Tag Archives: reinsurance strategy series

Lapse risk reinsurance

In July 2020, Milliman published the research report “Reinsurance as a capital management tool for life insurers.” This report was written by our consultants Eamon Comerford, Paul Fulcher, Rik van Beers 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 ninth in a series of posts about this research. Each post provides an overview of a certain section of the Milliman report.

Lapse risk reinsurance

One of the largest capital requirements for most life insurers arises in respect of lapse risk, which results from adverse changes in policy surrenders, paid-ups and other discontinuances. For most business, higher-than-expected policy lapses result in the loss of profitable policies, although the converse is sometimes the case, with the risk of loss-making policies remaining in force for longer durations.

The focus of this post is on lapse reinsurance, which can be designed to cover the lapse stresses under Solvency II, where the reinsurer pays out if lapses are higher or lower than expected. Lapse risk reinsurance solutions mainly focus on tail risk transfer and Solvency Capital Requirement (SCR) reduction, rather than full lapse risk transfer. A 100% quota-share reinsurance of a block of business fully transfers lapse risk, in the absence of other risks, if full lapse risk transfer is required.

Lapse reinsurance transactions are written to be “out-of-the-money” at inception, so may be a low-cost way to transfer lapse risk. An insurer considering entering a lapse reinsurance contract will reinsure the biting SCR lapse stress, thus allowing the insurer to hold less capital against the biting lapse risk. This structured reinsurance strategy is most likely to be used by an insurer calculating its Solvency II capital requirements using the Standard Formula (SF). The strategy is most practical where the biting lapse stress requires significantly more capital than the other lapses stress. If any of the other lapse stresses are at a similar level of magnitude, the usefulness of a reinsurance arrangement just covering one type of lapse stress as a capital relief tool is minimal. In this case, it may be necessary to use a lapse reinsurance strategy that covers multiple lapse stresses.

Overview

Lapse risk exists on most portfolios of life insurance business other than business for which lapses are not possible, such as traditional whole-of-life annuities. There are three main types of lapse reinsurance currently in existence, one for each of the three prescribed shocks under the SF, as shown in Figure 1.

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Mortality and catastrophe risk reinsurance

In July 2020, Milliman published the research report “Reinsurance as a capital management tool for life insurers.” This report was written by our consultants Eamon Comerford, Paul Fulcher, Rik van Beers 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 eighth in a series of posts about this research. Each post provides an overview of a certain section of the Milliman report.

Mortality and catastrophe risk reinsurance

Two common interrelated risks that life insurers can face are mortality risk and catastrophe risk. Mortality risk is the risk of both policyholders dying earlier than expected and more policyholders dying than expected. This risk occurs gradually throughout the duration of the portfolio. If best estimate mortality rates are set too low then, as a result, provisions for mortality covers are insufficient to cover liability payments.

Catastrophe risk is the risk of many policyholders dying or falling sick due to a sudden event, such as a pandemic. The effects of a catastrophe shock are felt more immediately than the effects resulting from a mortality shock. A recent example of this is the COVID-19 pandemic.

Determining mortality risk and catastrophe risk

Setting robust best estimate mortality parameters for an insurer’s portfolio can be subject to a substantial amount of expert judgement, especially in the case of smaller portfolios or where the insurer does not have a lot of experience. Mortality risk can be quite material, as a small variance in the portfolio’s mortality can readily lead to insufficient reserves. This especially holds true if this variance occurs on life covers from individuals with above average sums assured. Estimating catastrophe risk can be challenging. Parameters and models used to determine the catastrophe risk are dependent on the event driving it. In the case of a pandemic, variables such as social distancing, contagiousness, population age structure and lethality are important when calibrating a catastrophe risk model.

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Longevity risk reinsurance

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.

This blog post is the seventh in a series of posts about this research. Each post provides an overview of a certain section of the Milliman report.

Longevity risk reinsurance

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.

As argued in earlier posts (“Decision process for reinsurance implementation” and “Evaluating reinsurance strategies“), insurers can choose from among several reinsurance strategies. They all have their own trade-offs and each one’s effectiveness is dependent on a breadth of characteristics and considerations. Choosing which reinsurance strategy to implement is a complex puzzle to solve.

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.

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Collateral management for reinsurance

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.

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

Collateral

Many reinsurance transactions are collateral-backed to mitigate against counterparty default risk in respect of the reinsurer. The amount of collateral required to back a reinsurance transaction will depend on the type of reinsurance and the reinsurer’s creditworthiness. There are several different types of collateral which may be used to back reinsurance transactions, including:

  • Letters of credit
  • Funds withheld
  • Trust arrangements
  • Cash or other securities
  • Other assets, such as those that directly back the liabilities
  • Other third-party sureties

The Solvency II regulations outline various requirements that must be met for collateral arrangements to be recognised in the Solvency Capital Requirement (SCR) calculation. Some of the key requirements are that the:

  • Insurer should have access to the collateral assets in a timely manner in the event of default
  • Collateral should provide protection by being of sufficient credit quality and stable in value
  • Value of the collateral should not be materially dependent on the credit quality of the counterparty

Collateral invested in fixed income assets can, for instance, be highly correlated with the credit risk of the counterparty. If this is the case, the collateral placed will not effectively mitigate the counterparty default risk. These requirements can be quite onerous in practice, further emphasising the need for careful consideration as part of the treaty negotiations and design.

Insurers should set strict limits and investment guidelines on the collateral account when financial investments are involved. Also, insurers should understand how any remaining uncollateralised exposure can move over time and under different possible scenarios.

It is often desirable by insurers and/or by regulators that collateralised assets do not leave the jurisdiction in which the insurer is domiciled. This is typically possible through the use of custodians operating in the insurer’s home territory.

Collateral management is a very important component of a reinsurance arrangement and is sometimes the most critical part, particularly for asset-intensive reinsurance such as a full risk reinsurance cover. Not only is collateral management an important part of obtaining regulatory approval, it is also important to maintain the effectiveness of the risk transfer because collateral can be used to reduce counterparty risk without restricting the balance sheet optimisation mechanism of the reinsurance cover.

Milliman research paper

The full research paper can be found on Milliman’s website here, where 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.

Regulatory considerations for reinsurance

In July 2020, Milliman professionals published the research report “Reinsurance as a capital management tool for life insurers.” This report was written by consultants Paul Fulcher, Rik van Beers, 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 fourth in a series of posts about this research. Each one gives an overview of a section of the Milliman report.

Regulatory considerations

Demonstrating that a reinsurance deal is genuinely used as a risk-mitigating technique as part of a firm’s overall risk strategy is key for regulatory approval. Engaging with regulators early in the process is important, especially when considering reinsurance contracts that are highly bespoke in nature. Demonstrating enhanced policyholder protection is also paramount for most regulators.

The main criteria for accepting reinsurance transactions that a regulator will expect to see are:

  • A clear business rationale for implementing a reinsurance deal.
  • A strong understanding of the risks that are being transferred, the risks that remain and any new risks that emerge as part of the transfer, particularly counterparty risk. It is not necessary to have reinsured every component of the risk, but a clear understanding of what is and is not transferred is imperative. Furthermore, a genuine transfer of risk is expected to take place rather than arbitraging regulations to reduce capital requirements.
  • A low level of basis risk and a clear understanding of this basis risk.
  • Clear analysis and consideration of different possible outcomes, including scenarios where the reinsurance may not be effective.
  • A financially strong (and preferably large) counterparty and stringent security in the arrangement, particularly using collateral or other risk-mitigating measures. The reinsurer’s jurisdiction may also be relevant to the regulator.
  • Regulators are sometimes keen to see that assets transferred as part of a reinsurance transaction are held in local custodian accounts. This is very relevant for insurers that are considering entering into deals with reinsurers that operate outside of their jurisdictions.
  • Recapture plans in case of reinsurer financial distress or default.

The above criteria are typically important considerations for most insurers as part of their internal governance and risk management in any case. Early engagement with regulators is often the best way to achieve a positive outcome in terms of getting regulatory buy-in for a material new reinsurance arrangement.

Milliman research paper

The full research paper can be found on Milliman’s website here, where 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.

Evaluating reinsurance strategies

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.
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