With only a handful of players still seated at the US life reinsurance table, Scottish Re finds itself in a strong position, says Nigel Allen

Apply the term "newcomer" to Scottish Re and it does not sit well.

Despite the group's relative fledgling status in the life reinsurance market, having only seven years of active service under its belt, Scottish Re has established itself as one of the front runners in what has recently been one of the most volatile markets in the industry. North America, the group's stronghold, has undergone a period of such rampant consolidation and withdrawal that of those players still seated at the life reinsurance table some three quarters of the in-force life reinsurance chips are held by five reinsurers. But will the poor hand dealt to Scottish Re in the second quarter of 2005 see a change in the group's fortunes?

A disappointing quarter

Following the announcement of a 77% fall in net income for the second quarter compared to the same period in 2004, Scott Willkomm, president and chief executive officer of Scottish Re had little choice but to describe the results as "disappointing". Willkomm cited a "greater than expected number of large claims in North America" as the major contributing factor in the decline, with the region producing some 16 more claims than expected topping the $500,000 mark, three of which resulted in total claims of $5.3m. While expectations are that mortality rates will return to normal levels in the fourth quarter, "the nature of our business is such that our results will continue to be subject to mortality volatility that can impact our results in a positive or negative manner."

Managing volatility

The group however has built up a veritable arsenal of defensive weaponry to limit or dampen the volatility spikes, which are such a feature of the life reinsurance market in which it operates. "We have put in place a number of protection strategies to preserve our balance sheet," explains David Huntley, chief executive officer of Scottish Re Holdings. Central to this protection is the retention limits Scottish Re imposes on its life exposures. "The amount of the face-value insured which we keep on our books is relatively low compared to the rest of the market," Huntley points out, adding however that "we have been increasing some of our retention levels following recent acquisitions," thereby creating a tiered retention system for different markets or blocks of business which reflects the perceived risk levels. As of 1 January 2005, maximum life retention levels for the group's North America division were raised to $1m, whereas previously it had ceded amounts in excess of $500,000. For business acquired during the ING transaction, retention levels as of 31 December 2004 were set at $2m. Outside of North America, the group applies a $250,000 maximum corporate retention limit, although there are circumstances when this limit can be exceeded.

Coupled with this limited retention strategy is a well-established retrocession programme. The robustness of this programme was reflected in the degree of damage limitation which was achieved following the above-average second quarter claims. In one case, a $2m claim in actual fact exposed the group to around $16m on a gross basis and the life industry as a whole to $40m, but retrocession cover restricted the financial impact on the group to $2m. However, the degree to which the group leverages the retro market has raised concerns among rating agencies. In its affirmation of the "A-" (Excellent) rating on Scottish Re Limited, AM Best said that "the company's dependence on retrocession results in disproportionately high levels of reinsurance recoverables" and added that the agency "is monitoring the development of the reinsurance leverage ratio". At a group level, the amount recoverable from reinsurers as at 30 June 2005 stood at $792m compared to $775m as at 31 December 2004.

Further elements in the defensive armoury include the group's limited involvement in pool shares, "so as to minimise our exposure to mortality experience in any one individual company," explains Scott Willkomm. In addition, the balance sheet is enclosed in both catastrophe coverage, which effective 1 January 2005 provides reinsurance cover for losses of $50m in excess of $10m, and clash coverage to protect against accumulation risks.

Controlled growth

Scottish Re's North American division now accounts for some $1trn of in force life reinsurance, and provides cover for 13.9 million individuals with an average benefit per life of $74,000. Compare this to just one year ago and the growth rate is little short of phenomenal. In June 2004, the group reported in force life reinsurance of $298.1bn covering 7.4 million lives with an average per-life benefit of $40,000.

The acquisition of ING Re's US individual life reinsurance business in October 2004 is almost solely responsible for this astonishing growth spurt. Commenting shortly after the announcement of the acquisition, Scott Willkomm described it as "a transforming transaction" allowing the group to greatly expand and diversify its US mortality risk business.

However, with an acquisition of this scale, the integration challenges are numerous, particularly as this transaction followed relatively hot on the heels of the October 2003 GE ERC life reinsurance business purchase.

Despite revising its outlook on the group to stable from negative shortly after the ING agreement was confirmed, Standard & Poor's added that, "it also brings potential execution risk relative to the necessary additions to the infrastructure and the challenges of systems and administrative integration with Scottish Re's existing business." The rating agency also highlighted the group's "relatively modest size and short management track record". Countering these concerns was the fact that the acquisition not only brought about an increase in the size of Scottish Re's US portfolio, but also brought on board an experienced reinsurance team "and the technology needed to minimise transition risk and potentially aid in future expansion."

To date, the transition appears to have been progressing relatively smoothly, and according to Scott Willkomm is "slightly ahead of what was anticipated at the time of the transaction." Scottish Re is set to move all of its North American administrative operations from Charlotte to Denver by the end of the year and will also transfer the administrative platform to an upgraded version of the ING Re system.

The ability to grow with such rapidity brings with it questions as to how the group is able to ensure the quality of the business which it writes.

"We are not driven by market share and that is a fundamental truth of the way we do business" says David Huntley. "We are not driven by top line growth ambitions, instead we are a shareholder-focused organisation." It is useful to note that Scottish Re in the first half of 2005 reported an additional $87.5bn of new traditional life reinsurance volume, $38.5bn of which was gained in the second quarter, putting it well on its way to achieving its end of year target of originating $100bn - $110bn in new business. However, speaking to investors recently, Willkomm explained that far from sacrificing quality to achieve these goals the reinsurer is maintaining its stringent selection process, and having won 61 of the 92 quotes for business which it had put forward pointed out that the majority of the 31 they lost were as a result of price, and added that so far this year they had declined to participate in 29 quoting opportunities.

Outside North America

With approximately 95% of the group's global business rooted in North America, it is perhaps not surprising that Scottish Re's international operations are sometimes overshadowed. Focused on niche markets such as aircrew loss of licence insurance and developing countries such as the Middle East from its base in Windsor, England, Scottish Re Ltd (UK) reported earned premiums for the second quarter of 2005 of $27.9m down marginally from the same quarter in 2004, a fact which was put down to a reassessment of the pricing of its international business. "We have taken the opportunity over the past 18 months," said Scott Willkomm during a recent conference call, "to review the pricing of our international business and have chosen not to renew business that does not meet our return and risk management hurdles". Despite this slight decline, the group expects the international segment to continue to grow and "support significantly higher margins than our North American business". Willkomm also cited the growing capacity constraints being experienced by the non-US market as offering growth opportunities and providing favourable pricing conditions. However, before Scottish Re Ltd can seek to grow it must first get its house in order.

In March, Scottish Re announced that it was delaying the filing of its 2004 annual report, blaming a material weakness in its UK subsidiary as the reason for its Notification of Late Filing with the SEC. When Scottish Re acquired World-Wide Reassurance Ltd in December 2001, while they extended their geographic reach considerably and at the time raised group capital levels to over $300m, the group also realised they were taking on board an outdated operating system. "We always recognised that in Windsor we were dealing with a very manual-based environment and a relatively inconsistent series of processes," explains David Huntley. Scottish Re set about imposing a new administrative system, although Huntley is quick to point out that this was not a case of changing the existing system, because "there was nothing to change". Striving as a group to meet the requirements of the new Sarbanes-Oxley Act, the timing of the new system was poor, but "we had no choice". Unfortunately, inconsistencies in the figures produced by the new system meant that management were forced to declare a material weakness. Huntley is confident however that with a new administration manager, chief financial officer and chief actuary on board, and with the services of PricewaterhouseCoopers they can "put the situation right" by September.

Where to grow?

Ironically, while Scottish Re Ltd is based in Windsor, the company has never had a purchase on the UK, and has only relatively recently sought to expand into this well-established marketplace. Responding to rating agency concerns about the ability of the group to successfully compete in this mature market, David Huntley says: "I think that would be true if there wasn't so much change going on in the UK market." He believes that the combination of market upheaval and regulatory reform mean that their entrance is well timed. With roughly ten direct competitors in the UK life sector, Huntley admits that the market is more competitive than in the US, but adds that there is a lot of repositioning going on in the market on the life and annuity side and that to a degree this fortuitous combination of events means the time is right for them to push.

Scottish Re also announced recently that it is set to open up a new branch in Singapore. "We have secured resources in Singapore," confirmed Huntley, "and we are currently in discussions with the local regulators ... This is a very exciting development for the group as we begin to branch out." The group also confirmed that they have retained the services of an individual from one of their competitors to head up the operation, but refused to say who this was until the licence had been approved.

The signs are that the disappointing results reported by Scottish Re in the second quarter were a "blip", and one which was absorbed relatively painlessly by the barrage of risk dampening measures which the group has installed. "The business fundamentals and earning power of the company has not changed," said Scott Willkomm, "and we continue to believe that market conditions and the competitive advantages that we enjoy provide us with tremendous growth opportunities."

- Nigel Allen is editor of Global Reinsurance.

Scottish Re Regulation XXX

In February of this year, Scottish Re became the first reinsurance company to complete a securitisation of excess reserves resulting from Regulation XXX with the announcement that it had closed an offering of $850m of 30-year maturity securities from its wholly-owned subsidiary Orkney Holdings. Proceeds from the transaction will fund the reserves required under Regulation XXX for policies reinsured by the group between 1 January 2000 and 31 December 2003.

According to David Huntley, the problem with using Letters-of-Credit to meet the demands of Regulation XXX is that "you have a long-term liability in the market you are covering and you are matching it with a short-term Letter-of-Credit. The risk you run in doing this is that the supply of LOCs might not be there when you come to replace them or the price may have changed significantly as a consequence of limited supply." The Orkney Re facility has effectively created a permanent - or at least long-term solution - to a long-term liability.

Scottish Re Scott Willkomm

Scott Willkomm joined Scottish Re Group as its president in March 2000, was elected to its board of directors in June 2000 and became CEO on 1 January 2005. Mr Willkomm is responsible for the operations of the company and its subsidiaries.

Prior to joining the company, Mr Willkomm was an investment banker specialising in insurance, banking and financial services. Mr Willkomm was a managing director with Prudential Securities Incorporated responsible for that firm's insurance investment banking activities.

During his tenure with Prudential Securities, Mr Willkomm represented insurance and reinsurance companies in connection with public and private offerings of equity and debt securities, mergers and acquisitions and other strategic transactions. In addition, Mr Willkomm advised a number of clients in establishing offshore reinsurance companies in both life and property and casualty disciplines, including lead-managing the company's initial public offering in November 1998.

Prior to joining Prudential Securities in 1996, Mr Willkomm was a senior vice president with Oppenheimer & Co (now part of CIBC World Markets) in that firm's Financial Institutions Group. Before joining Oppenheimer in 1993, Mr Willkomm was associated with First Albany Corporation and Sandler O'Neill & Partners, LP. Mr Willkomm began his Wall Street career in 1987 with Merrill Lynch & Co's Mergers and Acquisitions Department.

Scottish Re David Huntley

David Huntley has served as chief executive officer of Scottish Re Holdings since May 2003.

Prior to joining Scottish Re Holdings, Mr Huntley served as chief executive officer of Swiss Re Life & Health Australia Ltd from September 2000 to March 2003. From February 1999 to September 2000 he served as technical operations manager, Swiss Re Life & Health Australia and from February 1997 to February 1999 as business manager, Swiss Re Life & Health Australia Ltd. Prior to his employment with Swiss Re, Mr Huntley served as directeur general of Mercantile and General Gestion de Reassurance SA, Paris and held positions with Prudential Financial Services and the National Provident Institution.