The emergence of lapse risk transfer

This blog post is part of an ongoing series of blog posts on capital efficiency. To see past posts in this series, please click here.

In recent months, we have seen the emergence of lapse risk reinsurance following the introduction of Solvency II. Lapse risk is one of the key risks that life insurers, and particularly unit-linked life insurers, are exposed to and it is a key component of the Solvency II Solvency Capital Requirement (SCR) for many life insurers. One of the benefits of lapse risk reinsurance is that it can be used to reduce the life underwriting risk capital charge, in addition to reducing the undertaking’s exposure to lapse risk. Many reinsurers are active in this area, and as undertakings begin to consider Solvency II capital efficiency in more detail, it may be an area where we will see further growth during 2017.

Reinsurance treaties
The nature of lapse risk transfer will depend on the most material lapse risk exposure of the cedant—either mass lapse, lapse up, or lapse down.

The mass lapse scenario under Solvency II is calibrated as an instantaneous loss of 40% of the in-force business (for retail business). While the actual occurrences of mass lapse scenarios are difficult to predict, the risk of lapses exceeding 20% to 30% in a given period may be low based on historical data. Reinsurers can therefore offer treaties that cover losses caused by lapses in excess of 20% to 30% in a given period, often setting a maximum threshold of 45% to 50%. In reinsurance parlance, the reinsurance treaty attaches at a level of 20% or 30% and detaches at 45% or 50%. The relevant period would be defined in the reinsurance treaty. The cedant would retain the risk exposure to lapses below the attachment point and above the detachment point.

We are also aware of some reinsurers considering lapse up and lapse down reinsurance. However, there may be significant practical challenges associated with lapse reinsurance of this nature, in particular with regard to defining when an increase or decrease from the long-term average, or best estimate, lapse rates has occurred.

Considerations
There are a number of general considerations in respect of lapse risk reinsurance (as well as other potential considerations, depending on the specific terms of an individual treaty). First of all, there is the premium charged by the reinsurer for transferring lapse risk. The cost is generally set with reference to the reduction in SCR achieved by the transaction. We understand that costs generally vary between around 2% to 3% per annum of the reduction in the lapse risk SCR, depending on the type of deal and the availability of data.

Buy-in from the regulators will be key for these contracts to be effective. There is likely to be a concern that reinsurance could be used to reduce the SCR without a real reduction in the underlying risk. It is difficult to argue that there is no reduction in lapse risk exposure in the example attachment points outlined above. However, it may be more difficult to justify real risk transfer where the treaty is set up in such a way as to only indemnify insurers when a mass lapse of exactly 40% occurs.

Other considerations include the following:
• The interaction between the different lapse risk components of the SCR needs to be considered. If the risk exposure to mass lapse is reduced through the use of reinsurance, the lapse up or lapse down risk module may bite instead. Therefore, the impact of mass lapse reinsurance will be limited to the margin over which the mass lapse SCR capital charge exceeds the next-highest lapse risk capital charge. Understanding this interaction will be an important factor in determining the optimal attachment point for a mass lapse reinsurance treaty.
• Reinsurance introduces additional risks to the balance sheet such as counterparty risk, which is also considered in the Solvency II SCR calculation.
• The impact of such a transaction on the financial statements or International Financial Reporting Standards (IFRS) balance sheet should also be considered.
• If the reinsurance contracts are short-term in nature, there may be a risk associated with getting renewal terms on the same basis.

An alternative
Insurance-linked securities offer an alternative approach to transferring risk compared with traditional reinsurance. Under these transactions, insurance risk is effectively securitised and bought by capital investors through an investment fund. We are aware of a number of insurance-linked security firms that are active in transferring lapse risk.

The solutions can be structured in a similar way to traditional reinsurance deals in terms of attachment and detachment points, although the deals tend to be longer in term than traditional reinsurance contracts (circa three to five years, as opposed to 12 to 18 months). This provides additional benefits in terms of impact on the Solvency II risk margin and also may be more preferable to regulators than short-term contracts. However, this results in slightly higher costs compared with traditional reinsurance deals.

One disadvantage is that insurance-linked security firms generally do not have credit ratings, which can result in a high capital charge for counterparty risk under Solvency II. However, it is possible to reduce this through the use of collateral.

MPL actuarial valuations in M&As

With mergers and acquisitions (M&As), it is critical that the medical professional liability insurance program be properly accounted for. Unpaid losses and loss adjustment expenses associated with the program can be a significant item on a balance sheet. There can be both substantial benefits and dangers associated with M&As that are important for management to consider in the preliminary stages of the M&A process. Milliman’s Richard Frese and Andy Hoffman provide perspective in this article.

This article was published in the February 2017 issue of Inside Medical Liability.

SFCR: A taste of what’s out there

This blog is the first part of a series on Pillar 3 reporting for Solvency II.

For most companies with a 31 December year-end, the first annual reporting deadline under Solvency II is on 20 May 2017. In preparation for this I think it’s interesting to look at some of the first examples of published Solvency and Financial Condition Reports (SFCRs).

What does an SFCR really look like?

To date, a number of companies with year-ends before 31 December have published their reports and I have included links below:

Company Link Country Reporting Date
Evolution Insurance Company Ltd Link Gibraltar 30/06/2016
Vitality Life Ltd Link UK 30/06/2016
The Wren Insurance Association Ltd Link UK 30/06/2016
Care Insurance Co Link Gibraltar 30/06/2016
Cornish Mutual Assurance Co Ltd Link UK 30/06/2016
Euroguard Insurance Co PCC Ltd Link Gibraltar 30/06/2016
Hansard Europe dac Link Ireland 30/06/2016
International Diving Assurance Ltd Link Malta 30/06/2016
Municipal Mutual Insurance Ltd Link UK 30/06/2016

While clearly a small sample, there is a variety of company types, lines of business, and territories represented in the selection above. In addition to the Solvency II requirements themselves, looking at what others have published can provide a useful reference point as you prepare your own SFCR report. As a health warning, it should be noted that these SFCRs represent approaches taken by some individual companies and can’t yet be taken as established market practice. We also have no feedback yet on the expectations and views of the various European supervisors.

Differences in approach

While the Solvency II requirements are generally clear on what should be included in the SFCR, as always there is scope for different interpretations. Furthermore, it is a general principle that the SFCR should be proportionate to the nature, scale, and complexity of the undertaking. It is therefore reasonable to expect variations in the length and level of detail in these reports. It is worth remembering that the SFCR is a public document for policyholders and other key stakeholders.

How long is a piece of string?
Looking at the nine publicly available SFCRs mentioned above, there is a wide variation in length, with the shortest report coming in at 24 pages, while the longest is 73 pages.
The longest section on average is the System of Governance chapter (B), while the shortest section is on Capital Management (E).

 Number of pages Average Min Max
A. Business and Performance 4.1 1.5 7.0
B. System of Governance 8.9 3.0 17.0
C. Risk Profile 5.4 1.5 10.0
D. Valuation for Solvency Purposes 4.9 2.0 10.0
E. Capital Management 3.0 1.0 5.5
Appendix: Public QRTs 19.1 5.0 39.5
Total 45.3 24.0 73.0

Layout
Generally, the SFCRs follow the order of required contents set out in the Level 2 Delegated Regulations Article 292 to 297, and the corresponding Level 3 Guidelines (with Chapters A to E, and subsections A1, A2, and so on). I think this is a sensible structure as it is easy for the reader to follow and ensures consistency across the industry.

Where a particular reporting requirement doesn’t apply to a company, most SFCRs still include the section and give a reason why it is not applicable. In cases where firms simply skip the section, it becomes difficult for the reader to determine whether it is not relevant or whether they didn’t complete it for another reason.

You are required to disclose your public quantitative reporting templates (QRTs) together with your SFCR. In almost all cases, the public QRTs are included as an Appendix.

Presentation
As a publicly available document, some companies have ensured their SFCRs are consistent with their brand and other policyholder documentation—Vitality Life is a useful example here. On the other hand, a number of other companies have taken a more functional approach, with very little additional formatting. This choice probably depends on how likely policyholders are to access your SFCR and whether you view it as marketing material.

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Capitalizing on your actuarial report

In this article, Milliman’s Richard Frese and Andy Hoffman offer organizations perspective concerning critical topics they should discuss with an actuary to enhance their insurance program, better manage liabilities, and maintain appropriate actuarial analysis for the needs of their program. The authors also discuss best practices when working with an actuary.

This article was published in The Risk Management Quarterly.

New developments in the computation of mortality rates: An actuary’s bread and butter

The computation of mortality rates has traditionally been the bread and butter of actuaries. The first mathematicians to venture into the actuarial field most likely spent their days analysing mortality rates and conducting life valuations. Nowadays, the work of actuaries is much more varied—which is a welcome development for most—but are we sometimes neglecting this core skill?

Milliman researchers in Paris certainly aren’t and their new research, hot off the press, published on 22 February 2017, represents a significant development in mortality and longevity risk modelling. It is vital reading for anyone working in this sphere.

My colleagues have developed a robust statistical methodology to correct the implicit inaccuracies of national mortality tables which are used widely in sophisticated mortality and longevity risk modelling. The results are striking.

Here I take a closer look at the relevance of these national mortality tables, the problems with them, and the corrections available in order to enhance mortality and longevity risk models. I will touch on the key technical points behind these developments from an Irish/UK perspective, leaving the rigorous mathematical explanations to the underlying research publications—the 2017 publication can be found here and the 2016 publication can be found here.

The use of national mortality tables
In Ireland and the UK, to set basic mortality assumptions in our pricing and reserving work, we tend to use insured lives mortality tables, such as the Continuous Mortality Investigation (CMI) tables. However, national mortality tables based on the population as a whole are also used extensively in mortality and longevity risk modelling, where a greater quantity of data is required.

National mortality tables are used to calibrate stochastic mortality models, to derive mortality improvement assumptions, in sophisticated mortality risk management models, in Solvency II internal models, in pricing mortality/longevity securitisations, and in bulk annuity transactions.

Bulk annuity transactions are popular in the UK market, with a number of large deals executed during 2016, including the ICI Pension Fund’s two buy-in deals completed in the wake of Brexit, totalling £1.7 billion. Legal & General completed a £2.5 billion buyout agreement with the TRW Pension Scheme in 2014.

Longevity hedging (in particular, use of longevity swaps) is also an attractive approach to the de-risking of pension schemes, and would equally require the use of national mortality tables. Transactions range from the large-scale £5 billion Aviva longevity swap in 2014 to the recent, more modest, £300 million longevity swap completed between Zurich and SCOR in January 2017.

While the use of internal models to calculate mortality and longevity risk capital requirements under Solvency II is not prevalent in the Irish market, which is due to the size of companies and the amount of risk retained, it is likely that reinsurers are looking at such models. In the UK, larger companies may opt to use internal models if they are retaining large exposures.

Indeed, national mortality tables also typically inform mortality improvement assumptions for all companies, as the analysis of improvements requires large volumes of data. Therefore, even companies that do not use sophisticated mortality and longevity risk modelling techniques are implicitly impacted by the new developments in relation to the construction of national mortality tables.

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Recovery and resolution planning considerations

Recovery and resolution plans (RRPs) are receiving a lot of attention from regulators lately. In an InsuranceERM article, Milliman consultants Bridget MacDonnell, Eamonn Phelan, and Eoin King explore the Solvency II requirements related to RRPs for insurers and reinsurers.

The article is based on the authors’ paper “Recovery and Resolution Plans: Dealing with financial distress.”