In today's insurance environment, life insurers in Asia are faced with many pressures on profitability and capital. Consumers are looking for better and cheaper deals, requiring life insurance companies to improve the efficiency of management, and to reflect these cost savings in pricing. Shareholders are demanding a return on capital commensurate with the underlying risk. Supervisory authorities are turning their focus to the financial stability of insurance companies in order to protect policyholders. These pressures, together with the goal to achieve continuous growth, force life insurance companies to seek the most efficient capital structure to carry out their business and to improve their risk/reward profile.
Traditionally insurance companies dealt with risk on a segmented basis, that is, the event risk was managed by the actuarial department and the financial risk by the finance department. Each department has a different approach and appetite for retaining or transferring risk. However, managements are beginning to look at risk beyond the traditional context. With the challenges and opportunities of the future, a more integrated approach to risk transfer and financing should enable life insurance companies to achieve their overall financial goals. So what are the options for insurance companies?
Sources of capital
The most common sources of capital are shareholder equity, debt (including contingent and subordinated, among others), and reinsurance. While shareholder equity is a permanent infusion of capital, there might be a limited possibility to raise such additional capital. For example for mutuals, such capital raising is prohibited. For other companies the addition of new equity may unacceptably dilute ownership interests. Debt can offer some relief to a cash problem, but it does not increase surplus.
Another source of capital is reinsurance. It is not a new source of capital, as risk transfer and financing have been the pillars of reinsurance solutions since their beginning. However, evolving with the needs of insurance clients, reinsurance solutions have expanded to include a more holistic approach to risk transfer and financing on an integrated basis.
Spectrum of solutions
A few examples of insurance risk and financing solutions via reinsurance are given below. Such solutions can offer new opportunities for clients seeking to transfer risk, as well as to enhance liquidity, smooth short term fluctuations in results, improve solvency, and finance growth and acquisition. Overall, such reinsurance solutions represent a versatile tool to enhance and stabilise the companies' earnings and surplus.
In Japan, for instance, although reinsurance as a tool for capital and financial management is a fairly new concept within the life insurance industry, the use of life reinsurance has grown from $0.5 billion in 1995 to $1.6 billion in 1998. This increase mainly relates to the use of reinsurance solutions for acquisitions, and for improving solvency margin ratios.
Discussions with regulators and other authorities, as well as rating agencies, are often necessary to achieve optimal results. Some Asian countries, such as Japan and Singapore, have already established financial reinsurance regulation, and therefore reinsurance solutions are not only tailored to the clients' specific needs, but also to the regulatory environment.
Most life insurance companies have an important asset – the embedded value (or the future profit) of in-force life business on a statutory reporting basis. This presents life offices with an issue: they have a large asset with no statutory value. Paradoxically, this means that offices can become victims of their own success. Despite writing good, profitable business, they may appear financially weak if profits emerge slowly.
The most common use of modern reinsurance solutions is to provide the insurance company with a commission income or reserve credit that flows through to its statutory earnings and surplus. This process of creating a surplus through reinsurance is commonly referred to as a surplus relief. Essentially, it accelerates the recognition of part of the future profits of the reinsured business.
In its simplest from, the reinsurer will guarantee the profit of the reinsured business to the insurance company by paying a commission or allowance up front, and will then look to recoup this commission from future profits generated by the reinsured business. Thus the allowance (net of tax) provides an immediate increase to the statutory capital. Surplus relief differs from a normal loan in that the repayment does not need to be shown as a liability on the balance sheet. This is because the repayment of the relief is tied to the future statutory earnings on the block of business reinsured. There is no guarantee as to the timing of the repayment, and the ultimate recovery of the relief is not certain to the reinsurer.
Surplus relief is based on the same instruments as traditional reinsurance. However, the characteristics of a surplus relief arrangement offer additional flexibility in terms of duration and ease of administration. Typically, the expected repayment period is in the region of five to seven years. If, however, surpluses emerge more slowly than expected, the treaty would continue until the financing and reinsurance charges have been repaid from subsequently emerging surpluses.
Contingent capital structures based on subordinated debt or equity financing techniques can be used to prospectively and cost-efficiently secure an insurance company's financial standing in the aftermath of a significant event, when a traditional refinancing would be rather costly, if available at all.
Upon the occurrence of certain events, the company has the right to exercise the option to issue capital within predetermined limits. The triggers may be related to a catastrophic event, or to a financial market event such as a stock market drop or a change in interest rates. The drawn-down capital could be theoretically any type of capital available to the company. In many cases, preferred shares or subordinated debt are chosen, in order to achieve optimal capital credit and not to dilute shareholders' interests. To make sure that such arrangements give the required capital credit, the arrangements are usually discussed in advance with regulators and rating agencies.
The capital markets can provide an alternative to surplus relief in the form of securitisation. The structure is a little more complicated than a surplus relief, but essentially works as follows: a Special Purpose Vehicle (SPV) is established to issue bonds to the capital markets, and the proceeds of the issue are lent to the life office. The loan has a principal and interest repayment profile based on the amount of surplus expected to emerge from the securitised policies, and the bond repayments mirror this profile. As with surplus relief arrangements, the loan is repaid if and only if future surpluses emerge, so the liability to repay the loan has no statutory value. The proceeds therefore count towards statutory capital.
The interest rate on such a bond may be either fixed or floating. This will depend on the capital market investors being targeted, which will in turn depend on the features of the bond profile. For example, life funds are major purchasers of long term fixed interest securities, as they can provide a better match for certain liabilities, such as annuities. Banks tend to prefer short-term floating rate investments.
The attractiveness of a securitisation issue to investors may be improved by obtaining a credit enhancement arrangement. This is where an institution such as a reinsurer with a higher credit rating than the life office effectively guarantees the bond repayments. In doing so, the credit rating of the bond issue rises to that of the guarantor. This is particularly valuable if the capital markets will only accept highly-rated paper, for example, due to market turbulence. In other circumstances credit enhancement may simply allow a larger issue than would otherwise be possible.
So far, around the world, insurance securitisation has mainly been used to provide catastrophe and weather insurance capacity. In the Asian life insurance industry, only a few embedded value securitisations have been completed. However, we consider that the future is likely to lead to further convergence of the insurance, reinsurance, and capital markets, and a greater use of securitisation is likely to be seen.
Life insurance companies in Asia are now facing, and will continue to face, increasingly challenging financial requirements. We believe that managing risk by integrating insurance risk transfer with financing solutions for life insurance companies in Asia is not a passing fashion, but a way to manage risk in the 21st century, as such solutions can be effective and cost-efficient, and can successfully supplement traditional capital instruments.
In many countries, however, regulatory and accounting frameworks for these reinsurance solutions still need to be developed. Such developments will hopefully accelerate due to an increasing demand from insurance companies which intend to take advantage of the economic momentum building in Asia.
Marielle Théron is head of Swiss Re Life & Health's Financial Solutions Section. Previously, she was Executive Director of the Singapore office of William M. Mercer.