Where Costs Lead, Retail Prices Soon Follow

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1 On August 9, 2011, SCOR SE, a global reinsurer with offices in more than 31 countries, acquired substantially all of the life reinsurance business, operations and staff of Transamerica Reinsurance, the life reinsurance division of the AEGON companies. The business of Transamerica Reinsurance will now be conducted through the SCOR Global Life companies, and Transamerica Reinsurance is no longer affiliated with the AEGON companies. While articles, treaties and some historic materials may continue to bear the name Transamerica, AEGON is no longer producing new reinsurance business Where Costs Lead, Retail Prices Soon Follow First Quarter April 2005 I ve said it before, and I ll say it again retail prices for level-premium term products are increasing. Increases have been threatened for some time but have been emerging much slower than originally anticipated. However, it seems that for a large portion of the market, change is imminent. Why? Because costs are going up. The basic cost sources of term insurance are relatively simple projected mortality costs, expenses including commissions and the costs of capital. Interest rates and lapses are secondary in that they don t cost anything themselves but they are extremely important as major contributors to projected and realized costs from the identified sources. Setting aside direct expenses, many companies have historically consolidated up to 90 percent of costs by substituting reinsurance costs for exposure to these various elements. I would say that virtually all of these costs are increasing and that reinsurance, which is in a way an amalgam of costs, is increasing too. So, companies must manage these cost elements downward to make margins at current prices. As this process is difficult and will take some time to determine success or failure, companies are looking instead to raise retail rates. It may be controversial to claim that costs are increasing, so I feel compelled to expand on a few points. First, my assertion that mortality is increasing I didn t really suggest mortality was going up, but that our perception of mortality rates will be higher than in the past. Insurance is unlike manufacturing in that the costs-of-goods-sold in our business is not known but guessed at (projected, if guessing is offensive to my actuarial brethren). If our guesses get higher, we need to charge higher continued next page By David Rains Vice President, New Business Acquisition Contents Deriving Mortality Table Assumptions... 3 Triple X Securitizations A Review of Transactions... 4 Underwriting and Treaty Language... 6 Enhancements Improve RSGuide Navigation... 8

2 It will be more important to actively manage cost drivers than in the past. Companies will need to rigorously capture and analyze more data to validate assumptions and demonstrate performance. The Messenger is produced by the Marketing Communications department of Transamerica Reinsurance. Pamela Granzin is the editor. If you have questions or would like to be added to or removed from the mailing list for The Messenger, please send your inquiries with name, company name and mailing address to prices or lower expected returns. For most companies, there is very little room to lower returns, so higher prices are the likely outcome. Cost of capital is historically the difference between the earned rate on invested assets and the return promised to investors, whether the investors are stockholders, policyholders or parent companies. In the case of reinsurance and for some direct writers, it is also the costs of reserve credit collateral for Triple X reserves. The former is obviously high because of the continued era of depressed interest rates against investors continuing to demand double-digit performance. It is debatable whether the latter is increasing, but it is clear that these liabilities are growing, and companies not only must spend considerable research budgets on new capital sources but also either make provisions for future cost increases or lock in more expensive solutions today. Finally, in defense of my price-increase contention, consider lapses. Today s level premium term products are, by their very nature, lapse-supported they need a certain number of lapses later in the level period to achieve profit expectations. From emerging data, lapse levels are generally lower than some companies have expected. Based on our modeling, lower lapses as early as year three can be detrimental to profitability. If other factors are, in fact, driving prices upward or even halting the historical decrease in rate levels, lapse incentive may be reduced, further supporting generally lower lapse expectations. So, what is the near-term future of the term reinsurance market? Well, from a product design and pricing perspective, rates for all but the premier term writers will increase, and companies will turn more attention to understanding and managing costs. Companies will look to lower mortality and reinsurance costs through tighter underwriting. Reinsurers will likely expect objective data demonstrating improvements before pricing responds to these changes. As reinsurance rates have increased, companies will re-examine their strategy of consolidating costs and explore retaining more risk. This will require considering term differently in light of overall risk and capital management strategies. For most, this will mean a significant investment in capital management solutions and increased exposure to earnings volatility. In most situations, I believe reinsurance will still be the optimal solution, but there will be exceptions. Even in exceptional cases, reinsurance will likely be a valuable tool for bridging other solutions. Whether companies take the path of continuing to reinsure or choose to retain more, it will be more important to actively manage cost drivers than in the past. Therefore, companies will need to rigorously capture and analyze more data to validate assumptions and demonstrate performance. From a retail perspective, companies have decisions to make. What investment can you make to drive costs and prices down? What retail rates can your customer base tolerate? What value proposition will effectively sell term insurance at rates 15 percent to 20 percent higher than market leaders? Are your term products a profit center or accommodation products supporting other profit 2

3 centers? From my limited perspective, I m not sure I believe in commodities outside of wheat and pork bellies. Brand and convenience still mean something, even to a younger, internet-savvy generation. I lose a little money every year from buying my homeowners and auto insurance together, from consolidating all of my banking and investing with one firm, from never again changing long-distance carriers no matter what rate they offer. How much money? I have no idea, and that s my point. If you don t share my view, you are probably looking to drive rates as low as possible and if they aren t within spitting distance of first place, the products aren t worth having. Several companies have managed their term products this way over the past couple of years and have made a call to exit the market. An alternative would be to consider a private label solution, where you provide the distribution and a third party provides tighter underwriting and lower cost administration and also shoulders the risk and capital management burden. For more information, you may contact the author at Deriving Mortality Table Assumptions A key responsibility facing today s reinsurance pricing actuary is the selection of mortality tables that best reflect the business being reinsured. The proliferation of preferred risk underwriting classes and corresponding changes in underwriting techniques have made many traditional mortality tables obsolete. Consider the experience underlying the Society of Actuaries Select and Ultimate Basic Tables and its relevance to a cohort of super-preferred non-tobacco insureds underwritten today. Even the more modern 2001 Valuation Basic Table may not have the appropriate slope to correctly predict future mortality from such a cohort. By David N. Wylde, FSA, MAAA, CLU, ChFC Pricing Actuary, Life Solutions Selecting the Table When choosing or deriving an appropriate mortality table, the pricing actuary must consider items such as product design, underwriting class definitions, current and future underwriting practices, current and future demographic mix and applicability of secular improvement. Transamerica Reinsurance has incorporated many of these items into its own proprietary set of mortality tables. We created base tables that differentiate mortality by gender, tobacco use and preferred underwriting class. For this last category, we have three distinct tables that allow us to best represent the mortality of insureds that are (1) clearly preferred, (2) between preferred and residual-standard or (3) clearly residual-standard. As life insurance products and underwriting selection tools continue to evolve, pricing actuaries must translate changes into appropriate modifications to their mortality tables. Customizing the Table From our base tables, we produce custom tables that reflect a client s product design, underwriting rules, age and amount requirements, preferred class continued page 7 3

4 Triple X Securitization A Review of Transactions to Date By David O Brien, FIA, FSA, MAAA Second Vice President & Chief Pricing Actuary, Life Solutions At the time of writing, three blocks of Triple X term portfolios have been successfully securitized by US insurers. The purpose of this article is to review emerging trends in structure and to discuss the emerging cost range for securitization. Trends in Structure The structures used in the transactions to date are similar. All involve capitalizing a captive insurance company domiciled in South Carolina. All involve investing the proceeds of debt in a high quality, liquid pool of assets. The following table summarizes the profiles of business securitized to date: Some Differences Profile Company A Company B Company C Initial bond issuance $300 million $550 million $850 million Maturity date Coupon fixed or floating Floating auction Floating auction Fixed Bank advisor Lehman Lehman Goldman Sachs Financial guarantor MBIA AMBAC MBIA Domicile of captive South Carolina South Carolina South Carolina Initial capital level in captive Figure 1 - Comparison of recent term life insurance securitizations Economic reserves +$100m Economic reserves +$40m Economic reserves +$135m The terms of the tax-loss sharing agreement between the captive and its parent can significantly alter the release pattern of earnings from the captive. There are some notable differences in the securitizations, including: Level of capitalization of the captive insurer One issuer chose to capitalize the negative spread ( carry ) between the cost of funds issued and expected yield on invested assets. This increased the structure s capital requirement but provided a more favorable rating agency view for the issuing company s financial strength. The terms of the tax-loss sharing agreement between the captive and its parent can significantly alter the release pattern of earnings/experience refund from the captive which in turn affects the effective level of capitalization of the structure. Structure of debt issuance to match Triple X reserve development pattern Rather than over-funding debt at inception, one issuer chose to lock in future debt tranches at known terms; another raised sufficient funds at inception to cover the expected peak reserve level with the excess funds offering a lower yield until made available to the captive for reserve support. Reinsurance terms between original issuing entity and captive A coinsurance agreement is usually structured between the original insurer and the captive in order to transfer the Triple X reserve strain to the captive. The 4

5 terms of this agreement must satisfy the insurer, the financial guarantor and the rating agency. Any concerns on the exact level of redundancy of Triple X reserves can be managed by overcapitalizing the captive and/ or paying relatively low coinsurance allowances from the captive back to the original insurer. This is usually acceptable to the insurer as emerging profits are routed back via an experience refund mechanism. Given the potential to significantly change the risk profile of the transaction, the timing and certainty of the experience refunds are carefully modeled by all parties to the transaction. Repricing risk of the coupon A choice exists. Locking in the coupon for 20 or more years will usually cost more, as there is a very small but increasing default risk over time. As the securities are usually wrapped by a AAA financial guarantor, this repricing risk is small. To date, two issuers chose to accept this risk in order to improve price; one issuer locked in a coupon level from inception. Coupon to investors Financial guarantor premium Less yield on assets raised Negative spread Cost of capital (debt charge) 2 Cost of capital (additional cost relative to default of retention) 3 Pre tax cost Cost of funds 1 Libor + 50 bps 35 bps Libor 10 bps 95 bps 10 bps 0 bps 105 bps Less value of tax losses 4? Figure 2 - Illustration of principles involved in securitizations 1 The costs are illustrative and do not relate to any particular securitization discussed earlier in this article. 2 The cost of capital assumes a 1% RBC charge on the debt issued. The exact treatment of the debt for RBC purposes is likely to vary on a case by case basis. 3 The aggregate capital requirement of the consolidated insurance operations may rise or fall following securitization. An opportunity cost assessment of this change is an important potential component of cost. 4 The tax losses arising in the captive have the potential to significantly change the cost benefit conclusion. Emerging Costs of Securitization The cost of securitization is difficult to boil down into one number in order to compare with other alternatives such as reinsurance and letters of credit (LOCs). The exercise is also hampered by the sparsity of public domain information on financial guarantor fee levels, variation in capital allocation decisions from transaction to transaction and tax structuring decisions made by each issuing entity. One simplified approach is to view the cost as shown in Figure 2 above. The numbers are included as very rough guidance and are not intended for use other than to illustrate the principles involved. The final range for the cost of securitization may not be known by an issuer until close to the end of the structuring process. The issuer s tax position is a critical driver of cost. What is clear is that LOCs are less expensive (at least on a pre-tax basis) but not a good hedge for the risk. Other funding alternatives than securitization exist. As the capital market supports further Triple X related issuances, the market s participants are likely to focus on an evolution of structure driven by demands to make them cheaper and faster to implement. The final range for the cost of securitization may not be known by an issuer until close to the end of the structuring process. The issuer s tax position is a critical driver of cost. For more information, you may contact the author at

6 Underwriting and Treaty Language By Eric Carlson Second Vice President, Marketing Actuary Underwriting guidelines have always been an implicit part of reinsurance pricing. Recognition of these guidelines is becoming much more explicit today. In order to make sure that the reinsurer and the ceding company have a mutual understanding and agreement on what these guidelines are, it is important for them to be attached to and made part of the reinsurance treaty. This eliminates any possible misunderstanding and reduces the chance of a possible disagreement on coverage in the future. Working together will mean fewer surprises, and fewer surprises always makes good business sense. What Happens When... For all policies issued according to the terms of the agreement, there very clearly is reinsurance coverage. The question then becomes, What happens when a policy is issued automatically but not according to the agreed upon standards? It is important to note that this may happen intentionally through a business exception or unintentionally through an underwriting error. In this case, there are a range of possible alternatives. One extreme is that the policy was issued in error, there is no reinsurance coverage, and the reinsurer s liability is zero. The other extreme is that the policy was issued in error, but there is full reinsurance coverage, and the reinsurer s liability follows the terms of the treaty. There are several alternatives in between these two extremes. It is important to note that the E&O section of a treaty is designed to cover administrative errors not underwriting errors. Art and Science Clearly, some underwriting is subjective and consists of both science and art. There may always be some difference of opinion between professional underwriters on the correct rate class for an individual. At preferred risks, however, underwriting tends to be much more objective. As an insured moves into a residual standard rate class or a substandard rate class, assigning the correct rate class becomes much more subjective. The underwriters at the ceding company and the reinsurer (as well as the treaty) should recognize this and work toward eliminating disagreements. How should the assignment of rate classes be monitored? It may be monitored through typical underwriting audits. It may also be monitored through real time access to lab reports for all issued policies or monthly reporting showing these same lab reports. The more confidence that a reinsurer has in the accuracy of the underwriting, the lower the required margin needed in pricing. The Impact of Exceptions Do policies get issued outside of the underwriting guideline? Yes. In every reinsurance seminar, underwriting conference and industry meeting, you can find examples of policies that were issued in a preferred best class that should have been declined or highly rated cases. The impact of this within the industry could 6

7 be profound. Reinsurers rely on the agreed upon underwriting guidelines to price the business. When that agreement is not followed, reinsurance prices are typically not sufficient. Losses to reinsurers may be reflected through more stringent claims handling by reinsurers, higher future reinsurance prices, additional loading into mortality to reflect uncertainty of the quality of business ceded or, in drastic cases, reinsurers pulling out of the market. In order to keep reinsurance a viable and competitive marketplace, there must be a clear understanding of the responsibilities of each participant. Including underwriting guidelines as part of the treaty and spelling out precisely what happens in the event of those guidelines not being followed are an important part of this process. Working together will mean fewer surprises, and fewer surprises always makes good business sense. For more information, you may contact the author at Mortality Table Assumptions, cont. from page 3 class system. For example, we may need to segregate our preferred non-tobacco table into super preferred and residual preferred non-tobacco components. The resulting mortality tables give the reinsurance pricing actuary an excellent starting point to determine the final mortality assumption for a specific deal. In the absence of other data, we use these customized tables without further adjustment. However, we are keenly aware that other factors shape anticipated mortality. Therefore, we typically request from a client a recent mortality experience study covering products and underwriting eras that are most similar to the deal being priced. Weighing Mortality Experience Using our own variation of standard credibility theory, we weight the client s experience with the mortality represented by our customized tables. (For more information on standard credibility theory, see the Canadian Institute of Actuaries July 2002 Note on Setting Expected Mortality Assumptions.) Our credibility formula includes quantitative factors such as number of claims and distribution of claim size and qualitative factors such as the level of detail in the study (e.g., splits by observation year, issue year and duration), the correlation of the study s business to the business being priced, the correlation of the study s underwriting era to current underwriting practices and the handling of exceptions in the study (e.g., conversions, impaired risks, contestable claims). As life insurance products and underwriting selection tools continue to evolve, pricing actuaries must translate changes into appropriate modifications to their mortality tables. At Transamerica Reinsurance, we review and update our base pricing tables at regular intervals using a multi-discipline approach that involves our Actuarial, Medical, Underwriting and Risk Management departments. Our goal is to apply pricing tables that most accurately reflect the mortality that will arise from current insurance industry practices. For more information, you may contact the author at

8 Enhancements Improve RSGuide Navigation Transamerica Reinsurance announces upgrades to its web-based underwriting manual RSGuide that significantly enhance the performance of the on-line manual. New features include Smart Search capabilities that save time and improve ease of navigation. The new Smart Search capability shortens the list of topics that match what you are entering in the Search field as your search string becomes longer and more specific. The Smart Search feature eliminates the need to scroll down a long list of possible matches to find a specific underwriting topic. We are dedicated to continuously improving our underwriting services and making RSGuide the risk selection guide of choice in the industry, said Jeff Leutert, Vice President, Underwriting Services. As full service life reinsurer, RSGuide is one of the most important resources we offer our customers, and we will continue to make the necessary investment to meet their risk selection needs. A solid underwriting program is fundamental to the life protection business, said Glenn Cunningham, Executive Vice President Traditional Markets. In a consolidating reinsurance market, Transamerica Reinsurance continues to demonstrate our leadership position through high value underwriting services to both our automatic and facultative reinsurance clients. This expertise is increasingly rare and differentiates us from other most other life reinsurers. Visit our web site at us at reinsurance@transamerica.com Main Marketing Office Asia Pacific Head Office Latin America Head Office Transamerica Square 27 F China Resources Bldg North Commerce Parkway 401 North Tryon Street 26 Harbour Road Suite 208 Charlotte, North Carolina Wanchai, Hong Kong Weston, Florida The information conveyed and the views expressed in this newsletter are provided for informational purposes only and are based on opinions and interpretations made by Transamerica Reinsurance. The opinions and interpretations expressed by Transamerica Reinsurance may not be the only interpretation available. This publication should not be copied or shared with any other company, reinsurer or consultant without obtaining prior approval from Transamerica Reinsurance. Transamerica Reinsurance, a division of Transamerica Occidental Life Insurance Company. Printed in USA 2005 Transamerica Occidental Life Insurance Company