There has not been a more important time for life insurers to consider the use of alternative reinsurance solutions. The aim of these structures is to optimise financially-related KPIs that the insurer may have such as an internal target solvency ratio, improving shareholder return on capital, or supporting new business strain. It could also be risk management-driven by reducing exposure to a specific risk such as reinvestment or longevity risk.
During the pandemic, yield curves used to calculate insurance liabilities fell to all-time lows, which has been felt acutely by insurers in Asia that have asset duration shorter than their liabilities and facing ‘negative spread’ problems. Additionally, many regulators across Asia are adopting, or have already adopted, risk-based capital frameworks that are similar to Solvency II and ICS which further necessitates efficient use of capital.
We see three broad pillars of alternative reinsurance solutions that are accepted by many regulators for healthy capital management reasons.
I. Balance sheet recognition for profitable business
Capital solutions covers reinsurance structures that provide a direct alternative source of capital to simply raising equity or issuing debt. There are various forms, with the most common being based on coinsurance with the reinsurer providing upfront commission. It is typically used to support products with high upfront costs where future profits are not fully recognised due to flooring of reserves or contract boundaries.
The upfront reinsurance commission can be settled in cash or transferred and tracked on a funds withheld basis. Effective structuring ensures there is material risk transfer whilst keeping the cost below the insurers own cost of capital.
One advantage of cash structures is that they create fungible capital which can then be used to support other portfolios in the company such as par/with-profits funds.
It is crucial to have terms in place with more than one reinsurer as having access to multiple sources of liquidity during stressed market conditions such as those experienced during the early stages of the pandemic, can ensure that management has more certainty when managing the solvency position of the company.
Given the dynamic regulatory landscape, structures that have worked in the past might be less useful under new regimes and vice versa so it is important to be open to exploring other structures.
II. Perfectly matched and secure asset
Since the shift towards market-consistent reporting standards and regulatory regimes throughout the region, insurers are focusing on managing asset-liability duration mismatches which would otherwise attract penal capital charges. Some regimes prescribe cashflow-matching tests that must be met in order for an insurer to take credit for any illiquid premium when discounting liability cashflows. This can prove challenging with the shortage of long-dated fixed income investments. In addition, credit and concentration risk charges can make holding assets expensive.
An alternative is for an insurer to transfer investment and reinvestment risk along with any underlying insurance risks to a reinsurer which is typically done under a coinsurance with asset transfer structure also known as ‘funded solutions’. This can be thought of as the insurer purchasing an asset that perfectly matches the liability cashflows as the reinsurer will be paying all future claims in exchange for a single upfront reinsurance premium. Funded solutions structures suit products that are medium-to-longer duration that contain an implicit or explicit investment guarantee component such as fixed and lifetime annuities, whole of life products and endowments.
The benefits to an insurer of using funded solutions are as follows:
- Release capital and reserves: All insurance, interest rate and credit risks are passed to the reinsurer so any regulatory capital can be released along with the statutory reserves.
- Reduce reinvestment risk: Insurer will be immunised against any changes in interest rates.
- Surplus distribution: Freed up capital can be returned to shareholders through dividends or buybacks.
- Increase volumes: By using reinsurer capacity, capital-constrained insurers are able to increase new business volumes.
- Refocus: Ceding out legacy portfolios can help insurers redeploy capital and resources to launching new ventures.
- Alternative investments: Reinsurers can access a wider range of asset classes than an insurer that has less global reach which ultimately delivers a lower cost
Through funded-solutions transactions, the credit risk exposure is now towards the reinsurer as opposed to the basket of assets backing the liabilities. This exposure can become significant relative to other credit exposures an insurer may have and would require some reinsurance counterparty capital to be held. Therefore, when evaluating funded solutions propositions, it is important to consider the overall security package on offer as opposed to simply chasing the lowest price or highest yield. The things to be aware of are:
- Financial strength: Insurers will see most benefit when transacting with highly rated, well capitalised, and diversified reinsurers
- Collateral: Having flexibility in collateral terms such as investment guidelines will enable the reinsurer to offer a better price and ensure smooth future operations for what is a long-term contractual relationship but for less well rated reinsurers one might want to impose stricter guidelines
- Diversify: Transacting with multiple parties reduces concentration risk
Pacific Life Re is a AA- S&P-rated life reinsurer that leverages the deep history of its investment management at sourcing illiquid assets such as commercial mortgage loans and private placements to deliver more attractive returns than simply investing in publicly traded bonds. The funded solutions team works across Bermuda, Singapore, Sydney, London and California with extensive experience at structuring and executing asset-intensive transactions such as in the pension risk transfer market.
III. Longevity solutions to support ageing populations
One type of non-traditional reinsurance structure popular in some European markets and becoming more popular in North America is longevity reinsurance, which aims to transfer risk that insurers have to pay claims for longer than expected typically from a portfolio of lifetime pay-out annuities, defined benefit pension or long-term care.
In most Asian markets, insurers have yet to build up material longevity-linked liabilities. However, onerous capital requirements could be stifling development of products with these features so working with a reinsurer could help with mitigating this. In some markets such as Japan and South Korea, the regulations have not made holding this risk onerous as their respective ICS-style regimes have yet to be implemented. It is only a matter of time, so getting contractual terms in place sooner rather than later will ensure a smooth transition into a regime that will make holding longevity risk more onerous.
Collaboration is key to success
All alternative reinsurance solutions involve bespoke and complex structures. It is imperative to work in partnership with a reinsurer that has the expertise and can support the insurer in engaging local auditors and the regulator to ensure no surprises. Both parties need to have clear alignment on the insurer’s goals in order to design and execute a solution that delivers capital relief at a lower cost than the insurer’s cost of capital. Shareholders and policyholders ultimately benefit from a more capital-efficient insurer by having improved returns on capital on in-force business and offer more competitive rates to end customers. The Pacific Life Re team has extensive experience across all of the solutions presented and would be keen support you in optimising capital. A
Mr Jonathan Haines is director, Alternative Reinsurance Solutions at Pacific Life Re based in Singapore.