Keith Parker explores the reinsurance options for US life insurers trying to tackle Regulation XXX.

In my previous article titled `XXX - unravelling the mystery' I provided a fairly high level exposition on the challenges posed by Regulation XXX and the tools being used to mitigate its impact (see Global Reinsurance Life Reinsurance special report, 2002, www.globalreinsurance.com). I concluded by suggesting that a reinsurance-based solution, particularly an offshore one, might be the most appropriate and sustainable option.

One of the reasons why an offshore reinsurer can assist a US life insurer with reserve and capital relief is that the offshore reinsurer usually reserves on a less conservative - but adequate - basis than under US statutory requirements. All else being equal, the sum of the reserves and capital held by both the insurer and the reinsurer after the reinsurance transaction has been entered into is less than the insurer alone would have been required to hold prior to the reinsurance transaction. This is a function of the different reserving requirements applicable in different jurisdictions. In addition, the offshore reinsurer is compelled to provide the insurer with a letter of credit (LOC) for reserve credit purposes, although placing equivalent assets in a trust can provide an alternative to an LOC. This alternative can be sub-divided into two parts; the reinsurer can either place existing assets in a trust, or it can consider using a `synthetic letter of credit'. The `synthetic' alternative has been investigated in some detail by various investment banks and some very ingenious and convoluted structures have been designed as a result.

Asset/liability mismatch
There are, of course, advantages and disadvantages to both the conventional LOC and the `synthetic' alternative. Probably the most significant disadvantage in the usage of a conventional LOC is the asset/liability mismatch that arises. LOCs are usually 364 days in length (the asset) whilst the underlying policies (the liabilities) being reinsured can be for level term periods up to 30 years in length. The unknown future cost of LOCs creates the asset/liability mismatch. The reinsurer is exposed to forces out of its control that play a role in determining the cost, such as changes (increases) in risk-based capital requirements for banks, reduced availability of capital in the market (possibly through M&A activity), banks possibly limiting the allocation of their capital to back LOCs and banks further limiting their aggregate exposures to single issuers.

The investment banks will tell you that the `synthetic' alternative can mitigate most of these disadvantages. This is indeed true, though there are some disadvantages to the `synthetic' alternative. First is the cost vis-à-vis the current market rate for conventional LOCs. Most conventional LOCs are simply cheaper, and strong opinion exists that prices aren't likely to increase significantly in the near future. Time will tell of course. The second disadvantage relates to the inherent mechanics of the `synthetic' alternative. The minimum size that will interest an investment bank is likely to be in the $200m range which might exceed some reinsurers' requirements. The `synthetic' alternative also has many moving parts including the requirement to have a special purpose vehicle (SPV). Although an SPV is widely used in the capital markets, it is relatively unknown in the life reinsurance industry and hence reinsurers may shy away from this alternative.

Sharing costs
Evidence seems to suggest that reinsurers are almost exclusively using LOCs. However, although reinsurers seem content to use LOCs, they want to hedge out the impact of cost increases by passing this risk to the insurer, an option some insurers may find unacceptable. Possible solutions include the reinsurer providing a short-term but multi-year guarantee or the insurer and the reinsurer sharing costs. One way in which they could share the costs would be for the reinsurer to assume any increases in the cost of the LOC up to a certain threshold with any increases beyond this threshold passed to the insurer. There are some subtleties that will need to be ironed out but nonetheless this presents a seemingly workable solution.

With respect to a conventional Regulation XXX reinsurance transaction, where risk is ceded to reinsurer, the main drivers to the efficiency of the transaction are the reinsurer's lower reserve and capital requirements, a possible tax differential (if the reinsurer is domiciled in a jurisdiction where the tax rate is lower than that of the US) and the additional benefits to the economics of the transaction if Federal Excise Tax is not required to be paid. This will apply if the reinsurer is domiciled in a jurisdiction that has a tax treaty in place with the US, such as Ireland.

There are some `second generation' Regulation XXX solutions available, enabling the insurer to obtain reserve and capital relief but retain most of its underlying insurance risk. In this instance, the reinsurer needs to be even smarter than before and be aware of a few additional considerations. At this point, the LOC consideration again comes into play. However, owing to the possible involvement of an affiliate or subsidiary company of the insurer, additional counterparty credit risk issues and cashflows need to be considered. The multitude of potential benefits to the insurer in entering into this type of transaction seems to indicate that the cost to the insurer is relegated in importance to some extent. Some will disagree no doubt.

At this point, 2003 looms large. The `hump' in the humpback reserve curve drifts ever closer as Regulation XXX marches relentlessly forward. Some insurers are even being restricted from writing a single new term policy until such time as an adequate long-term and sustainable solution is put in place to mitigate and manage the inevitable reserve and capital squeeze posed by Regulation XXX. Reinsurers are currently faced with an extremely difficult market within which to compete. Investment income, the historical mainstay of reinsurers' profits, is vanishing, and it's not any easier for insurers out there either. Capital is scarce; its allocation is vital. Regulation XXX tells us so.
--

  • Keith Parker is vice president of sales and marketing, Canada Life International Re. He can be contacted at keith.parker@canadalife.ie