Transforming your liabilities into assets
Until recently, US insurance companies writing longer tailed business (eg, workers’ compensation, professional liability, healthcare) made most of their profits from their investments, with the majority of those investments being held to back loss reserves. Now, as underwriting margins are also being squeezed, investment yields are at historic lows providing no such support to profits.
In 2006, the five-year US Treasury yield averaged 4.75 percent. Through 2016 to date it has averaged 1.25 percent. With a typical company having invested assets of two to three times shareholders’ equity, a 3.5 percent drop in investment yield would equate to a 7 to 10.5 percent reduction in annual return on equity. Some companies are attempting to address this issue by finding extra yield where they can: lengthening the maturity of their portfolios or lowering the credit quality of their investments, but both of these are risky strategies. The latter by definition introduces more credit risk to the portfolio and the former risks a significant hit to the fair value of the investment portfolio when interest rates eventually rise.
While the asset side of the balance sheet is under siege in this way, the liability side has its own challenges to address. Reserves for longer tailed lines of business have always represented an area of significant risk and potential earnings volatility. Now with an increased focus on prudent capital analysis, whether enforced under a regulatory regime (eg, risk-based capital, Solvency II or equivalence) or under a process of good governance, capital allocations to reserves are generally increasing.
So, at the same time that the investments backing the reserves are no longer working for you, the reserves themselves are becoming more costly. Reserves have gone from being an asset to a liability.
Reinsurance has traditionally been thought of as a solution for addressing risks related to prospective exposure, whether for individual risks, catastrophic event risks or an accumulation of losses over a period of time. This article will consider a form of reinsurance intended to address risks related to exposure that has already passed, where the loss has occurred but either has not yet been paid or fully developed or perhaps has not even emerged or been reported.
This reserve-based reinsurance is intended to provide the ceding company protection against latent adverse experience, which in turn can reduce the capital burden on the company. Additionally, it may enhance and provide greater stability to the ceding company’s overall operating performance by providing a guaranteed interest credit on the reserves transferred that exceeds the investment income that would otherwise be earned on those assets and which is not subject to market volatility.
Pool of reserves
The most familiar of reserve-based reinsurance covers is the loss portfolio transfer (LPT). In these structures, generally the entire pool of reserves is transferred to the reinsurer for an amount in excess of the book value. Often these are purchased to create finality for a company which has had poor experience in a book of business or who is exiting a particular line of business.
The reinsurer hopes to benefit by managing claims down, to bring in the total losses for less than they have been paid. In most cases, therefore, the ceding company is giving up any potential upside in the reserves and often will have to cede control over claims, potentially having an impact on their relationship with insureds.
The structure discussed here is a combination of a partial LPT with an adverse development cover (ADC) (see Figure 1).
The structure has several components, each intended to deliver a particular benefit. It is set out in terms of the existing pool of loss reserves that the ceding company, in this case assumed to be a captive, holds on its books. The percentages shown are each as a proportion of 100 percent of the currently held—the ‘Existing Reserves’ (note that all amounts are purely illustrative).
- Existing reserves: 100 percent of the pool of currently held reserves (including IBNR). This is split into two layers:
- Reserves retained: Some of the reserves are retained unreinsured by the captive. As these are the first-to-pay reserves, there is great certainty that they will be paid so little benefit to the captive in reinsuring them.
- Reinsurance layer 1 (LPT): This is the portion of the reserves that is transferred to the reinsurer. As the last-to-pay reserves, the reinsurer will likely be holding on to the funds for longer (more on this below). - Adverse development retention: The captive retains losses arising from adverse development on the reserves up to a set limit. This provides alignment of interest between the captive and reinsurer and allows for the reinsurance to be priced more cheaply.
- Reinsurance layer 2 (ADC): This is the layer that provides protection against deterioration or emergence of losses to the captive. This layer and the adverse development retention are sized together so that between them they cover the capital charge for the reserves or address the captive owners concerns for potential adverse loss experience.
- Reinsurance premium: This typically is the cash associated with the transferred reserves, ensuring that the upfront net income impact to the captive is minimal. There is normally a small amount in excess (often less than 1 percent) to compensate for the risk in reinsurance layer 2.
- Aggregate limit: The total limit available to the captive from the reinsurance, equal to the sum of the two reinsurance layer limits.
- On commutation: The captive has the option, in their sole discretion, to commute the transaction after a certain period of time (eg, five years). If they elect this option, they receive back the reinsurance premium paid, less a small margin for the reinsurer, less any claims paid to date plus an interest credit granted on the balance of these amounts over time.
- Interest credit: This is determined according to the circumstances of the transaction but generally would be expected to be significantly more than the captive would earn on a comparable risk-free security. The rate is pre-agreed and fixed at inception: the captive is not exposed to the investment performance or profitability of the reinsurer.
One of the more unusual characteristics of this sort of structure is that under almost any scenario the captive’s net income is expected to be higher having purchased this cover than if they had not. For almost all insurance and reinsurance, the buyer spends more than they expect to recover in return for protection in adverse circumstances. With this cover, that is not the case: the buyer should be better off under almost all circumstances. This can only occur when the reinsurer values the funds they hold for the term of the transaction materially more than the captive.
To return to the points made at the beginning of the article, this hopefully has illustrated how non-traditional reinsurance structures can address issues relating to both assets and liabilities, providing significant risk transfer, capital relief and protection against asset volatility and underperformance.
Nick Campbell is the chief risk officer of Third Point Re. He can be contacted at: nick.campbell@thirdpointre.bm
