Capital Structure

Convert Statutory PVFP to Statutory Capital

Resolution Holdings

Lincoln Benefit

Life Insurance Hannover Re

RBC Relief

Captive LLC

Structured Note

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Options to Optimize a Target's Capital Structure

Convert Statutory PVFP to Statutory Capital

No Reinsurance

AXXX Only

A/XXX and RBC Deal

Total Stat Capital $1,000

XXX Financing $0

Sponsor Capital $1,000

CAL RBC $300

RBC Relief $0

Net CAL RBC $300

Total Stat Capital $1,000 XXX Financing ($250)

Sponsor Capital $750

CAL RBC $300

RBC Relief $0

Net CAL RBC $300

Total Stat Capital $800 XXX Financing ($250)

Sponsor Capital $550

CAL RBC $300

RBC Relief ($100)

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Insurance Lending for Acquisition Financing

Lever returns with favorable rating agency treatment

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Group Life Capital YRT Structure

Quarterly (or monthly) renewable term structure, with

quarterly accounting.

Premiums are set at or near the gross premiums of the

ceding company.

No expense allowance is typically paid.

Premiums are paid in arrears, therefore minimal reserve

transfer.

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Group Life Capital YRT Structure

Loss Carryforward and Experience Refund

All profits net of a risk fee are returned to the ceding

company through an experience refund.

Losses to the reinsurer are carried forward and repaid out

of future profits, if they emerge.

Ceding company can terminate on short notice (must repay

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Group Life Capital YRT Structure

Common Risk Reducing Features

Reinsurer may have a right to increase premiums.

Reinsurer may have right to increase the risk charge after

some period.

Reinsurer may be able to remove experience refund at a

future date.

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Group Life RBC Reinsurance Example

Happy Insurance Company writes only group life

$100B of Net Amount at Risk

Average premiums are $2.5/1000 of NAAR

Average claims are $1.75/1000 of NAAR

Total expenses are 20% of premium

 Assumptions: Taxes ignored, static state – no reserve impact, RBC for other than C2 ignored

NAAR 100,000,000,000 Premium 250,000,000 Claims 175,000,000 Expenses 50,000,000 Profit 25,000,000 CAL RBC 84,300,000 ROC (@200% CAL) 14.8%

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Group Life RBC Reinsurance Example

Happy Insurance Company reinsures 50% of business under a YRT

arrangement:

Reinsurance rate is $2.4/1000

Risk Charge = $.01/1000 of NAAR

Gross Ceded Net

NAAR 100,000,000,000 50,000,000,000 50,000,000,000 Premium 250,000,000 120,000,000 130,000,000 Claims 175,000,000 87,500,000 87,500,000 Expenses 50,000,000 - 50,000,000 Risk Charge - 500,000 500,000 ER - 32,000,000 32,000,000 Profit 25,000,000 500,000 24,500,000 CAL RBC 84,300,000 42,150,000 42,150,000 ROC (@200% CAL) 14.8% 29.1%

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Impacts to Cost/Benefit of YRT Reinsurance

Covariance Adjustment - Companies with large amounts of C1/C3 relative to

C2 may not get much benefit from reducing C2

Target Level of CAL RBC will alter ROC benefit of the RBC relief

Reinsurer’s willingness to cover business and the level of Risk Charge will

be affected by:

Loss ratio

Volatility of the business

Catastrophic exposure – considering any existing reinsurance

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AG 48—Could Have Been Worse…

 The NAIC spent the last three years of compiling data, reading very boring transaction documents, studying actuarial models and consulting with consultants, lawyers and other advisors related to the life insurance industry’s use of captive reinsurers for AXXX and XXX reserve financing transactions.

 The result was Actuarial Guideline 48 (dated November 14, 2014, “AG 48”), which defines the rules to be followed for new life reserve financing transactions after January 1, 2015.

• Grandfathers policies financed prior to 1/1/2015

• Exempts most commercial reinsurance transactions with third party reinsurers who are licensed, certified, accredited or post collateral under the “old rules”

• Exempts any transaction which the regulator determines should not be subject to AG 48 subject to approval of a life insurance company’s domiciliary regulator (after consultation with the Financial Analysis Working Group or “FAWG”).  These rules were finally adopted by the Executive Committee and Plenary of the NAIC on December 16, 2014.

 AG 48 is clearly still a work in progress with material holes for RBC treatment of captives and the lack of the revised CSO table and reinsurance methods required for VM-20,

 But, AG 48 should give regulators and companies more clarity in many respects for how to price their ULSG and term business and transition reasonably easily to PBR when implemented.

 Basically, AG 48 is a compromise that eliminates many existing captive transactions and allows companies to early adopt PBR to determine the portion of the statutory reserve which must be backed by SVO-listed securities which would be admitted for an insurance company (i.e. excludes LCs, certain structured notes and other LC-like securities which have been used to back the redundant portion of reserves).

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Capital Structure for Typical Pre-Rector Captive

Capital and Surplus (i.e. 200% CAL RBC) Other Security Economic Reserve Funded with Traditional NAIC-eligible Securities Total Statutory Reserve (Model 830) Financed Portion of Reserve Funded with Traditional NAIC-eligible Securities Economic Reserve (Defined in Transaction Documents)

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Capital Structure for AG 48 Captive

To trifurcate or quadrificate?

Capital and Surplus (i.e. 200% CAL RBC)

Other Security

Conservatism Added to Best Estimate Reserves Under

Actuarial Method

Best Estimate Reserve

Funded with Traditional NAIC-eligible Securities Total Statutory Reserve Funded with “Other” Security Eligible Under AG 48 Funded with Traditional NAIC-eligible Securities Actuarial Method Reserve (i.e. modified VM-20

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How Much Redundancy to Finance?

Capital and Surplus (i.e. 200% CAL RBC)

Other Security

Conservatism Added to Best Estimate Reserves Under

Actuarial Method

Best Estimate Reserve

Finance Only Excess of Model 830 Reserve over Actuarial Method Reserve Some companies will choose to finance both the “Other Security” and a Portion of

the

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Additional Complexity for Post-Rector Captives To Be Resolved

 Closing or modifying pre-Rector facilities open for 2015 and 2016 new business

 Grandfathered Business—language is clear but not clear  Higher Financing Expense?

 Consequence of Primary Security falling below the level required

Loss of all reserve credit

Dollar for Dollar Reduction

Proportional Reduction

 Risk‐Based Capital Calculations

 Additional Disclosure Requirements

 Higher Transaction Costs

 Accreditation Issue Still Lingers

 Transactions Without Captives (e.g. financial reinsurance and insurance backed lending solutions are relatively more attractive)

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The Spirit of AG 48!?!?

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Does PBR Eliminate the Need for Captives?

 When PBR is finally adopted and implemented, an interesting question is whether that will actually eliminate the need for life reinsurance finance transactions.

Many if not most regulators would say that captives and financing is no longer required.

Many if not most industry participants would disagree.

 In recent conversations with several life insurance companies, we found that the Actuarial Method produced reserves in the range of 75% to 110% of their Model 830 reserves for death benefit UL products.

No mortality improvement (huge impact on long duration business) plus

Explicit pads on all assumptions including prescribed pad on mortality plus

Limiting benefits of 3rd party reinsurance plus

Grading off experience when no longer credible plus

 How do we, as an industry, want to balance our dual mandate of providing affordable life insurance to the most people with having strong insurance companies which are able to pay claims?

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References