In July 2020, Milliman professionals published the research report "Reinsurance as a capital management tool for life insurers." This report was written by consultants Eamon Comerford, Paul Fulcher, Rosemary Maher, and myself.

Capital management is an increasingly important topic for insurers as they look to find ways to manage their risks and the related capital requirements and to optimise their solvency balance sheets. Reinsurance is one of the key capital management tools available to insurers. The paper investigates common reinsurance strategies, along with new developments and innovative strategies that could be implemented by companies.

This blog post is the third in a series of posts about this research. Each one gives an overview of a section of the Milliman report.

Evaluating reinsurance strategies

Insurers can typically choose between several reinsurance strategies, each with its own benefits and trade-offs. When deciding on which reinsurance strategy to implement, the key areas of consideration can be broken down further into the following characteristics:

Capital requirement considerations

• Impact on required capital: An effective reinsurance cover transfers risk from the insurer's balance sheet, generally lowering the capital requirement for the risk transferred. The overall impact on required capital depends on (i) the amount of risk transferred, (ii) the diversification benefits, (iii) the additional risk introduced by the reinsurance cover and (iv) the basis risk.
• Additional risk introduced: Additional risks might be introduced by the reinsurance cover, requiring the insurer to hold capital against them. Examples are (i) counterparty default risk, (ii) expense risk due to a changing expense basis and (iii) a loss in diversification benefits.
  • Counterparty default risk can be substantial, depending on the credit rating of the reinsurer and the scope of the treaty. This can even lead to the Solvency II Standard Formula not being appropriate to capture the counterparty default risk. Additional capital buffers might be required in this case to protect the insurer against adverse scenarios, such as a downgrade of the reinsurer in combination with a decrease in interest rates. These buffers can be substantial and additional mitigation might have to be put in place.
• Renewals required: In cases where reinsurance covers are short-term (e.g., five years) there can be a duration mismatch compared to the liabilities. This requires the cover to be rolled forward at maturity. Replacements can impose additional risks due to, for instance, the absence of liquidity in the market or increased reinsurance costs. This might cause an issue for recognition as a risk mitigation technique as per the requirements under Solvency II.

Profit and loss (P&L) considerations

• Cost of reinsurance: Implementing a reinsurance cover leads to several additional costs:
  • A premium is to be paid to the reinsurer. This premium usually includes a margin that reduces the expected profitability of the insurer.
  • Collateral can be required to mitigate against counterparty default risk of the reinsurer, leading to additional costs such as letter of credit fees.
  • Administration costs might be introduced. The insurer, for instance, might need to provide the reinsurer with data on a regular basis, and valuation and financial reporting needs to be adjusted for the reinsurance cover.
  • The reinsurance contract might lead to additional regulatory reporting such as assessing the effectiveness of the cover in the Own Risk and Solvency Assessment (ORSA).
• Capital generation: The insurer's capital generation is impacted through both the required capital and own funds. Generally, the reinsurance cover leads to an increase in the solvency coverage ratio, unlocking capital that can be used to further improve the capital generation, for instance by introducing more risk to the asset portfolio, improving the return on equity. Furthermore, the transfer of risk can lead to a release in the risk margin, increasing the own funds further.
  
  On the other hand, the reinsurance cover might be ceding away profitable business. Additional costs introduced by the cover will decrease the profitability even further. This is exacerbated in the case where assets are involved in the risk transfer, as it leads to a lower overall return on assets. This can be partially offset when the cover is on a 'deposit back' basis.

• P&L volatility: Transferring risk potentially reduces the overall volatility on the insurer's P&L. This volatility might reduce further in cases where the risk margin decreases, lowering the interest rate sensitivity on the insurer's balance sheet. However, less risk might decrease diversification, partially offsetting this decrease. Also, in some reinsurance structures the insurer does not retain control over part of its assets and, therefore, has fewer possibilities to use these assets for interest rate and inflation hedging strategies.
• Timing and amount of dividend: An insurer is usually only allowed to pay out a dividend when the solvency coverage ratio exceeds a certain threshold. Increasing the solvency coverage ratio therefore enables the insurer to pay out dividends earlier, increasing the value of the company.
  
  In cases where the reinsurance cover leads to a decrease in capital generation, the total amount of dividends paid decreases. As such, there is a trade-off between the timing and the amount of dividends to be considered when implementing a reinsurance strategy.

Implementation and approval of the reinsurance cover

• Time required to implement the arrangement: The due diligence phase of a reinsurance agreement can be a lengthy process. Extensive portfolio analysis is required, and policy and claims administration might need to be changed to be able to exchange, for instance, seriatim data and death certificates. Additionally, regulatory approval may be needed. This can all lead to increasing transaction costs, increasing the price of the strategy.
• Flexibility of the arrangement: Reinsurance covers can span many years, even decades, and due to the evolving nature of an insurer's business, a reinsurance deal might become suboptimal in the longer run. Optionality to change or dissolve the reinsurance contract could therefore be considered.
• Availability: For a strategy to be effective it is important that there is sufficient liquidity in the market for the insurer's risk to be transferred, that there are enough reinsurers available in the market willing to take on this risk and that the solutions offered guarantee an effective risk transfer.
• Regulatory approval: One of the key hurdles ahead of implementing a reinsurance arrangement is getting regulatory acceptance or buy-in. We observe that regulators are generally keen to see reinsurance arrangements involving a genuine transfer of risk, as opposed to companies effectively looking to reduce capital requirements using regulatory arbitrage.
  
  Obtaining regulatory approval can be challenging and introduces further expenses. In cases where the regulator only partially recognises the risk transfer, the reinsurance treaty becomes less capital-efficient.

All in all, choosing which reinsurance strategy to implement, whilst keeping in mind these considerations, is a complex puzzle to solve. Ultimately, the value of a company is largely based on expected dividend payments. Therefore, the timing and amount of dividend payments is a good starting point for the evaluation of a reinsurance strategy.

Milliman research paper

The full research paper can be found on Milliman's website here, where you can also find an executive summary version that notes some of the key highlights of the research and acts as a guide to the full paper.