Downlolad PDF
The Changing Role Of The Life Reinsurer
Life reinsurers must adapt to a new environment, says Chris Stroup.
As we enter the final quarter of 2006, I am reminded of a line from
a song by Counting Crows: "Maybe this year will be better than the
last." When the final surveys are available next spring, we guesstimate
that the reinsurance cession rate in the US life industry will have
fallen to its lowest level in a decade.
Recent behavioural changes by life reinsurers (and resultant reactions
from life insurers), coupled with regulatory developments and
capital market initiatives, likely have led to the contraction in traditional
reinsurance demand, and further suggest a challenging 2007
for many marketplace participants.
The most visible indicator of life reinsurance prosperity is the new
business cession level, which is summarised annually by Munich Re
under the auspices of the Society of Actuaries. Continuing a trend
that began in 2005, cession rates have declined again in 2006. A number
of market changes have contributed to this development. First
and foremost, the costs of reinsurance have increased, and the debate
over whether price changes are warranted does not change this fact:
reinsurance demand is price elastic. Faced with reinsurance pricing
that may have a negative effect on overall profitability, many insurers
have chosen to cede less business.
In addition to the increase in reinsurance prices, many reinsurers
also have enacted stricter (when compared to recent treaties) terms
and conditions in their reinsurance contracts. While this may have
improved operational risk management at reinsurers (and arguably
at cedants, although many seem to miss this subtlety), tighter terms
create greater incentive for direct writers to modify retention and
reinsurance bases.
Further, we have seen the growing emergence of capital market
solutions as alternatives to traditional reinsurance (both for financing
and risk management). Perhaps the convergence of insurance and
banking, and the disintermediation of reinsurers by banks, which
had been forecast by many for some time, may be occurring.
Lastly, a number of direct writers have found themselves carrying
excess capital on their balance sheets. Putting that capital to work by
funding mortality risks is viewed by some as an attractive alternative
to seeking costly (which is a perception) reinsurance.
One result of these developments has been a dramatic two-year
decline in cession rates as direct writers increase retention levels as
well as migrate away from coinsurance in favour of yearly renewable
term (YRT). While not all insurance companies have chosen
this path, it has been employed by many of the largest direct writers
—which has had a material impact on the volume of premiums ceded
to reinsurance.
The effect of these changes is enumerated in the 2005 Munich Re
Survey. The survey shows that the 2004 cession rate of 59 percent
dropped all the way to 45 percent by year-end 2005. As still more
companies continued to make changes to their reinsurance bases and
retention levels over the course of 2006, we expect to see even further
reductions—perhaps to as low as 40 percent for the year 2006.
In 2007, we will see a reinsurance market competing fiercely over
diminished reinsurance premiums.
These changes also are indicative of another important development.
Direct writers always have been faced with a balancing act in
their purchasing of reinsurance. Their tolerance for retaining varying
levels of risk has a direct impact on the degree to which they rely on
reinsurance as a source of capital. For the time being, higher prices
and tighter terms have tilted the scales in favour of retaining higher
risk. Cedants' tolerance for higher levels of risk, combined with the
growing variety of other financial resources (banks and investment
houses) that offer alternate capital solutions, could create a 2007 that
looks to be a challenging and competitive year for life reinsurers.
One example of the alternate sources of capital currently available
to insurance companies is the option to securitise their XXX
reserves. A number of the larger insurance companies have put XXX
securitisation facilities in place and have eliminated their reliance on
coinsurance with reinsurers for XXX reserve relief. While seemingly
an attractive alternative to reinsurance, some are finding this a much
more costly and time-consuming endeavour than they had anticipated.
In the end, it is another balancing act between risk tolerance,
the cost of reinsurance, and the expense of putting a XXX facility
in place. Life reinsurers face not only increased competition over reduced
premiums ceded, but they also face ever-growing competition
from sources outside of their traditional competitors.
2006 was witness to still another development that is already having
a noticeable impact on the reinsurance market. The struggles
of Scottish Re have put direct writers on alert. The life reinsurance
industry has seen a substantial consolidation over the last several
years—as Swiss Re and Scottish Re increased scale via acquisitions,
and as Lincoln Financial and ING opted to exit the market in order
to focus on core competencies.
Direct writers face a 2007 with fewer choices for reliable reinsurance
partners, and we wouldn't be surprised if there were to
be continued consolidation over the course of the year to come.
Direct writers rely on placing a number of reinsurers into a pool in
order to alleviate potential concentration risk within the pool, and in
2007, direct writers may be forced to accept more risk. In this case,
that increased risk could take the form of increased concentration
risk, as consolidation continues to reduce the options available to
cedants. Or, it could take the form of increased counterparty credit
risk if cedants instead opt to maintain current levels of concentration
risk and invite lesser-rated reinsurers to participate in pools.
The Scottish Re travails already have produced a reaction from direct
writers. A number of them are reviewing their own risk management
guidelines and are considering setting higher barriers to entry
for their reinsurance partners. This 'flight to quality' may produce
more confidence in the long-term viability of their partners, but it
likely will lead to increased concentration risk within their reinsurance
pools.
Changes in regulatory requirements for the valuation of insurance
reserves are creating a new environment for direct writers to
consider. In the short term, a new model regulation (Interim Reserve
Changes and Preferred Mortality Tables) has been passed that will
allow companies to use preferred mortality tables when calculating
statutory reserves, starting at January 1, 2007 (subject to State
adoption). The new model carries the potential of reducing required
reserves. We don't anticipate any short-term ramifications for reinsurers
from this regulation.
This new model regulation is intended as a stop-gap solution as
the industry awaits the adoption of the long-term solution—Principles
Based Reserving. Principles Based Reserving will produce a
substantially reduced financial burden from reserves. For some, this
may create less need for reinsurance support. It also means that insurers
carrying excess capital on their balance sheets will be putting
less capital to work by funding their reserve requirements. This may
eventually lead to a further reduction in cession rates as they opt to
put their own money to work rather than ours.
On the other hand, numerous direct writers still rely on reinsurers
for increased capacity as well as facultative support, underwriting
manuals, mortality expertise and product development. Many direct
writers still prefer to balance their risk and financial performance by
embracing reinsurance partners and sharing the risk. Further, not all
direct writers are pursuing their own securitisation facility. It is a
lengthy and expensive process that requires a great deal of expertise
to finalise. For the majority of life insurance companies, building a
securitisation facility is not a realistic option. For these reasons, we
are not ready to predict comprehensive disintermediation of the life
reinsurer. Instead, it may be time to predict what the reinsurer of
the future needs to look like. It is time for reinsurers to rise to the
challenge of adapting to a new environment.
What can today's reinsurers do to not only survive, but to thrive
in this challenging environment? The best opportunity for growth
comes from being viewed as a strategic partner to the direct writers.
To achieve that status, a reinsurer needs to fully understand the
challenges faced by its clients. And, understanding those challenges,
it needs to be able to craft creative solutions that create a symbiotic
relationship between direct writer and reinsurer. Adaptability, creativity
and diversification provide a recipe for success in this challenging
environment. Let's take a look at what that might mean as
we approach 2007.
A strategic reinsurance partner needs to do more than provide a
price quote on a traditional request for proposal for new business.
Because of the inroads being made by the banking industry, the successful
reinsurance partner needs to be well versed on the alternative
capital solutions offered by its competitors. It ought to be able to
compare and contrast the various solutions available to its clients.
One option for the successful reinsurer might be to participate with
a banking/financial services 'partner' as a defensive response to the
pending threat of this new competitive sector, as well as to expand
its own solutions offering.
Its other choice would be to build the same level of capital markets
expertise in-house in order to compete with this new competition.
Acting more like a consultant, the successful reinsurer will
bring a depth of knowledge on regulatory issues, capitalisation,
tax issues and securitisation. The successful reinsurer will carry an
attractive credit rating, have access to substantial amounts of capital,
and have the expertise to keep capital and expense loads at an
absolute minimum.
As previously mentioned, ceding companies increasingly are leery
of taking on potential credit risks with their counterparties. This creates
a challenging opportunity for lesser-rated reinsurers to focus on
ways to change their current credit ratings. This may pose a daunting
task for smaller or newer reinsurers, but it is vital to their ability to
gain market share in today's environment. Reinsurers without an adequate
credit rating, or without sufficient available capital, will find
fewer and fewer opportunities in 2007.
These market conditions also will limit greatly the potential entrance
to the market of start-up life reinsurers. It is hard to imagine
that there is much investment capital eager to fund a de novo effort
facing all of these challenges. A lack of capital and a lack of
an adequate credit rating would spell almost certain failure for any
start-up in this environment. On the other hand, adequate capital
accompanied by an outstanding credit rating (banks and financial
institutions) would have a good chance at success as a new entrant in
the reinsurance space.
The year 2006 proved challenging for life reinsurers, as market
changes negatively affected reinsurance premium volumes. In 2007,
we expect a further reduction in cession rates, increased competition,
changing regulations and cautious direct writers. The time is now for
reinsurers to adapt to this new market.
What is the right recipe for success? We believe it will continue
to require the convergence of reinsurance expertise and capital market
expertise, while keeping pricing reasonable through capital and
expense efficiencies. Perhaps that is why we see more banks and
financial institutions testing the reinsurance waters lately. They offer
the clout, but they are missing the reinsurance expertise and management.
The reinsurers bring expertise and management, but lack the
financial institutions' clout. The stage is set for an exciting and challenging
2007 in the life reinsurance market.