Kenneth M. Mihalka and Robert L. Buckner examine the US life reinsurance market, finding plenty of paradox in the process.

On the surface, conditions would appear to be abysmal for life reinsurers in the United States. Our clients in the life insurance industry are consolidating at a record pace, creating economies of scale but also ever-increasing retention levels. Simultaneously, demographic trends have shifted the chief insurance worry in the United States from dying too soon to living too long, causing life insurance sales to be flat for most companies. Yet, even given some potential double counting of production, chart 1 illustrates the reinsurance market is booming. What is going on here?

Term insurance and the rise of preferred underwriting

In the 1970s, reinsurance in the United States was conducted using loaded yearly renewable term (YRT) risk premiums, frequently with an experience refund provision. The underlying products were typically whole life plans.

With the economic gyrations of the late 1970s to early 1980s, life insurance companies developed a new breed of product, select and ultimate annual renewable term with separate rates for smokers and nonsmokers. With its introduction, the US reinsurance market saw the arrival of foreign entrants and the resultant fight for market share. Not only did rates drop, but reinsurers switched from using YRT premiums to coinsurance. Soon, reinsurers were competing on the basis of how much of an allowance they would give in the first year. Eighty percent? One hundred percent? Try one hundred and fifty, two hundred or more!

What reinsurers discovered quickly, though, was that the persistency of this business was atrocious with lapse rates often exceeding 40%. Reinsurers were seeing the same individuals being reissued by different insurers annually. They did not have a chance to recover their high first-year commissions. This had to stop, and stop it the reinsurers did, by tightening replacement guidelines, lowering allowances, and terminating accounts.

By the late 1980s, to combat high lapses, the term product of choice had become the 10-year level premium plan. In an effort to differentiate themselves, several companies began offering two underwriting classes. Now one would think that a classification such as nonsmoker would be fairly consistent throughout the industry, but the truth is quite different. Variations on the original 12-month, no cigarettes criteria soon proliferated as companies tried to capture an ever-so-slightly better risk. First to go were cigars and pipes. Then all forms of tobacco.

Then, in a continuing effort to offer even lower prices to the consumer, insurers searched for new and better ways of classifying risks. In addition, companies realised there were other benefits to be derived from the blood testing they were performing to control their AIDS exposure. And thus was born the Preferred Class.

The Preferred Class splits the nonsmokers into two groups, by attempting to identify those who are particularly healthy. Criteria used include cholesterol levels, family history, blood pressure, avocations, etc. With the advent of preferred underwriting, term prices plummeted for these better risks. As rates dropped, individuals could afford larger and larger sums assured. This in turn led to reinsurers seeing more cases in excess of an insurer's retention. The by-product was that reinsurers were able to collect data on the efficacy of numerous preferred criteria from multiple insurers, creating a credible database unavailable to a single insurer.

In the never-ending search for a competitive edge, life insurers today frequently have multiple preferred classes. We are aware of several companies that subdivide the nonsmoking population into six underwriting classes and the smoking population into two more. And all of this is before any additional substandard rating, which is typically applied to the "worst" nonsmoker or smoker class.

As these products are created many insurers turn to the reinsurance community for assistance. Insurers have industry data to support the pricing differential between smokers and nonsmokers but little data to split the nonsmokers. By working with a reinsurer, they have access to their experience. In exchange for this and other product development work, many reinsurers require some kind of quota share arrangement.

First dollar quota share

The explosive growth in life reinsurance is attributable to the increasingly frequent use of first dollar quota share arrangements by insurance companies. Many of these reinsure 90% of the mortality risk. Some of these arrangements are the result of product development work on the part of the reinsurer. Others are the result of value-added reinsurer services, such as an electronic underwriting manual. But most cannot be explained this way.

One of the oft-cited reasons for using reinsurance is to reduce the volatility of earnings. While this would be expected for a small or medium-sized company, many larger stock companies are equally concerned, and for good reason. In analysing blocks of business from some of these companies, we have discovered that many exhibit greater volatility than theory would call for. With the increasing penalty imposed by the capital markets for unpleasant earnings surprises, even large companies worry about volatility.

A second, and related, reason for using quota share arrangements is to improve capital management. Insurance regulators in the United States have considered changing the reserve calculation method for the last several years. One consequence of the proposed method would be to increase dramatically the level of reserves for term insurance, particularly the increasingly popular 20, 30 and 40-year level term plans. Even without this change, companies writing mountains of term insurance may find the capital strain too great to bear alone. By partnering with a reinsurer, the insurer can use the reinsurer's capital to write additional business. We have not found a company yet that wants to tell its agents to stop writing business for it. First dollar quota share arrangements assure companies they will not need to do so.

Even these reasons, though, do not fully explain all of the first dollar quota share arrangements flooding the reinsurance market. Companies are putting older blocks of business out for bids as well. These and many of the new product arrangements can be explained quite bluntly by price.

In spite of some consolidation within the life reinsurance market, competition among reinsurers is fierce. Insurers are taking advantage of rates that "appear too good to be true." Adding fuel to this fire is the increased number of opportunities to bid. Products are being developed and revised more frequently. The shelf life of a product is often under six months. In pricing these deals and in performing due diligence work on acquisitions, we have seen the pricing assumptions used by the life insurer. Frequently, the winning reinsurer's offer is 30% lower. Why would an insurer not quota share its business? From its viewpoint, it has now locked in a substantial profit, since the rates are typically guaranteed for 10 years or more and there is no option to terminate inforce business, only for new issues.

While differences of opinion exist as to expected mortality on new business, there is another troublesome trend emerging. More and more frequently, reinsurers are pricing mature blocks of business with a substantial discount. This experience is credible, though, which makes one wonder what justifies this discount. Before committing to such arrangements, all parties should consider that the long-term viability of the reinsurance marketplace depends on both the ceding company and the reinsurer making a profit.

Consolidation

Consolidation is occurring at both the insurance company and the reinsurance company levels. As companies strive for improved efficiencies, acquiring another company is frequently used to achieve economies of scale. In the insurance industry, the reinsurer often lends a helping hand.

Well-capitalised reinsurers use their capital to support acquisitions. We, for example, have partnered with several acquirers to help finance their acquisitions. In exchange, we keep a quota share portion of the acquired business.

In addition, reinsurers help clean up after the acquisition. A common problem is the insurance company buys more than it wants. It has to take an additional line of business it would rather not have to close the deal. Several reinsurers, including ourselves, are carving a niche in this market. We help companies divest themselves of unwanted products. A perfect example of this would be a company that used to sell whole life but now only sells annuities and equity-linked products. With whole life de-emphasised, the insurer may not view upgrading computer systems for the year 2000 to be economically feasible. Wouldn't it be better just to sell the block to someone who already has the systems in place?

We see little opportunity for the US life reinsurance industry to become heavily concentrated. To demonstrate this, chart 2 uses a measure called the Herfindahl-Hirschman Index (HHI).

The HHI sums the squares of the market shares of the competitors in the market. It is used by the US Department of Justice to assess the competitive impact of mergers. HHI values are divided into three categories of below 1000, 1000 to 1800, and over 1800. These broad categories represent markets which are unconcentrated, moderately concentrated and highly concentrated, respectively. The HHI has remained relatively flat over the years even though there have been several mergers and no significant new entrants. In fact, if you were to go back to 1984 you would find that the index was flirting with going over 1000. Therefore, in spite of recent acquisitions, the US life reinsurance industry has actually become less concentrated. Furthermore, given current valuation levels, significant additional consolidation is unlikely. Even though some opportunity remains, reinsurers may find their main opportunity for rapid growth to be the acquisition of closed blocks of business from life insurers.

New products

With the shift in emphasis from death benefits to wealth accumulation, reinsurers in the US market are being confronted with a host of new challenges. The unprecedented performance of the US equity markets has led many insurers to develop products that are linked directly or indirectly to them. These products enjoy the benefits of tax deferral. The most common are the variable deferred annuity, where all investment risk is passed to the consumer, and the equity-indexed deferred annuity, where consumers participate in the upside but have downside protection.

Because of regulation and in an effort to differentiate themselves, life insurers have added increasingly complex guarantees. For example, variable annuities used to offer the return of principal as a minimum death benefit. Now, a typical variable annuity will offer as a guaranteed minimum death benefit the greater of principal compounded at 5% to 7% and the value on any prior anniversary. The complexity of this guarantee has encouraged many companies to reinsure it. From the reinsurer's perspective, this requires a new skill set. In addition to needing to forecast mortality and persistency, pricing actuaries now need a strong understanding of the capital markets. Each company has to decide whether to run the risk or to hedge it and what the risks or costs of each position would be.

Yet another investment product is the guaranteed minimum income benefit. Also attached to deferred variable annuities, this product provides a minimum income stream upon annuitisation regardless of the performance of the underlying investments. The consumer gets as a monthly benefit the greater of the stream purchased using current purchase rates and the current account value and the stream purchased using guaranteed purchase rates and the "guarantee" account value. The "guarantee" account value is typically the principal compounded at 5% to 7% and is only used for determining the guaranteed annuitisation stream.

Related products are popping up in Canada. Called segregated funds, they guarantee not only a return of principal upon death but also a return of principal after 10 years. As an added feature, consumers are allowed to "reset" their guarantee to their current account value while resetting the maturity benefit to 10 years from the time of reset. In effect, this product guarantees the consumer will not lose money on his investment. With US mutual funds controlling over $5 trillion, this product has strong potential in the US market.

Keeping with annuities, we are beginning to see an interest in reinsuring immediate annuities. Life insurers realise that the billions they have accumulated under deferred annuities are maturing and eventually will leave. Historically, few individuals annuitise; they take their money in a lump sum and place it elsewhere. Some insurers are turning to the reinsurers for help in designing products which will encourage policyholders to leave the money with the insurer for as long as possible. Others seek investment advice for these potentially very long liabilities. Still others want to reinsure the longevity risk.

One popular product in global markets which has not fared well in the United States is Critical Illness, either on a stand-alone basis or as a rider to a life policy. While there have been a few modest success stories, it is a product which is not yet being accepted by the buying public. Unclear is whether this is due to product complexity, low perceived value, lack of agent training and knowledge, unclear tax status or no major company selling it. Or perhaps Critical Illness as a viable product in North America is just ahead of its time.

"It was the best of times; it was the worst of times . . ."

Whether reinsurers will look back on the 1990s with longing or regret remains a mystery. The potential is tremendous, with acquisitions, exciting new products and unprecedented opportunities to reinsure entire portfolios of business. Or will they remember the competition and price-shaving caused by excess capacity? The wise and strong will survive, the weak and foolish will be chased from the market. Choose your reinsurer carefully.

Kenneth M. Mihalka and Robert L. Buckner are vice president and assistant vice president, respectively, of Employers Reassurance Corporation. Tel: Mr Mihalka (1) 913 676 6541, Mr Buckner (1) 913 676 3190; fax: (1) 913 676 6273; e-mail: Ken.Mihalka@ercgroup.com, Robert.Buckner@ercgroup.com