Reinsurance - Tiller and Tiller - Chapter 5 - FINANCIAL REINSURANCE
Uses of Financial Reinsurance
- based on diffences in timing for stat of tax earnings and on stat Vx redundancy
- usually structured so only cash that changes hands is for fees or risk charges
- Surplus Relief
- most common
- to improve current stat earnings and surplus position
- creates an increase in stat surplus for ceding co in year relief is given
- repayment of relief tied to future cash flow or stat earnings on reinsured block, therefore not guaranteed
- since risk is less than if trad reinsurance, less risk charge
- Tax Plannings
- not as much as before
- company cedes, creates a taxable gain, used to offset taxable loss
- - useful if company hasexpiring tax loss carryforwards
- translates more commonly permanent than with surplus relief
- gain to ceding co is loss to reinsurer
- company might also assume reins to create a loss to offset a gain
- ceding co can usually terminate reins once inital gain repaid
- comany may ced/assume life/health to change co status to/from life/non-life company
- Strategic Business Planning
- may wish to acquire reinsurance to
- - increase future profits
- - utilize excess admin capacity
- - assist co in entering a new market
- may cede to
- - exit a certain market
- - financing in a LBO
- typically permanent in nature
- recapture typically not a provision
- normally assumption reinsurance
Terminology
- Initial Reinsurance Premium
- typically = policy reserve
- Allowances
- used to adjust effective amount of renewal premium
- initial allowance provides first year gain
- stated as % of initial premium, amt/unit coverage, or flat amt/trx
- renewal allowances may provide for ceding co commission/maint and adjust expected results to agreed upon level
- higher allowances => longer for reinsurer to recover intial strain
- Risk Charge
- portion of reins premium retained (by reinsurer) for providing reins
- normally stated in terms of amt outstanding surplus/gain
- amt depends on
- - nature of risks assumed
- - size of trx
- - reinsurer's profit objective
- - mkt conditions at time of trx
- - ceding co's stability
- - tax considerations
- - company relationships
- - reinsurers expenses for analysis, administration, or intermediaries
- historically between 1 and 5% of outstanding surplus relief each year
- Experience Refund
- mechanism to identify and return a portion of stat earnings on rens business to ceding co
- typically not paid until inital allowance is recovered (for fin reins)
- negative experience refunds are uncommon
- - if part of treaty - usually disqualifies stat Vx credits
- loss deficit carryforwards (or similar provisions) OK as long as reinsurer can't terminate treaty to force ceding co into loss position
- Outstanding Surplus Account
- used to track the defined portion of stat gains on business reinsured
- - portion after risk charge, experience refund, and int accumulated on outstanding amount
- usually can't terminate treaty while this is in a deficit position (treaty says)
- ceding co can usually terminate treaty after deficit eliminated
Comparative Model - see book beginning p 112
Plans of Financial Reinsurance
- YRT
- Vx is relatively small, therefore doesn't provide significant relief unless reinsured product also YRT
- Uses of YRT
- most common: I/S Life product where reinsurer doesn't want to be involved in accum element
- if on YRT, typically create special YRT scale as % of policy prem rates
- if on YRT, little difference from coinsurance
- for surplus relief, most effective if reins prem scale has 0 1st yr prem
- - chargebacks for lapses may be appropriate
- could be used where ceding co wants to minimize asset transfer
- OK for health policies, NOT annuities
- Advantages
- limits reinsurer investment and lapse risk (no Vx or CV build-up)
- possibly lower ongoing cost than coins if risks limited to mort or morbid
- Disadvantages
- low cash limits amout of possible future profits (therefore limits allowance/bonuses reinsurer can offer)
- allowance limits limit financial reins applications
- relatively difficult to admin IN FIN REINS situations (fin reins commonly admin on simplified basis & YRT does not work well w/ this type of admin)
- rarely used in financial reins applications
Coinsurance
- Typical arrangement: inforce block, intial reins prem = Vx, reinsurer pays allowance which provides initial gain
- future years - allowance covers ceding co maint and commission expenses
- Alt Arrangement: initial prem = initial Vx - desired gain
- renewal premiums defined w/o reference to policcy gross prem or specific expense allowance
- same effect as typical arrangement, just stated differently
- Subsequest years - reins prems (net of allowances) used to
- pay claims
- fund Vx increases
- cover admin costs
- PADs
- included a charge to reimburse for year 1 investment
- pricing done same as a product actuary used to develop product
- current mkt highly competitive, therefore little PADs in pricing
- larger allowances preferrable to experience refunds for most companies
- in financial reins mkts, pricing not so precise
- in fin reins - usually has exp refund feature
- in fin reins - uses outstanding surplus account
- Advantages
- simplest to admin on a quota share method
- regulators like because no question of risk transfer
- Disadvantages
- primary - need to transfer assets
- can be significant if large inforce block
- if IS or Par, reinsurer has control over part of the div or int rate determination
- requires reinsurer to manage the assets, subject to additional investment risk
- if reins is terminated, reinsurer must transfer assets back and could generate g/l that could have a negative impact on financials
- loss of Vx credit if reinsurer not admitted
- additional insolvency risk to ceding co (ceding co responsible for claims even if reins is insolvent)
- Coins Illustrations - text p. 122
ModCo
- popular for fin reins since ceding co keeps reserve adn assets supporting reserves
- typical arrangement: inforce block, prem = Vx on portion reinsured, ren prems = portion of gross prems, reinsurer pays allowance
- anticipated gain at end of each accounting period
- Advantages
- applicable to all plans of ins
- avoids need to transfer assets
- ceding co retains control of investment policy
- eliminated Vx credit problem
- reinsurer may deduct entire Vx increase for FIT even if Vx not otherwise qualified as tax deduction
- reinsurer avoids necessity of managing assets
- Disadvantages
- more complicated to admin than coins because of mod-co adjustment
- special transactions for surrenders and death
- transfer of assets back to reinsurer @ treaty termination can create capital g/l for ceding co
- Mod-Co Illustrations - text p 131
Funds Withheld Coins
- looks like trad coins in many ways
- impossible to tell difference when looking at intial stat gain
- only difference in initial tranaction - reins retain allowance and ceding co retains intial prem
- if allowance exceeds initial premium, reinsurer sets up an accounts payable item adn ceding co sets up accounts recievable asset
- if initial premium exceeds allowance, reverse is true
- in subsequent periods, account balance increase/decrease as profit emerges, surplus repaid, & reserves increase/decrease
- no cash will change hands until initial account balance reaches zero
- ceded co maintains assets underlying reserves, reinsurer holds reserves on fin stmt, therefore int adjustment like mod-co adjustment is made
- Advantages
- no cash changes hands initially
- cash flow minimized throughout life of treaty
- lessens ceding co insolvency risk
- if reinsurer is non-admitted, ceding co can still take Vx credit up to amount of funds it is holding
- Disadvantages
- more complicated than regular coins
- receivables and payables must be tracked carefully
- int adjustment for net account receivable (foregone int income)
- may still result in Vx credit problem if reins is non-admitted (but somewhat alleviate by amount of funds held)
- Illustrations - text p 140
Funds Withheld ModCo
- looks like ModCo in initial transaction
- reinsurer retains initial allowance and creates payable item
- ceding co sets up corresponding receivable item
- Advantages
- reins retains initial allowance, therefore no need to liquidate assets to pay allowance
- reinsurer has lessened risk in event of ceding co insolvency
- Disadvantages
- one more layer of complexity to admin of treaty
- mod-co adjustment further complicate b/c ceding co doesn't get cash
- special adjustment b/c interest not earned by ceding co on the allowance
- may be viewed as violation of Model Reg
- Illustration - text p 148
Partially Modified Coins (PartCo)
- Initial Coinsurance Vx = initial reinsurance allowance
- remaining reserve liablities reinsured on mod-co basis
- no cash transfer at treaty inception
- renewal years: proportions of co and mod-co are adjusted
- adjustment may be scheduled of may float w/ increase in coins Vx
- Advantages
- no inital cash transaction
- eliminates need to create paper a/l (necessary in funds withheld)
- Disadvantages
- main: very complicated to comprehend and to admin
- if coins reserves float w/ outstanding surplus, 2 stat gain from operatoins calcs necessary
- 1) premlim stat gain from operations needed to calc surplus repaid
- 2) final to show change in Vx from co->mod-co (or vice versa)
- Illustrations - text p. 157
Regulation and Taxation
- < 1984, very little (effective) legislation on financial reins
- used often to reclassify components of taxable income & significant reductions in taxes
- TRA84 - Sectoin 845 - IRS can change an individual tax return if signifianct tax avoidance found
- reins transactions were used to mask true financial condition of company
- therefore State DOI now looks at treaties for significant risk transfer
- treaty terms that concern
- - schedule gains to reinsurer, regardless of actual experience of block
- - reinsurer never having to pay out benefits, just building up a payment due liability
- - reinsurer has right to terminate or automatic termination if
- + reinsured becomes insolvent
- + reinsured has mgmt change
- + business reinsured proves unprofitable
- some states challenge ALL "cashless" reinsurance
- conditions to include to keep regulators happy
- - reinsurer must pay benfits at certain experience level
- - gains to reinsrer based on actual experience of reinsurance
- - no event (insolvency/mgmt changes) can automatically terminate reins (may be terminated after certain level of earnings attained or warranty voided)
- - inforce reins cannot be unilateraly terminated by reinsurer - except for premium non-pmt
- - int paid/credited s/b reasonable w/r to invemenst mkts/assets involved
- - relevant significant risks s/b transferred to reins - including capital loss, disintermediation, and asset default risks (if relevant)
- - ceding co shoudl not be forced to pay back losses except for voluntary termination
- regulators object to Vx credits or receivable credits wehre risk transferred is disproportionate to reserve credit
Security Considerations
- "cashless" reins transactions under criticism
- led to use of trusts, escrow accounts and letters of credit
- also helps protect assets, preserve Vx credits, minimizes currency fluctuations and protects other party in insolvency
- Trusts and Escrow Accounts
- trusts used to secure amounts owed from co that secureds trust to co that is benef
- equitable title to the assets is in the trustee
- commoonly used to segregate assets related to Vx of an inforce block
- most common as alternative to funds withheld trx
- escrow accounts earmark assets w/o actually transferring ownership
- typically used to support funds withheld trx
- if certain stipulated events happen, assets held in escrow are transferred
- possible events include
- surplus dropping below agreed upon level
- change in mgmt
- financial performance of reins below expected levels
- if used to secure reserve credits, Trusts subject to Model Law on Credit for Reins
- Advantages
- - assets separate and identifiable
- - investment income can be limited to performance of specific assets
- - ceding co can still take Vx credit if reinsurer not admitted
- - if recaptured, assets of trust/escrow can be used to effect payment, reducing dispute over mkt values
- - trust is true transfer of ownership -> less suspect to IRS and state regulators
- - on default, benef has right to w/d assets as a secured creditor
- Disadvantages
- - creates additional expense
- - can result in restriction on investment mgmt
- - transfer of assets to trust may necessitate recognition of cap g/l for tax purposes or current mkt values for stat stmt purposes (agreement should state which party takes the cap g/l)
- - if trust, company giving up assets will see reduction in magnitude of assets it reports
- - if an asset transfer reversal occurs, depreciation in mkt values could create surplus straing
- Letters of Credit
- most states will allow Vx credits from non-admitted reinsurer if reinsurer provides a letter of credit for the amt of the reserves
- requires very little admin
- disadvantage (from Reins view) - ceding co and draw down on a letter of credit w/o warning