More Life Reinsurance Deals Head Offshore
Life reinsurance for U.S. insurers has grown impressively over the past 5 years.
Insurers booked $110 billion in reinsurance reserve credit in 1999, a figure that increased to $193 billion by 2003, producing an annualized growth rate of 15%, according to data filed in their statutory financial statements and published by Conning Research & Consulting in its recently released Strategic Study, “Life Reinsurance, Capacity and Other Challenges2004.”
Part of this increase involves unauthorized (read “offshore”) reinsurers. While the 15% growth rate in the total is impressive, it is dwarfed by the almost 35% annual growth rate in the offshore component.
Two of the major causes of the recent growth in life reinsurance are the Valuation of Life Insurance Policies model regulation, also known as Regulation Triple-X, with the sharply increased reserve levels that it mandates, and aggressive marketing by reinsurers. The Guideline Triple-X reserving requirement is the primary driver of reinsurance in offshore reinsurers. The reserve levels it mandates are well in excess of what many consider to be an appropriate level of economic reserve, with the excess of regulatory reserves over economic reserves being labeled “redundant.”
Companies not subject to domestic reserving requirements are quite willing to reinsure this business, with the result that there is significant regulatory arbitrage in transferring the business to an offshore reinsurer. Actuarial Guideline 38 (formerly referred to as AG AXXX), which became effective in January 2003, clarified the application of Regulation Triple-X to universal life policies, and may create a similar scenario for those products if the complications associated with product guarantees can be worked out. However, this was not a significant component of the 1999-2003 experience.
Bermuda, Barbados and the Cayman Islands appear to be the offshore locations of choice for serving the U.S. market. In addition to the advantage of lower reserve requirements, offshore reinsurers frequently benefit from lower taxes, significantly simpler financial reporting structures and less restrictive investment requirements, all of which contribute to a more efficient operating model.
The connection with the offshore reinsurer can occur in several ways. A direct relationship between a domestic insurer and an offshore reinsurer is the most obvious, but these are not very common. A more frequent configuration involves reinsuring business with an authorized U.S. reinsurer, which can then retrocede some or all of the original cession to one or more offshore reinsurers, either an affiliated subsidiary or a nonaffiliated reinsurer. Finally, there is an increasing trend for large primary insurers to establish their own offshore reinsurers. As offshore business has become more visible, as outsourcing has taken hold and as viable third-party reinsurance administrators have been established, offshore captives have become more common, and the size needed to cost-justify them has declined.
While they may not have to set up the same redundant reserves as their onshore counterparts, unauthorized reinsurers are required to collateralize the reinsurance credit taken by their primary insurers before the domestic insurer is permitted to take credit for those reserves. This is done either through:
w LOCs (letters of credit) arranged by the reinsurer with a financial institution on the approved list for such transactions;
w a reinsurance trust funded by the reinsurer with the primary insurer as beneficiary; or,
w funds deposited by the reinsurer with and to the benefit of the primary insurer.
Using LOCs eases the capital required for an offshore reinsurer. Generally, little or no capital is required of the reinsurer when the LOC is set up. And, until such time as the primary insurer calls on the LOC in accordance with the reinsurance treaty, the bank or other financial institution providing the LOC needs to put aside only the collateral required to satisfy the banking regulations, normally only a small percentage of the credit guaranteed.
Trusts and funds on deposit, on the other hand, must be fully capitalized. But, in many cases, collateral to fund reinsurance trusts is obtained in the credit markets. Much of what is held as funds on deposit comes from funds withheld by the primary insurer under coinsurance treaties.
Growth in Offshore Reinsurance
Under the assumption that the reinsurance ceded to unauthorized companies is with offshore reinsurers, Conning used the data reported in Schedule S, Part 4, of the statutory financial statement as an appropriate measure of offshore reinsurance activity.
As noted earlier, the overall level of reinsurance reserve credit taken by U.S. life insurers increased from $110 billion in 1999 to $193 billion in 2003, producing an annualized growth rate of 15%. However, the portion of that credit from offshore sources has grown at a much faster rate (almost 35% annually), from $15 billion in 1999 to $48 billion in 2003.
Reinsurance transactions between affiliated companies used offshore reinsurance more often than those between unaffiliated ones. While reserve credits within each group accounted for approximately half of the total reinsurance reserve credit in each year, and have grown at the same 15% overall rate, the authorized/unauthorized mix differs for credits from affiliates vs. nonaffiliates. Reserve credits from unauthorized but affiliated sources were $30 billion, or 31% of the total, in 2003 vs. $18 billion, or 19% of the total, from unauthorized nonaffiliated sources.
As might be expected, since most of the reinsurance for Regulation Triple-X reserves goes first to a domestic reinsurer before being retroceeded offshore, the largest portion of offshore reinsurance between affiliated companies involves reinsurers. However, domestic companies have become much more comfortable developing their own offshore affiliates, and a growing share of these transactions involve a domestic primary insurer and an affiliated offshore reinsurer.
As mentioned earlier, reinsurance in unauthorized reinsurers must be collateralized before the primary insurer can take credit for the reserves. LOCs get the most attention when this subject is discussed, but an analysis of Schedule S, Part 4, indicates that they are not the collateral source of choice for transactions between either affiliated or nonaffiliated companies. Funds on deposit was the favored collateral for transactions involving affiliates from 2000 through 2003. Much of this is the result of funds withheld under coinsurance treaties, but the total of amounts withheld involving unauthorized reinsurers could not be isolated. Nonaffiliates favored reinsurance trusts from 1999 through 2002, with funds on deposit taking the greatest share in 2003.
Driven by the regulatory arbitrage resulting from the significant difference between the economic and regulatory reserves under Guideline Triple-X, reserve credit from reinsurance in offshore companies has grown at a rate greater than twice that experienced in total. Transactions between reinsurers and their affiliates account for the greatest portion of this, but the establishment of offshore affiliates of domestic insurers is an increasing trend.
George McKeon, CLU, is an assistant vice president and life analyst with Conning Research & Consulting, Hartford, Conn.
Reproduced from National Underwriter Edition, October 21, 2004. Copyright 2004 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.