Jeffery R Burt looks at the current state of the North American life reinsurance sector
More than 200 years ago, Thomas Jefferson offered that a little rebellion now and then is a necessary medicine for sound health. He was speaking of government, but does the same prescription hold true for the reinsurance industry? Well, to say the North American market is in the midst of its own rebellion would hardly be unfounded.
While the overall level of life reinsurance business did not change significantly in 2003 from the previous year, the terms on which it was written and the reinsurers writing it began to change considerably. While many of the old stalwarts remain in the mix, there are certainly fewer of them.
In 2003, at least three mainstream life reinsurers failed to survive the year in the same capacity in which they entered it. The reduction in players with an ever-increasing need for reinsurance suggests that those who remain can expect to see an improving situation with regard to any or all of market share, profitability and/or reduced competition. This is confirmed by 2003 results as measured in a recent sector publication, which show increases in production from all but one of the industry top five as measured by inforce written. This objective proof, combined with rumours of a hardening market, suggests the coming year could be a good one for the life market.
The number of life reinsurers in the North American market declined in 2003 and this trend could continue in the current year. The constant review of operations and profitability in multi-line financial services organisations creates an additional pinch on life reinsurers, and has resulted in a proliferation of downgrades by the rating agencies. Collateral to these downgrades is a rapidly-tightening noose around the neck of the industry to raise necessary capital (both cash and letters of credit) at a cost not seen before. Interestingly, although the jury is still deliberating on whether capacity has been greatly restricted, the cost of capital instruments has unquestionably increased, causing added pressure on profitability.
Profitability or poor house?
It appears there are two conflicting trends; dwindling supply versus improving prices. The success of one or the other ultimately will depend on the reaction of the direct market. Price pressures and capacity constraints have begun to be passed through, but the question remains as to how the market will react. Will the market accept these increases? If so, how and where will the direct market find the margins? Prices are hard to change, and life insurance products have been thinly priced in recent years. If the market chooses not to accept these price increases, what options do they have? Certainly there are some insurers which can provide the capital to support an increase in retention, but there are many who cannot. Many direct writers have become dependent on reinsurers to take both risk and the associated capital requirement.
So what is the current indication? Frankly, both. Those who can are looking for ways to retain more risk and avoid increased reinsurance costs. Those who can't are looking to find other markets and rebuild products to increase margins. One of the more interesting implications of all these changes is the effect on the various markets. Historically, 'traditional reinsurance' was used to describe term and universal life (UL) business for the upper middle class in the US. This segment is, however, becoming too competitive for some direct writers to support. Instead, insurers are looking to diversify into markets where they believe superior margins can be realised. Likewise, many reinsurers are exiting 'non-core' or even niche markets in an effort to increase profitability. The result could be a shortage of reinsurance capacity in those markets.
Targeting the aging 'baby boom' generation, many marketing officers view senior life business as an exciting new market. Other than offering products for estate planning and final arrangements, however, insurers are still unclear as to the needs of these individuals. Unfortunately, the estate planning market is unmistakably saturated and the final arrangement line provides only minimal coverage and, consequently, profit.
More interesting is the direct life writer's interest in what has commonly been referred to as the 'middle market'. For years, the industry has regarded it as being undeserving on the belief that distribution methods for life products are cost prohibitive. Five years ago, some in the industry incorrectly posited that the internet would solve this issue, probably because they forgot a fundamental tenet of insurance - 'life insurance is sold not bought'. Like the false hopes of the internet, bancassurance, brought about by the Gramm-Leach-Bliley Act, has also fallen short of its expectations.
The industry has realised that serving the middle market requires the same level of personal service as was historically provided to each customer.
After all, casualty products (home, fire and auto policies) are typically purchased not over the internet or by direct mail, but through a trusted advisor. Why should life insurance be different? Well, it is not, except that the cost to apply for, underwrite, sell and deliver life insurance is appreciably greater. A possible solution is that the market is beginning to use technology to approach these 'issue cost' problems.
The reinsurance market is undergoing serious change. The current players are dwindling, almost quarterly it seems, and as of now few have stepped in to replace them. It is hard to say if 'rebellions' result in permanent noticeable change. The current North American market appears to be no exception. Clearly there are many opposing forces at work; pressure on profitability, consolidation, reduced capacity, increased costs, new entrants and the withdrawal from niche markets are all factors which are interrelated and paradoxically reinforcing and opposing at the same time.
Many will cite a myriad of causes, but if I had to point to a single factor it would be commodity-driven reinsurance as the keystone of the change. In recent years, the impetus behind insurers increasingly using reinsurance comes not from any value added component, but from their own belief, mistakenly or not, that some reinsurers will assume risk at a price (including expenses and profit) below the insurers' own expected mortality. Reinsurance then merely becomes another profit centre providing an arbitrage play.
Who is right? Without possessing a crystal ball or other remarkable prescience, mortality is a risk that is not immediately credible after only a year or so of experience. While reinsurers may not be wrong in their estimation, if the recent profitability struggles are any indication, they've begun to view it as calling tails with a two-headed coin - a gamble they're not willing to take.
It is difficult to pinpoint the reason - or reasons - for the reinsurance industry's recent struggles. Rare are the press releases in which a company admits it is selling/merging its business due to poor operating decisions and risk assessment. There is no doubt that the overall economy, equity markets, interest rates, bond defaults and a host of other financial challenges have brought enough pressure to bear on profitability to force financially-sound life reinsurers out of the market. Consolidation is a natural consequence of the increasing pressure on profitability in recent years. Unfortunately, this increase in consolidation compounds the issue by limiting the available capacity within the life sector, both in terms of risk taking and access to capital instruments.
However, as mentioned before, the direction of the market is unclear.
High costs typically translate into higher prices. If these higher prices are supported by the direct writers through the means described previously, such as new markets with better margins, and do in fact materialise, this should then lead to the ability for new entrants to profitably join the industry. Basic economics and capitalism at work!
I agree, so what? It is bliss to spend all your time in the theoretical world. Sure, the market was in turmoil during 2003. That much is clear.
What can we expect for 2004 and beyond? The answer is not so straightforward.
The market seems to be at a crossroads and each direction has its own varying implications, depending on whether you are on the direct side, currently in the market from the reinsurance perspective, looking to join, or looking to exit.
Regardless, there is opportunity. Those who stayed in the market last year saw production increase and the reason is somewhat obvious. The need for reinsurance is still present and there are fewer players. What's still to be seen now is whether the increase in production will translate into an increase in profitability. This is really the answer we seek. If so, we should begin to see new entrants into the market, whether they come as new reinsurers, existing reinsurers who now will enter lines they may have previously avoided, or simply capital sources which see the ability to 'buy low'. If not, there may be even greater attrition exacerbating the capacity and capital crunch.
Additionally, as a consequence of consolidation, accounts which traditionally have been closed or difficult to enter are opening up. Reinsurers are finding they can be more selective in whom they choose to support. But it is not just the reinsurers controlling the strings. Many direct writers are actively looking for new solutions and new partners. Make no mistake, more than anyone, direct companies realise the implications of what has been a struggling life reinsurance sector in recent years. Many are out looking for 'new blood', having seen their pool of three or four mainstay reinsurers be consolidated or eliminated down to, in some instances, a single remaining partner. The desire to find new 'partners' in the truest sense of the word is re-emerging. Price, while still important, is quickly being teamed with financial stability, strength and service as important components in a reinsurance partner.
In addition to new players, new solutions are being investigated. If necessity is the mother of invention, then the life reinsurance industry in North America is primed for innovation. As direct writers consider alternative methods of risk mitigation, there is increased discussion of viable alternatives to first dollar quota share YRT (yearly renewable term) or coinsurance. New pools are already being discussed along with alternative attachment points for reinsurance including portfolio level coverage. Even more prevalent are the requests for risk support on new product and underwriting launches designed to support the growing markets described as senior life and middle market business.
Stay or go?
There is opportunity in the North American life reinsurance sector, an opportunity which takes many forms. It appears as though for the first time in almost ten years prices are beginning to firm, which should lead to improved profitability. However, as a result of those same price changes, risk tolerances are also changing, promoting the need for alternative reinsurance structures such as portfolio covers as well as alternative partners to provide them. In addition to the need for alternative solutions to existing products, products are being designed for new markets creating additional opportunity. The emerging trend seems to be that the life reinsurance market is becoming somewhat less commoditised and, instead, more customised.
Regardless of how this rebellion emerges, I would tend to agree with Jefferson that the industry will be better for it.
- Jeffery R Burt, FSA, MAAA, Vice President - Marketing, joined Hannover Life Reinsurance America in 2003 with more than 12 years of actuarial experience.