Kenneth M. Mihalka and Robert L. Buckner survey the life reinsurance market and report that it is anything but staid and complacent.
One might think that a centuries old business that deals primarily in mortality would become staid and complacent. But forces, both internal and external, are conspiring to keep that from occurring.
As we reported last year, the single-digit growth rates of direct writers should not bode well for life reinsurers in the United States. In addition to slow growth, our clients in the life insurance industry continue to consolidate, although in fewer, larger deals. The combined entities often have a larger retention level that, on first blush, should reduce reinsurance opportunities. Simultaneously, demographic trends have shifted the chief life insurance worry in the United States from dying too soon to living too long, creating a stagnant life insurance market for many companies. Yet, even given some potential double counting of reinsurance production, the chart below illustrates the reinsurance market continued to boom in 1998.
In fact, for the first time, the amount of recurring new life business retained was less than the amount ceded! While the compound annual growth rate for gross life insurance written since 1993 was under 5%, the comparable figure for reinsurers was over 30%. Furthermore, portfolio reinsurance has also picked up, with 1998 production up 25% over 1997. The result of all this is to concentrate the mortality risk of contracts sold by hundreds of direct writers onto the books of fewer than twenty reinsurers.
The details of why this phenomenon continues to occur were covered in depth in our article in the September-November 1998 issue of Global Reinsurance. Rather than cover the same ground, let's look into some areas that have experienced change since then.
Consolidation continues to occur at record levels for both direct writers and reinsurers. While the number of deals in 1998 was similar to the number in 1997, the value of the transactions was substantially greater. This was almost entirely due to the monster $18.0 billion acquisition of SunAmerica by American International Group. Another large deal was the $5.0 billion acquisition of the Provident Companies by UNUM. In addition, the mix of buyers changed as recognized acquirers Conseco, GE Capital and others were noticeably quiet in 1998.
Reinsurers continued to help clean up after an acquisition, as was demonstrated several times in 1998. Typically, the acquiring company must accept an undesirable line of business to close the deal. Several reinsurers and direct writers, including us, are carving a niche in this market. We help companies divest themselves of unwanted product lines.
Another example would be of a company that used to sell whole life but now only sells annuities and equity-linked products. Rather than diverting resources to convert a nonstrategic block to a new computer system, why not sell it to someone who is interested in that line of business? Not only does the company save the expense of conversion, but it also reaps a ceding commission! As an added plus, the policyholders may be better served by a company specializing in that line of business.
On the reinsurance side, oh, what a difference a year makes! The ink was barely dry on last year's article when Swiss Re announced that it had bought Life Re for $1.8 billion. Then, in May 1999, the affiliated companies, ERC Life Reinsurance Corporation and Employers Reassurance Corporation, announced that they were acquiring Phoenix Home's Life Reinsurance Division. Those two acquisitions have concentrated the market to historically high levels. To demonstrate this, the chart below uses a measure called the Herfindahl-Hirschman Index (HHI).
The HHI sums the squares of the market shares of the competitors in the market. The US Department of Justice uses it 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 that are unconcentrated, moderately concentrated and highly concentrated, respectively. The HHI has remained relatively flat over the years in spite of several mergers and no significant new entrants. In fact, one has to go back to 1984 to find a time when the index was barely over 1000. Factoring in the Phoenix Home Reinsurance Division acquisition, the index would move to a historically high level of nearly 1050. So much for our statement last year that, given current valuation levels, significant additional consolidation is unlikely!
This year, we are predicting that additional consolidation could occur, since two other transactions involving reinsurers have been announced. First, Aegon acquired Transamerica, including their Reinsurance Division. Second, General American, the majority owner of RGA, has agreed to be acquired by Metropolitan. Neither Aegon nor Metropolitan previously owned a US life reinsurer. Will they fuel consolidation by acquiring other reinsurers? Or will they divest the ones they have? The year 2000 may ring in more than the new millennium as far as the US life reinsurance marketplace is concerned.
Model Regulation XXX
“XXX” is currently the hottest topic for many US direct writers, but not in the way you might suspect. Regulation XXX is a “new” reserving guideline that affects all policies, especially term insurance with guaranteed level premiums and certain forms of universal life. It was first proposed over ten years ago in a different form but was never widely adopted. That is about to change. In March 1999, the National Association of Insurance Commissioners adopted a new version of the model regulation with an effective date of 1 January, 2000. Many states are either in the process of adopting the regulation or have already done so.
The regulation closes perceived loopholes in the current statutory valuation method. Presently, the reserve many direct writers hold on level term products approximates an unearned mortality cost for the current year. The new regulation requires a “humpback” reserve that builds to a peak a little over halfway through the guaranteed level period and then declines. This “humpback” reserve can be over ten times greater than current reserves. For the whole industry this could mean billions of additional reserves.
Not surprisingly, many direct writers are attempting to mitigate this reserve increase by changing their products. Shortening the guarantee period reduces the required reserve. Increasing premiums offsets the additional cost of capital. Direct writers are also seeking assistance from their reinsurers.
The popular belief is that XXX will be a boon for reinsurers. But does this new regulation really create opportunities for them? If reinsurers continue to quota-share and retain term business, they may find themselves saddled with significant reserve increases that strip them of statutory surplus. Instead, many are ceding the business to offshore affiliates. This permits more flexibility in reserving than is available under the prescribed US statutory methods, effectively converting highly redundant reserves to more reasonable levels. However, it also means using letters of credit to receive the appropriate reserve credit.Using letters of credit, though, raises several concerns. First, of course, letters of credit add additional, variable costs. The cheap letters of credit being used today typically are guaranteed only for a year. Who is to say that three, five or ten years from now, the rates will still be low?
Also, the large reserve numbers we've discussed could result in a capacity crunch. The “humpback” reserves under Regulation XXX don't reach their peak for many years. While the letters of credit issued today must be “evergreen”, banks do not have to guarantee additional capacity in the years ahead. Offshore reinsurers with prearranged limits may find letters of credit unavailable for the growth inherent in the reserves, let alone for additional years' issues.This places companies in the unenviable position of funding a long-term liability with a short-term instrument without guaranteed cost or availability in the future. Some reinsurers are trying to pass this variable cost back to the direct writer; others are willing to absorb it to some extent. A major opportunity exists for anyone who can surmount these hurdles.
Our comments from last year need little update. Equity-linked products continue to be a source of innovation and differentiation. The real change, though, is on the reinsurance side.
Last year we discussed guaranteed minimum death benefits and guaranteed minimum income benefits. At the time, we commented on the need to develop a new skill set to price these risks. In the intervening year, market volatility has increased, greatly increasing the cost of these guarantees. Direct companies now have a problem. They have created an expectation for these guarantees in the mind of the consumer. They believe, though, that they cannot pass on the increased costs to the consumer.
At the same time, reinsurance capacity has shrunk. The dominant carriers a year ago have, for strategic reasons, exited this market. Several other carriers have entered the field, others are considering entering, but capacity remains constrained.
“It was the best of times; it was the worst of times...”
As the 1990s come to an end, whether reinsurers will look back with longing or regret still remains a mystery. Will they remember the tremendous potential of acquisitions, new regulatory guidelines, demutualizations and unprecedented opportunities to reinsure entire portfolios of business? Or will they remember the competition and downward price spirals caused by excess capacity? We'll leave you with the same words as last year, which we feel are even more pertinent and true. Choose your reinsurer carefully.
Kenneth M. Mihalka and Robert L. Buckner are vice president and assistant vice president, respectively, of Employers Reassurance Corporation.