In July 2020, Milliman professionals published the research report “Reinsurance as a capital management tool for life insurers.” This report was written by 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.

This blog post is the third in a series of posts about this research. Each one gives an overview of a section of the Milliman report.

Evaluating reinsurance strategies

Insurers can typically choose between several reinsurance strategies, each with its own benefits and trade-offs. When deciding on which reinsurance strategy to implement, the key areas of consideration can be broken down further into the following characteristics:

Capital requirement considerations

• Impact on required capital: An effective reinsurance cover transfers risk from the insurer’s balance sheet, generally lowering the capital requirement for the risk transferred. The overall impact on required capital depends on (i) the amount of risk transferred, (ii) the diversification benefits, (iii) the additional risk introduced by the reinsurance cover and (iv) the basis risk.
  
• Additional risk introduced: Additional risks might be introduced by the reinsurance cover, requiring the insurer to hold capital against them. Examples are (i) counterparty default risk, (ii) expense risk due to a changing expense basis and (iii) a loss in diversification benefits.
  • Counterparty default risk can be substantial, depending on the credit rating of the reinsurer and the scope of the treaty. This can even lead to the Solvency II Standard Formula not being appropriate to capture the counterparty default risk. Additional capital buffers might be required in this case to protect the insurer against adverse scenarios, such as a downgrade of the reinsurer in combination with a decrease in interest rates. These buffers can be substantial and additional mitigation might have to be put in place.
    
• Renewals required: In cases where reinsurance covers are short-term (e.g., five years) there can be a duration mismatch compared to the liabilities. This requires the cover to be rolled forward at maturity. Replacements can impose additional risks due to, for instance, the absence of liquidity in the market or increased reinsurance costs. This might cause an issue for recognition as a risk mitigation technique as per the requirements under Solvency II.

In July 2020, Milliman professionals published the research report “Reinsurance as a capital management tool for life insurers.” This report was written by 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.

This blog post is one of a series being released in relation to this research. Each blog post will give an overview of a certain section of the Milliman report.

Decision process for reinsurance implementation

There are several ways reinsurance can be used as a capital management tool. In practice, their efficiency is dependent on a lot of factors and, when implementing a reinsurance arrangement, several choices therefore need to be made.

Before deciding on which arrangement to implement, it is important to decide:

1. What key performance indicators (KPIs) and key risk indicators (KRIs) the company wants to improve using the reinsurance strategy. Examples of KPIs are return on capital, stable dividend payments, new business growth and operating profit. Examples of KRIs are the solvency coverage ratio, liquidity of the portfolio, credit exposures and capital requirements.
2. What the trade-offs of the strategy are and whether they are acceptable.
3. How these trade-offs evolve during the run-off period of the insurer’s portfolio.

If an insurer is well capitalised—there is enough capacity to write new business, volatility in the coverage ratio does not cause serious issues and the company favours a higher profit margin over lower and/or more stable capital requirements—then the need for capital management actions might be less urgent. This does not mean that reinsurance strategies are completely out of the picture. Instead, the company can take preemptive measures by putting capital management actions in place to prepare for situations where the coverage ratio is not at an acceptable level.

An example of such a preemptive measure is so-called ‘just-in-time’ reinsurance cover. Here, the insurer implements a reinsurance treaty with minimal risk transfer that can be scaled up relatively easily and quickly when needed, because most of the preparations required for the scaled-up treaty have already been carried out as part of the initial due diligence process.

Therefore, a fourth factor to consider when deciding on capital management actions relates to timing:

• When to implement the capital management action.

Based on the answers to these questions the board of an insurer can decide on which reinsurance cover and strategy to implement. It is important to reach this conclusion in the early stages of the process as due diligence of the reinsurance implementation can require quite some time and significant resources. Furthermore, once a reinsurance arrangement is implemented, it can be challenging to recapture it or to transfer it to a different counterparty.

Milliman research paper

The full research paper can be found on Milliman’s website here. At the same site, you can also find an executive summary version that notes some of the key highlights of the research and acts as a guide to the full paper.