Capital solutions for life insurers

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Capital solutions for life insurers
Milos Ljeskovac Swiss Re, Zurich 23 April 2004
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Table of contents

• Introduction
• Differences between traditional and financial
  reinsurance
• Examples
• Back to capital

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Forces of change

• Globalization
• Consolidation
• Bancassurance
• Demutualisation
• Consumerism

• Shareholders' expectations
• Changes in regulatory environment
• Technology
• Demographics
• Increased comparability

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Economic environment

• Policyholders prefer firms with high credit
  quality
• insurance regulators and rating agencies play an
  influential role
• An insurers balance sheet is not transparent
• can be substantially changed in terms of size and
  risk
• results in more costs to raise equity capital or
  debt
• Highly competitive market requiring initial
  capital
• up-front expenses and regulatory strain
• decreasing margins

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Insurance companys objective

• Maximise the present value of firms after-tax
  free cash flows, given a limited amount of
  capital and multiple choices (e.g. issue new
  policies, alter investment strategy, purchase or
  merge with another entity, develop an e-business
  strategy, etc)
• but how?
• also known as distributable earnings

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Choices available
Must know both the type and the magnitude of
the risk

• Change the business or asset mix
• (i.e. modify the risk landscape)
• Hedge certain risks using financial instruments
  
• Adjust the capital structure

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Adjusting the capital structure

• Issue subordinated debt
• benefit produces liquidity and limited amount of
  statutory capital
• drawback it is expensive to create statutory
  capital because of the constraints on the
  acceptability and recognition of the subordinated
  debt
• Issue new equity
• benefit produces liquidity and statutory capital
• drawback high issue costs, shareholding is
  diluted and shareholders demand a high return
  given the risk
• Financial reinsurance

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Differences between traditional and financial
reinsurance
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Financial reinsurance
Any reinsurance arrangement where the purpose is
statutory capital optimisation
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Financial reinsurance

• A loan secured against future surpluses on a
  block of business

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Traditional life reinsurance is very good for

• Risk management
• stability / protection of the portfolio
• increase in capacity
• Services
• know-how transfer
• underwriting
• actuarial
• consulting
• international experience / lessons learned

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Financial reinsurance structures are attractive
to insurers when...

• The insurer needs reliable long term solvency
  capital
• to improve capital ratios
• to grow (either organically or through
  acquisition)
• to decrease debt, buy-back shares, give an
  extraordinary dividend
• The insurer needs an increase in the ratings
  capital for the same reasons as above
• The insurer is looking for taxable profits to
  offset tax losses

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Financial reinsurance structures are attractive
to insurers when...

• The insurer wishes to increase profits to meet
  objectives
• The insurer wishes to efficiently move capital
  into subsidiaries
• The insurer wants to change its equity exposure
  without impairing current or future capital
  ratios
• They wish to rebalance their asset liability
  mismatch while protecting their capital from
  costly yield movements

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Type of business reinsured

• Any type of life business
• which is easy to define
• with large amounts of future profits expected to
  emerge
• where the future profits have not been assigned
  to another entity
• with a relatively stable profit signature
• Usually exclude medex, disability, annuities
  business

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Examples
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Margin swap

• A margin swap reinsurance transaction creates
  statutory capital because the initial reinsurance
  commission flows through as income to the insurer
• The profits on a pre-defined business block are
  transferred to the reinsurer as long as the
  treaty is in force
• Credit analysis and volatility of future
  surpluses will drive the reinsurance price and
  maximum financing limit

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To create capital, insurers can collateralize and
mortgage their insurance margins
Margin swap initial transaction
The size of the initial reinsurance commission is
a function of the near- to mid-term expected
insurance margins that the reinsurance contract
can use to collateralize its risk
The profits on a pre-defined business block are
transferred to the reinsurer
Insurer
Reinsurer
Pays an initial reinsurance commission
commission is withheld, it is a receivable from
the insurers perspective
Capital is created because the reinsurance
commission is considered a profit and thus flows
to retained earnings
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To create capital, insurers can collateralize and
mortgage their insurance margins
Margin swap renewal years
Reinsurance premium the positive profits on a
pre-defined book of business
This is normally a "no insurance risk transfer"
transaction under US GAAP. The insurance risk is
limited, but the credit risk remains.
Insurer
Reinsurer
Amortizes the reinsurance commission
Terminates when the initial reinsurance
commission has been fully amortized
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Value of inforce (VIF)

• Life insurers generally have significant inforce
  blocks of life business
• Local regulatory requirements include a
  significant level of conservatism, particularly
  on mortality
• These features combine to hide a major life
  company asset

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Value of inforce (VIF)

• Value of inforce is the discounted actuarial
  present value of future statutory mortality
  margins on a block of inforce business. VIF is
  generally not an admissible asset for solvency
  calculations
• The value of inforce from mortality margins alone
  is very large compared to the solvency needs for
  many European insurers but not recognized in
  statutory accounts
• As a rule of thumb, the mortality value that is
  used to finance the reinsurance commission is
  approximately 5 -10 of sum at risk depending on
  the conservatism

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The mortality margin in the business is sold to
generate statutory financial capital
VIF - initial transaction
The size of the initial reinsurance commission is
a function of the development of the sum at risk
and the conservatism embedded in the valuation
mortality assumption
Reinsures X of the mortality risk on inforce
business
Insurer
Reinsurer
Pays an initial reinsurance commission
commission is withheld, it is a receivable from
the insurers perspective

• The solvency margin ratio is improved because
• - capital is created by the reinsurance
  commission
• - less solvency capital is required because X of
  the mortality risk is reinsured

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The mortality margin in the business is sold to
generate statutory financial capital
VIF - renewal years
This is not a "no insurance risk transfer"
transaction under US GAAP. The insurance risk is
shared with the reinsurer.
Reinsurance premium Y of the reserving
mortality basis on reinsured business
Insurer
Reinsurer
Pays mortality claims, interest on reinsurance
commission and amortizes the commission
After n years (e.g.10) the outstanding
reinsurance commission is paid in cash
Terminates when the last of the reinsurance risk
has been extinguished
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More smooth...
O. Razum, H. Zeeb, S. Akgün, S. Yilmaz Low
overall mortality of Turkish residents
in Germany, Tropical Medicine International
Health 3 (1998)
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... and less smooth
European Health for All db, WHO Europe,
Copenhagen http//hfadb.who.dk/hfa/
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The best solution for the insurer depends on
their needs and the attributes of the structures
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The best solution for the insurer depends on
their needs and the attributes of the structures
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The best solution for the insurer depends on
their needs and the attributes of the structures
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Timetable

• Experience shows that it can take 3 to 9 months
  to complete a transaction
• Several steps are needed
• commitment
• detailed analysis of data
• agreement on parameters
• obtaining approval risk committees, insurer
  board, regulators, auditors
• executing treaty and legal documents

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Every transaction is tailor-made for the specific
needs of the client
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Every transaction is tailor-made for the specific
needs of the client
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Every transaction is tailor-made for the specific
needs of the client
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Back to capital
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Optimising capital structure

• Given a level of total statutory capital
  necessary to support an insurers activities, is
  there a way of dividing up that statutory capital
  into debt, equity and financial reinsurance that
  maximises current firm value? Why should an
  insurer choose one type of financial instrument
  versus another?

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It depends...

• Consider future changes to business decisions and
  opportunity costs, for example
• required statutory capital growth gt retained
  earnings growth
• acquisitions
• consequences of a weak solvency position
• Consider tax
• highly dependent on jurisdiction
• interest payments and reinsurance premiums may be
  tax deductible
• reinsurance gains may be taxable

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Also consider...

• Credit risk issues
• contributed to the mixed reputation of financial
  reinsurance in the past
• Future financial reinsurance structures and use
  will depend on accounting and regulatory changes
  and consequential insurer needs
• IAS
• solvency rules
• insurance and reinsurance supervision and
  taxation rules

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Conclusion

• No universal optimal mix between debt, equity
  and financial reinsurance
• The best solution and the mechanisms to reach
  it will change as the economic and regulatory
  landscapes change

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Ambrose Bierce (1842-191?)
FUTURE, n. That period of time in which our
affairs prosper, our friends are true and our
happiness is assured.

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Thank you!