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The Actuary The magazine of the Institute & Faculty of Actuaries
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A common purpose

Investment banks and reinsurers offer insurers complementary services. They have both developed from different routes, the banks through asset management and the reinsurers through liability transfer. They also manage similar risks differently: the banks provide access to the capital markets and the reinsurers make use of their own balance sheets. This article looks at the differences between reinsurers and investment banks and how, working together, we can manage life insurers’ business more efficiently.

Survival
The life industry has grappled with considerable change over the last five years and will continue to do so for the foreseeable future. Now more than ever, to survive in this tougher market insurers have to have a credible strategy, operate efficiently, and effectively manage their business risks and capital base.
The financial conditions today of low interest rates, increased equity market volatility, and falling capital values has exposed the flaws in some of our products. These risks have been accentuated by higher equity-backing ratios and some promises to maintain these. All companies are weaker as a result, some have not survived independently, and few could not find purchasers. In such conditions the need to understand and carefully manage the business is even greater.

Interesting times
In future the scale and focus needed will be just as important. The environment of harder regulatory conditions, with the continuing review of existing business, a 1% expense cap, consumer-driven legislation, advances in medicine, in particular the catalyst of genetics on our rights to underwrite, etc will all make for interesting times.
To be successful a company must recognise its strengths and areas where partners can add to the business proposition. Companies can no longer do everything sufficiently well and must be open to outside ideas and support. The reinsurer and investment bank can play a major role in optimising many of the life office’s risk and rewards both for customers and for shareholders.

Reinsurers
The reinsurer is an integral a part of the insurance industry and has traditionally supported insurers with its capacity for large risks and its underwriting expertise. Reinsurers employ insurance experts, in particular actuaries, who have been recruited from the direct market and speak the insurers’ language.
Today the reinsurer provides a much wider range of services, including the research and development of new products, the provision of capital, the acceptance of wholesale risks, and the facilitation of market knowledge and information. In particular, reinsurers can improve the design, underwriting, competitiveness, profitability, and capacity of the office, as well as enhance the shareholders’ return and smooth the earnings of the business. Used wisely, the reinsurer can be a seamless extension of the direct writer, offering expert risk and capital management advice.
Term assurance is a good example where the use of reinsurance has changed dramatically over the last five years, with even the largest insurers making heavy use of reinsurance. The reinsurer provides capital to reduce the new business strain, where the return is linked to both mortality and business persistency. The expected mortality has been market tested (and there is excess capacity at the present time) and allows for expected future improvements. In addition, the reinsurer can leverage its tax basis, its lower statutory solvency, and its ability to write the business offshore where the reserving regulations are less prescriptive (and for term assurance the strains are considerably lower). These advantages can considerably increase the present value of the new business margins and have enabled market rates to fall dramatically. The consumer has materially benefited from this changing reinsurance role.

Long-term business
Reinsurers are long-term risk-takers with the business placed on their balance sheet for the contract term. These risks may be offset through retrocessions or via the capital markets (using investment banks). Given the long-term nature of the relationship, reinsurers do not aggressively seek short-term opportunities that damage their long-term business prospects. Reinsurers authorised in the UK are regulated in the same way as UK life offices. There are many reinsurers who have the highest S&P credit rating of AAA.
The long-term successful partnership between the reinsurer and insurer requires the alignment of interests and an equitable distribution of risk and reward. For some products, such as disability business in particular those written on guaranteed terms the on-going risk management will be critical and the interests of the insurer and reinsurer can diverge.

Investment banks
Investment banks are more recent entrants to the insurance industry and bring in a new range of knowledge, skills, and risk-management techniques. Investment banks have typically provided advice on mergers and acquisitions, asset management programmes and balance sheet management. More recently they have supported the development of guaranteed equity products, the provision of more effective asset liability management tools, and access to the capital markets, both to raise funds and to manage guaranteed annuity option exposure.
Investment banks offer an effective gateway to the capital markets and restructure complex insurance risks into standardised investment building blocks. The risks need to be hedgeable, which means that they have size, can be quantified (with a track record), and independently rated. In the short term this can mean warehousing risk, but they generally do not use their balance sheets as long-term risk-takers.

Broad access
The capital markets provide significant capacity and can filter risks, or raise funds across a wide investment audience. However, the advantage of this broad access also necessitates standardised, independently rated transactions, involving significant initial and ongoing disclosure.
In many cases the investment banks’ long-term relationship with the insurers is through a continual series of short-term transactions.
The investment banks do not have the same strength of balance sheet as the reinsurers and there are few AAA-rated entities.
The regulation of investment banks is different from the insurers and reinsurers and, in some cases the their disciplines are more rigorous, in particular the need to ‘mark to market’. However, there is now a common regulator in the FSA and over the long term we can expect the rules to converge.
Investment banks have now recognised that they can play a wider role in the insurance business and are also seeking to better understand the life insurers’ market and communicate more effectively. The banks are rapidly developing insurance experts and some now employ actuaries.

A common purpose
With their different histories and methods of risk management, both reinsurers and investment banks are working with insurers to more effectively manage complex risks. The reinsurers can work on both sides of the insurer’s balance sheet, in removing liabilities and raising capital.
In contrast, the investment banks work on the assets side of the balance sheet. In this case, given that regulation has placed more restrictions on asset admissibility, the instruments of the investment banks can be more effectively accessed through a reinsurance structure. This has the additional benefit of wrapping the solution within a known reinsurance treaty, instead of the less familiar investment banking contract and collateral computations. It can also enhance the financial security of the transaction.
In many recent cases the reinsurers and investment banks have worked together to solve problems. Some topical examples are:
– Mergers and acquisitions reinsurers and investment banks co-operate in providing advice to the companies on the business and methods of financing or risk control.
– Guaranteed annuities the liabilities can be capped by reinsuring the annuity options, or through the direct purchase of suitable assets.
– Immediate annuities the reinsurer can manage the longevity risks by swapping defined premiums (of the expected annuity payments) for claims (of the actual annuity payments). In addition, the investment bank can enhance the yield on the assets and optimise the matching of liabilities.
The cost of mitigating these risks provides a good discipline for the life office in setting reserves. In some cases, where neither the reinsurer nor the investment bank can offer a perfectly hedged solution, the insurer should look to avoid these risks.

Into the future
Life offices are reviewing their method of risk and capital management and are now more open to new methods of raising capital and risk mitigation. This will provide a larger role for both reinsurers and investment banks, either separately or in combination.
For the reinsurers and investment banks, their skills will become increasingly blurred and their activities will move from being generally complementary to more competitive. Some reinsurers have already set up investment banking divisions and some investment banks have subsidiary reinsurance operations. However, as for the life offices, these businesses must play to their strengths and this may still suggest that the more focused entities that work with partners will offer the best service.

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