strategic considerations in financial reinsurance

STRATEGIC CONSIDERATIONS IN FINANCIAL REINSURANCE

Amit Ayer

March 25, 2016

TRAINING AGENDA

Reasons for insurers to employ reinsurance

Summary of industry issues with in-force business

Review potential structures to alleviate reserve redundancies

Introduction to financial reinsurance

Summary of potential financial reinsurance structures (in-force business)

Detailed review of potential financial reinsurance structures (in-force business)

Coinsurance

Coinsurance with funds withheld (“WFH”)

Modified coinsurance

2

1

2

3

Rationale Description Examples in industry

1Transfer risk to limit

volatility in future

income or capital needs

• Products that cause insurers to incur significant volatility in GAAP

reserves or required capital do not promote stability of earnings over

time

• Variable annuity rider modified

coinsurance (Lincoln / Union

Hamilton)

• Fixed annuity coinsurance

(John Hancock / RGA)

2

Receive product

development,

underwriting or other

services

• Cedants that lack expertise with certain product lines (Indexed

Annuities, Variable Annuities, etc.) may work in conjunction with

reinsurer to develop tractable product(s) for distributors in market

• Co-developed product(s) are reinsured, leveraging reinsurer’s

administration systems, hedging capabilities, etc.

• Mutual companies looking to

start distribution of Fixed

Indexed Annuity products

3

Reduce current capital

needs or improve

returns on current

capital

• Reinsurance structures to alleviate redundancy in reserves can free

“trapped capital”

• Financial reinsurance structures can reduce the required capital

through transfer of risk to the reinsurer (solvency / capital support) and

provide alternative means of raising capital

• Numerous insurers use financial

reinsurance to increase overall

return on capital

Focus of training material

RATIONALE FOR IMPLEMENTING FINANCIAL REINSURANCE STRUCTURES

3

THREE QUESTIONS POSED BY CEDING COMPANIES AROUND FINANCIAL REINSURANCE

1 2 3Would financial reinsurance for in-force blocks be a viable strategy to increase overall return on capital?

What types of reinsurance structures are preferred?

What types of reinsurers would be most tenable in a financial reinsurance transaction?

A. Sourcing capital through reinsurance can provide significant flexibility and cost efficiencies over alternative capital sourcing, such as issuing subordinated debt or share issuance

B. Increasing overall return on capital is contingent on efficient deployment of capital that emanates from reinsurance structure

A. Structures that do not materially disrupt balance sheet

B. Obtaining reserve credit is imperative in any structure

C. Structures that allow option to recapture business at some point in time

A. On-shore and off-shore reinsurers are both tenable options, each with their own pros / cons

B. Price differentiation across reinsurers revolves around percentage of value of in-force paid as ceding commission

C. Off-shore reinsurers would need to hold assets in a Regulation 114 market value trust; trust may need to be on-shore depending on chosen structure

4

Dimension Redundant reservesRealizing high projected statutory net

income

1Present on balance sheet

today?Yes

No; contingent on projected statutory net income

materializing as expected

2 Target products to reinsureIn-force products in which statutory

and economic reserves differ

materially

In-force products that have generated high statutory

net income from strong underwriting and pricing

margins

3 Goals of reinsurance

Transfer profits embedded in

redundant reserves into capital,

increasing available capital at inception

of reinsurance

Realize future profits of business today, increasing

available capital at inception of reinsurance via

ceding commission

Increase overall return on capital Increase overall return on capital

4 Reinsurer domicile Off-shore On-shore or off-shore

5Reserve basis of reinsurer in

structureStatutory (“Economic” like)

• On-shore: US NAIC RBC

• Off-shore: Local statutory (“Economic” like)

6Impact of reinsurance to

balance sheet• Liabilities decrease

• Available capital increases

• Assets and available capital increase by

amount of ceding commission

SUMMARY OF TYPICAL ISSUES WITH SELECTED IN-FORCE BUSINESS

5

In-force A&H

reserves

ISSUE 1: REDUNDANT RESERVES ON BALANCE SHEET

Alleviation of redundant reserves on cedant’s balance sheet through reinsurance

6

Definition of issue• Statutory reserves requirement for A&H products can

be overly conservative, often multiples of an“economic” type reserve requirement (e.g., U.S. GAAP)

• Traditional methods of reserve funding have become costly

Impact of issue to cedant• Capital strain / reduction in free surplus

• Reduction in return on capital

Reinsurance structures to alleviate• Cede redundant reserves to offshore entities,

where local statutory reserving requirements are less onerous, such as permitting the use of U.S. GAAP

Key impacts of reinsurance structures• Unlocking of statutory profits embedded in

reserves: transform statutory reserve into an “economic” type reserve upon transferring liabilities to an off-shore entity

• Increase in capital: Available capital is increased by difference between statutory and economic reserve

Statutory reserve redundancy

Statutory reserve redundancy reduces available capital / free

surplus

Statutory profits embedded in

reserves realized in capital

“Economic” type reserve

ISSUE 2: EXTRACTING CAPITAL FROM IN-FORCE PRODUCTS ON BALANCE SHEETExtracting capital on balance sheet through modified coinsurance structure

7

Definition of issue

• In-force A&H products have demonstrated consistent track record of high statutory net income, which increases available capital as profits emerge

• Need to wait for statutory profits for its high margin in-force A&H products to materialize to improve its capital position

• Raising capital through subordinated debt or share issuance is expensive

Impact of issue to cedant

• Reduction in return on capital

Reinsurance structures to alleviate

• Financial reinsurance

• Reinsurers can be domiciled on-shore or off-shore

• Typical structures include (but are not limited to) coinsurance, modified coinsurance and coinsurance with funds withheld

Key impacts of financial reinsurance structures

• Financing considered an asset: Ceding commission is a cash item and is reflected directly on the balance sheet

• Capital: Available capital is increased by value of the financing

• In-force products have realized high statutory net income over time

• Without reinsurance, the distributable earnings that will emerge from these products cannot be realized today

Realization of quota share of future profits of in-force A&H products

(financing)

Subsidiary

Debt Issuance

to investors

Funded from cash flows from in-force

A&H products ceded

Contributed capital

Parent

POTENTIAL SPECIAL PURPOSE VEHICLE (SPV) #1DEBT ISSUANCE

8

Commentary

• SPVs are expensive to establish

and often not established until a

sufficient volume of business has

been issued to justify expenses

• Issuance of bonds in capital

markets has dried up since global

financial crisis

• Risks ceded to SPV are some form

of coinsurance; YRT generally will

not transfer redundant reserves,

although guaranteed premium YRT

could do so

• Asset structure must be formatted in

a manner to allow cedant to take

US statutory reserve credit; use of

trust facilitates allowance of reserve

credit

% coinsurance

Captive

Issue bonds

Cash

Cash proceeds from bond issuance

Redundant

Reserve Trust

Economic

Reserve Trust

Capital

Account

Contributed capital from holding company

Subsidiary

Bank

Funded from cash flows from in-force

A&H products ceded

Contributed capital

Parent

POTENTIAL SPECIAL PURPOSE VEHICLE (SPV) #2LETTERS OF CREDIT / ASSETS

9

Commentary• Primary advantage of Letters of Credit

(LOC) financing is that only the amount

of annual redundancy needs to be

funded by the LOC, along with a bank

commitment to increase the LOC

amount each year during the period of

financing at the fixed charge for the

LOC

• Prior to financial crisis, only long-dated

financing option was securitization

because banks would not issue LOCs

for more than 5-7 years

• After securitization in the capital

markets disappeared, some banks

became willing to provide long-dated

LOC financing

• With impending AG48 Guidelines,

investors have to provide hard assets

% coinsurance

Captive

LOC / Assets

Cash proceeds from bond issuance

Redundant

Reserve Trust

Economic

Reserve Trust

Capital

Account

Contributed capital from holding company

Business Application of financial reinsurance Typical cedant characteristics

1 New business

• Help alleviate cost of acquiring new policies (new business

strain financing)

• Many statutory frameworks do not allow insurers to fully

capitalize acquisition expenses, resulting in a technical loss in

first year

• Young, fast growing insurers in initial

stages of building a liability portfolio

that is incurring particularly high up-

front acquisition costs

2In-force

business

• Provide early realization of value of in-force policies (value of

in-force financing)

• Enables insurer to finance growth initiatives or re-investment

into other businesses at any time

• Mature companies with profitable in-

force policies

• Companies looking to earning higher

return on capital

INTRODUCTION TO FINANCIAL REINSURANCE

Financial reinsurance background• Geared either to help alleviate the cost of acquiring new policies (new business strain financing) or to

the early realization of the value of in-force policies (value-of-inforce financing), enabling an insurer to finance growth initiatives at any time

• Financing is an upfront commission from the reinsurer based on the future earnings of the new business or in-force business; ceding commission factors in earnings from renewal premiums

Financial reinsurance can be applied to both new or in-force business

10

Dimension Commentary

1 Flexibility

• Size and timing of ceding commission (available capital) is flexible

• Reinsurance contract can continue after ceding commission (plus reinsurer risk

charge) has been paid off or business can be recaptured

2 Cost

• Cost of financial reinsurance generally compares favorably to other available

means of accessing capital from public sources, such as share issuance and

subordinated debt

3 Risk Based Capital (RBC) • Higher RBC ratios, given lower required capital and higher available capital

4 Transactional efficiency • Minimal transaction costs

5 Transparency• Clear definition of derivation of ceding commission and pay-back arrangement

(amortization of ceding commission)

6 Partnership• Aligned interests of cedant and reinsurer

• Continuity via long-term business partnership

7 Additional services• Potential additional services from reinsurer, such as medical underwriting, claims

management, and product development support

ADVANTAGES OF FINANCIAL REINSURANCE

11

Cedant cash flow profile: portfolio before

in-force financial reinsuranceCedant cash flow profile: portfolio after

in-force financial reinsurance

-100

-50

0

50

100

150

200

250

300

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Profits

KEY CONSIDERATIONS WITH IN-FORCE FINANCIAL REINSURANCE

12

-100

-50

0

50

100

150

200

250

300

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

Profits Financing Reinsurance Premium

Represents repayment

of financing from

earnings of ceded

portfolio (plus profit

margin for reinsurer)

Future profits

of ceded

portfolio at

present value

• Portion of future payments used to pay down

financing commission is contingent on quota-

share

• Financing commission is reduced

proportionately by lower quota share

Desired

characteristicCoinsurance

Coinsurance with funds

withheldModified Coinsurance

1Provides infusion

of capital

• Financing commission increases

available capital to deploy to

increase return on capital


available capital to deploy to

increase return on capital


available capital to deploy to increase

return on capital

2Minimal

disruption to

balance sheet

• Premium and reserves are ceded

• Ceded assets from investment of

premium maintained by reinsurer

• Premium and reserves are ceded,while assets are retained by cedant

as a receivable (liability)

• Premium is ceded, while assets and

reserves are retained by cedant

• Ceded premium is offset by Mod-co

adjustment from reinsurer

3Provides reserve

credit

• Risk transfer definition met

through ceding of underlying

liability obligations, as reinsurer

takes risk of profits not

materializing as expected

• Risk transfer definition met through

ceding of underlying liability

obligations, as reinsurer takes risk

of profits not materializing as

expected

• Risk transfer definition met through

ceding of underlying liability

obligations, as reinsurer takes risk of

profits not materializing as expected

4Allows

recapturing of

ceded business

• No risk charge, so less flexibility to

recapture liability obligations after

financing commission is paid

down

• No risk charge, so less flexibility to


financing commission is paid

down

• Risk charge affords option to


financing commission is paid down

Overall

Meets dimension Fails to meet dimension

EXECUTIVE SUMMARYCOMPARISON OF POTENTIAL IN-FORCE FINANCIAL REINSURANCE STRUCTURES

13

Dimension

CoinsuranceCoinsurance with funds withheld

(“WFH”)Modified coinsurance

Retained / received by

cedant


reinsurer


cedant

Retained / received by reinsurer

Retained / received by cedant


reinsurer

1Liability obligations

X X X

2 Reserves X X X

3 Premium X1

1 X1

1 X1,6

1,6

4 Assets X 4 X5

X

5Collateral requirement2

X X X

6Ceding commission3 X X X

7Interest on reserves

NA NA NA NA X

DESPITE TECHNICAL VARIATIONS, FINANCIAL REINSURANCE STRUCTURES ALL INVOLVE RISK TRANSFER

1. Initial premium equals the gross reserves on portion of policies reinsured

2. Off-shore reinsurers are required to hold a market value trust; for funds withheld

and modified coinsurance structures, book value trust (if needed) is held on-shore

3. Paid by reinsurer to cedant at initiation of reinsurance treaty

4. Cedant establishes a liability for the funds withheld

5. Reinsurer establishes an asset for the funds withheld; (receivable from cedant) trust for

the funds withheld and financial performance of assets belong to reinsurer

6. Initial mod-co adjustment paid by reinsurer is equal to reserves at inception of contract;

the mod-co adjustment thus offsets the gross reserve held by the cedant

Key considerations –Cedant• Gross reserves for ceded business

are calculated and ceded

• Premium ceded is set equal to the

gross reserves ceded

• Assets will need to be liquidated to

cede premium or sufficient cash

needs to be available

• Range of practices around

reflecting increase in available

capital into statutory net income

Key considerations –Reinsurer• Financing commission = x% *

Present Value of distributable

earnings from ceded business

(based on local statutory)

• Premium ceded is invested in assets

to support liability obligations

• Off-shore reinsurers are required to

post collateral using a Regulation

114 Trust (market value)

Reinsurer

Financing

commission

% Reserves and Premium associated

with in-force business

Cedant

POTENTIAL STRUCTURE 1COINSURANCE (1/3)

15

Balance sheet gross and net, 50% quota-share

Balance sheet commentary

• Assuming 50% quota share, $40 of gross

reserves are ceded; gross premium ceded is

set equal to gross reserve ceded

• Financing commission is $10

• Quota share = 50%

• PV(distributable earnings) = $25

• X% = 80%

• 50% * $25 * 80% = $10

• Available capital increases by amount of

financing commission ($10)

% Liability obligations ceded

Realization of quota share of future profits of in-force A&H products (financing)

Quota-share reduction in

gross reserves

Premium is not quota-shared, but instead reduced by ceded gross reserves

DimensionCedant

ImpactCommentary

Reinsurer

Impact1 Commentary

1 Required capitalNo capital charge applied to ceded premium

Higher; extent of increase depends on capital treatment in reinsurer’s domicile of ceded premium and assets supporting ceded reserves

2 Available capitalFinancing commission increases available capital

Free surplus reduced by amount of financing commission and increase in required capital

3 RBC Ratio(Available / Required) ratio increases

(Available / Required) ratio decreases

4 ReservesReserves calculated for in-forceliability obligations to be ceded to reinsurer

Reserves ceded; extent of increase depends on reserve treatment in reinsurer’s domicile

5 PremiumSet equal to reserves ceded to reinsurer

Equal to ceded reserves assumed by reinsurer

6 Assets

No general account assets are ceded to reinsurer, but assets will likely need to be liquidated to cede premium

Reinsurer will use ceded premium to purchase assets to support liability obligations

1. Assumes on-shore reinsurer managing to statutory framework

POTENTIAL STRUCTURE 1 COINSURANCE IMPACT AT INITIATION OF FINANCIAL REINSURANCE (2/3)

16

DimensionCedant Impact

CommentaryReinsurer

ImpactCommentary

1 Required capital1No change in required capital requirement; less than 100% quota share would increase requirement

Ceded renewal premium and assets supporting ceded reserves increase required capital requirement

2 Available capitalAssume available capital from financing commission is deployed

Higher required capital requirement will reduce available capital / free surplus

3 RBC Ratio1 (Available / Required) ratio decreases (Available / Required) ratio decreases

4 ReservesReserves associated with renewal business ceded to reinsurer

Higher reserves from initial and renewal in-force premium ceded

5 Premium Premium = quota share * renewal premium Renewal premium ceded

6 AssetsNo general account assets are ceded to reinsurer, but assets will likely need to be liquidated to cede premium

Renewal ceded premium funds purchase of assets to support liability obligations

Key considerations – Cedant• Gross reserves are calculated for

liability obligations underlying ceded

renewal premium

• Gross premium = quota-share * renewal

premium

• Unlike treaty inception, ceded premium

and reserves are not equal throughout

treaty

• No assets are ceded

• Cedant retains no responsibility around

paying down financing commission

Change from treaty inception, assuming 100% quota-share

Key considerations – Reinsurer• Experience refunds are seen in

coinsurance structures as way of cedant

participating in “upside” (e.g., lower

expenses / claims than expected, higher

investment income on assets than

expected)

• Retain risk of statutory profits being

sufficient to pay down financing

commission

• Responsible for increase in reserves and

capital from ceded in-force liability

obligations


POTENTIAL STRUCTURE 1COINSURANCE TREATMENT THROUGHOUT FINANCIAL REINSURANCE TREATY (3/3)

17

%Claims

Experience refund

% Expense allowance

ReinsurerCedant % Reserves and Premium associated with in-force renewal business are ceded


Key considerations –Cedant• Gross reserves for ceded business

are calculated and ceded

• Premium ceded is set equal to the

gross reserves ceded

• Ceded reserve credit taken

• Liability established for funds

withheld

• RBC treatment is same as RBC

treatment in a coinsurance structure

Key considerations –Reinsurer• Reinsurer is assessed capital charges

on the assets supporting the reserves

• Assets backing ceded statutory

reserves are either composed of 1) a

receivable from cedant or 2) a deposit

of assets to cedant (and reinsurers

own assets if needed)

• Asset established for funds withheld

• Financial performance of assets

belong to reinsurer

ReinsurerFinancing commission

% Reserves and Premium associated

with in-force business

Cedant

POTENTIAL STRUCTURE 2COINSURANCE WFH (1/3)

18

Balance sheet gross and net, 50% quota-share

Balance sheet commentary


reserves are ceded, requiring $40 of gross

premium to be ceded

• Reinsurer invests $40 of ceded premium in

assets to back ceded reserves, which are

subsequently deposited back to cedant

• Cedant recognizes $40 of assets on balance

sheet and $40 of accounts payable (liability)

• Available capital increases by amount of

financing commission ($10)


Assets backing ceded

reserves

Assets supporting ceded reserves are deposited back to cedant and treated as a liability

Dimension Cedant Impact CommentaryReinsurer

Impact1 Commentary

1 Required capitalNo capital charge applied to ceded premium and funds withheld assets

Higher; extent of increase depends on capital treatment of ceded premium and funds withheld assets in reinsurer’s domicile



3 RBC Ratio(Available / Required) ratio increases

(Available / Required) ratio decreases

4 ReservesReserves calculated for in-forceliability obligations to be ceded to reinsurer

Reserves ceded; extent of increase depends on reserve treatment in reinsurer’s domicile

5 PremiumSet equal to reserves ceded to reinsurer

Equal to ceded reserves assumed by reinsurer

6 AssetsEstablish liability for the funds withheld

Establish asset for the funds withheld


POTENTIAL STRUCTURE 2COINSURANCE WITH FUNDS WITHHELDIMPACT (2/3)

19

DimensionCedant

ImpactCommentary

Reinsurer

ImpactCommentary


Ceded renewal premium and assets for funds withheld increase required capital requirement




4 ReservesReserves associated with renewal business ceded to reinsurer

Higher reserves from initial and renewal in-force premium ceded


6 Assets Establish liability for the funds withheld (renewals) Establish asset for the funds withheld (renewals)

Key considerations – Cedant• Treat funds withheld as an account

payable (liability)

• Pay investment income on funds

withheld liability to reinsurer

throughout treaty

• RBC treatment is same as treatment

in coinsurance structure


Key considerations – Reinsurer• Assets backing statutory reserves for

renewal business are deposited to

cedant

• Receive investment income from

cedant on funds withheld



commission

• Retain responsibility for increases in

reserves and capital


POTENTIAL STRUCTURE 2COINSURANCE WFH TREATMENT THROUGHOUT FINANCIAL REINSURANCE TREATY (3/3)

20

%Claims / % Allowance / Experience Refund

ReinsurerCedant% Reserves and

Premium (in-force renewal business)


Assets backing ceded reserves

Investment income on funds withheld

Key considerations –

Cedant• Premium ceded is set equal to the

gross reserves of the policies

reinsured

• Reserves are retained by cedant, so

gross and net reserves are equal

• Assets supporting liability

obligations are retained by cedant

Key considerations –

Reinsurer• Financing commission = x% *

Present Value of distributable

earnings from ceded business

(based on local statutory guidelines)

• Reinsurer is assessed capital

charges on the assets supporting the

reserves (retained by cedant)

• Modified coinsurance adjustment is

paid by reinsurer to cedant to offset

the reserves held by cedant

ReinsurerFinancing commission

% Premium associated with in-force business

Cedant

POTENTIAL STRUCTURE 3MODIFIED COINSURANCE (1/3)

21

Cedant balance sheet gross and net, 50%

quota-shareBalance sheet commentary

• Gross and net reserves are equal under ModCo,

as ceded reserves are retained on cedant’s

balance sheet


reserves would be ceded (but are retained)

• Gross premium ceded always equals ceded gross

reserves ($40)

• Cedant maintains all assets supporting reserves

• Available capital increases by amount of financing

commission ($10)


Modified coinsurance

adjustment

Gross and net reserves are the same under ModCo because ceded reserves are retained on cedant’s balance sheet (on behalf of the reinsurer)

DimensionCedant

ImpactCommentary

Reinsurer

Impact1 Commentary

1 Required capitalNo capital charge applied to ceded premium and assets supporting gross reserves

Higher; extent of increase depends on capital treatment of ceded premium and assets supporting reserves (held by cedant)



3 RBC Ratio (Available / Required) ratio increases(Available / Required) ratio decreases

4 Reserves Gross and net reserves are equivalent No reserve increase, since all reserves are assumed by cedant

5 PremiumSet equal to reserves for policies to be reinsured but is offset by Mod-co adjustment payment

Increased in ceded premium is offset by Mod-co adjustment payment

6 AssetsAssets supporting gross reserves are retained , but assets may need to be liquidated to cede premium

Mod-co adjustment negates ceded premium that would be used to purchase assets


POTENTIAL STRUCTURE 3MODIFIED COINSURANCE IMPACT (2/3)

22

DimensionCedant Impact

CommentaryReinsurer

ImpactCommentary


Ceded renewal premium and assets supporting reserves (both retained by cedant) increase required capital requirement




4 ReservesReserves associated with renewal business retained by cedant

No reserve increase, since all reserves associated with renewal business are assumed by cedant


6 AssetsAssets supporting reserves for renewals are held by cedant

Renewal premium will be used to purchase assets to support reserves for renewal business

Key considerations – Cedant• Risk charge (x%) Mod-co reserve

adjustment over treaty pays back the

initial mod-co adjustment paid by the

reinsurer to cedant; calculated using

interest rate assumption applied to

reserves at inception of treaty

• is applied to financing commission

balance; it pays down the financing

commission balance and allows

cedant the option of recapturing


%Claims / % Allowance

Key considerations – Reinsurer• Reinsurer receives investment

income on assets supporting ceded

reserves (assets and reserves are

both fully retained by cedant)

• Reinsurer is assessed capital

charges on the assets supporting the

reserves for renewal business

(retained by cedant)



commission


POTENTIAL STRUCTURE 3MODIFIED COINSURANCE TREATMENT THROUGHOUT FINANCIAL REINSURANCE TREATY (3/3)

23

ReinsurerCedant% Premium (in-force renewal business)


Experience refunds

Mod-co adjustment

Risk charge