Capital solutions for life insurers

1. Capital solutions for life insurers Milos Ljeskovac Swiss Re, Zurich 23 April 2004

3. Table of contents • Introduction • Differences between traditional and financial reinsurance • Examples • Back to capital

4. Forces of change • Globalization • Consolidation • Bancassurance • Demutualisation • Consumerism • Shareholders' expectations • Changes in regulatory environment • Technology • Demographics • Increased comparability

5. Economic environment • Policyholders prefer firms with high credit quality • insurance regulators and rating agencies play an influential role • An insurer’s balance sheet is not transparent • can be substantially changed in terms of size and risk • results in more costs to raise equity capital or debt • Highly competitive market requiring initial capital • up-front expenses and regulatory strain • decreasing margins

6. Insurance company’s objective • Maximise the present value of firm’s after-tax free cash flows*, given a limited amount of capital and multiple choices (e.g. issue new policies, alter investment strategy, purchase or merge with another entity, develop an e-business strategy, etc) • but how? * also known as distributable earnings

7. Choices available Must know both the type and the magnitude of the risk • Change the business or asset mix (i.e. modify the risk landscape) • Hedge certain risks using financial instruments • Adjust the capital structure

8. Adjusting the capital structure • Issue subordinated debt • benefit: produces liquidity and limited amount of statutory capital • drawback: it is expensive to create statutory capital because of the constraints on the acceptability and recognition of the subordinated debt • Issue new equity • benefit: produces liquidity and statutory capital • drawback: high issue costs, shareholding is diluted and shareholders demand a high return given the risk • Financial reinsurance

9. Differences between traditional and financial reinsurance

10. Financial reinsurance • Any reinsurance arrangement where the purpose is statutory capital optimisation

11. Reinsurance financing PV future surpluses (non-admissible asset) Admissible asset Financial reinsurance • A “loan” secured against future surpluses on a block of business

12. Traditional life reinsurance is very good for • Risk management • stability / protection of the portfolio • increase in capacity • Services • know-how transfer • underwriting • actuarial • consulting • international experience / lessons learned

13. Financial reinsurance structures are attractive to insurers when... • The insurer needs reliable long term solvency capital • to improve capital ratios • to grow (either organically or through acquisition) • to decrease debt, buy-back shares, give an extraordinary dividend • The insurer needs an increase in the ratings capital for the same reasons as above • The insurer is looking for taxable profits to offset tax losses

14. Financial reinsurance structures are attractive to insurers when... • The insurer wishes to increase profits to meet objectives • The insurer wishes to efficiently move capital into subsidiaries • The insurer wants to change its equity exposure without impairing current or future capital ratios • They wish to rebalance their asset liability mismatch while protecting their capital from costly yield movements

15. Type of business reinsured • Any type of life business • which is easy to define • with large amounts of future profits expected to emerge • where the future profits have not been assigned to another entity • with a relatively stable profit signature • Usually excludemedex, disability, annuities business

16. Examples

17. Margin swap • A margin swap reinsurance transaction creates statutory capital because the initial reinsurance commission flows through as income to the insurer • The profits on a pre-defined business block are transferred to the reinsurer as long as the treaty is in force • Credit analysis and volatility of future surpluses will drive the reinsurance price and maximum financing limit

18. To create capital, insurers can collateralize and mortgage their insurance margins Margin swap – initial transaction The size of the initial reinsurance commission is a function of the near- to mid-term expected insurance margins that the reinsurance contract can use to collateralize its risk The profits on a pre-defined business block are transferred to the reinsurer Insurer Reinsurer Pays an initial reinsurance commission; commission is withheld, it is a receivable from the insurer’s perspective Capital is created because the reinsurance commission is considered a profit and thus flows to retained earnings

19. To create capital, insurers can collateralize and mortgage their insurance margins Margin swap – renewal years Reinsurance premium = the positive profits on a pre-defined book of business This is normally a "no insurance risk transfer" transaction under US GAAP. The insurance risk is limited, but the credit risk remains. Insurer Reinsurer Amortizes the reinsurance commission Terminates when the initial reinsurance commission has been fully amortized

20. Value of inforce (VIF) • Life insurers generally have significant inforce blocks of life business • Local regulatory requirements include a significant level of conservatism, particularly on mortality • These features combine to hide a major life company asset

21. Value of inforce (VIF) • Value of inforce is the discounted actuarial present value of future statutory mortality margins on a block of inforce business. VIF is generally not an admissible asset for solvency calculations • The value of inforce from mortality margins alone is very large compared to the solvency needs for many European insurers but not recognized in statutory accounts • As a rule of thumb, the mortality value that is used to finance the reinsurance commission is approximately 5 -10‰ of sum at risk depending on the conservatism

22. The mortality margin in the business is sold to generate statutory & financial capital VIF - initial transaction The size of the initial reinsurance commission is a function of the development of the sum at risk and the conservatism embedded in the valuation mortality assumption Reinsures X% of the mortality risk on inforce business Insurer Reinsurer Pays an initial reinsurance commission; commission is withheld, it is a receivable from the insurer’s perspective • The solvency margin ratio is improved because: - capital is created by the reinsurance commission - less solvency capital is required because X% of the mortality risk is reinsured

23. The mortality margin in the business is sold to generate statutory & financial capital VIF - renewal years This is not a "no insurance risk transfer" transaction under US GAAP. The insurance risk is shared with the reinsurer. Reinsurance premium = Y% of the reserving mortality basis on reinsured business Insurer Reinsurer Pays mortality claims, interest on reinsurance commission and amortizes the commission After n years (e.g.10) the outstanding reinsurance commission is paid in cash Terminates when the last of the reinsurance risk has been extinguished

24. More smooth... O. Razum, H. Zeeb, S. Akgün, S. Yilmaz:: Low overall mortality of Turkish residents in Germany, Tropical Medicine & International Health 3 (1998)

25. ... and less smooth European Health for All db, WHO Europe, Copenhagen http://hfadb.who.dk/hfa/

26. The best solution for the insurer depends on their needs and the attributes of the structures

27. The best solution for the insurer depends on their needs and the attributes of the structures

28. The best solution for the insurer depends on their needs and the attributes of the structures

29. Timetable • Experience shows that it can take 3 to 9 months to complete a transaction • Several steps are needed: • commitment • detailed analysis of data • agreement on parameters • obtaining approval – risk committees, insurer board, regulators, auditors • executing treaty and legal documents

30. Every transaction is tailor-made for the specific needs of the client

31. Every transaction is tailor-made for the specific needs of the client

32. Every transaction is tailor-made for the specific needs of the client

33. Back to capital

34. Optimising capital structure • Given a level of total statutory capital necessary to support an insurer’s activities, is there a way of dividing up that statutory capital into debt, equity and financial reinsurance that maximises current firm value? Why should an insurer choose one type of financial instrument versus another?

35. It depends... • Consider future changes to business decisions and opportunity costs, for example: • required statutory capital growth > retained earnings growth • acquisitions • consequences of a weak solvency position • Consider tax: • highly dependent on jurisdiction • interest payments and reinsurance premiums may be tax deductible • reinsurance gains may be taxable

36. Also consider... • Credit risk issues • contributed to the mixed reputation of financial reinsurance in the past • Future financial reinsurance structures and use will depend on accounting and regulatory changes and consequential insurer needs: • IAS • solvency rules • insurance and reinsurance supervision and taxation rules

37. Conclusion • No “universal optimal” mix between debt, equity and financial reinsurance • The best solution – and the mechanisms to reach it – will change as the economic and regulatory landscapes change

38. Ambrose Bierce (1842-191?) FUTURE, n. That period of time in which our affairs prosper, our friends are true and our happiness is assured.

39. Thank you!