Financial reinsurance Charles McLeod September 2002

2 Agenda 1) What is financial reinsurance? 2) A brief history in other countries 3) Why do companies use financial reinsurance? 4) How does it work? 5) Some benefits of financial reinsurance

3 1. What is financial reinsurance? No legal or regulatory definition in most countries.  Traditional reinsurance > Focused on risk management through the transfer of risk.  Financial reinsurance > Primary objective is the achievement of a specific business goal, e.g. improve ROE, reduce capital requirements.

4 What is financial re. (cont’d)?  Financial reinsurance tools are mainly the same as for traditional reinsurance – the difference is why and how they are used.

5 Some general observations 1. Financial reinsurance often relies on the ceding company and the reinsurer being subject to different: > Accounting rules > Regulatory practices > Tax regimes > Profit measures or motives, etc 2. Don’t play games with the regulators!

6 Trouble in the U.K. – 6 August 2002 “ The UK's insurance industry watchdog has warned firms not to use reinsurance contracts as a way of misleading policyholders on the true state of their balance sheets. In a discussion document, the Financial Services Authority (FSA) acknowledged that financial engineering of balance sheets was perfectly legitimate in many cases. However, it warned of instances where controversial methods of bolstering balance sheets might be used to mislead policyholders - or even the regulator itself. "Financial engineering may threaten the actual financial resources of a firm or create a false impression of financial strength", the FSA noted.”

7 2. History of financial reinsurance  Started in North America in late 1970’s.  Initially driven by desire to reduce surplus strain on new business, and to reduce taxes.  Its use increased as companies started recognizing the cost of required capital when pricing products.  Demutualization of some large companies has resulted in a further increase in use.

8 History (continued)  In Canada, 60% of new business was reinsured in The ratio increased to 75% in 2001!  Some very large companies are reinsuring up to 90% of their new business.  Trends are similar in the USA.

9 History (continued)  Financial reinsurance is not as common in other countries as in North America.  Countries where financial reinsurance is used include the U.K., Hong Kong, Japan, Taiwan and Mexico.

10 3. How can financial reinsurance help companies?  Reduce surplus strain/cost of writing new business.  Reduce required capital/increase actual capital  Improve the level and timing of earnings  Improve the stability of earnings  Improve the level of IRR, ROE, etc.  Manage income taxes

11 4. How does it work?  Reinsurer’s capital used instead of the ceding company’s capital and/or  Conservative valuation assumptions replaced with competitive reinsurance rates and/or  The reinsurer advances part of the future profits of new business or in-force insurance business – so that income is recognized sooner.

12 How does it work (continued)?  As a result, the ceding company can: > Improve its IRR or ROE > Finance its surplus strain/cost of writing new business > Reduce its required capital/increase actual capital > Manage its taxable income

13 Some definitions  Yearly Renewable Term (YRT) reinsurance  Coinsurance  Coinsurance funds withheld

14 YRT reinsurance  Simplest type of reinsurance  Ceding company pays reinsurer a premium to cover reinsured death (or disability) claims.  Reinsurer pays only death (or disability) claims, and does not pay other benefits such as surrender benefits.  Required capital for ceding company reduces because it has transferred some risks to reinsurer.

15 Coinsurance  Shares all risks with the reinsurer  Assume 50% of business is coinsured (quota share).  Ceding company pays reinsurer 50% of premiums paid by policyholders.  Reinsurer pays ceding company 50% of ALL benefits paid to policyholders (not just death claims).  Reinsurer pays an allowance/ceding commission to cover ceding company’s expenses.

16 Coinsurance (continued)  Reinsurer holds reserves for its share of business.  Not used often (except for products, such as term insurance, with low reserves) because: > Ceding company “loses” assets > In some countries, ceding company still has to hold reserves for 100% of business

17 Coinsurance - funds withheld Same as coinsurance except that:  Ceding company keeps assets backing reserves.  Ceding company credits reinsurer with investment income on assets/reserves for the business reinsured. ( A variation of this is “modified coinsurance”)

18 Coinsurance – impact on solvency margin ratio of ceding company  Required capital decreases – because some risks have been transferred to reinsurer.  Actual capital increases - because of allowances/commissions paid by reinsurer.

19 A simple example  Block of single premium non-participating (without profits) life insurance  Acquisition expenses equal to 5% of single premium  All numbers on pre-tax basis

20 Simple example Statutory results before reinsurance (First five years only shown) YearReservePremiumInvest. income Benefits and expenses Change in reserves Statutory earnings Required Capital Inv. Inc. on Req’d Capital Distrib- utable earnings (5.0)5.0-(10.0) (0.0) (0.3) (0.5) (0.6) (0.7) Value of business 7.2IRR14.6%

21 Improving IRR Insurer Reinsurer Coinsurance (funds withheld) of 50% of business with full risk transfer Initial cash allowance paid equal to embedded value of business reinsured

22 Improving IRR Statutory results after reinsurance (first five years only shown) YearReservePremiumInitial allow- ance Invest. income Benefits and expenses Change in reserves Stat earn. Req’d capital Inc. on req’d capital Distrib- utable earnings (1.4)3.8-(5.2) (0.0) (0.1) (0.3) (0.3) (0.4) IRR15.7%

23 Key Points  Reinsurer has paid an initial allowance equal to full embedded value of 50% of business.  In return for its share of all future premiums, the reinsurer agrees to its share of all future claims.  Reinsurer’s capital replaces part of ceding company’s capital.

24 Financing acquisition costs Insurer Reinsurer Coinsurance (funds withheld) of 50% of business without full risk transfer. Repayment expected in five years Initial cash allowance paid equal to a smaller portion of embedded value of business reinsured

25 Financing acquisition costs Statutory results after reinsurance (first five years only shown) YearPremiumInitial allow- ance Invest. income Benefits and expenses Risk fee Change in reserves Stat earn. Req’d capital Inc. on Req’d Cap Dist. Earn. Deficit account (3.2)3.8-(7.0) (0.0) (0.1) (0.3) <0.1(0.3) >0.0(0.4) repaid IRR15.9%

26 Two new concepts Deficit account – this equals:  Initial allowance, less  Statutory earnings on reinsured business Risk fee  Expressed as a percentage of deficit account  Paid to reinsurer

27 Key Points  Reinsurer has paid lower initial allowance since it expects to be repaid for financing provided within 5 years.  When financing is repaid, the ceding company can recapture the business from the reinsurer (without penalty). > Thereafter all risks and rewards return to the ceding company.  Initial allowance acts like debt. > But unlike debt, allowance acts as additional capital since repayment is contingent on profitability of business.

28 Reducing required capital  Each of the previous examples resulted in a reduction in the required capital.  The largest reduction in capital occurs through reinsuring a large percentage of the business, and by using coinsurance to transfer reserves.

29 Manage taxable income  Suppose the ceding company has a tax loss carryover due to expire.  An initial cash allowance is paid as previously. > Amount determined so that any expiring tax loss carryover is utilized. > Full amount advanced is not taxable (sheltered by tax loss carryover).  In subsequent years, when ceding company is taxable, reinsurance financing is repaid on a tax deductible basis.

30 Using reinsurance to manage expiring tax losses (results for all years shown) YearPre-tax income Expiring TLCF TaxPost-tax income Unused TLCF Reins. Allowance Pre-tax income TaxPost-tax income 1(15)10-(15) (8)13-(8) (6) (16) (16) (17) (18) (19) p.v. = Before reinsuranceAfter reinsurance

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32 Summary – uses of reinsurance  Finance acquisition cost strain > Reduce cost of writing new business; improve offers for acquisition targets  Reduce required capital/increase actual capital  Improve the level and timing of earnings  Improve the stability of earnings  Improve the level of IRR and ROE  Manage income taxes

33 5. Benefits of reinsurance  Simpler and faster to implement than other structures  Confidential  Competitive pricing/low transaction costs  Access to reinsurer’s expertise  Flexibility of duration  Flexibility of size  Flexibility of structure

34 Any questions?