By John E. Tiller
Until recently, capital was barely an issue in the life and health reinsurance business.
The business was growing profitably and experience was stable. Profitability was fueled by bouyant investment markets and mortality improvements.
What has happened to change that happy state? As in so many situations in business, no one factor is responsible for the reversal. Rather, several factors have combined to bring capital adequacy, quality of capital and return on capital under the spotlight.
Some of those factors relate to the life reinsurance business itself and some are extraneous but have had significant effects on the industry.
Sins of the Parent. Many of the worlds largest life reinsurers are part of corporate groups that include a significant property-casualty reinsurance or large European life operation. As a result of several years of “soft” p-c market prices, the impact of the events of Sept. 11, 2001, and deteriorating claims experience on the run-off of prior years writings, these p-c operations have experienced substantial losses.
The result is a draining of capital surplus across the organization. This has forced companies to increase focus on the availability and utilization of capital and, in many instances, to take steps to strengthen their balance sheets. If additional capital is not available, then the reinsurer must reduce the business it would otherwise accept.
Given that prices in the p-c market have hardened significantly, it is likely that most new capital will be used to support p-c business at projected returns of 20% and upwards, and little will be used to write life business, which has traditionally earned 9%-12%.
Life is Not Blameless. It would be wrong to conclude that all of the life reinsurance industrys issues with capital stem from losses in the p-c business.
Falling stock market values have also had an impact. This is particularly so in Europe where life insurers and reinsurers have invested much more heavily in equities than their counterparts in the United States.
As equities have fallen in value, with no countervailing reduction in liabilities, the pressure on the capital base has increased. Added to that, lower interest rates have led to lower investment income so that another source of return has diminished.
To add to the woes of life reinsurers operating in the United States, mortality losses have risen over the past year or so.
While there does not seem to be any evidence that aggregate mortality rates are increasing, in some instances the rate of improvement may have been slower than that assumed in the pricing and the differentials applied to preferred lives categories may have deviated from assumptions made. Mortality results have not been as stable or positive as many had assumed they would be.
Furthermore, many insurers and reinsurers have had poor operating results with many of the accident and health products.
Regulation. Regulators have increased requirements for capital to back new products, especially those with long-term guarantees.
The implementation of the Valuation of Life Insurance Policies model regulation, also known as Guideline Triple-X, in the U.S. has led to very significant increases in the reserves required for mortality risks and hence in the amount of capital needed to support that business. (Similar requirements exist in the U.K. and Canada.)
This change and the seemingly attractive rates offered by reinsurers have lead to an acceleration of the pre-existing trend for primary writers to cede large proportions of their mortality risk.
In 2001, 58% of new individual primary mortality business written in the U.S. was reinsured, compared to 15% in 1991, according to information culled from Merrill Lynch and a Munich American 2002 survey.
Many reinsurers have managed the resulting increase in their own capital requirements by ceding these blocks of business offshore using a letter of credit to achieve a reserve credit. The problem is that the letters of credit are shorter in duration than the liability; the liability rises rapidly and it is uncertain whether the letter of credit solution will be available in sufficient amounts for the life of the underlying policies.
There is also another potential strain on capital. Other reinsurers have chosen to minimize their participation in these high capital products. Similar problems exist with long-term guaranteed premiums for critical illness or other accident and health products.
AAA or BB-, That is the Question. Rating agency assessments have become increasingly important to reinsurers. The preponderance of downgrades over the past 18 months or so has signalled that a downgrade per se is not necessarily a problem, as some of these changes have been the result of a change in rating agency criteria.
But, there is a level at which a reinsurer may feel that a further downgrade will impact its ability to attract the business it desires. Thus, retaining sufficient (higher) capital to match the agencies rating standards has become a critical business consideration. Those agencies have made it clear that it is the quality of the capital, not just its quantity, which will drive their assessment. These considerations have caused many reinsurers to reconsider the real amount of capital required to support the risks they underwrite.
So, capital is now a very real issue for life reinsurers. Its availability, its nature and the return on it are all under greater scrutiny. Given the requirements of shareholders, rating agencies, analysts and regulators, life reinsurers are becoming much more selective about where they choose to utilize their capital and the return they are prepared to accept on it.
John E. Tiller is President and Chief Executive Officer of GE ERC Global Life & Health.
Reproduced from National Underwriter Edition, July 7, 2003. Copyright 2003 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.