Ruud van Doorn and Benoit Rio examine the complexities and challenges of customised reinsurance
Reinsurance is a powerful tool for insurers, but implementation isn't always optimal. The IFoA Life & Health Reinsurance Working Party has been considering how to improve the structuring and management of reinsurance solutions, and has drafted a paper to help practitioners make informed decisions about the development and implementation of reinsurance strategies and frameworks. In it, we set out thoughts on best practice, as well as misconceptions, inefficiencies and mistakes observed in the market, using real-life examples. While this article draws upon that work, it focuses on what is often referred to as 'structured reinsurance' - a class of reinsurance characterised by its one-off nature and customised features.
Traditionally, from a quantitative perspective, reinsurance has been used primarily to mitigate insurance risk (such as mortality and morbidity) in accordance with the risk appetite of the insurer, effectively reducing profit and loss (P&L) volatility. Due to its flexibility, reinsurance can address a wide range of needs, including funding, liquidity, profit extraction and capital management. With the arrival of Solvency II, reinsurance solutions that not only mitigate risk but also manage capital and the wider balance sheet have become more common (for example longevity reinsurance, asset-intensive reinsurance transactions, closed book reinsurance, mass lapse protection, multi-line covers, and so on). This has led to increased marketing efforts to find the best solution and providers, increased sophistication in reinsurance structuring, and an increased need for a coherent reinsurance strategy. It's essential that the insurer keeps its own key objectives in mind throughout the reinsurance structuring and purchasing process, in order to effectively progress complex transactions.
Metrics and indicators
Like any other instrument of the capital management toolkit (including equity, hybrid equity/debt, and contingent capital), reinsurance comes with benefits and constraints, so criteria to assess the 'value add' and rank different options are needed. These include quantitative financial and risk metrics, such as the targets and tolerances for the level and volatility of the solvency ratio, the implied cost of capital reduction (which can be benchmarked against the insurer's weighted average cost of capital), as well as 'softer' qualitative indicators (eg regulatory and legal risks, ease and speed of implementation, termination events, and impact on the insurer's wider strategy and future new business). The insurer needs to develop a way to take well-informed reinsurance structuring decisions, such as the use of a scorecard which takes multiple dimensions into account, including relative prioritisations. In our experience, inefficiencies often stem from assessment frameworks that are not fit for purpose at the outset - for example, they might be incomplete or lack accuracy. It is crucial to have full clarity upfront regarding these assessment criteria and any structural red lines. As an example, careful consideration needs to be given to collateral: does the insurer want its counterparty default risk exposure on a reinsurer to be collateralised - and at what level? If so, what are its expectations regarding the collateral mechanism, applicable thresholds, eligible assets, and the law governing the collateral agreement? Although it's tempting to deal with these qualitatively, the above quantified approach cannot be skipped - showing the trade-off of risk versus cost. If not managed well from early in the process, these questions can derail reinsurance transaction execution completely.
A deeper analysis
Executing structured reinsurance is a complex exercise from start to finish, typically taking longer than traditional reinsurance. This is mostly because of the need for in-depth financial and risk assessments, and the lack of precedents. Unlike traditional and 'business as usual' reinsurance, key decision-makers not only need to approve, but first need to become familiar with the mechanics of the tailored transaction. This raises the bar for internal stakeholder management, as substantial interaction is needed with the head of the business, CFO, CRO, chief actuary, head of capital management, actuarial function holder, and legal and tax personnel. Regulators expect boards not only to understand the risk transfer that takes place, but also to ensure the economic impact is reflected in business planning and capital requirements, and they need to appreciate the wider risks resulting from the reinsurance transaction (such as counterparty default and concentration risks, and reputation risk).
Furthermore, a wide range of expertise is needed during the course of the structuring and purchasing process, from objective and initial idea generation to execution and implementation: product knowledge, transaction structuring, impact testing, valuation, accounting principles, tax, administration, reporting, implementation in internal models, treaty wording, counterparty credit, concentration risk management, and so on. During this process, poor project management, lack of collaboration and absence of clarity on roles and responsibilities can lead to suboptimal outcomes, failed execution or even regulatory or tax breaches. Although the governance and project structure depends on the organisational set-up, company culture (and size), and the materiality and complexity of the transaction under consideration, structured reinsurance is often best managed as a project in its own right. For reinsurance managers, this means a skillset that goes further than what would suffice for commoditised reinsurance purchasing, in terms of communication and project management. For example, they should have a good understanding of all the details upfront and find the right balance between passing milestones and addressing details early on. An appropriate governance process, robust stakeholder management and an experienced versatile reinsurance manager help to prevent inefficiencies and misunderstandings.
In addition to internal due diligence, another key part of the exploration phase is the due diligence process with respect to the various reinsurers. This may start with broad market conversations and transition into a shortlist, before entering into exclusive discussions with a single reinsurer. It is often beneficial to start the process by approaching the market widely: reaching out to not only the big reinsurers, but also a representation of so-called Tier 2 and Tier 3 reinsurers, as well as alternative capital providers (such as insurance-linked securities managers, sovereign wealth funds and private equity firms). We observe that the 'one-stop shop' for all capital and risk transfer solutions is a misconception: the risk transfer market is highly heterogeneous, with different parties having different appetites, capital regimes, pricing methodologies, credit strengths and innovation capabilities. Intra-group reinsurance solutions deserve consideration, too: mixing risks in internally-held reinsurance vehicles can realise group P&L savings and monetise group diversification. It is worth noting that there are other key external stakeholders to manage, such as regulators, auditors, rating agencies and tax authorities - consultation with whom is often needed during the structuring process.
Reinsurance is a highly flexible strategic instrument. It can support balance sheet management and growth ambitions. The design and implementation of structured reinsurance solutions can be a complex process with many pitfalls, and so a robust framework for risk transfer, a comprehensive scorecard for measuring and prioritising the various financial and risk implications, a sound governance system, and adequate internal and external stakeholder management is crucial for successful and smooth reinsurance purchase. In our experience, this includes being clear from the outset on what we want to achieve and how this supports the company's core objectives and strategy, while ensuring there is a common view on how the opportunity will be assessed and how benefits will be measured. For insurers in today's world, maximum value from reinsurance requires that structured reinsurance is managed similarly to other strategic initiatives, rather than merely following the established processes that are in place for traditional and more commoditised reinsurance transactions. At the same time, a broad market approach that appreciates the heterogeneity of the risk transfer market must also be adopted.
It's our opinion, as a multi-disciplinary Working Party, that there is significant potential to get better value out of structured reinsurance. Addressing just a few of the points set out in the working party paper can produce substantial improvements.
Ruud van Doorn and Benoit Rio are members of the IFoA Life & Health Reinsurance Working Party.