Session 39 PD, The Advantages of Reinsurance as an Alternative Capital Source. Moderator: Michael L. Kaster, FSA, MAAA

Transcription

1 Session 39 PD, The Advantages of Reinsurance as an Alternative Capital Source Moderator: Michael L. Kaster, FSA, MAAA Presenters: Dale J. Mensik Michael David Mulcahy, FSA, MAAA

2 The Advantages of Reinsurance as an Alternative Capital Source Michael Mulcahy VP, Marketing Canada Life Reinsurance 1

3 Financial Reinsurance as Alternative Capital Dale Mensik VP Life Financial Solutions 2015 SOA Annual Meeting Austin, Texas

4 Disclaimer This presentation does not address the investment objectives or financial situation of any particular person or legal entity. Investors should seek independent professional advice and perform their own analysis regarding the appropriateness of investing in any of our securities. While Hannover Re has endeavoured to include in this presentation information it believes to be reliable, complete and up-to-date, the company does not make any representation or warranty, express or implied, as to the accuracy, completeness or updated status of such information. Some of the statements in this presentation may be forward-looking statements or statements of future expectations based on currently available information. Such statements naturally are subject to risks and uncertainties. Factors such as the development of general economic conditions, future market conditions, unusual catastrophic loss events, changes in the capital markets and other circumstances may cause the actual events or results to be materially different from those anticipated by such statements. This presentation serves information purposes only and does not constitute or form part of an offer or solicitation to acquire, subscribe to or dispose of, any of the securities of Hannover Re. Hannover Rück SE. All rights reserved. Hannover Re is the registered service mark of Hannover Rück SE. 3

5 Reinsurance For Capital Management Sources of Capital Types of Reinsurance for Capital Management Coinsurance New Business Financing Surplus Relief Redundant Reserve Financing Capital Relief Example Group Life Capital Relief Reinsurance Future Regulation 4

6 Financial Reinsurance Vs. Insurance Lending: Two sides of the same coin Terminology differences are often distinctions without differences Financial Reinsurance Traditional financial reinsurance utilizes traditional reinsurance structures to transfer liabilities to and thus increase surplus or lower capital requirements for a ceding insurer May impact the asset side of the balance sheet but primarily impacts the liability side of the balance sheet Insurance Lending Focuses on providing traditional (i.e. cash, securities) and structured assets Financial guarantors have still not rebounded to pre-crisis health so the pre-crisis negative basis trade is often not an option Rating agencies have limited amount of financial and total leverage and have assigned leverage to more instruments There are economic, regulatory and accounting considerations which make one approach preferable to the other for different applications and different companies, but this presentation will focus on all such solutions without much distinction 5

7 Sources of Capital Retained Profits Takes Time Difficult when in Growth Mode Raise Equity/Capital Contribution Expensive (up front costs)/dillution if external Existing Owners may be unwilling Borrow (Surplus Notes or Debt) May be expensive depending on company and market conditions Debt Covenants Limited Duration 6

8 Current State of Capital Markets for Insurance Companies Debt, Equity and ABS Markets Plenty of traditional capital is available to the insurance market Traditional Debt Capital Markets and Equity Capital Markets are deep and a reliable ABS markets have come a long way since the financial crisis but still have less depth Many investors are willing to consider structured insurance risk to generate incremental yield But. A skeptical market exists for structured life insurance risk after pre-crisis XXX risk securitizations and life settlements underperformed expectations Financial guarantors have still not rebounded to pre-crisis health so the negative basis trade is often not a reliable option Rating agencies have further limited financial, operating and total leverage insurance entities can carry and expanded what structures create leverage Complexity, lack of insurance expertise and small bite size makes executing meaningful transactions difficult in capital markets 7

9 8 All Financial Reinsurance is really Asset-backed Lending and all reinsurance contracts are derivatives Financial Reinsurance involves Hannover Re advancing the present value of future profits of a collateral block of life insurance, health insurance or annuities Can involve an asset transfer (e.g. cash ceding commission) Can involve a reduction of liability (e.g. transfer less assets than liability) May impact GAAP, IFRS or only statutory accounting Can advance full value (i.e. equity-like cost) or a small fraction (less than debt financing cost). Cost of a Financial Reinsurance solution is a function of Loan-to-value ratio of collateral block Cost of liquidity or collateral required Variability of future profits (i.e. risk that value drops below the value of the loan) Correlation to reinsurer s portfolio of risk (i.e. diversifying risks attract less economic capital than core risks) Typically, ceding company credit spread is a secondary or tertiary consideration on price

10 Return Pricing is a Function of Risk and Reward But, risk to whom and how do you calculate reward? Hedge Funds? Hedge Funds? Private Equity Public Equity Real Estate Hi-Yield Bonds Investment Grade Bonds Cash Risk 9

11 Financial Reinsurance Pricing Relative to Alternatives - Financing Expense + Debt-levels Equity-levels Pricing levels can be inside of Debt-levels to wider than Equity-levels and anywhere based on the Value of the Insurance Collateral 10

12 USES OF FINANCIAL REINSURANCE 11

13 12 Uses of Financial Reinsurance NAIC RBC and other capital ratios are often a limiting factor for insurance companies which constrain insurance companies with rating agencies, regulators and capital Most are some variation of Surplus divided by Required Capital May be highly prescribed (i.e. RBC or most rating agency frameworks) May be more principles based (i.e. Solvency II and MCCSR) Both can make sense at a high level but can make very little sense for a given product, company or situation. RBC Ratio = Total Adjusted Surplus = Modified Surplus Company Action Level RBC Required Capital Most folks focus on increasing surplus in the numerator, but lowering the denominator is often easier and has a levered impact

14 Surplus Relief Goal: Improve Ceding Company Surplus Structure: Typically Coinsurance and Modified Coinsurance Expense Allowance paid by reinsurer may be cash or non-cash. Non-cash allowance acts to reduce the reserve held by the ceding company Profits in excess of the risk charge are returned to the ceding company through an experience refund. Typically on inforce business. If on new business, allowance improves income as well as surplus. Advantages to conventional financing: Often much cheaper than surplus notes or other capital sources No leverage created Majority of profits on business are retained 13

15 Reducing Required Capital Sell Less Business/Limit Sales Reduces Profits Upset Sales Force Take Advantage of Covariance Limited impact Difficult to control and grow Control Business Volume through Reinsurance 14

16 Reinsurance To Control Sales Volume Advantages Can reduce capital/strain without restricting sales Can exit business without selling a company Potential cost savings from reduced administration Exit business that is no longer strategic May unlock future profits Disadvantages Portion of future profits passed to reinsurer Impedes Growth 15

17 New Business Financing Goal: Raise funds to cover expense of issuing new business Structure: Typically Coinsurance Expense Allowance paid by reinsurer to cover a portion of the new business strain Reinsurer charges a risk charge as a portion of the outstanding allowance. Charge may be fixed or related to some index Profits in excess of the risk charge are returned to the ceding company through an experience refund Experience refund typically expires when allowance is repaid, and reinsurance is typically recaptured Advantages to conventional financing: May be only option No leverage created Often cheaper 16

18 Redundant Reserve Financing Goal: Finance Reserves Considered to Be Redundant More Efficiently than Conventional Methods Structure: Often use of captives involved Reserves financed over fixed period of time Alternative assets used to fund the reserves considered redundant Reinsurer takes the risk that conventional assets won t be sufficient to pay claims Advantages to conventional financing: Lower Cost 17

19 Capital Relief Reinsurance Structure: Varies depending on business covered Cover moves required capital from the ceding company to the reinsurer Unlike surplus relief reinsurance, typically no allowance is paid above normal expenses Reinsurer charges a risk fee, and returns the remainder of profits to the ceding company through an experience refund Experience refund usually expires after a set time to encourage recapture Advantages to conventional financing: Low Cost Flexible Financing 18

20 RBC Relief and A/XXX Facility to Facilitate an Acquisition

21 Options to Optimize a Target's Capital Structure Convert Statutory PVFP to Statutory Capital Resolution Holdings Lincoln Benefit Life Insurance RBC Relief Hannover Re Credit Enhancement Structured Note Captive LLC 20

22 Options to Optimize a Target's Capital Structure Convert Statutory PVFP to Statutory Capital No Reinsurance AXXX Only A/XXX and RBC Deal Total Stat Capital $1,000 XXX Financing $0 Sponsor Capital $1,000 Total Stat Capital $1,000 XXX Financing ($250) Sponsor Capital $750 Total Stat Capital $800 XXX Financing ($250) Sponsor Capital $550 CAL RBC $300 RBC Relief $0 Net CAL RBC $300 CAL RBC $300 RBC Relief $0 Net CAL RBC $300 CAL RBC $300 RBC Relief ($100) Net CAL RBC $200 RBC Ratio 333% RBC Ratio 333% RBC Ratio 400% 21

23 Insurance Lending for Acquisition Financing Lever returns with favorable rating agency treatment Source: Resolution Nebraska Form A Filing Dated August 14,

24 Life RBC Reinsurance Structure 23

25 Group Life Capital YRT Structure Quarterly (or monthly) renewable term structure, with quarterly accounting. Premiums are set at or near the gross premiums of the ceding company. No expense allowance is typically paid. Premiums are paid in arrears, therefore minimal reserve transfer. Usually claims are net of existing reinsurance 24

26 Group Life Capital YRT Structure Loss Carryforward and Experience Refund All profits net of a risk fee are returned to the ceding company through an experience refund. Losses to the reinsurer are carried forward and repaid out of future profits, if they emerge. Ceding company can terminate on short notice (must repay loss carry-forward if they terminate). 25

27 Group Life Capital YRT Structure Common Risk Reducing Features Reinsurer may have a right to increase premiums. Reinsurer may have right to increase the risk charge after some period. Reinsurer may be able to remove experience refund at a future date. May include limits to catastrophe claims. 26

28 Group Life RBC Reinsurance Example 27

29 Group Life RBC Reinsurance Example Happy Insurance Company writes only group life $100B of Net Amount at Risk Average premiums are $2.5/1000 of NAAR Average claims are $1.75/1000 of NAAR Total expenses are 20% of premium NAAR 100,000,000,000 Premium 250,000,000 Claims 175,000,000 Expenses 50,000,000 Profit 25,000,000 CAL RBC 84,300,000 ROC CAL) 14.8% Assumptions: Taxes ignored, static state no reserve impact, RBC for other than C2 ignored 28

30 Group Life RBC Reinsurance Example Happy Insurance Company reinsures 50% of business under a YRT arrangement: Reinsurance rate is $2.4/1000 Risk Charge = $.01/1000 of NAAR Gross Ceded Net NAAR 100,000,000,000 50,000,000,000 50,000,000,000 Premium 250,000, ,000, ,000,000 Claims 175,000,000 87,500,000 87,500,000 Expenses 50,000,000-50,000,000 Risk Charge - 500, ,000 ER - 32,000,000 32,000,000 Profit 25,000, ,000 24,500,000 CAL RBC 84,300,000 42,150,000 42,150,000 ROC (@200% CAL) 14.8% 29.1% Cost of relief (@200% CAL) = $500K/$84.3M = 0.59% 29

31 Impacts to Cost/Benefit of YRT Reinsurance Covariance Adjustment - Companies with large amounts of C1/C3 relative to C2 may not get much benefit from reducing C2 Target Level of CAL RBC will alter ROC benefit of the RBC relief Reinsurer s willingness to cover business and the level of Risk Charge will be affected by: Loss ratio Volatility of the business Catastrophic exposure considering any existing reinsurance Ceding Company Financials and position in the market 30

32 AG 48 Captives in a Post Rector / Pre-PBR World

33 AG 48 Could Have Been Worse The NAIC spent the last three years of compiling data, reading very boring transaction documents, studying actuarial models and consulting with consultants, lawyers and other advisors related to the life insurance industry s use of captive reinsurers for AXXX and XXX reserve financing transactions. The result was Actuarial Guideline 48 (dated November 14, 2014, AG 48 ), which defines the rules to be followed for new life reserve financing transactions after January 1, Grandfathers policies financed prior to 1/1/2015 Exempts most commercial reinsurance transactions with third party reinsurers who are licensed, certified, accredited or post collateral under the old rules Exempts any transaction which the regulator determines should not be subject to AG 48 subject to approval of a life insurance company s domiciliary regulator (after consultation with the Financial Analysis Working Group or FAWG ). These rules were finally adopted by the Executive Committee and Plenary of the NAIC on December 16, AG 48 is clearly still a work in progress with material holes for RBC treatment of captives and the lack of the revised CSO table and reinsurance methods required for VM-20, But, AG 48 should give regulators and companies more clarity in many respects for how to price their ULSG and term business and transition reasonably easily to PBR when implemented. Basically, AG 48 is a compromise that eliminates many existing captive transactions and allows companies to early adopt PBR to determine the portion of the statutory reserve which must be backed by SVO-listed securities which would be admitted for an insurance company (i.e. excludes LCs, certain structured notes and other LC-like securities which have been used to back the redundant portion of reserves). 32

34 Capital Structure for Typical Pre-Rector Captive Total Statutory Reserve (Model 830) Capital and Surplus (i.e. 200% CAL RBC) Other Security Funded with Traditional NAIC-eligible Securities Financed Portion of Reserve Economic Reserve (Defined in Transaction Documents) Economic Reserve Funded with Traditional NAIC-eligible Securities 33

35 Capital Structure for AG 48 Captive To trifurcate or quadrificate? Total Statutory Reserve Actuarial Method Reserve (i.e. modified VM-20 Reserve) Capital and Surplus (i.e. 200% CAL RBC) Other Security Conservatism Added to Best Estimate Reserves Under Actuarial Method Best Estimate Reserve Funded with Traditional NAIC-eligible Securities Funded with Other Security Eligible Under AG 48 Funded with Traditional NAIC-eligible Securities 34

36 How Much Redundancy to Finance? Some companies will choose to finance both the Other Security and a Portion of the Conservatism Capital and Surplus (i.e. 200% CAL RBC) Other Security Conservatism Added to Best Estimate Reserves Under Actuarial Method Finance Only Excess of Model 830 Reserve over Actuarial Method Reserve Best Estimate Reserve 35

37 Additional Complexity for Post-Rector Captives To Be Resolved Closing or modifying pre-rector facilities open for 2015 and 2016 new business Grandfathered Business language is clear but not clear Higher Financing Expense? Consequence of Primary Security falling below the level required Loss of all reserve credit Dollar for Dollar Reduction Proportional Reduction Risk Based Capital Calculations Additional Disclosure Requirements Higher Transaction Costs Accreditation Issue Still Lingers Transactions Without Captives (e.g. financial reinsurance and insurance backed lending solutions are relatively more attractive) 36

38 37 AND

39 The Spirit of AG 48!?!? 48 38

40 Does PBR Eliminate the Need for Captives? When PBR is finally adopted and implemented, an interesting question is whether that will actually eliminate the need for life reinsurance finance transactions. Many if not most regulators would say that captives and financing is no longer required. Many if not most industry participants would disagree. In recent conversations with several life insurance companies, we found that the Actuarial Method produced reserves in the range of 75% to 110% of their Model 830 reserves for death benefit UL products. No mortality improvement (huge impact on long duration business) plus Explicit pads on all assumptions including prescribed pad on mortality plus Limiting benefits of 3 rd party reinsurance plus Grading off experience when no longer credible plus How do we, as an industry, want to balance our dual mandate of providing affordable life insurance to the most people with having strong insurance companies which are able to pay claims? Limiting insurance companies to Debt and Equity financing of redundant reserves may be the best answer, but it will make insurance more expensive and result in people buying less insurance. 39

41 Questions?