United States insurers and reinsurers viewed 1 January, 2000, with a sense of foreboding. The dreaded day came, and with it shock waves that rocked the US insurance industry. Market disruptions. Product obsolescence. Fallen angels. Rising stars. This is a strange forum to be discussing Y2K, you may be thinking. Who's talking about Y2K? We were thinking of the new life insurance statutory reserving requirement, Regulation XXX, which became effective in many states on 1 January.
In case you do not have your copy of Global Reinsurance from last year (Volume 8 Issue 7) handy, we will provide a brief description of what Regulation XXX requires. Following that, we will discuss how the market has reacted to the new regulation.
Statutory reserving in the United States leaves little latitude for the valuation actuary. Companies are required to hold reserves that are at least as great as those produced using a specified method and specified assumptions. Prior to 2000, this reserve on level premium term insurance products amounted to roughly half a year's expected mortality cost. Starting in 2000, though, the method has been changed as a result of Regulation XXX. The new method creates “humpbacked” reserves that peak slightly past the halfway point of the level premium period. These reserves can be significantly higher than reserves under the old methodology, peaking at three, five or even ten times the old number.
These added capital requirements have forced insurers and reinsurers to adapt. The simplest means were to increase premiums or shorten the guarantee periods. As anyone who has worked in the marketing/sales area knows, though, these are not popular solutions. Nevertheless, some companies have increased rates modestly or experimented with shorter guarantee periods. Neither approach has proven to be very successful as consumers have flocked to companies that have held the line on premium rates. Consumers also continue to prefer products that fully guarantee the rate during the level premium period.
By far, the most popular Regulation XXX solution has been to “drop the reserves in the ocean.” In this scenario, direct insurers cede the business to offshore reinsurers. The insurers are allowed to reduce their reserves as long as the offshore companies post letters of credit in the amount of the reserves. With the cost of the letter of credit being less than the cost of capital, this solution is more cost effective than merely raising premiums, creating a more competitive product.
A less common reaction has been to redesign the product. Some new products utilize several tracking or “shadow” accounts to indirectly provide guarantees. However, there is disagreement whether these accounts actually satisfy the requirements of the regulation.
Yet another method is to employ regulatory arbitrage to mitigate the regulation's impact. This technique uses a property/casualty insurer to guarantee that the life insurance premiums will not increase. The property/casualty insurer probably needs to be affiliated with either the insurer or a reinsurer to make this successful.
The US term insurance industry will remain in a state of unrest as companies test the market with various product designs. This will lead to unprecedented quoting and re-quoting opportunities for reinsurers. It will also lead to increased regulatory scrutiny as companies test the boundaries of the regulation. The effect on term product sales could be dramatic.
In the midst of all this change, the reinsurance market continued to boom in 1999. This was partially driven by the expected 1 January, 2000, adoption of Regulation XXX. In fact, for the second year in a row, the face amount of recurring new life business retained was less than the amount ceded! However, portfolio reinsurance dropped in 1999 with production declining more than 20% from 1998 levels. The reduction in portfolio reinsurance was due in large part to companies concentrating on preparing their systems for Y2K and to handling the influx of pre-Regulation XXX business. Year 2000 results will be interesting as the full impact of the Regulation XXX “fire sale” of pre-2000 policies gets reported to reinsurers.
The US reinsurance industry continues its shuffling of owners. Recent reinsurance acquisitions include CIGNA's reinsurance operations (acquired by Swiss Re), ReliaStar (acquired by ING Re) and Sun Life of Canada's reinsurance operations (acquired by Clarica). In addition, PartnerRe sold its life reinsurance subsidiary to the France-based Scor Group. It is likely that more acquisitions will be completed in the future.
With all this consolidation, we expect the Herfindahl-Hirschman Index (HHI) to register a new high when year 2000 data is available. The HHI is a measure of an industry's concentration used by the US Department of Justice to assess the competitive impact of mergers. The index sums the squares of the market shares of the competitors in an industry. HHI values are divided into three categories of below 1000, 1000 to 1800, and over 1800. These broad categories represent markets that are unconcentrated, moderately concentrated and highly concentrated, respectively. As the chart overleaf shows, the HHI continues its flirtation with breaking 1000.
Why doesn't the index increase more dramatically given the amount of consolidation that has taken place? We have noticed over the last several years that acquisitions of reinsurers by other reinsurers frequently do not result in significant additional market concentration. In the US market, direct insurers typically cede to a pool of four or five reinsurers. Often, these reinsurers have identical terms and shares. If another pool member acquires one of the reinsurers, the naive observer might think that the pool member has doubled its share. Instead, the ceding insurer generally adds another reinsurer, preferring not to have too great a concentration with one reinsurer. In effect, the market is dictating a natural maximum market share of between 20% and 25%. As a result, reinsurance mergers demonstrate interesting merger mathematics; one plus one is less than two. Reinsurers who ignore this do so at their peril. The most effective mergers tend to be those where the reinsurers served different customers.
Perhaps the most significant development in the US reinsurance market is the rise of the importance of offshore reinsurers. While the property/casualty reinsurance market has become used to this source of competition, it is new for US life reinsurers. Undoubtedly, Regulation XXX has been a significant catalyst for this growth. As noted above, an easy way for domestic insurers to reduce the capital requirements under Regulation XXX is to cede the business offshore. Companies such as Annuity & Life Re, Scottish Life and Annuity, Max Re and Tempest Re were unknown (if not non-existent) two years ago. Each of these is located in the Caribbean, with favorite locations being Bermuda, Barbados and the Cayman Islands.
Offshore companies enjoy several advantages over their onshore competitors. First and foremost is that they are not subject to US regulations. While we have emphasized the cost of capital advantage for Regulation XXX solutions, insurers are interested in other regulatory advantages. In many of these jurisdictions, insurers may hold reserves on a GAAP or economic basis instead of the much higher US statutory basis. US companies also have strict limits as to the kinds of investments they may use. Particularly punitive are the limits regarding equities, which may be the most appropriate investment for very long duration business such as terminal funding of pension fund liabilities. Reinsuring offshore and utilizing experience refunds allow insurers to invest in equity markets that offer the potential of much higher returns.
The second major advantage enjoyed by offshore companies is in the area of taxation. Many Caribbean jurisdictions have little or no ordinary income or capital gains tax. US companies can cede business offshore and delay the taxation of the profits until they are repatriated. This tax deferral confers a significant economic advantage to the offshore companies.
Not everything is rosy on the islands, however. Already, premiums sent offshore may be subject to a 1% excise tax. In addition, several US companies are lobbying to have the excise tax increased as a way of eliminating the offshore companies' advantage. Tax havens in general are coming under increased scrutiny and even attack from the G8 nations. Finally, these new offshore companies have all the difficulties of start-ups everywhere, ranging from attracting and keeping the best talent to developing effective administrative and accounting systems. Even so, we anticipate that offshore competition is here to stay.
The way forward
As we enter a new millennium, reinsurers face many new challenges. What will the fallout from Regulation XXX turn out to be? Will term sales dry up? Will direct companies cede even more risk to reduce their capital strain? Will consolidations continue at their current rapid pace? Will offshore reinsurers enter the market as fast as onshore reinsurers are consolidated? Will the pricing advantages of being offshore outweigh the strong balance sheets of traditional reinsurers? Direct companies have more choices than ever when it comes to placing their business. But, freedom of choice brings with it the burden of responsibility. Choose your reinsurer carefully.
Kenneth M. Mihalka and Robert L. Buckner are vice president, operations leader and vice president, appointed actuary, respectively, of Employers Reassurance Corporation.