Luc Gagnon outlines the brave new world of ART.
The CFO of a life insurance company (‘LifeCo') which stopped writing annuities one year ago just learned that lower mortality assumptions will result in more costs to LifeCo and impact its results. Under conventional thinking, If people live longer than the assumption used when the rates were originally calculated, there is only one thing to do – increase the reserves and take a hit. But in these days of alternative risk transfer (ART), an alternative exists.
LifeCo could reinsure its annuities business on an original terms basis and completely forget about longevity or interest rate assumptions on this block of business. In the process, LifeCo would free up capital that could be put to work in core strategic business areas.
The new generation of reinsurers makes this possible through an innovative asset management strategies.
ART was borne out of a need to develop a more sophisticated approach to handling risk. Some of the earlier developments stemmed from insurers' need to discount loss reserves or to create structures to handle their liabilities in a more efficient manner. The evolution of products in this arena has been fairly constant over the past 20 years. The early financial reinsurers led the initial development, writing time and distance policies for Lloyd's syndicates. They were followed by the finite risk reinsurers which combined risk transfer – albeit limited – with financial concepts such as profit commissions accruing investment income into reinsurance contracts. Then the investment banks got involved, applying pricing and risk management techniques borrowed from the capital markets to what, up until then, had been considered pure insurance exposures. Just as most people were digesting the last round of evolution, a new generation of reinsurers has emerged, mixing the traditional finite risk concept with innovative asset management strategies.
The best ideas are often the simplest. The efficient frontier theory would imply that investing in two uncorrelated asset classes is likely to be more efficient than investing in a single one. In other words, it is possible to achieve the same expected return with lower risk, or alternatively to produce a higher return for the same risk when investing in diversified asset classes. Therefore, to optimise the risk-reward characteristics of a portfolio and be on the efficient frontier in an asset-only environment, one needs to consider as many asset classes as possible, working within whatever constraints exist.
Reinsurers, however, do not work in an asset-only environment. Instead, they work in both an asset and liability environment, and typically have onerous constraints on their asset classes. Because of these constraints, reinsurers historically have been typically very focused on the risk management of their liabilities while keeping their assets in fixed income portfolios. By ignoring the asset side of their balance sheet, reinsurers have not been able to achieve the combined asset-liability efficient frontier.
The new generation of ART reinsurers have evolved to make the most of both its assets and its liabilities. One example of this is Max Re, a Bermuda-based reinsurer which has embraced this whole balance sheet optimisation approach by investing 60% of its assets in a portfolio of high-grade fixed income instruments while investing 40% in a fund of funds (or diversified asset management strategy) made up of over 40 fund managers and three main alternative asset strategies. By adding additional uncorrelated asset classes to the universe of investable assets, Max Re has removed some of the constraints that have historically kept reinsurers away from the efficient frontier. At the same time, because Max Re can derive value from the asset side of the balance sheet, Max Re takes a more even-handed view regarding the risks assumed on the liability side of the balance sheet. Combining a less constrained asset strategy with a balanced amount of risk on the liability side allows Max Re to achieve a new and better asset-liability efficient frontier, the ‘Max Frontier'.
This Max Frontier represents a very efficient way of achieving superior returns with a relatively small increment in asset risk, offset by a corresponding decrease in risk on the liability side. In aggregate, similar to adding an additional asset class to the asset-only strategy, this strategy can result in either lower risk for the same expected return, or higher expected returns for the same risk. The new-generation reinsurers can benefit from the Max Frontier strategy and in turn pass on part of the benefit to cedents.
Traditional reinsurance has typically provided an offset to reinsureds' liabilities: if the liabilities come in better than expected, then reinsurance purchased has less value; but if they come in worse than expected, reinsurance purchased has more value.
In ART reinsurance solutions, especially when the reinsurer has created a Max Frontier, this concept can be taken further. If in the reinsurance transaction there is a sharing of the upside of the reinsurer's diversified and less constrained asset performance, then the reinsured can benefit from this sharing. In fact, this ART reinsurance structure could be viewed as an additional asset class which expands the universe of assets which the reinsured can invest in. This will allow the reinsured to move closer to its own asset/liability efficient frontier due to this expanded set of asset classes.
This is a highly attractive feature that can add significant value to the contract. However, the reinsured will only be interested if it believes in the quality of the investment strategy of the reinsurer. Max Re has partnered with Moore Capital Management to create an investment strategy that is expected to produce higher returns with below average volatility.
Moore is recognised as one of the premier fund management firms in the world. It has been chosen to manage some of the assets in the diversified strategy and to help Max Re allocate a large portion of the diversified assets to many fund managers to achieve the optimal diversification and risk adjusted returns. The funds are segregated into three asset classes comprised of global macro economic hedge funds, long/short equity funds and convertible arbitrage funds. The fund managers are selected for their ability to provide excess returns, while constraining volatility and managing downside risk. The focus is on risk-adjusted returns, making the risk management skills as important as the talent to generate high returns. On an as-if basis, the alternative asset classes would have generated a return of approximately 19% over the last five years. An illustration of how the benefit of such a strategy can be shared follows.
NONLIFECO – A CASE STUDY
A non-life insurance company (‘NonLifeCo') is looking for ways to improve its ability to compete in the marketplace. NonLifeCo writes a book of varied liability business in the UK. Like most of its competitors, NonLifeCo is prudently investing its assets in fixed income instruments. As unexciting as this may be, NonLifeCo's management is well aware that this is an acceptable approach to its shareholders and the rating agencies alike. For NonLifeCo, risk must come from the liabilities only and not be compounded with asset risk.
One reinsurance contract could help NonLifeCo to access a more attractive investment strategy without increasing the downside risk, while at the same time protecting its underwriting results over the next three years. A three-year stop loss cover from Max Re can achieve all these objectives. Let's assume that NonLifeCo writes £100m of premium annually and this remains constant for the next three years. NonLifeCo expects the loss ratio to be 75% in each of these years, an amount of £75m in losses per year. Some observers remain sceptical at these predictions since the loss ratios have reached heights of 100% or more over the last few years.
The Max Re stop loss would protect NonLifeCo book of business for £18m in excess of £60m per year for a premium of £12m per year. Most of this £12m premium would go into an experience account balance (‘EAB') which could earn a five year interest rate (‘floor'). This floor could be enhanced by part of the difference earned by the fund of funds invested by Max Re. This could increase the expected credited rate by up to 2%, still leaving no risk for the EAB to be credited with less than the floor. Note that the reinsurer's compensation in this example is the premium and the investment income that do not go into the EAB.
The above figures show the original expected ceded losses at inception for the year 2000 followed by the ceded losses if the expected losses deteriorated by a further £3m by the end of the year. It is interesting to note that the money in the EAB at year-end 2000 could exceed £12m, the premium paid at inception for the year 2000. As mentioned earlier, this EAB when credited with a portion of the excess return generated by the Max Frontier strategy could provide up to £6m extra upon commutation of the cover for all three years covered by the stop loss.
Seasoned life block
The phrase ‘alternative risk transfer' has generally been used in the property and casualty marketplace. The closest analogy in the life and health marketplace is structured reinsurance, in which the primary goal of a customer is capital management rather than risk management. These transactions are usually associated with well-seasoned books of business that entail quite predictable cash flows; a customer enters into a structured reinsurance transaction to release capital for a specified period of time, the expiration of which leads to the customer recapturing the business. Asset transfer is rarely involved and the treaty is typically written on either a modified co-insurance or a co-insurance funds-withheld basis. In addition, there are a number of more exotic structures in the toolbox of an experienced reinsurance underwriter.
Max Re is in the forefront of a new market creating a relatively new version of structured reinsurance. In some ways, this new market can be viewed to be in the M&A business because the transactions essentially entail the permanent purchase of a book of business. The comparison to structured reinsurance and ART is twofold; first, the customer's needs are being served and second, there is low volatility in the liability cash flows. The typical customer is a premier provider in its market with a seasoned book of business with predictable cash flows that ties up more regulatory capital than is warranted, particularly in comparison to other liability categories. Books with predictable and long-tail cash flows are a very good fit with Max Re's business model in general and its investment approach in particular.
As an example, we could look at a recent transaction Max Re entered into with UnumProvident (‘Unum'), a world leader in disability insurance. Unum devotes large resources to sophisticated claim adjudication activities. These resources are primarily directed at new claims, where a very high percentage can return to work within a few months, sometimes with rehabilitation required. Claimants who have been receiving benefits for several years have a low probability of returning to work and disability writers usually devote a lower level of resources to these claims. In fact, these claims are regarded more as annuities than disabled life reserves. Nevertheless, on the regulatory statements they are slotted under disabled life reserves and require the same conservatism in the reserve calculations and the same level of regulatory capital as newer claims, which have significantly more inherent volatility. By selling the block to Max Re, Unum released idle capital to be redeployed into growing new business volumes, allowing Unum to leverage their competitive underwriting and claim rehabilitation expertise.
Using its in-house modelling expertise, Max Re projected the monthly cash flows on the book of business and fitted a precise asset portfolio to the liability cash flows. This tight integration of asset risk with liability risk is one of Max Re's core competencies. Since liquidity needs for assets backing liability payments well out into the future are modest, the company can enhance investment yields by selectively acquiring assets that provide higher yields to match these liabilities.
At first glance this transaction appears to be a typical sale of a book of business, but when examined at a deeper level there are many similarities to structured reinsurance and to ART. This is just another example of the convergence in the marketplace as traditional reinsurers, finite risk reinsurers and investment bankers are increasingly venturing into each others' territories making a blur of the lines which define their respective roles in the market.
Just as the CFO of LifeCo found a risk-financing ART solution to his frustration over the lack of capacity in the longevity risk area, risk-financing ART solutions may be found to resolve other long-tail business problems. There is no need to have a continuing drag on current earnings due to adverse development on prior year results.
The new generation of reinsurers should be able to find a way to cap the potential of adverse development for prior year liabilities on a client's balance sheet. Equally, some of the same principles can be applied to present and future business, so long as the time between the premium payment to the reinsurer and the claims or indemnities paid out is sufficiently long.
Whether it is transferring a block of annuities business or buying a stop loss to cap results and access a more attractive investment income, the new generation of reinsurers can provide efficient solutions helping stabilise current and future earnings. These reinsurers can also help clients better achieve their own asset-liability efficient frontier. Would it not be great to solve a few problems before your next reporting date?