Session 106 PD, Reinsurance for Capital Management of Health Insurance Business. Moderator/Presenter: Michael David Mulcahy, FSA, MAAA

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Session 106 PD, Reinsurance for Capital Management of Health Insurance Business


Michael David Mulcahy, FSA, MAAA


Rob Healy

Katrina E. Spillane, FSA, MAAA Brad Quinn


Collateralized Health Reinsurance Overview


Aetna Life Insurance Company

June 17, 2015

Executive Summary

 Aetna launched a non-recourse collateralized reinsurance program for a portion of its commercial insured healthcare business portfolio in December 2010

 Six separate transactions with a total of $1 billion of coverage completed to date  Utilizes a highly innovative structure that allows Aetna to transfer risk to capital

markets via reinsurance

 Program allows Aetna to improve its capital efficiency, obtain catastrophic risk protection and enhance its financial flexibility

 Risk Modeling performed by Milliman provides expected loss and probability of attachment for each transaction


Conceptual Overview

Health insurance risk + premium

Structure transfers health insurance risk to reinsurer whose investors commit their capital in exchange for a coupon payment


INSURER Catastrophic

protection + reduced cost of capital


Floating rate + additional spread for risk

Capital at risk if medical claims exceed

predefined threshold


Aetna Life Insurance Company

June 17, 2015

Structure Overview

Insurer Reinsurer

Health Insurance-Linked Debt

Investors Proceeds Interest Principal Repayment less reinsurance payouts Excess of Loss Reinsurance Agreement Premiums Reinsurance payouts

(1) Medical claims as a percent of premium

Insurer transfers its MBR(1) risk in a defined corridor to investors via reinsurance contracts

Capital benefit provided by reinsurance lowers insurer’s cost of capital

Reinsurance debt is non-recourse to the insurer and does not impact the insurer’s debt-to-capitalization ratio


Structural Overview

Probability of Attachment under Excess of Loss (XOL) Reinsurance Agreement

Ceded Premiums Insurer Capital $[ ]mm Reinsurance $[ ]mm Risk Coverage Z% MBR X% MBR Y% MBR XOL Attachment/ Exhaustion Points (MBR) Probability of Attachment / Exceedance <B bps A bps

The XOL attachment point is X% MBR and exhaustion point Y% MBR with a probability of A bps and less than B bps, respectively

• A portion of the medical

claims for the subject business is covered by the insurer’s reserves and capital

• If the subject business MBR

does not exceed the XOL attachment point, no payment is triggered under the XOL


Aetna Life Insurance Company June 17, 2015

Benefits to Insurer

1. Improves Capital Efficiency  Lowers capital requirement for the underlying business  Improves Return on Capital 2. Provides Catastrophic Risk Protection  Earnings protection in the event MBR (medical claims as % of premium) exceeds a level in excess of expected (e.g. 95% on an expected MBR of 85%) 3. Enhances Financial Flexibility  Diversifies funding sources

 Lowers cost of capital by replacing equity with reinsurance at lower cost

 No impact to debt-to-capitalization ratio

Improves insurer’s capital efficiency, provides catastrophic risk protection and enhances financial flexibility


Risk Modeling Overview

Portfolio Size Rating Formula Trend Variability Pricing Lags Pandemic

Risk The model simulates

many paths and the distribution of results is used to assess the risk of exceeding a defined

MBR level

Risk Modeling provides expected loss and probability of attachment that create the groundwork for these transactions


Aetna Life Insurance Company

June 17, 2015

Reinsurance Payment Mechanism

Reinsurance payment (and loss of investors’ principal) is triggered if MBR exceeds a defined level. Trigger level is set to be remote and primarily driven by pandemic risk.

• Trigger is tied to a Health

Index rather than an

individual insurer’s claims experience

Option 2: Parametric Trigger

• Reinsurance payment

triggered by insurer’s actual claims experience

Option 1: Indemnity Trigger

Indemnity Trigger ties reinsurance protection directly to the performance of the subject business (“no basis risk”)


Subject Business

Subject business is a carefully defined block of “plain vanilla” policies with geographically dispersed risk

Block of Business

1 Written on a single legal entity

2 “Plain vanilla” policies


Surplus Relief Reinsurance



Case Study

A 1.5 m member Non-profit Health Plan in the Midwest

• Reinsurance client for 15 years

• Holding company ownership structure including Two insurance





Case Study

ABC Holding Company

ABC Health

Plan 1 ABC Health Plan 2 FoundationABC ABC Research Institute ABC Affilliated Services

ABC Health

Management ABC Self Insured

ABC Insurance Company



•HMO was primary vehicle to issue policies to their commercial and

government membership

•Market and needs of their members changed

• More and more policies issued under the P&C Company

•Including their existing HMO membership, who began migrating

over to Ins. Company, attracted to PPO and HSA plans options not offered by HMO



$100m surplus deficit as a result

Previously, HMO holding company would instruct HMO to issue a Surplus note, transfer monies from HMO to P&C

• Simple

• Efficient

• Inexpensive

And so company proceeded to do same this time

(Note: HMO regulated by State Health Dept and Ins. Company by State commerce)



Company now had a surplus problem that needed resolved.

Sources of capital

* Raise funds- as Non-profit, limited market appeal

* Retained Earnings- minimal margins (non-profit) with rapid growth


Example of Traditional QS


A Simple Example of Traditional Quota Share

Premium Claims Expenses RBC Capital Gross Profit ROE

Before Reinsurance $100M $80M $5M $15M $45M $15M 33% Ceded @ 60% $60M $48M $3M $9M $27M $9M NA After Reinsurance $40M $32M $2M $6M $18M $6M 33% Assumptions:

60% Reinsurance Ceded RBC = 15% of Premium

60% of Expenses Shared Capital Required = 300% of RBC

Surplus requirement reduced from $45M to $18M However, you had to part with profits!


Example of Surplus Relief A Simple Example of Surplus Relief Financials

Premium Claims Expenses RBC Capital Profit Refund Gross ProfitExp. ROE

Before Reinsurance $100M $80M $5M $15M $45M $15M NA $15M 33% Ceded @ 60% $60M $48M $1M $9M $27M $11M $10.4M $600K NA After Reinsurance $40M $32M $5M $6M $18M $4M $10.4M $14.4M 80% Assumptions:

60% Reinsurance Ceded RBC = 15% of Premium 1% Reinsurer Risk Charge Fee 20% of Expenses Shared Capital Required = 300% of RBC




50% quota share reinsurance. .75% reinsurance fee. 6.5% expense allowance. 100.0- 110.0% Stop Loss Cover Ceding Carrier-100%

Gross Loss Ratio (GLR) 92% 91.50% 91.75% 94% 91% 105% 90.00% 90% 104%

Earned Premium (100%) 100.00% 1,000,000,000 1,000,000,000 1,000,000,000 1,000,000,000 1,000,000,000 1,000,000,000 1,000,000,000 1,000,000,000 1,000,000,000 Claims Incurred (GLR) 920,000,000 915,000,000 917,500,000 940,000,000 910,000,000 1,050,000,000 900,000,000 900,000,000 1,035,000,000 Expenses allocated 6.50% 65,000,000 65,000,000 65,000,000 65,000,000 65,000,000 65,000,000 65,000,000 65,000,000 115,000,000

Total Combined Ratio 98.50% 98.00% 98.25% 100.50% 97.50% 111.50% 96.50% 96.50% 110.00%

Reinsured Portion

Reinsured Premium 50.00% 500,000,000 500,000,000 500,000,000 500,000,000 500,000,000 500,000,000 500,000,000 500,000,000 500,000,000 Less: Claims Incurred (GLR) 460,000,000 457,500,000 458,750,000 470,000,000 455,000,000 525,000,000 450,000,000 450,000,000 517,500,000 Less: Expenses Allowances 6.50% 32,500,000 32,500,000 32,500,000 32,500,000 32,500,000 32,500,000 32,500,000 32,500,000 32,500,000 Subtotal (UW margin) 7,500,000 10,000,000 8,750,000 -2,500,000 12,500,000 (57,500,000) 17,500,000 17,500,000 (50,000,000) Less: Reinsurer Fixed Fee 0.75% 3,750,000 3,750,000 3,750,000 3,750,000 3,750,000 3,750,000 3,750,000 3,750,000 4,000,000 Subtotal-AHS Margins 3,750,000 6,250,000 5,000,000 (6,250,000) 8,750,000 (61,250,000) 13,750,000 13,750,000 (54,000,000) Experience Refund 3,750,000 6,250,000 5,000,000 (6,250,000) 8,750,000 (61,250,000) 13,750,000 13,750,000 (54,000,000)

Less: Prior Carryforward 0 0 0 0 (6,250,000) 0 (61,250,000) (47,500,000) 0

Net/ Loss Carryforward 3,750,000 6,250,000 5,000,000 (6,250,000) 2,500,000 (61,250,000) (47,500,000) (33,750,000) (54,000,000)

AHC capital reduction 0 0 0 0 0 (7,250,000) 0 0

(losses above 110% GLR)


HMO Combined Gross Loss Ratio capped from 100.0%-110.0% via Stop Loss Policy

Reinsurer Buys Stop Loss Policy from HMO that caps Reinsurer losses at 110.0%. Pays HMO .50% Premium (pass thru - credit Prem, debit Exp. Refund)

Reinsurer pays losses in current year excess of 100.0% GLR and collects from next years Experience Refund (profits) Capital available = $500m QS / 15 (at current 5 to 1 leverage ratio) =


Effective cost of capital= $ 3,750,000 / $ 100m = 3.75%

Transaction credited as Reinsurance Accounting and does NOT add to debt

Reinsurers QS up to 75% and $500,000,000 GWP (2 week Underwriting) and $3,000,000,000 GWP (30 days to underwrite)


Structure of a RBC Relief Deal

•The reinsurance is designed to meet risk transfer and

generate reinsurance accounting

•If business is profitable, profits in excess of a Risk Charge are returned to the client by an experience refund

•Expense allowances may not include “overhead” expenses –

risk transfer rules require only renewal expenses directly related to the business be covered

•Assets are typically left with the ceding company by using

mod-co or funds withheld. Unless losses occur, only cash transferred is the risk charge


Structure of a RBC Relief Deal


•If losses occur, they are tracked in a loss carryforward and

repaid to the reinsurer out of future profits (if they emerge)

•The ceding company must repay any loss carryforward if they

terminate the transaction (some transactions may have a date after which losses don’t have to be repaid)

•Reinsurer will typically want the insurer to maintain some

quota share of the business to insure they have a risk interest

•Investment risk may or may not be covered under the

agreement (not required to be covered to have risk transfer for health business)

•The premium and the reserves are ceded to the Reinsurer and


What the Reinsurer Will Analyze to determine Feasibility and Cost

•How Risky is the Business being Reinsured?

•Product Type


•Volatility and Historical experience

•Expense levels

•Ability of client to adjust rates to reflect experience

•Reinsurance Structure

•Volume of business being reinsured

•Duration of Agreement and any termination provisions

•Any loss mitigating features in the Treaty Financial Strength of the Ceding Company


Administrative Considerations


•Depending on the size of the transaction, and ceding

company/reinsurer familiarity, the transaction may take as little as a month or up to a year to finalize.

•Capital benefit is driven by the amount of premium/claims ceded,

so having the transaction in early in the year could be important to meet a specific capital saving target

•Reinsurer may or may not ask to be involved with rate

setting/reserving while the transaction is in place.

•Reporting almost always on a bulk basis. Reinsurer is rarely

involved with claim decisions.

•ACA reimbursements (the 3 R’s) and Fees can cause timing

problems and need to be spelled out in the contract if they apply to the covered business.


Brad Quinn 952- 358- 6201


Reinsurance for Capital Management of

Health Insurance Business

Katrina Spillane AVP, Pricing



Required capital is the amount of capital a company must hold to support fluctuations in their business

 Known as Risk Based Capital (RBC) in the US

 Minimum Continuing Capital and Surplus Requirements




The four main components of RBC include:

 C1: Asset Default Risk

 C2: Insurance Risk

 C3: Interest Rate Risk


Capital Formula

 The RBC formula includes a covariance adjustment to take into

account the independence of C2 risk from C1 and C3 risk. In general, this formula is:

√ [C22 + (C1 + C3)2] + C4

 In reality, this formula is much more complex

 Formulas are different depending on whether you are

completing a life statement or a health statement

 The actual capital calculation is dependent upon the loss



Capital for Health


The largest component of capital on health business is the C2 Risk

 The C2 Risk component is a factor times the premiums

 The factor varies by:

 Underlying product

 Net premium levels


RBC Factors

Product C2 RBC Factors *

Comprehensive Medical 9.0%

Medicare 9.0%

Medicare Supplement 6.7%

Dental and Vision 7.6%

Stand-alone Medicare Part D

Coverage (excluding supplemental benefits)


Supplemental benefits within Stand-alone Medicare Part D


The Answer




A few reinsurance terms:

 Modified Coinsurance

 Coinsurance Funds Withheld

 Risk Charge

 Expense Allowance

 Experience Refund


How is Reinsurance Structured?


 Reinsurance for the purpose of capital relief can be structured in

such a way that the Cedant gets C2 risk off their books but still retains all the profit less a risk charge

 The Cedant enters into a Coinsurance Funds Withheld or

Modified Coinsurance quota share arrangement with the Reinsurer

 At inception:

 the Cedant pays the Reinsurer a premium equal to the

quota share of statutory reserves

 Either (i) a notional funds withheld account is established

(a payable for the Cedant and receivable for the

Reinsurer); or (ii) the Reinsurer pays the Cedant an Initial Modco Adjustment

 The net effect is that at inception, no funds are


How is Reinsurance Structured?

 Going forward,

 The Cedant pays the Reinsurer the quota share of

 Premiums,

 Any decrease in statutory reserve

 The risk charge

 The Reinsurer pays the Cedant the quota share of

 Expense allowance

 Claims

 Any increases in statutory reserve

 Experience refund


How is Reinsurance Structured?


Key Things to Remember:

 On an expected basis (i.e. the business is profitable), the

only money that changes hands is the Risk Charge. The Cedant continues to retain the assets supporting the

statutory reserve for the reinsured business on its balance sheet

 Reporting is typically done on a monthly basis, with

settlement occurring on a quarterly basis

 Bulk reporting – the Reinsurer never receives individual

claim information unless during an audit

 Other features, such as expense allowances and loss

corridors, may be part of the transaction and are designed to reduce the Cedant’s cost while still meeting risk transfer


Risk Transfer

 According to the Life and Health Reinsurance Agreements

Model Regulation, the Cedant shall not take credit for a

reinsurance arrangement unless all of the significant risks are reinsured

 Risk categories include:

 Morbidity  Mortality  Lapse  Credit Quality  Reinvestment  Disintermediation


Credit for Reinsurance


 Appendix A-791 of the NAIC Accounting Practices & Procedures

Manual offers guidance on the application of the model regulation to specific reinsurance features

 This guidance does not apply to YRT reinsurance,

assumption reinsurance, stop loss arrangements or cat covers


Appendix A-791, Paragraph 2a

2. No insurer shall, for reinsurance ceded, reduce any liability or establish any asset in any statutory financial statement if, by the terms of the reinsurance agreement, in substance or effect, any of the following conditions exist:

a. Renewal expense allowances provided or to be provided to the ceding insurer by the reinsurer in any accounting

period are not sufficient to cover anticipated allocable renewal expenses of the ceding insurer on the portion of the business reinsured, unless a liability is established for the present value of the shortfall…


Risk Transfer – Expense Allowance


 Credit for reinsurance is prohibited where

…the ceding insurer is afforded a large ceding commission at the inception of the agreement resulting in a significant increase in surplus only to have such surplus increase be drained away in subsequent periods because renewal expense allowances provided under the agreement are insufficient to cover the direct allocable costs estimated at the time the business is reinsured.

 A Cedant may avoid complete disallowance of credit for

reinsurance if they establish a liability for the present value of the shortfall between the expense allowance and the directly attributable expenses


What expenses are in the EA?

Q: What should be included in the renewal expense allowances

with regard to direct expenses? An allocation of salaries?

Computer usage? Or just marginal expenses directly related to the business reinsured such as claim payment expenses,

postage, etc,?

A: … In determining what the ceding insurer should include in the

renewal expenses with regard to direct expenses, there should be an allocation of all renewal expenses anticipated at the time the business is reinsured including salaries, computer usage, postage, etc. …


Appendix A-791, Paragraph 2b


2.b The ceding insurer can be deprived of surplus or assets at the reinsurer’s option or automatically upon the occurrence of

some event, such as the insolvency of the ceding insurer, except that termination of the reinsurance agreement by the reinsurer for nonpayment of reinsurance premiums or other amounts due, such as modified coinsurance reserve

adjustments, interest and adjustments on funds withheld, and tax reimbursements, shall not be considered to be such a


Appendix A-791, Paragraph 2c

2.c The ceding insurer is required to reimburse the reinsurer for negative experience under the reinsurance agreement, except that neither offsetting experience refunds against current and prior years’ losses under the agreement nor payment by the ceding insurer of an amount equal to the current and prior

years’ losses under the agreement upon voluntary termination of in force reinsurance by the ceding insurer shall be

considered such a reimbursement to the reinsurer for negative experience. Voluntary termination does not include situations where termination occurs because of unreasonable provisions which allow the reinsurer to reduce its risk under the

agreement. An example of such a provision is the right of the reinsurer to increase reinsurance premiums or risk and


Risk Transfer – ER and LCF


 Experience Refunds are not considered part of “surplus or

assets” under Paragraph 2b

 While they serve a powerful function, they are not a

necessary feature for the Cedant to take credit for reinsurance

 Furthermore, Paragraph 2c allows for losses to be placed into a

Loss Carryfoward and any current Experience Refund can offset that Loss Carryforward

 However, if the Cedant decides to voluntarily terminate the

reinsurance arrangement while in carrying a Loss Carryforward, they are depriving the Reinsurer of any future profits that could be used to repay that Loss Carryforward.

 Therefore, credit for reinsurance is allowed when the

reinsurance arrangement requires the Cedant to pay the amount of the Loss Carryforward upon voluntary termination


Appendix A-791, Paragraph 2k

2.k The reinsurance agreement is entered into for the principal purpose of producing significant surplus aid for the ceding

insurer, typically on a temporary basis, while not transferring all of the significant risks inherent in the business reinsured and, in substance or effect, the expected potential liability to the ceding insurer remains basically unchanged.


The “10/10 Rule”


 A metric used by accountants in P&C business to demonstrate

that a Reinsurer assumes significant insurance risk and that they have reasonable chance at experiencing a significant loss

 “Significant” is not defined but the standard rule of thumb

became the 10/10 Rule which is that the Reinsurer has at least a 10 percent chance of sustaining a 10 percent or greater loss

 Does not apply to life covers

 However, if such a rule were applied to a health capital relief

cover, credit for reinsurance would still be granted because the type of cover is a quota share and the Reinsurer participates in first dollar losses



 Reinsurance for capital management purposes is a powerful

tool. It:

 Boosts a products return

 Increases the Cedant’s RBC ratio

 Meets credit for reinsurance requirements

 Most importantly, it:

 Reduces the Cedant’s required capital while still allowing the

Cedant to

1) retain all of the profits on the business, in excess of





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