Guy Carpenter: A dynamic approach to managing life reinsurance arrangements

September 27 2019

Insurers no longer need to pay for service and advisory capabilities through a reinsurance treaty.

By Matthew Rose, BEc FIAA, Managing Director; Justin Ward, Senior Vice President; and Victor Hai, BEc FIAA, Senior Vice President; Guy Carpenter, Asia Pacific

The traditional life reinsurance model typically involves perpetual treaties linked to an underlying product. To create alignment between the contracting parties, the treaty would follow the underlying terms of the product. However, the treaty structure may concurrently include provisions that reduce alignment between the insurer and reinsurer, to the insurer’s detriment. This approach is often wrapped in the reinsurer’s value proposition — providing services to support the pricing, underwriting and claims management of the underlying product.

In today’s operating environment, that value proposition is becoming less relevant as insurers now have the capabilities to develop their own customer proposition through improved access to data, market knowledge and skills for pricing, analytics and underwriting. This issue is especially relevant in Asia Pacific because of its rapid growth and dynamic economic development.

Arguably, insurers no longer need to pay a premium for value-added services. The purchase of service and advisory capabilities from a reinsurer through a reinsurance treaty is an expensive way to access these skills — even more so in mature markets.

At the same time, and of particular reference to emerging markets, is the reduced cost of capital and the convergence between reinsurers and insurers. Capital is entering the global reinsurance market from pension funds and other non-traditional sources. This capital, searching for non-correlated return rather than absolute return, is comfortable with longer-term durations and is effectively entering as debt rather than equity. This changes the fundamental return characteristics of the market as the capital moves between different classes and regions.

The current life reinsurance model has at best been managed passively; and at worst has been a set-and-forget exercise. Notably, neither approach will fully satisfy risk management, capital management and relationship management objectives. Operationally, this approach limits insurers’ ability to manage risks from a top-down perspective and actively adjust the underlying portfolio (and associated economic capital) from a strategic and tactical perspective that is reflective of a contemporary view of the risk.

This model does not adequately link strategy, risk appetite and capital management to the resultant reinsurance purchase. The way reinsurance is typically purchased is the function of a legacy process — solely because it has always been done a certain way, usually overseen by product and pricing professionals, with little understanding of the strategy, risk appetite and capital objectives of the complete organisation.

Inadvertently, these actions have resulted in increased operational risk. Multiple treaties written by reinsurers have accumulated over time and each has vastly different terms and conditions even though they cover the same risk. These treaties must be interpreted by a variety of internal stakeholders — valuation actuaries, pricing actuaries, financial controllers, reinsurance administration and product managers — creating multi-dimensional frictional costs that are not often incorporated in any profit or valuation metrics. With some insurers managing more than 30 reinsurance treaties simultaneously, and administration and valuation engines usually confined to off-the-shelf solutions, there is a greater chance of human error and deterioration of data quality.

Treaty design and implementation

Many treaties were created at the earlier stages of product development with a value proposition whereby the reinsurer co-developed the product, pricing and features. As the relationships with reinsurance partners change over time, the ability to adjust the terms of the relationship may be limited and in many cases an imbalance in the partnership emerges.

This imbalance, or misalignment of interests, results from sub-standard day-to-day management of the reinsurance programme, compounded by the fact that the treaty tends to be written by the reinsurer, not the insurer or the insurer’s intermediary. There exists a significant information asymmetry between the insurer and reinsurer related to cost of capital differentials and treaty provisions for repricing, recaptures and errors and omissions. The cost of this asymmetry emerges over the lifetime of the treaty.

At the same time, insurers lose their ability to capitalise on reinsurance pricing cycles and access more diverse capital pools. Reinsurers typically construct life treaties to maintain their margin over time — if a treaty is written during a capacity shortage the margin is higher than it would be in an environment of abundant capacity. Current reinsurance market conditions suggest that capacity is abundant in both the life and non-life sectors. However, many life insurers are not able to leverage this pricing cycle.

Despite the long-term nature of the underlying insurance policy, a more dynamic approach to managing reinsurance arrangements and adopting shorter-term/multi-year treaties may provide greater flexibility and speed in responding to industry changes such as regulatory and accounting frameworks, and a benefit from improved price discovery. Reinsurance pricing is more transparent and will better reflect the current market cycle.

Additionally, an insurer’s risk appetite may evolve over time because of societal, environmental and business climate changes. This is illustrated in the changes that have occurred in Asia over the past 50 years of enormous wealth creation and economic growth. The vast amounts of data sources that are now available enable insurers to better understand their risk and achieve a greater level of confidence in managing their risks.

Guy Carpenter is working to help reinsurers and the life reinsurance market better serve the needs of clients by curating partnerships with capital and service providers that highlight the advantages that each party brings.

Guy Carpenter’s deep market insights help clients restructure reinsurance relationships and negotiate treaties. For example, we have supported the development of reinsurance contract language for clients that enables transition out of treaties that have become less reflective of the company’s current capital needs to those that bring the best opportunities to free up capital for deployment to achieve growth.

Guy Carpenter & Company, LLC provides these responses for general information only. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only. Guy Carpenter & Company, LLC makes no representations or warranties, express or implied. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. Please consult your insurance/reinsurance advisors with respect to individual coverage issues.

The purchase of service and advisory capabilities from a reinsurer through a reinsurance treaty is an expensive way to access these skills

There exists a significant information asymmetry between the insurer and reinsurer related to cost of capital differentials and treaty provisions for repricing, recaptures and errors and omissions