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.
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.Continue reading