In July 2020, Milliman professionals published the research report “Reinsurance as a capital management tool for life insurers.” This report was written by our consultants Eamon Comerford, Paul Fulcher, Rosemary Maher and myself.
Capital management is an increasingly important topic for insurers as they look to find ways to manage their risks and the related capital requirements and to optimise their solvency balance sheets. Reinsurance is one of the key capital management tools available to insurers. The paper investigates common reinsurance strategies, along with new developments and innovative strategies that could be implemented by companies.
For pension funds and pension insurers, longevity risk can be substantial. High capital requirements, reflecting this risk, are a key reason for insurers looking to de-risk longevity exposures. Reinsurance covers and capital market solutions can be used for this. Several of these solutions, including their characteristics, are included in the table in Figure 1.
To help solve it, and to come to the right conclusions, it is important to fully understand the mechanics and characteristics of the reinsurance solution used to implement the strategy. In Figures 2 through 5, we give a brief overview of several solutions and their advantages and disadvantages.
National mortality tables are crucial inputs to the quantification of mortality and longevity risks. In the absence of data specific to insured or pension populations, national mortality tables are based on general population data. Recent work by Milliman demonstrates problems with the reliability of these reference tables, including false cohort effects, and offers methodological improvements for their construction. In this paper, Milliman consultants Laurent Devineau, Alexandre Boumezoued, and Dale Hagstrom present both historical perspectives and new solutions to this problem.
Insurance companies can generate value when pricing, setting deterministic margins, determining economic capital, and determining its optimal mix of business by performing stochastic modeling with volatile mortality assumptions. In this case study, Milliman consultants Dan Theodore and Stuart Silverman explore relevant questions related to margins using a simple combination of life insurance and payout annuity products by applying stochastic projections of future mortality rates. It also compares percentile values from the stochastic projections to results using deterministic projections and margins. In addition, the study demonstrates the relative diversification benefit of the longevity exposure from the annuity product along with the mortality exposure of the life insurance product.
Life insurers in South Africa are now translating statistically significant risk factors into their pricing models and are grappling with producing a credible expectation of future increases in longevity. One product that can help insurers reduce their longevity risk exposure is the longevity swap. In this article, Milliman’s Peter Carswell discusses how various longevity swaps work. Here’s an excerpt:
Longevity Swap An alternative risk transfer mechanism is the longevity swap, which sees the insurer make a series of pre-agreed fixed payments to the reinsurer (the ‘fixed leg’) in return for the reinsurer making payments to the insurer based on actual longevity experience (the ‘floating leg’). The payments made under each of the legs are typically netted off with only the difference transferred.
Longevity swaps come in two major classes: indemnity swaps and index-based swaps. Indemnity swaps see the floating leg payment being linked directly to the insurer’s portfolio. Index-based swaps see the floating leg payments being linked to a predefined objectively calculated index, for example a specific national population metric.
The term of the longevity swap is also something that can vary, with short-term swaps being made available in the market (so called ‘shortevity’ swaps) with a term of around five to seven years, swaps with a term that is expected to cover the bulk of the benefits covered around 25 years, and terms that provide cover until complete runoff of the reinsured portfolio.
Fees In addition to the fixed leg, the insurer will typically pay a regular fee to cover the reinsurer’s expenses, profit margin, and cost of capital. The separate fixed leg and fee structure has the advantage of promoting transparency in that it allows the parties to hold a technical discussion around the expected longevity rates for the fixed leg while holding a parallel commercial discussion around the level of the fees. The resulting rates used for the longevity swap typically reflect a commonly held best estimate view of mortality, which provides a useful reference point for the actuary when setting a basis for valuation work. This same structure also allows for a better matching of cash flows to profit recognition for the reinsurer. The alternative approach is to build the profit loading into the base longevity rates, but this results in the reinsurer receiving cash from fees at a much later date in the lifetime of the contract.
According to consumer data in Japan, it appears more adults are girded in diapers than babies. This statistic offers an analogy for the country’s aging population. Increased life expectancy is putting a financial strain on individuals. There is also evidence that increased longevity can have an economic effect on a country’s finances. In a recent Best’s Review (subscription required) article, Milliman consultant Stephen Conwill talks about the role the life insurance industry can perform to help governments cover the costs of those living longer.
Here is an excerpt:
Living longer has massive financial implications, both for individuals and governments…
Stephen Conwill, chief executive officer of Japan Milliman, said the insurance sector can pick up where governments leave off.
“Governments are usually successful when they provide something very simple, the basic needs, and then let the insurance sectors provide either more complex risks or fill in the gaps the government can’t adequately provide,” he said. “That’s certainly been the philosophy in Japan with respect to both health care and pensions. It’s worked very well to date, but the government plans are under extreme pressure for cost cutting, figuring out how to fund it going forward.
“So funding is really the issue and I think it’s really on the funding side that the insurance and private sector can hopefully get in and encourage people to do a little more for themselves, and can encourage companies to work together and provide solutions.”
Maritime Super, Plato Investment Management, and BetaShares have this year employed Milliman’s Managed Risk Strategy (MMRS), which stabilizes investment volatility and reduces the impact of major market declines by dynamically managing market exposure using derivatives.
The potential to hold onto the returns of growth assets while minimizing the downside has quickly found a receptive market among pre-retirees and retirees that understand the benefit of holding growth assets to protect against longevity risk.
The $4.5 billion Maritime Super fund began offering members a version of its popular Balanced and Growth options with the Milliman overlay in July. The Balanced and Growth “Managed Volatility Process (MVP)” options have already received more than $200 million in inflows from members and defined benefit sub-funds.
“There are some very complex and very expensive ways to minimize volatility and protect members from the severe downturns in equity markets but there aren’t many that can be understood by members, are low-cost, and can be turned on and off by individual members at any time,” Maritime Super chief executive Peter Robertson said.
“A lot of other protection strategies require us to hand over the money to someone else to manage. Milliman’s approach allows us to still invest in the fund managers that we want to use,” Robertson said.
Milliman practice leader Wade Matterson said its overlay is a cost-effective way to manage the risk of a significant market downturn while allowing investors to retain an exposure to growth assets.
“Delivering this process as an overlay allows us to enhance a product that people are already familiar with, and offers a nudge to those that are seeking to manage the risk in their portfolio,” Matterson says. “The power of that structure is that it allows you to combine the best of both worlds: the fund manager’s portfolio construction with Milliman’s specialist risk management expertise and scale.”
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