Tag Archives: reinsurance

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.

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.

Milliman chairman to moderate panel discussion on investment strategies

Milliman Chairman Ken Mungan is moderating the discussion “Chief Investment Officer Panel – Searching for Yield” at the ReFocus Conference 2017 on Monday, March 6. Panel participants will address the challenges of investing in a low interest rate environment and offer their perspective on strategies that can be employed.

ReFocus 2017 is a global conference for senior-level life insurance and reinsurance executives. It is sponsored by the American Council of Life Insurers and the Society of Actuaries. Milliman is also a sponsor of this year’s conference. ReFocus 2017 is scheduled from March 5-8 at The Cosmopolitan of Las Vegas. To view the entire conference agenda, click here.

Capital efficiency under Solvency II: Part II

clarke-sineadOur continuing series of blog posts addresses some ways in which companies may be able to achieve capital efficiency under Solvency II. This post looks at three additional capital management techniques that have become popular since the introduction of the new Solvency II capital regime.

Internal reinsurance
We have seen an increase in the use of internal reinsurance to improve Solvency II capital. The use of internal reinsurance can reduce the capital requirements of solo entities through risk transfer to the internal reinsurer. The group may also benefit from greater capital efficiencies through diversification at the reinsurer level.

Aviva significantly increased the amount of business ceded to its internal reinsurer,* Aviva International Insurance, during 2016. AXA also has an internal reinsurer to manage reinsurance for the insurer’s global property and casualty (P&C) business, which was recently upgraded by AM Best, and the Belgian insurer Ageas set up an internal reinsurance vehicle in 2015.*

Corporate restructuring
We have seen a large increase in mergers and acquisitions (M&A) activity and corporate restructuring as a result of Solvency II. Recent M&A activity includes:

• Scor announcing plans to merge its three French businesses* to reduce its risk margin by €200 million under Solvency II
• AXA’s exiting of the UK life and savings market with the sale of its offshore investment bonds business, Axa Isle of Man, and its UK portfolio services business, Elevate
• Aegon selling two-thirds of its UK annuity portfolio business to Rothesay Life with the aim of freeing up capital in its UK subsidiary
• Allianz selling its Taiwanese traditional life insurance portfolio* to a local Taiwanese life insurer to improve the group’s capital efficiency under Solvency II

Unit-linked matching
We are aware of a number of unit-linked providers that are currently rethinking unit-linked matching. The Solvency II regulations state that the technical provisions in respect of unit-linked benefits must be matched as closely as possible with unit-linked assets. Under Solvency II, the technical provisions for unit-linked benefits generally include a best estimate liability, which is lower than the unit value. This opens up the possibility to invest a lower amount in unit-linked assets than the outstanding unit value, i.e., “mismatching” the unit-linked assets and liabilities, which can enhance the capital position of unit-linked portfolios and stabilise economic balance sheets.

However, as usual, such benefits come at a price, and insurers will have to decide whether or not the capital savings are sufficient to offset the operational complexities, coupled with a more volatile solvency coverage ratio. Unit-linked matching is considered in more detail in our briefing note entitled Unit-linked matching considerations under Solvency II.

We have published a number of papers on this topic including Capital management in a Solvency II world, which focusses on life (re)insurance business, Capital management in a Solvency II world: A nonlife perspective (looking specifically at nonlife or P&C issues) and Unit-linked matching considerations under Solvency II.

If you are interested in more information on capital management under Solvency II please contact your usual Milliman consultant.

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Optimizing nonlife reinsurance strategy under risk-based capital measures

This research report by Jeffrey Courchene and Vincent Robert explores the possible impact of risk-based economic capital and enterprise risk management (ERM) frameworks on a nonlife insurer’s reinsurance strategy. It provides a brief overview of common types of nonlife reinsurance coverage currently available. The paper also describes the broad context in which reinsurance decisions are made, highlights the importance of aligning reinsurance decisions with risk appetite, and describes an economic perspective for optimizing the reinsurance strategy.

Reinsurance: Optimizing your strategy

The latest edition of Milliman Impact entitled “Reinsurance: Optimising your strategy” offers perspective on how insurers should approach their reinsurance options in light of changing market conditions.

Here’s an excerpt from the article:

Increasingly, insurers are seeking bespoke reinsurance solutions to address a range of issues, from dealing with property risk accumulations to protecting reserves or achieving capital efficiencies under Solvency II. There is also a wider emerging trend towards more innovative internal and external reinsurance mechanisms, and a growing business case to bring certain reinsurance purchasing functions in-house.

“Despite an increasing complexity of reinsurance mechanisms, there are a number of factors leading insurance companies to internalise their reinsurance strategies, underpinning a sound and efficient decision process in terms of reinsurance,” says Fabrice Taillieu, principal at Milliman in Paris….

With changing regulation, a shift to enterprise risk management by insurers, and the increasingly cross-border nature of insurance, a number of firms have sought innovative capital management and reinsurance frameworks to help enhance earnings and deliver on their corporate strategies.

Many of the large multinational insurance groups have now centralised their reinsurance purchasing, taking a more sophisticated and global approach. Typically, these groups use dedicated legal entities to more effectively manage risk and capital across the group through internal reinsurance agreements. They also use such entities to leverage their purchasing power, consolidating their reinsurance purchasing globally.

While these types of arrangements tend to be favoured by the large multinational insurers, there are ways in which other insurers can achieve many of the same advantages, according to Adam Senio, senior consultant at Milliman in Paris.

“There are now many options open to insurers looking to optimise their capital and reinsurance purchasing. More insurers are using internal and external reinsurance schemes to optimise and transfer capital at the group level,” he says.

For example, Milliman has worked with a number of European insurers, helping them take a more global approach to reinsurance and establish internal reinsurance mechanisms that cede portions of portfolios from local subsidiaries back to the parent company, highlights Senio.

The evolving insurance-linked securities market

In a recent Captive.com interview, Milliman consultant Aaron Koch discusses the effects that insurance-linked securities (ILS) have had on captives and the reinsurance market. He also provides some perspective on the prospects of the ILS landscape. Here is an excerpt from the article:

Captive.com: What has the impact of ILS been on the traditional reinsurance markets that captive owners are familiar with?

Mr. Koch: There have been at least three major impacts: reductions in prices, loosening of terms and conditions, and an increase in reinsurance mergers and acquisitions (M&A) activity.

ILS provides a product that competes with traditional reinsurance. The increased supply of risk-taking capacity has led to reductions in the price of coverage, particularly on property catastrophe business. Alternatively, some contracts have seen their terms and conditions changed in a way that benefits the cedent, often by including more risk or by otherwise making it more likely for the contract to pay out (e.g., by extending the “hours clause,” which defines the length of a catastrophe event).

The increased competition in the market has also helped drive a wave of M&A activity, as reinsurers seek to gain economies of scale and diversify their writings away from the property catastrophe market.

Captive.com: Two follow-up questions: (1) What do you see as the market impact of ILS in the next 3–5 years? (2) Do you see the ILS market evolving to cover other risks?
Mr. Koch: The ILS market is at an interesting crossroads. In my opinion, the first wave of ILS growth has largely passed. The traditional sources of risk—primarily large insurance and reinsurance companies—seem comfortable with the amount of ILS they currently buy. The market has reached somewhat of a steady state among these participants.

However, there is still a huge amount of investment capital looking to enter the market. As a result, ILS is poised to grow over the next 3 to 5 years through product innovation. There are two major vectors for this growth. One is market expansion to cover different types of insurance risk. Examples include the recent rise in specialty insurance transactions and the ongoing efforts to bring liability risk to the ILS market.

Perhaps more interesting to captive owners, however, is a recent trend toward expanding the ILS market to a more diverse range of cedents. The ILS market’s willingness to invest in smaller, more customized transactions is high. This provides opportunities for cedents that do not have enough scale to sponsor a full-sized catastrophe bond to still purchase coverage. Investors have been willing to sponsor innovative transactions to accommodate the needs of new cedents—and this is something where captives will likely take advantage.