Life without reinsurance
Ronn Mullins: Consider that one dark day; life insurers decided they didn’t want to reinsure their policies with life reinsurers. What alternatives would they have to transfer their risks, relieve reserves, and replenish their surplus? And are any of these mechanisms available today, or will there be in the near future? To put it succinctly, could primary life insurers get along without life reinsurers?
John Nigh: I don’t think anyone has really found a way to get life insurance risks into the capital markets. There certainly isn’t an alternative today for that basic life insurance risk to become a part of a catastrophic risk, as on the property casualty side, in cat bonds. But if that one dark day is 20 years from now, ten years from now there might be a solution, a capital market solution, but today I haven’t seen one.
Rodney Clark: You can find it in pockets and you see it, for example, in the availability of Triple X funding alternatives through securitisation, which hasn’t meant the death of the individual life reinsurance market but it has led to the shift from coinsurance to first dollar quota share excess retention. It has allowed those types of shifts that has decreased the utilisation of life reinsurance. You can find it in embedded value securitisations, which are not commonplace but have occurred in a few cases and could become a more viable alternative to financial reinsurance. You can find it in the mortality cat bonds out there that are really reinsuring a catastrophic risk in a way that the life reinsurers haven’t been offering. At the moment, they are probably not economical considering the manner in which the transactions have been done. One thing you do find is those markets are slow to develop and are usually expensive in the development phase and are often usually inaccessible to smaller companies because of the scale requirements and the extreme expense in putting together a highly structured alternative solution. But if the life reinsurers don’t keep their pencils sharp you will find more and more of the Goldmans and the Lehmans finding better ways to bring capital market structures into these solutions, and possibly find more ways to pull smaller companies’ risks together in terms of solutions and in effect using a capital market structure to replace life reinsurers in some ways. I don’t think that is going to mean the death of life reinsurers any time soon but I think life reinsurers have to continue to think about new ways to provide coverage for various risks and keep it economical to the cedant because they will not be completely without alternatives one day.
Rob Griffin: There are some new things coming out, not from the traditional reinsurers, not from the big five necessarily, but there are some significant alternative markets out there that are going to be growing in the next few years.
Rodney Clark: There is a lot of interplay too in the ways in which the capital markets are not only pushing life reinsurers but also creating risk management structures that helped them enter new markets. If you look at the pandemic risk, for example just a few years ago there wasn’t much in the way of catastrophe cover offered by reinsurers that would address that risk. Some companies are starting to develop that now, in part because they see the market demand, in part because they see the capital markets beginning to offer alternatives for them to hedge out that risk. There is a great deal of interplay that the reinsurers can view capital markets as an enemy that is stealing their business but if they are smart about it and innovative they can also use it to stay in certain markets as a risk management tool.
Pat Kelleher: I would completely agree with that. I view the life reinsurance market as kind of a private secondary market for the life insurance industry and as such we have accumulated a lot of experience and skills relating to operating that market. Access to the public markets is something that you know would have great value to the life reinsurance enterprise and I think it could almost reinforce the value of the life reinsurance market because it is a place where you can pool certain risks and basically pass it on to the markets that can most efficiently handle and manage it.
Mark Sarlitto: You know, I am not so sure that expectation will persist. Life risks don’t have a lot of homogeneity. There are a lot of aspects to the way policies are designed and the way that mortality and longevity versus risk correspond, but it is not like mortgages where you have one or two or five or six variants. Over time, it will probably become possible, but it is not now. I think life reinsurers beyond pooling and warehousing will be the shapers of risk for distribution to the capital markets where it makes sense. The trick is how you manage the transition. Life reinsurance will be something different five years from now. I do believe that Triple X was our front porch to embedded values securitisations and we will get there as we leverage that experience.
Ronn Mullins: Let’s take another topic. In what regions of the world do you see life insurance sales growing the fastest? What types of life products – individual, annuity, term, group, others – do you predict will be the best sellers in those areas? Have you as representatives of the life reinsurance industry recognised this growth and included it in your strategic plans?
John Nigh: In terms of growth opportunities, Asia is where most people focus and that would include Japan, Korea, certainly China and India. Those are countries that even a slight penetration in the market, a small market share percentage can translate into a significant operation. Latin America has always been the continent of the future and still is, and will likely still be in ten years. I would suspect that we could not say that about Mexico in the sense that Mexico tends to have a more stable economy in spite of what is happening throughout the rest of Latin America. Possibly Brazil has potential, but Brazil certainly remains the country of the future. The most activity you see in Europe is through M&A. I don’t see growth there. In the UK there is certainly a lot of activity on retirement-related contracts and payout annuities, but most of the conversations that I have had and from my experience and knowing what companies are doing, Asia is where the action is and where companies hope to be.
Pat Kelleher: I will share with you what we have been seeing and experiencing. It differs slightly from John’s perspective. To some extent it depends on what your company is and what kind of core capabilities it has. Transamerica is a US company. We serve a sophisticated market and so the skillset and the confidence we have doesn’t necessarily translate well in emerging markets. They do translate well to markets where there is a fairly well-developed life insurance sector and there is room for a sophisticated secondary market which is doing financing work and product development that helps the primary market expand. We have seen a significant amount of growth internationally – probably a full third of our new business is coming out of both Latin America and Asia, primarily from Asia – and really it is working with companies who are not in the traditional reinsurance services and stop loss. We don’t have big underwriting shops but we do have financing and direct marketing in those emerging markets and that seems to have value. We have no presence right now in Europe but we see significant change both from the European Directive, which helps to break down artificial country barriers and allow different companies from various country markets to operate across Europe creating greater competition. I think that will spur some innovation. What we are seeing from our parent, Aegon, is the work that is going to be required and the risk analytics that are associated with implementing Solvency II requirements is going to create risk based capital requirements and demand for capital, and, hopefully, for a demand in a secondary market in Europe. This is going to create some fairly substantial change. For us, we view Europe as a potential growth opportunity, although it may just be change in the market which would allow a new entrant.
John Nigh: You are answering the second part of this question, which is the reinsurance. I was really focusing on the direct side. Yeah, a direct marketer isn’t interested in Europe. It is too fragmented, players are all over the place. However, reinsurers who support them, would naturally have a different perspective. Point well taken.
Michael Pado: XL Re is bullish regarding the European market and also in Asia. In fact, it is expanding operations from the UK into France as we speak.
Rodney Clark: If you look at the life insurance markets globally, you’ll find there are pockets of potential, but for the most part it is a mature industry. Some of the best growth markets in Asia, where many life reinsurers have been for a long time, counts for a fraction of the global reinsurance sector. For life reinsurers to grow, given the maturity of the UK and the North American markets, it has to do things it hasn’t done before. One way is to expand into some of those more mature markets of Western Europe by finding new ways to do business and to exploit regulatory changes in those markets. It is going into developing Asian markets and bringing out critical illness products or creating new marketing approaches or being a new entrant in bank assurance or what have you. It is really going to take some outside-the-box thinking because taking a US- or Canada- or UK-style product and trying to sell it in Germany or in Japan is a recipe for failure as it has been for everybody who has tried it thus far.
Ronn Mullins: With short-term interest rates edging upward to 5% and long–term 30-year bond rates moving closer to 4.5%, what affects will this low-interest condition have for older life products, which carry higher interest rate guarantees? Will the industry come up with competitive products to offer when multi-year guarantee annuities mature over the next few years? Will this leave insurers and reinsurers with a massive number of surrenders on annuities and fewer new products to offer consumers?
Rodney Clark: It is hitting significantly now. 2001 and 2002 was a huge time for selling five-year, seven-year locked in products and we are hearing anecdotally companies seeing those products coming up for renewal now and getting 50% and higher surrender rates. Why? Because the insurance companies have focused on those annuity products, on longer-term guarantees, longer-term products supported by longer-term investing. These products have no advantage now over a bank offering a six-month or a one-year certificate of deposit (CD) at a higher rate than a product with a seven-year surrender period. I think a lot of companies are going to see a lot of money flowing out over the next few years, unless they come up with some good alternatives, like variable products, equity indexed products and new hybrids to stem the tide of outflows that will last through 2007 maybe a little bit beyond. It will take some real creative work but it could lead to increased growth in some niche areas. It is another area where the life reinsurance market can look for growth; the basic core life market is not going to increase as it did in recent years. The industry has to look to offer something new, something innovative to assist primary companies to keep cash flows positive.
Michael Pado: I’d like to comment on a point Rodney made concerning guarantees. I think in today’s product design the interest-rate guarantee is factored in a great deal more than in the past, such as equity market guarantees designed for variable new products. A whole number of living benefits have been designed into such products. There has been a lot of innovation around indexed annuities and their evolution. I just see that the market has evolved in this product design far beyond just offering straight life insurance or a straight return on an asset. The industry is sort of marrying these two contingencies and the one potential growth area for a reinsurer is to be able to address what I refer to as a convergence risk. This is combining both insurance risks that provide the policyholder both optional and non-optional features, as well as capital market risk management techniques.
A changing landscape
Rodney Clark: We are really in a different environment now from a distribution standpoint. In that area you are describing, most insurance was sold by captive insurance agents and now life insurance is sold by independent insurance brokers and banks and stockbrokers, among others. They have scant loyalty to the insurance company. They have very sophisticated financial tools and can advise their clients to take the money and walk and put it somewhere else. This wasn’t happening before and the gradual paradigm shift over the last ten to 20 years in the way products are distributed is creating a challenge in terms of conservation of those policies and those funds.
Ronn Mullins: This next topic has to do with life settlements. In the late 1990s, life settlements emerged from the viatical industry. Since then, the value and the volume of the life settlement industry has increased dramatically. In 2004 alone, life settlements provided older policyholders with $1bn in purchasing power, $660m in excess of their policies’ cash surrender value, according to the Life Insurance Settlement Association. Institutional money managers may have invested more in life settlements last year – an estimated $10bn to $15bn in face amounts – than in the previous seven years combined. Private studies estimate 19,000 policies will have been bought in 2005, and 26,000 will be purchased in 2006. How does this new twist on reaping cash from life insurance policies affect the life reinsurance industry?
Eugene Woodard: It is pretty clear to me at least that the industry continues to evolve and that direct writing companies have to evolve to preserve their in force books of business. Looking back several decades, insurance companies had to develop new investment or innovative products for insurance buyers, so they came out with annuities. These new products were initially looked at like they were the plague, similar to how life settlements are regarded now. I understand that some direct writers are now searching for ways of offering some other options to their insureds because life settlements are not going away. How do you deal with it? You come up with a product that makes sense from an insurer’s and reinsurers’ standpoint. Eventually, I think we will begin to look at that market not so much like the plague, but as an opportunity for reinsurers.
Pat Kelleher: In the long term I personally believe it is a good thing. Anything that offers liquidity in the life insurance market will help with the value to the consumer and the potential growth of the business so it should be good for our customers in the long term and good for us. We have looked pretty closely at life settlements and we haven’t really done anything with it yet but that is because we are trying not to be too stretched. In the short term, we don’t want to dilute our business strategy by trying to do too many things at once. Maybe in the future it will be good for us to participate in the life settlement business. It’s not that we are not interested, but we haven’t taken action as yet.
Michael Pado: Several weeks ago, I attended a life settlement conference in Greenwich, Connecticut, just to see what the heck was going on. I believe I was the only reinsurer at the conference and again I just wanted to see what everyone was talking about. The room was filled with lawyers and hedge fund guys, who determined it was their birth right to be able to buy policies in the secondary market and treat them like any other asset. During the course of the discussion, it was interesting to hear that at least one insurance company has responded by dramatically changing its application and, since I haven’t confirmed it I don’t want to say the company’s name, but it changed the application to require the applicant to give them a sort of first look before they sell it to anyone else. This clause is broadly accepted in about 50 states, so it seems to be a considered response to the life settlement issue.
John Nigh: From state regulators’ perspective, and perhaps Mark will comment on this, there is a whole insurable interest issue this year with life settlements so perhaps the insurance company you mentioned is reacting to this issue. The insurance company certainly has to make sure that there continues to be an insurable interest.
Mark Sarlitto: There is a policy concern there and it is not immaterial.
John Nigh: I am not a fan of the life settlements industry, but you are right, Mike. It is the hedge funds and attorneys that are pushing these life settlements. There has been two securitisations in life settlements and both of those were done a number of years ago. I am told there is about to be another one but I haven’t seen it.
The road ahead
Ronn Mullins. Before we adjourn, do any of you have any final comments to make about the future of the life reinsurance industry? Where do you think it is going? Is the future rosy or are there clouds on the horizon?
Michael Pado: I believe the industry will continue to evolve at an accelerating rate. Many of the players will come up with new processes, particularly the newer players which have the ability to be nimble. But there is going to be a shift toward complete collaboration. Some of the players will be better at working and collaborating with banks, direct dealers, risk management consultants, but those who don’t adjust to this different relationship will end up at the back of the pack.
Rob Griffin: Over the last three or four years, we have seen a retreat by most of the reinsurers back to the core confidences. They used to do so many things and now they are getting focused on what and where they can do best. The new entrants are coming in and saying, “We are going to stick to our knitting, and do those things we know how to do right.” But I have heard in the marketplace that there are reinsurers looking for that next edge, for the next big thing or the next big couple of things because they are not going to be able to live or pay the bills on the traditional products of the marketplace. I think part of the future is going to depend on how much the capital markets get into the Triple X market before principal-based reserving gets established over the next two or three years. There is great potential that the reinsurance marketplace will shrink more next year as companies are not only looking at reinsurance as a cost but also looking at other risk alternatives to manage that enterprise risk issue, whether it be mortality or capital or pandemic or fluctuations or what I call the “C1 risks”, that is the risk of bad news about your company appearing on page C1 of The Wall Street Journal.
John Nigh: I believe a reinsurer has to set a profit margin that it wants to achieve and it adopts a discipline to get there. It creates a partnership with the direct writer; together they should have a stronger relationship and one that helps to solve their problems. I think when it settles down it will be a stronger reinsurance industry. There is the risk, however, of some hotshot CEO declaring he won’t put up with this decline in sales and beginning to underprice the product to increase sales. Soon an environment of ruinous competition takes over.
Eugene Woodard: We see the North American market as a niche market for us. We don’t view ourselves as trying to compete with the Munich Res and the Swiss Res, but rather we find niches where we think we can leverage our expertise and find attractive returns for our capital that will sustain the growth plans for our organisation. Given the dynamics in the North American market there are opportunities in those specialised niches. We find there are a lot of new things going on where reinsurers can play an important role and we hope to find those places where we can leverage our intellectual capital to get into those markets.
Rodney Clark: For the near term, we are still seeing things remaining relatively rational. Margins are better on new business as well as for terms and conditions and these act as a strong pricing power. There is probably room for a couple of new entrants without upsetting that balance. But what will happen if huge sums of money from hedge funds or other sources come into this sector because they see it as lucrative? That may upset the apple cart and spoil the pricing discipline and cause other problems. It is going to be a very careful investor who puts money into the life reinsurance sector today and that is likely to keep discipline a little bit more in line than it was a decade or so ago. But a lot depends on what is happening on the non-life side in terms of how good the capital investment opportunities are seen there versus life reinsurance. Standard & Poor’s broad view on the life reinsurance sector is that now is a moderately rosy time.
Ronn Mullins: Thanks to you all for your candid and enlightening remarks.