Revisiting An Offshore Operations Discussion
Revisiting An Offshore Operations Discussion
by Hank Sulikowski, Kin Gee, Robert Reale, Robert Johnson, John Tiller, Morris Fishman and Jay Novik
Much like a few ill-fated flights that have crossed the path of the mysterious Bermuda Triangle, some offshore operations have disappeared without a trace. For others though, it's been fun in the sun while sipping tropical drinks from bamboo glasses with mini umbrellas.
The January 2001 edition of The Actuary newsletter ran a panel discussion titled "Actuaries discuss reasons for growth of offshore operations." There have been major changes in the offshore market in the last three years. New faces have appeared and then disappeared. Major players have become minor players. Business plans have changed.
What has gone on recently? What has really changed and how do experts view the landscape today? We asked industry experts to participate in an update. With the benefit of hindsight, we asked more questions. Four of the original participants took part in this update, and three new experts were added.
Why do you think some companies did not achieve the success that was suggested by the original article?
John Tiller: I see two aspects. First, there weren't as many companies started as we projected. Second, the existing companies used offshore facilities and capabilities quite freely-more than anticipated.
Hank Sulikowski: Environmentally, there were a couple of factors that made the life sector less attractive. Clearly the September 11 attacks created an immediate need for non-life reinsurance, which the capital markets quickly responded to. In addition, volatility in the equity markets and interest rates at historical lows put substantial pressure on profitability and returns on the life side that made it very difficult to raise capital. These are macro observations. With respect to the players that did manage to commence operations more specifically, strategic issues caused some to reassess operations or withdraw and there have also been issues, such as poor underwriting, related to business plan execution.
Jay Novik: When we had our first conference, we didn't have specific conversation about pricing. It would seem that the expectations that were held four years ago just weren't accurate.
Morris Fishman: I think if you broke down the pricing and where expectations were not met, other than hedge funds, I'm not sure that any part of the Bermuda part of the equation did not hold up. So, the areas where returns were lower than expected were areas that were more universal as opposed to Bermuda specific.
Hank Sulikowski: I think that's where we continue to struggle today. If you look at the companies or business plans that are currently on the drawing board, whether or not they come to fruition is ultimately dependent on investor appetite for what many perceive to be a low-return business. Given the recent consolidation among life reinsurers, there are certainly investor groups that would love to stick a toe in the water-the question is, are returns acceptable?
Jay Novik: I was always a little concerned about the logistical things like marketing and due diligence from offshore. Does anyone else find that was a problem?
Kin Gee: I think it's hard to make a general statement. I believe there's some truth to all the comments made, but, like a lot of things, you have to look at it in a one-by-one situation. As a general statement, I do agree with Jay, that perhaps there were unfulfilled promises. However, even though the outcomes were similar, each situation was different. For instance, one company's strategy was to focus on the asset management side, they saw that as an advantage. Then corporate objectives changed. They went from a finite risk appetite to taking CAT risks and liability risks and so on. Probably because they thought the returns would be much greater-even though there is perhaps greater volatility and greater variance with that. Then there were companies that were in a different segment, more traditional life and so on, where it's not as much as an asset play. So, I think it's hard to make a general statement even though the outcomes are similar.
Jay Novik: I think that's a good point, Kin. Because, in one case, I think it was a repositioning to focus on higher-return business, which makes a lot of sense. In others, it seemed to be more of a realization as to losses in the business without any real refocusing. What Morris is saying, is that when you compare apples to apples, the offshore experience was not much different than the onshore experience. A lot of the differences, on the pricing level, were in the investment strategy. Is that what you said, Morris?
Morris Fishman: That's a good way to paraphrase it. You bring up a couple of other good points that are not as severe as they were, maybe, a decade ago when offshore was an unknown. Trying to deal with a customer from a distance is a handicap.
Bob Reale: Jay had asked a question about the difficulties from offshore marketing and due diligence. Certainly from a marketing standpoint you are limited in what you can do, depending on your market. My prior company had a focus on traditional life and that market is a mature market. So, on the plain vanilla stuff, it really wasn't a hurdle to get new business in the door. I think that company had most of the top 50 companies as clients. So, it depends on what it is.
Jay Novik: Did you do that through brokers or direct or both?
Bob Reale: Almost exclusively direct. Probably the biggest hurdle to that is to make sure you have the right people who already have the contacts in place. Again, it's a small industry, it's a mature market, with most of the business done, on the life side, without brokers. I think it really depends on the market you're in, whether you're going to have your hands tied or not. Due diligence is a different issue. I think that does create a bit of a problem for some of the business you acquire.
Kin Gee: I think the marketing issue is less of a problem than is perceived. While there are limitations, those limitations are generally determined by very specific terms of negotiations. Marketing in general has not seen many limitations. Although, we used to joke that depending on how strict an interpretation you use, you were almost limited to golf, lunch and dinners. From a pure business opportunity standpoint, I'd argue that there hasn't been many limitations. I think more of the limitation is that there's still a perception that despite the fact that some of the capitalization of the companies and the ratings of the company were reasonably strong, anything that's offshore is tainted. I think it took some of the companies a good amount of time to change that. At least in the business we've done, due diligence hasn't been a huge issue. It's certainly different than an on-site meeting. Again, the financial data and financial information and historical experience and so on, that hasn't been a major hurdle for us. From a marketing standpoint, we never look at being offshore as a real issue, other than the stigma that some companies have about Bermuda. Again, over time we were able to overcome that.
Bob Johnson: Bob Reale, in your comments earlier, were you addressing the difficulties that the ceding company had in doing due diligence on the Bermuda reinsurer or were you addressing the difficulties of the Bermuda reinsurer doing due diligence on the ceding company?
Bob Reale: It applies to both. It's difficult to walk into a client and do the kind of review you'd like to do, as an offshore company. It depends on your tax status and other things whether or not you're doing business in the States. I think that was the real crux of the problem. We could not go into companies on a routine basis and do the kind of due diligence one would like to do, not just on inforce blocks, but also with on-going business practices. As far as due diligence annuity, like Kin has said, we really did not have much of a problem in the types of contracts and companies we were dealing with. There was a stigma in the first year or so in getting companies comfortable with an offshore company. And smaller companies, in general, would tend to shy away from offshore companies.
Bob Johnson: The observation that I've made in trying to follow from a distance what is going on, is that it appears that there is a basic structural problem that Bermuda life reinsurers have in terms of doing the kind of in-depth underwriting and building of close relationships with the ceding companies that is necessary for a profitable operation. For some reason, that does not seem to be a problem in the P/C industry. I'm not familiar enough with the P/C industry to understand why they seem to be so much more successful in their underwriting operations than the life industry. Does anybody have any insight on that?
Jay Novik: They're on a more level playing field with the onshore companies because so much of the business for most reinsurers comes through brokers. There are a few direct writers, but that's changing because of a consolidation in the market that's creating larger direct writers. But, still, a very large portion of the P/C reinsurance business comes through reinsurance brokers. One is equally disadvantaged with the onshore operation in terms of being somewhat separated from your client by the broker. So, other than the large direct companies, pretty much any offshore reinsurer can start-up and have about the same level of contact, by way of the brokers, as the onshore companies.
Bob Johnson: Where as in the life business, with the start-up Bermuda companies, they're going head-to-head with established onshore life reinsurers that have a fairly long history of dealings with their ceding companies.
Jay Novik: Well, not nearly as much business. There are many P/C reinsurers who never do business other than through brokers, onshore and offshore. So, the ease of acquiring business that way is there and brokers are willing to go to Bermuda or London or pretty much anywhere to find good homes for the business. In addition, you tend to see more consortiums on P/C business where a broker will lay out a slip and then go around and get percentages. So, it's easier for small companies and new companies to take pieces of a slip that's set-up by a broker. I think the logistics of the non-life business makes it much easier to be a reinsurer from a distance. Now, on the other hand, when I say it's easier that doesn't necessarily mean it's profitable. A lot of the Bermuda reinsurance companies that were started were disasters. They lost enormous amounts of money, especially the ones that started off as captives of industrial companies. So, I don't know that the fact that much of the business is managed by brokers means there's an advantage to the offshore company or if it means that all of the broker market reinsurers tend to be equally disadvantaged in that they lose a lot of the direct relationship with the ceding company.
Bob Reale: I want to follow-up on Bob Johnson's comment. From an underwriting standpoint, for many of the clients we dealt with, we dealt directly with their actuary. I don't think there was much difference, if any, in the underwriting information provided to an offshore reinsurer versus an onshore reinsurer. Secondly, whether you're a start-up company, either offshore or onshore, the history is not there. You have to hire experienced reinsurance pricing actuaries to help you in that process. The key difference in onshore versus offshore in the performance of the business written, according to what I saw, is access to information regarding how a company is managing the performance of the business. As an offshore company, you're not going to be on the pulse of the company as you will be onshore.
Jay Novik: John brought up an interesting point. What he got me thinking about is that there weren't that many stand alone life reinsurance start-ups. I count four; Life & Annuity, Max Re, Scottish and Hampton.
Hank Sulikowski: I assume you're not counting companies that never began issuing business.
Jay Novik: No. There were a number of companies that did not get started, did not get financed. When I look at that and compare it to the onshore operations, basically I'm wondering-certainly Max Re and Scottish are doing well. Does anyone have any information to the contrary?
Bob Johnson: Max Re is doing quite well, but I doubt that they're doing more than a small percentage of their volume on the life side. It seems to be primarily P/C.
Jay Novik: Ok, so they've basically refocused. What about Scottish? They're still pretty much life reinsurance, right?
Bob Johnson: They're pretty much life reinsurance and I think they're selling at around 20-21 versus an IPO of 15 and a low of seven.
Jay Novik: So, when I compare that to the sales of the U.S. books of business, we've had Lincoln and CNA and there are a couple on the market, and I look at the pricing, I wonder if the offshore companies haven't been more unsuccessful than the onshore companies.
Bob Johnson: Coming back to Scottish for just a moment; they're kind of a hybrid. Essentially, they transformed themselves into a U.S. reinsurance company with a holding company in the Caymans that was moved to Bermuda.
Jay Novik: Annuity & Life Re also has a U.S. company.
Bob Johnson: Yes, but it's different in terms of focus. Scottish does virtually everything in the U.S.
John Tiller: Scottish also has a very significant non-U.S. component, and I believe that they run a lot of their business through Ireland.
Hank Sulikowski: I think it's interesting to point out that five or six years ago the capital markets valued life companies at several times book value. Current multiples are substantially lower, often close to book value or only slightly higher. We now know, with the benefit of hindsight, that the recent past was a somewhat inopportune time to launch a start-up. Rather, the environment and economics were more conducive to a period of rapid consolidation as opposed to expansion.
John Tiller: I would like to go back to comment earlier, that much of the activity is due to the onshore companies' use of offshore capabilities and facilities.
Jay Novik: That's something you had brought up earlier. There's certainly a much larger number of "offshore subsidiaries" of either U.S. or global companies. When I talk about "offshore subsidiaries" of a global, what I'm talking about is subsidiaries located in places like Dublin or Bermuda that have tax and regulatory advantages.
John Tiller: If you look at the new business written in the last four years in the U.S., you will find the majority of it is winding up offshore in some way, shape or form.
Jay Novik: Either directly or through retrosession.
John Tiller: Yes.
Hank Sulikowski: And as you said, most of it ends up not with stand-alone offshore companies, but with subsidiaries of the larger domestic companies.
John Tiller: Right.
Jay Novik: The question I have on this is, is that a good thing, a bad thing or neither? Clearly what that's doing is allowing companies to provide a tremendous amount of capacity without necessarily putting up the capital.
John Tiller: I think it is a bad thing. It has led to the industry having to accept sub-par returns along with a belief that we are getting returns that are higher than we are in reality. We have obfuscated what is really happening through the use of very optimistic assumptions and offshore capital facilities.
Bob Reale: I think my prior company was a good example of what could happen. We grew fairly quickly in the first few years-by a number of measures it was a successful operation. But the problem was that we grew too quickly and when the need for additional cash arose to fund XXX reserves, we couldn't do a planned debt offering because of other non-XXX related reasons. That put us in a hole and ultimately led to a "fire sale" of most of the business. Now, what happens to the rest of the industry at this point if they are not controlled? They may be more controlled than Annuity was, but, in any case, funding for XXX reserves could be a significant problem for the industry down the road.
John Tiller: I agree. I think it has been widely agreed upon that business, U.S. life reinsurance, written from roughly 1995 to 2002 is at a loss, or at best is resulting in returns well below expectations.
Bob Johnson: Are you talking about on a gross basis or net of reinsurance?
John Tiller: I am talking about the reinsurers. I doubt that the U.S. life reinsurance industry has made money overall. The last half of the 1990s for us is just like the whole 1990s for the P/C industry. I believe the cheap use of letters of credit on offshore capital helped fuel that loss, that aggressiveness. This is not truly the offshore issue, however, it is a derivative of the offshore issue.
Jay Novik: I think it's a broader offshore issue. A lot of our early discussion was more focused on some of the true offshore companies and your comments would encompass most of the major companies. Is the problem the use of letters of credit or is the problem in pricing, that actuaries don't count that in the way they would other capital. Who's responsible for creating the problem? I've had recent discussions about a situation with a lot of L/C capacity and what appropriate return on equity would be. My view is I look at L/Cs as equity and when I do that, the returns are pretty horrendous.
John Tiller: Yes, and the results are not good even if you don't do that. The real problem was the underlying mortality assumption. I don't think anybody would have just said, "We're going to make all of our money from offshore plays." But, it was so easy and at the same time there was so much focus on solving that problem that there was not enough focus on the mortality itself. We took our eyes off the ball.
Jay Novik: The other ball we certainly took our eyes off of was investment return. It seems to me that the offshore companies took more than their share of the reinsurance of the variable guarantees.
Bob Reale: I'd be surprised if we were above 3 percent of the market. A lot of it was reinsured to other parties. We had two contracts primarily.
Jay Novik: So, if you're market share wasn't that large, where did most of it go?
Kin Gee: The domestic was still more than half of that business.
Bob Reale: There were several onshore companies that had a sizeable GMDB exposure. Some of it was retroed out, some of it was in run-off. A couple of companies were reinsuring GMDB and then got out of it, so they do have a fair amount of run-off. I don't think that was exclusive to offshore companies.
Jay Novik: I don't think it was exclusive, it just seemed like a disproportionate share relative to market share in the other business.
Kin Gee: I'm not sure I would agree with that, because I've followed that pretty closely. I think the U.S. domestic market share from a reinsurance standpoint probably had better than 75 percent of that business.
Jay Novik: Right, but it probably had better than 90 to 95 percent of total business. It was disproportionate to total market share.
Morris Fishman: Jay, I think you're right, but I think the drivers were a couple of onshore companies, at different periods of time.
Kin Gee: Maybe I'm missing the point. Jay, when you first started talking about this and you mentioned investment, I thought perhaps you were going down a different path, that path being there are again at least two unnamed companies that originally had focused on more of the assets side as opposed to the liabilities side. GMDB is a very different animal than where I thought you were headed.
Jay Novik: Basically, if one had made assumptions that the equity market continued to grow at a reasonable pace, then these time tracks were free money. I think that there was a bet on the investment markets that went wrong. You have a good point: there were some companies that started-up with the idea of focusing on lower-risk life reinsurance combined with aggressive investment management. Those strategies were also somewhat defeated by the investment climate. Had they started-up a few years earlier, they would've probably had a very nice run.
Kin Gee: Based on what I know, I'm not sure GMDB was a big factor in the topic here. I think one company had two contracts out there, out of 100-plus contracts and there's at least another company writing it and that's still active in it and have gone through a lot of internal review and they're still very comfortable with the risk exposure they have. In fact, they're still, on both an annual and accumulative basis, making money out of that particular line of business.
Bob Reale: I think the offshore companies do have a bigger hurdle with that type of business because the funding for the reserves, as reported to the company, had to be held in trust account or provide a letter of credit. As pointed out, the cost of an L/C is the cost of capital to support the L/C, debt or equity, in addition to the L/C fees. Whereas an onshore company may have a little more latitude with its own risk profile to determine what kind of reserves there were.
Jay Novik: I see what your point is, because essentially you have a requirement to post collateral as opposed to the onshore companies.
Bob Reale: They theoretically have to post the same reserve. But, the question is, are the onshore reinsurance companies that maintain those products onshore, posting the same level of reserves that were required for offshore reinsurance companies?
Kin Gee: Bob, the largest onshore reinsurer is a New York domiciled company.
Bob Reale: Right. So, it's hard to say whether that was the case or not. Also, note that onshore reinsurers can reduce onshore reserves by retroceding, but offshore reinsurers do not reduce collateral requirements on assumed business by retroceding. Kin raised a point on the investment side. Interest rates went lower, credit spreads went higher, lower performance of some asset managers, all of those things contributed to lower investment returns, even on the traditional business. So, you had mortality that did not come as what was thought, you had expenses, especially for letters of credit that were higher than anticipated and on top of that you had an investment market that really underperformed as well. So, it was like a triple hit.
Jay Novik: To summarize, it sounds like the consensus is that the offshore companies, looking at the pure reinsurance business, probably didn't perform much differently than the onshore companies and overall the industry really did not do well for quite a few years.
Morris Fishman: I would agree with that. Maybe the fact that the Bermuda companies were being watched made it a little more visible.
John Tiller: They were being watched, I won't disagree with that. But, for example, Annuity & Life Re was new, it was fast growing and all of this business was written right in the teeth of the bad period. There was no offsetting upside. If that was the case, they didn't have the clout and the size to survive.
Bob Johnson: And, also John, there was no inforce book of business that was spinning off historic profits that could cushion the loss on the writings.
John Tiller: Right, that's part of what I mean.
Jay Novik: That was my point. If you had started-up an onshore company with comparable capital, as far as the business assumed, you probably would have achieved about the same results, plus you would have had to pay tax on your capital which would have lowered your return even further. That's assuming your business was at least marginally profitable.
John Tiller: One of my points is that if you had started-up a new onshore company during that period, you would have put a lot of the business offshore anyhow.
Bob Johnson: But, I think the point that Jay was bringing up is that because of writing in that period, you were heavily exposed to marginally profitable business with no flow of profits coming in from your historic book. And that's true whether you're onshore or offshore.
Hank Sulikowski: In a way it's almost the flip side of the P/C industry, where the Bermuda start-ups have not had to deal with legacy issues that have long been a drag on earnings for the older companies. Unlike existing companies, the life start-ups do not have the benefit of seasoned books of profitable business.
Jay Novik: It's true, overall, the legacy of life business has been positive and the legacy of P/C business has been generally negative. We're again seeing a lot of interest in the life reinsurance business, a lot of investment venture firms, discussions of specialty offshore reinsurance companies,-especially ones that are focused on reinsurance of variable guarantees. In addition, there seems to be a lot of confidence that pricing has improved, which given the consolidation in the life market, would be rational, although I've never found the life reinsurance market to be rational.
Bob Johnson: Mortality profitability always appeared marginal while the on-going trend of mortality improvement bailed out the reinsurance industry, decade after decade, until recently.
Jay Novik: I guess the question is, there is a lot interest now, do we want to go out on a limb and have higher hopes for the next few years?
John Tiller: From a distance, it looked to me like for the last 10 years the U.S. life reinsurance industry, onshore and offshore, has been willing to settle for sub-par returns. It did not have discipline around the business; it had more optimism in pricing than it had discipline in pricing. The offshore companies, to some degree or another, seemed to me to have carried on that same base optimism and probably priced in, implicitly or explicitly, some of the offshore benefits that they had, thereby driving returns even a little bit lower. The people I have talked to lately are much more disciplined. The type of money that is coming into and backing the market is not traditional insurance money. Money is coming out of Europe, for example-it is new money, private equity money. People are more disciplined about their returns. I am optimistic about the future because of that.
Hank Sulikowski: I'm reasonably optimistic, but I think there are two issues that investors need to grapple with. One is the image of lackluster returns in the life business, and the other is the prospect of a long ramp-up period as new capital is deployed. Having been involved with several start-ups, I can tell you that investor tolerance for a long, expensive ramp-up period is very limited. So, while I'm optimistic, I think we're likely to see a start-up in connection with the acquisition of a seasoned book of business that will help mitigate start-up costs.
John Tiller: Hank is basically on point-that is the preferred way. I think there are some players who are willing to look at the market as a true start-up, but it does complicate the situation.
Morris Fishman: I'm more optimistic about potential specialty lines of reinsurance in the life and annuity area than I am for traditional life, even though I'm slightly optimistic about traditional life. The returns on life reinsurance are a little bit better than where they were, but I don't know that they will be significant enough to attract outside capital. I don't know that the returns will be high enough inside the insurance industry compared to other investments, but in specialty areas, and the one that gets a lot of talk right now, GMDB reinsurance, is one area in which there currently is tremendous demand and very low supply. So, I see the potential for growth there and reasonable returns.
Jay Novik: Kin, do you think we're going to see a lot more broker activity in the life reinsurance business?
Kin Gee: That's a good question. I believe that if you look at the major brokerage houses now, the top three largest reinsurance brokerage houses all have some sort of life accident and health (A&H) practice. I think on the A&H side, a number of them had that for a good number of years. I feel the life side is aspiring too, but I think their approach will probably be very different; earlier, we were comparing the life and P/C business. It is clear on the life side, more than 90 percent of the business is written by the direct writers. I think as the reinsurance industry consolidated and as some of the industry problems they now seem to be facing (e.g., XXX and GMDB) continue to be issues, I believe more and more of the reinsurance brokerage houses are seeing opportunities where they can bring some value to their clients other than just trying to place traditional life business. Yes, I think we're seeing a trend towards that, but it'll probably be the larger reinsurance brokerage houses that can make that sort of investment into a new area.
Kin Gee is a Life/A&H practice leader at Benfield Group.
Bob Reale is former SVP and chief underwriter at Annuity and Life Re.
Hank Sulikowski is president, RE International Consulting, LLC.
Bob Johnson is former president and CEO of Hamilton Harbour Re.
John Tiller is senior vice president of Research & Development at Employers Reinsurance Corp.
Morris Fishman is consulting actuary and principal at Insurance Strategies Consulting, LLC.
Jay Novik is chairman at The Black Diamond Group, LLC.