The Valuation of Life Insurance Policies model regulation, better known as Guideline Triple-X, has been a topic of discussion for more than five years. Initially we were uncertain about many things–its effect on reserves, price, short-term and long-term guarantees, and reinsurance programs, just to name a few.
Today we know a great deal more, but now we need to extend our learning to the implications of the reinsurance solutions–offshore for the most part–that have been put in place to manage Triple-X reserves.
Whether your company is just beginning to consider a more effective Triple-X reserve solution or already has one in place, it’s important to understand how today’s arrangements address reserves over the short term and whether they are sustainable over the long term.
This becomes more apparent if we look at the guideline’s impact on level premium term products. Universal life products with lengthy secondary guarantees are also profoundly affected by Triple-X, but the insurance industry has not developed sufficient supportable solutions for the strain associated with these products.
Triple-X requires pre-funding of future liabilities of term life over the level period of the product. This practice is actuarially sound and follows basic, generally agreed-upon principles of life insurance. However, outdated mortality assumptions required in the calculations do not reflect today’s risk selection practices. This means term writers need to hold back significantly more of each premium dollar to cover conservative estimates of deaths later in the level period of a term product. Prior to Triple-X, this portion of the premium went right to earnings.
To prepare for the strain on earnings for the January 2000 effective date, many companies covered their bases by:
–Developing a term portfolio with guarantees shorter than the level premium period, for which Triple-X had little impact, so no pricing increases were necessary; and
–Increasing prices for their longer-term guaranteed term portfolio to offset new reserving expenses.
It took a few months to know which approach was more attractive to consumers, but when the dust settled, the choice was clear: Both consumers and agents prefer guarantees for the duration of the level premium period. Today, products with full level premium period guarantees continue to represent 75% of the market, or $900 billion in face amount.
To maintain profitability at a level comparable to pre-Triple-X, it originally appeared that life insurers would have to charge consumers an average of 20% to 25% more for a fully guaranteed 20-year level term product. In fact, life companies today, on average, are charging about the same for fully guaranteed 20-year level term products. What happened?
Reinsurance Cushions the Impact
Rather than increase prices, life insurance companies have found more economical ways to fund Triple-X reserves. Reinsurance has been the most common and effective way to manage capital and keep level premium term products viable.
The most popular reinsurance solution involves first-dollar quota share coinsurance–either with a direct or indirect connection to an offshore facility. While coinsurance has long been important for managing risk in the term market, it now has powerful capital management benefits.
Through these solutions, life insurers are realizing the economic benefit of holding economic reserves that reflect GAAP as compared with the Triple-X reserves required in U.S. jurisdictions.
Offshore: Direct or Indirect Approach
In today’s market, a growing number of direct writers are ceding business directly to offshore reinsurers. Others are ceding to onshore reinsurers, who subsequently send the business offshore to an affiliated or unaffiliated retrocessionaire.
Interestingly, these latter arrangements are often called “transparent,” when in fact they are opaque because the business practices of the offshore business partner are hidden from view. Life insurers that have never used offshore reinsurance and are unfamiliar with related concepts and terminology may be inclined to favor a ‘transparent’ offshore solution.
Despite the familiar facade, a transparent arrangement should not be treated as “business as usual.” Whether a company cedes business offshore directly or indirectly, the risks are essentially the same–most importantly, future reserve management capacity for business written today. As always, the ceding company’s due diligence process should uncover the full extent of the reinsurance program and all entities involved so the solution can be fully evaluated.
Properly designed, offshore reinsurance arrangements are perfectly acceptable within today’s regulatory guidelines. They provide valuable economic advantages to life insurance companies and meet the security requirements set out by the National Association of Insurance Commissioners.
Many newcomers to offshore are concerned about regulatory considerations. Ceding companies want assurance that reserve credit is allowed for the business ceded offshore, and that regulators will view the transaction favorably.
The NAIC has established specific reinsurance credit criteria for obtaining reserve credit for business reinsured with an offshore entity, including criteria for letters of credit and reserve credit trusts. Though RCTs are acceptable to regulators and include holding real assets, LOCs are the most common collateral used to support reserve credit today.
LOCs must be issued by a bank that is regulated in the U.S. and approved by the Securities Valuation Office of the NAIC.
LOC as Security
When reinsurance is secured by an LOC, the ceding insurer has at its disposal a highly liquid instrument, which may be converted to cash at any time. This security is more than adequate to cover future claims because the amount of the LOC is based on U.S. statutory reserving requirements.
The bank’s obligation to pay on an LOC is not contingent on its ability to recover the amounts drawn from the reinsurer. This feature fortifies the security of an LOC, and arguably, makes an LOC more dependable than the solvency or credit-worthiness of another third party such as an onshore company that subsequently sends the business offshore.
While the security of a properly structured LOC may be sound, there are other risks to consider, most notably cost and capacity. To help ensure the success of an offshore Triple-X solution, companies need to perform thorough due diligence on reinsurance partners. Whether considering a direct or indirect solution, it’s important to ask reinsurers the following:
–How do you anticipate handling future LOCs for business being ceded today? This is a critical question because LOCs are often one-year instruments with costs that can escalate with market conditions, and reserves tend to increase over the first several durations.
–What is your LOC capacity? In other words, does the reinsurer have an LOC credit line sufficient to handle the security demands of the term business it has and will reinsure?
–What is your company’s financial history and outlook? Financial strength and stability should always be a foremost concern when selecting a reinsurance partner.
Sustainable Triple-X Solutions
Whether one uses direct or indirect reinsurance solutions today, companies must also be prepared to pursue other arrangements as conditions change. Companies should continually ask themselves the following questions:
–What is the effect of other regulatory activities that may change the impact of Triple-X in the future? These issues are not entirely intuitive and require careful analysis. For example, in the near future the NAIC is expected to adopt a new valuation mortality table, which will result in lower Triple-X reserves.
At first glance, we would expect this to lower the overall cost of reserves, thus leading to significantly lower consumer prices. However, as discussed above, for the long-term guaranteed term products most retail companies’ prices already reflect very economic reserve management strategies–the only difference would be a slight decrease in reserve management charges. Therefore, we would expect to see a minimal decrease, if any, in price of the fully guaranteed term products as a result of the new valuation table.
–Are the current reinsurance solutions sustainable?According to industry estimates, $400 billion of term business has been ceded offshore since the advent of Triple-X. The amount of LOC capacity securing this business grows to approximately $6.5 billion in 10 years. Assuming no growth in the market and similar solutions are continued for the next five years, the needed LOC capacity would grow to approximately $30 billion. Are the current solutions sustainable?
–What are the necessary characteristics of ‘next generation’ term solutions?Both reinsurance and retail companies are developing awareness of the long-term sustainability of the current generation of Triple-X solutions. The next generation solutions will almost certainly include innovative forms of security, which will provide more capacity and longer-term sustainability.
Reinsurance has proven to be an acceptable and economic solution to dealing with the implications of Triple-X, and working with a knowledgeable, experienced reinsurance partner can make this regulatory challenge manageable for a direct company. Though we have learned much about Triple-X and its ramifications, the market is in a state of constant change.
Certainly, future regulations and product innovations will need to be addressed by the insurance and reinsurance industries. Solutions developed and implemented at present will need to both meet today’s demands and have the flexibility and scalability to adapt to a changing environment.
is vice president of life products with Transamerica Reinsurance in Charlotte, N.C. He can be reached via e-mail at [email protected]
Reproduced from National Underwriter Life & Health/Financial Services Edition, September 3, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.