Utilizing Reinsurance for Capital Management
ISSUE 1 -SEPTEMBER 2013
Douglas Lum, Managing Director, Life Reinsurance Operations
Although the markets are showing signs of recovery since the financial crisis from 2008, there continues to be the looming uncertainty of the full recovery of the global economies. Europe is still not out of the woods with sovereign debt issues, and the ability for the troubled EU countries to fulfill their obligations in the future is questionable. Is the US quantitative easing program working and when will come to an end? Will the US policymakers agree to raise the debt ceiling and to what level?
How much longer will the major world economies continue to lull in a low interest rate environment? The result of globalization means that economies around the world are more intertwined and it has become progressively more difficult to isolate negative economic events within the borders in which the crisis originated. With the mounting concerns, regulatory bodies around the world continue to focus on capital sufficiency of financial institutions to sustain extreme stress scenarios.
Historically, in order to raise capital, insurance companies have sold off assets and /or sectors of their business, issued rights offers and subordinated debt, and some have “spun off” part of their company through initial public offerings.
Up to this point, the aforementioned strategies have been effective on a larger scale for some organizations, however, the approach may not be ideal for smaller to medium sized organizations. What other options are there for insurance companies to strengthen their balance sheet? Can reinsurance play a role to help insurance companies to manage and raise capital?
Managing a Diversified Portfolio
Unlike, some of the small to medium sized local insurance companies, global reinsurance players manage a diversified portfolio of risks from both an insurance line and geographical perspective. This diversification provides reinsurance organizations with the ability to manage peak risks, and the capital associated with it, more efficiently.
For example, under the proposed Solvency II framework, there is an offset in solvency capital between risk capital applied to write P&C risks and biometric risks for European reinsurance companies that underwrite both property and casualty and life and health business. This implies that tzhe same dollar of capital consumed to write P&C business can be simultaneously utilized to write biometric risk. Given the balance sheet diversification, reinsurance companies tend to be in a better position to provide portfolio volatility protection and capital relief to insurance companies.
Capital management arrangements can be in various forms, in which they can rang e from simple annual quota share structures to long term funding contracts.
Quota Share Arrangements
Simple quota share arrangements have proven to be effective for solvency margin relief. The quota share arrangements do not require any funding upfront from the reinsurer and only the biometric risk is transferred. These structures are predicated that the regulations allow for insurance companies to recognize credit for
reserves ceded. Companies usually consider these types of transactions to manage their statutory capital
On the other side of the spectrum, if working capital is required, then surplus or new business strain relief arrangements are most effective. The capital funding structures provide a dual impact to a company’s balance sheet. Not only do the tarrangements provide working capital but they also provide statutory reserve and solvency margin relief. Surplus relief transactions apply to the reinsurance of closed blocks of business whereby the reinsurer assesses the future value of a block or blocks of business and crystallizes the future value for the business for the ceding company at the start of the contract.
The reinsurer provides upfront funding to the ceding company in return that the future profits generated from the blocks of business are paid to the reinsurer as the profits emerge. New business strain relief arrangements are similar to surplus relief transactions except the intent of the transaction is to alleviate the initial statutory strain created from the acquisition costs and reserve impact for new policies issued.
The reinsurance mechanism in these cases is to fund the initial statutory loss for the ceding company at the point of issue of each policy and the reinsurer relies on the future cash flow generated from the policy to recover the initial outlay. For these types of transactions the reinsurer may only participate in the returns from the biometric risk or may participate in all the risks that the ceding company encounters (e.g. biometric, investment and expense gains).
As an example, to illustrate the impact to the cash flows for a new business strain relief structure for a portfolio of non-participating whole life policies, please refer to the exhibit above.
For the illustrated transaction, it is evident that the initial strain from underwriting the business is mitigated through reinsurance, for the ceding company. Not only does the structure smooth the cash flows for the ceding company, the return on capital for the company also improves.
Balance Sheet Impact
When funding is involved with reinsurance transactions, the impact of the capital outlay is treated differently compared to a loan. The future repayment of the funds provided by the reinsurance transaction is contingent on the performance of a particular cohort(s) of business and it is not definitive that the outlay from the reinsurer will be repaid over time. Thus, the funded capital is recognized as an asset on the ceding company’s ba- lance sheet and because repayment is contingent on the performance of the business, the ceding company is not required to establish the corresponding liabilities for the future repayment stream.
It is important to note when structuring any capital management reinsurance, the reinsurer needs to understand the local regulations in which the ceding company is domiciled in order to establish the most optimal solution for the client. One common requirement is that significant risk transfer must be demonstrated in order for the ceding company to take credit for reinsurance. Otherwise, the transaction will be deemed as “deposit accounting”. Regulatory recognition of risk transfer is crucial in determining the success of such transactions.
The Reinsurance Option
For the insurance company, the reinsurance option allows for more flexibility compared to a loan (i.e. a loan has predefined schedule of payments) and provides a bigger impact to the balance sheet. Contrary to a loan arrangement, the reinsurer directly participates in the performance of the business reinsured. Thus, the reinsurer acts as a business partner rather than a creditor.
Ultimately, if an insurance company has capital needs, the organization must assess all the available options. Reinsurance is one of the means for a company to improve its capital positioning. For the ceding company, if the impact to the balance sheet is similar or better than other available sources, and the cost of reinsu- rance is more economical than the cost of capital or financing, then reinsurance can be an effective capital management tool.
Reinsurance Management Associates has experience in structuring capital management transactions. The RMA team provides consultative services to develop optimal solutions to address the ceding company’s needs and to bridge the transactions with financially sound reinsurance partners.
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