Tag Archives: reinsurance strategy series

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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Decision process for reinsurance implementation

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.

Reinsurance and IFRS

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

Reinsurance and IFRS

The new International Financial Reporting Standards (IFRS) accounting standard for insurance contracts, IFRS 17, is expected to have an effective date of 1 January 2023. This will change the accounting treatment of reinsurance contracts under IFRS reporting. IFRS 17 requires a reinsurance contract to be accounted for separately from the underlying insurance contract, which hasn’t previously been the case under IFRS 4.

Both insurance contracts and reinsurance contracts held will have a separate contractual service margin (CSM) on the balance sheet, which is a mechanism to spread profit over the lifetime of the contract.

The separate accounting treatment of reinsurance and insurance contracts will mean that there may be earnings volatility due to mismatches between the accounting treatment of the contracts.

Accounting mismatches may occur in a number of areas:

  • The underlying insurance contracts and reinsurance contracts may have different terms, which may lead to different measurement models being used to value them. If the coverage period of a reinsurance contract is one year or less, it may also be possible to model the reinsurance contract under the premium allocation approach. A mismatch will occur if the underlying insurance contracts are modelled using the general measurement model.
  • Differences in contract boundaries can occur between reinsurance contracts and the underlying insurance contracts. Reinsurance contracts often have cancellation clauses where contracts can be cancelled prematurely, leading to instability in financial results.
  • Aggregation of contracts into units of accounts may also differ between insurance and reinsurance contracts. Insurance contracts may only be aggregated into cohorts that are incepted no more than one year apart, whilst reinsurance contracts may cover many years of insurance contracts.
  • Coverage units used to allocate the CSM over an accounting period may differ between the underlying insurance contracts and the reinsurance contracts, which may result in differences in the timing of profit and loss recognition.
  • The CSM of the reinsurance contract can be both positive and negative, but the CSM for an insurance contract must be positive or floored at zero. Losses from onerous groups of insurance contracts are recognised immediately in the profit and loss (P&L) statement. Onerous reinsurance contracts can have a negative CSM which is spread over the lifetime of the reinsurance contract. This can lead to an accounting mismatch between the reinsurance contracts and the reinsured portfolio.
  • Inception dates of reinsurance and reinsured portfolios often differ as reinsurance is taken out after insurance contracts have been written. This will lead to different locked-in rates being used to value contracts, leading to a mismatch in finance income and expenses.
  • The separate presentation of insurance and reinsurance contracts can lead to balance sheet accounting challenges. The risk adjustment is the compensation that an entity requires for bearing the uncertainty about the amount and timing of nonfinancial risks. The risk adjustment of the reinsurance contract is not netted against the risk adjustment of the underlying insurance portfolio. This leads to the question of how to allocate diversification benefits to the reinsurance contract.

As a result of changes in financial reporting impacts, including possible additional earnings volatility, some insurers may require some elements of reinsurance treaties to be commuted or rewritten (where possible) to remove some of this earnings volatility. This will affect both internal and external reinsurance contracts and will depend on the reinsurance treaty terms.

As insurers develop familiarity with IFRS 17 reporting requirements, their appetite for reinsurance solutions
will evolve.

Insurers taking out new reinsurance contracts for capital relief should also consider the impact on financial reporting in addition to capital optimisation.

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.