Joseph F Kolodney explains the various uses of financial reinsurance in the life sector

The use of financial reinsurance for the life insurance industry in the US has had a long history. The words 'financial reinsurance' may have different interpretations depending on how the prospective cedant interprets its needs, but basically it is the use of reinsurance to accomplish a financial goal.

There are three major groupings:

1) surplus relief;

2) financing of new business; and

3) RBC relief (capital adequacy tests).

Historically, financial reinsurance has been associated with surplus relief. This generally is pursued to augment a company's balance sheet when it is writing a level of new business where the initial acquisition costs to put the business on the books eats into the company's available surplus and may reduce it to an unacceptable or less than desirable level until profits start emerging from that business. Unfortunately, many companies cannot afford to wait for that happy eventuality and need to bolster their balance sheet by replenishing a certain level of surplus invested in this new business acquisition. This transaction only impacts the statutory balance sheet as it is collapsed for GAAP.

The typical structure for this transaction is co/mod-co (coinsurance/modified-coinsurance), where the company cedes to the reinsurer an agreed upon block of business, the reinsurer deposits back its proportionate share of the reserve (modified coinsurance) and provides a ceding commission (coinsurance) that funds the level of relief sought. To avoid ultimate mortality exposure or attendant fluctuations, the payback period is generally structured to be about five years, after which the cedant usually recaptures the business.

Years ago, in the US market, many companies entered into transactions which were called 'surplus relief' but were in reality loans which could be forced back to the ceding company for immediate repayment if experience was not as the reinsurer projected. This all changed over a decade of evolution and impairments when the National Association of Insurance Commissioners (NAIC) promulgated the Model Regulation on Reinsurance which specifically detailed the components of a reinsurance transaction which had to exist in order for the ceding company to obtain statutory reserve credit.

Provisions included:

- defined risk passage of certain key product elements, e.g. for term insurance both mortality and persistency risks;

- capital gains and losses included in investment rate calculation;

- renewal allowances must cover anticipated allocable renewal expenses;

- 'entire treaty' clause which prohibited the use of 'side letters' or 'understandings' which might vitiate the actual treaty entered into by the cedant and reinsurer; and

- the repayment of the surplus provided by the reinsurance transaction was contingent on the performance of the business reinsured, i.e., only the profits of the reinsured business could be used to pay down the outstanding relief and the reinsurer was 'at risk' during the entire period of the agreement no matter if it ran beyond that originally projected for payback.

Since the enactment of the model regulation, all surplus relief treaties in the US have to be in compliance for the cedant to obtain statutory reserve credit, and those in existence at the time the model regulation was promulgated had to be made to conform to the new regime.

Surplus relief reinsurance is also transacted in the UK and Europe, but to differing extent. The first 'real' surplus relief reinsurance transaction in the UK took place in 1993. When presented to the cedant's auditors it was sufficiently unique to the UK environment that there were no existing audit criteria for it. As a consequence, the UK accounting practice working group decided to adopt the US Model Regulation on Reinsurance as the guide to determine the validity of that transaction. This is a vivid example of cross-border 'regulatory pollination'. Similar successful transactions have taken place in other European countries and even though structured slightly differently, still contain the risk passage components, contingent repayment, no forced recapture and the entire agreement clause.

In addition to using surplus relief to mitigate the amount of capital invested in new business writings, it is also used to maintain credibility with rating agencies. These agencies look for a certain level of 'free surplus' in arriving at their evaluation of a company's financial strength, taking into consideration how much reinsurance is outstanding and its overall impact on the company. In addition, depending on jurisdiction, surplus relief may be used to use expiring Tax Loss Carry Forwards or reduce surplus impact of tax or regulatory changes.

Another form of de facto surplus relief would be when a company looks at its in force book of business, finds a retained block which is tying up capital which it may need for other purposes, and effectively 'sells' the block to a reinsurer, realising a negotiated embedded value on the business where profits have yet to materialise. This is usually done on a coinsurance basis with generally no recapture. A recapture provision could be included, but the cost of that to the reinsurer would need to be taken into account in the pricing. In the US, transactions involving in force business cannot go through the cedant's income statement.

The motivation for doing an in force transaction is to increase the cedant's embedded value, smooth possible mortality fluctuations and replace company mortality assumption with reinsurer assumption, which will be lower and lock in profit. With new accounting rules, this accelerated embedded value cannot be immediately realised, but an enhanced GAAP earnings stream will emerge over time as a result of the reinsurer's more aggressive assumptions.

New business financing

Some think of financial reinsurance as involving the financing of new business - the second of the three groupings referred to earlier. This differs from traditional surplus relief which is done on an existing block of in force business where the experience of that business is reasonably ascertainable and the reinsurer is willing to provide relief with the collateral of the existing block it's reinsuring.

In financing new business, the reinsurer is taking a bigger bet as there is no historical predictability as to how profits will emerge, just a thoughtful assumption based on actuarial analysis. This particular strategy is more of a partnership because it involves an acceleration of some of the embedded value in the business to generate the financing needed to support new business writings.

For certain products it is not unknown for a reinsurer to provide a first year ceding commission more than 100% of the first year premium, and sometimes up to 150% or 160% depending on the kind of business reinsured. Unlike the 'fee' structure for surplus relief, the reinsurer will receive an appropriate interest rate plus a risk charge as it will be exposed to the mortality and persistency elements of the product. The duration of this transaction usually is greater than five years and, generally, offers the cedant the opportunity to recapture after ten years, assuming the reinsurer's financing investment has been recovered. Recapture can still be accomplished at the end of ten years, but the cedant would have to repay to the reinsurer the outstanding amount of financing that had not been recovered to the point of recapture.

The third grouping, RBC relief, has been used by companies whose RBC ratings have fallen below a 'benchmark' number where a continued low percentage of RBC might significantly impact a company's security rating. These transactions are usually done on a modified coinsurance or coinsurance funds withheld basis. NAIC rules indicate that the RBC should be the responsibility of the ultimate risk-taker, so the RBC is transferred from the cedant to the reinsurer even though the assets are not moved. These transactions usually involve an experience refund mechanism whereby the profits of the business are transferred back to the cedant, less an appropriate fee to the reinsurer. However, losses can only be made up out of future profits, so the reinsurer must be careful to analyse the block of business very diligently to feel confident that it can sustain the relief involved.

Some of the most capital intensive products in the marketplace today which definitely mandate some form of surplus relief are long-term, level premium term insurance products which have rate guarantees from five to as much as 30 years. They also encompass components like secondary guarantees to Age 100 for Universal Life products. The NAIC, whose principal concern is ceding company solvency, has mandated that a new statutory reserve must be held by companies. This reserve, which increases with the duration of the guaranty and then reduces to the GAAP reserve, is called 'Triple X', so named because its regulation number is Roman numeral XXX.

This has caused tremendous capital strain in the industry. To a greater extent it has been overcome by companies engaging in ceding large amounts of this business on a coinsurance basis to reinsurers who have to post the required reserves to enable the cedant to take statutory credit. This obligation is, in large part, funded by the use of Letters of Credit (L/Cs) provided by the reinsurer. This has been a cause of evolving controversy as L/Cs, while 'clean, irrevocable and evergreen', are annually renewable.

Depending upon the appetite from the marketplace, it is possible that there could be an L/C capacity shortage, or, if cedants' or reinsurers' ratings have changed, L/Cs may not be available, throwing the reserve burden back to the ceding company. In addition, constrained availability will raise prices for L/Cs to reinsurers and cedants alike. Certain rating agencies have criticised the dependence of the reinsurance marketplace on the continued availability of these one year guarantees.

As a result of this, certain reinsurance brokers and investment bankers have developed structures that provide reserve relief on a longer duration basis and, depending on the financing vehicle, at a cost lower than that of conventional L/Cs. The structure of these mechanisms usually has some form of securities aspect. Since these devices are usually subject to confidentiality agreements, few specifics are known about the multiple approaches that are currently being used.

The use of reinsurance as a financial management tool continues to evolve.

As the European market continues to open and new regulations affecting capital and solvency margins come into play, companies will be looking for reinsurance solutions that can assist them in dealing with an all-too-frequently changing playing field. Financial reinsurance by whatever name - surplus relief, financing, Triple X reinsurance or securitisations - will continue to play a major role in a company's ability to produce the business it needs to maintain shareholder/policyholder value.