David Laskey explores the innovative ways in which speciality reinsurance products and techniques can assist growing life insurance offices.
Markets in Asia are complex and diverse, defying generalisation. Yet across the continent, in both mature and developing markets, reinsurers face the challenge of implementing strategies that recognise the differences between various markets, while leveraging their own core competencies.
Historically, a reinsurer's role has been to assume excess or unusual risks, while continuing to play a vital part in the field of risk management. However, the result of consolidation and increased retentions in the primary insurance industry has lowered demand for reinsurance. This trend has forced reinsurers to develop new and innovative applications for their products.
As insurance novices, we learned about non-admitted assets - those assets that could not be recorded on the statutory balance sheet. Yet few of us were taught to regard our in-force business as a non-admitted asset, and to manage it accordingly. Reinsurers and their customers have developed techniques to bring that value onto the balance sheet for a several reasons:
For capital adequacy: Increasingly, insurers are aware of the need to manage and augment capital due to such factors as:
However, shareholder capital is expensive (or not available at all, as in the case of mutual companies). Insurers in Japan and Hong Kong realise that reinsurers can be a source of moderately priced short-term capital, and have used reinsurance to release part of the future profit in their in-force business. (The reinsurer typically pays a ceding allowance that represents a significant percentage of the present value of future profits.)
The regulatory environment in Hong Kong is open, and such transactions are judged on their merits. Japanese regulations are more restrictive, and the circumstances in which reinsurance can be used for financial engineering are carefully delineated. Taiwan has introduced regulations regarding such uses of reinsurance, but the initial transactions have been tentative and much remains unclear. China lacks regulations in this area, but major transactions are unlikely until the currency is fully convertible.
To reduce risk-based capital (RBC): In markets such as Hong Kong, life offices may achieve substantial reductions of their required margins of solvency through reinsurance. A typical arrangement will allow up to 50% of business to be ceded to a reinsurer, with most of the emerging experience flowing back to the insurer through profit-sharing provisions. Thus, the life office realises the bulk of benefits from the business it writes, but reduces the amount of capital to be serviced. Such a transaction may involve a surplus-rich reinsurer for whom solvency is not an issue, or one whose domestic RBC requirements are less onerous than those facing the cedant.
For tax planning: Tax regimes in many Asian countries place significant limits on tax loss carry-forwards. Start-up companies, typically faced with ten years or more of losses, are unable to fully utilise the early losses, and shareholder value is reduced. Reinsurance can be used to release some of the embedded profit in portfolios, in order to use up the expiring tax losses. However, mandatory cession requirements in some countries dramatically reduce the scope for such measures.
In certain parts of Asia, profitable insurers look for ways to defer taxation. By assuming a block of high-strain business from a loss-making company, insurers can postpone the payment of taxes while helping the counterparties reduce their tax loss carry-forwards. In some Asian countries we have also seen transactions designed to maximise profits in a particular year, in order to take advantage of special tax concessions or in anticipation of future tax rises.
In Japan, the use of reinsurance for tax planning has been limited, as corporate culture has leaned towards paying `one's fair share'. Given the financial turmoil of the last dozen years, this attitude may change.
For asset management: Insurers frequently find themselves holding assets that cannot be fully recognised on the balance sheet. The owners of these investments often have compelling reasons for holding such assets, despite any restrictions on their book values. In some cases, a life office will cede a block of business (with substantial reserves) on a coinsurance basis, then transfer selected assets to match the reserves. If the assets have been held on the balance sheet for less than their true economic value, the net result of the transaction is the reduction in liabilities exceeding the reduction in assets - an increase in capital and surplus for the insurer.
Of course, such reinsurance arrangements are structured so that the ceding office maintains control of the assets, and receives virtually all of the economic benefits arising from them. Recapture provisions allow the cedant to cancel the arrangement at any time and bring both the assets and the liabilities back onto the books.
Release of redundant reserves: The valuation systems in certain Asian countries are very conservative, mandating reserves at a level far in excess of the best estimate reserves. In Japan, for example, the reserves required on annuities create a substantial reserve strain in the early years. So-called surplus relief transactions (as practised for many years in the US and other mature markets) have become more common. In such situations, insurers cede the business to a reinsurer domiciled in a country that permits reserves to be held at a more realistic level. This release of reserves allows the ceding company to deploy its capital for more lucrative opportunities.
Potential users of such financial engineering should note, however, that regulators now scrutinise transactions carefully to ensure that they are not simply loans in disguise. Regulators insist that risk be transferred from cedant to reinsurer. For the most part, this means that virtually all risks taken by the life office (ie mortality, morbidity, investment, lapse and expense risks) must be assumed by the reinsurer.
Taiwan has taken the step of quantifying the risk that must be transferred. Potentially, this could lead to the reinsurer requiring a greater risk than is inherent in the product being reinsured, giving the ceding office a disproportionately large reduction in its own risk. Ultimately, this will increase costs for the ceding insurers.
Japan has also limited the ways in which the proceeds of a financial engineering transaction can be used. Specifically, the proceeds should be used to strengthen the reserve basis, limiting the possibilities for companies that already hold net level premium reserves.
Of course, the reinsurer also has some concerns about the creditworthiness of its potential clients. While it is absolutely necessary for the reinsurer to model accurately the cash flows under the proposed transaction, this is not sufficient. Indeed, the reinsurer must conduct a due diligence inspection of the client in order to determine the likelihood of failure before the natural termination of the reinsurance treaty. A life office's reluctance to freely share information would be enough to scare off any enlightened reinsurers.
We witness, as regulatory barriers are lowered and markets are opened up to full and free competition, the formation of new insurers to occupy product, distribution and geographical niches. These companies tend to rely heavily on reinsurers for assistance in product development as well as in risk management.
The accession of China to the World Trade Organisation (WTO) is gradually opening the market, and interest among foreign players is intense. Meanwhile, domestic groups, with the encouragement of central government, are mobilising capital to form new companies. Japan has seen a surge in the formation of new companies, or the reshaping of existing firms. Non-life companies have created life subsidiaries, and the number of foreign-invested firms has expanded dramatically.
Taiwan's market is very different to its shape a dozen years ago, as both domestic and foreign interests have founded new insurers. The range of options available to consumers has expanded several times over. Vietnam and Philippines have lowered or removed entry barriers, and thus many new providers have sprung up. Among these companies, the demand for assistance in new product development continues unabated. Reinsurers scramble to deploy the resources that their clients need immediately, in order to seize opportunities.
As a result of their international networks and their skills in risk management, reinsurers are able to introduce products from other parts of the world, while also providing the knowledge transfer needed to allow clients to underwrite and administer the business. Reinsurers also bring skills in claims adjudication and experience in monitoring, so that price adjustments can be made in a timely fashion.
Fast-growing markets like China and India create demand for knowledgeable people that far exceeds the supply. Recent graduates are able to secure positions very easily and the competition for people with some experience is intense. In exchange for quota-share reinsurance arrangements, reinsurers are happy to provide consulting services and project management. This process allows insurers to acquire experience beyond that which years of service might otherwise generate.
Likewise, reinsurers can provide certain systems that are needed by their clients. Policy administration, underwriting, claims adjudication and point-of-sale are some of the areas where reinsurers may be able to help, either on a fee-for-service basis or through quota-share reinsurance.
The majority of Asian markets still rely on captive agents for most life sales. Personal relationships have traditionally formed the basis of sales activities, and insurers spend vast sums of money to recruit, train and motivate their legions of agents. The high cost of this distribution channel has encouraged insurers to consider other channels. Of course, the entry of foreign players with strategies based on alternative distribution has also forced domestic insurers to respond with appropriate defensive measures.
Here again, the international networks of reinsurers enable them to gather the skills, knowledge and systems needed to help clients create new channels. As their reward for providing assistance, reinsurers will seek a quota-share of new business arising from new channels.
In many industries we have seen the development of `virtual' companies, ones that purchase most of the components of the value chain from outside providers. These companies have, apparently, concluded that their core competence is the ability to create and nurture a distinctive brand. In the insurance industry we are seeing the development of firms that outsource the development and administration of their insurance products, as well as the underwriting and claims adjudication functions. Many have concluded that it is less expensive to purchase these services from a reinsurer or some other supplier than to hire and train staff and to develop internal systems.
A growing number of Asian insurers have determined that they are in the asset accumulation business, and that risk management is no longer a core competence. These offices happily gain access to the required risk management skills through the purchase of reinsurance. Some insurers have also discovered that they can purchase reinsurance at a price that is lower than their most optimistic mortality or morbidity projections. This may arise from the risk management expertise of the reinsurer or from the reinsurer's focus on cash flow rather than profits. For many companies, the opportunity to lock in predictable levels of future profits may prove irresistible.
The ways in which reinsurers can assist life offices have expanded greatly over the years. Whether helping clients to release value from existing business or generate future new business through new products, new skills or new channels, reinsurers are uniquely positioned to create long-lasting partnerships with Asian insurers.