A Discussion on the State of Life Reinsurance: Part II
A Discussion On The State Of Life Reinsurance: Part II
The second part of a panel discussion on the state of life reinsurance. Jay Novik, Black Diamond Group, moderated the in-depth conversation. The panel members included: Gaetano Geretto, Pelecanus Strategic Advisory Services, Inc.; Kin Gee, Savont Corporation; Mel Young, RGA Reinsurance Company; and Mike Pado, Transamerica Reinsurance.
The first part of this discussion appeared in the October/November issue of The Actuary and covered topics such as: start-ups, supply and demand, mistakes made and more. You can find the first article on the Web at: www.soa.org, Research & Publications, The Actuary Magazine, October 2005, A Discussion on the State of Life Reinsurance: Part I.
Jay: One other issue that was brought up was other capital alternatives. I'm skeptical because I've been hearing about it for quite a while. I remember when securitizations were going to be the major alternative to traditional reinsurance as the major capital-providing vehicle through these, what was the name of those special purpose vehicles? Mel, you probably remember ...
Mel: Maple Leaf.
Jay: I think what's really protected the industry from capital alternatives is that the return on equity isn't that high, even in the best of times. And sometimes it's very low, so it's hard to come up with capital alternatives that are priced better. I think the banks got frustrated with the fact that there wasn't a big pot of money to encroach on. We do see a lot of discussion now; given that other capital offerings and other risk management offerings will replace a large portion of reinsurance business.
Mel: I don't know that we're the right audience to address that.
Jay: Somebody mentioned they thought that we were going to become one of a few choices, that's why I was bringing it up.
Kin: I was the one who was bringing up competition and potential participants. Certainly if you look at capital intensive products solutions for XXX reserves, as opposed to more traditional mortality protection, financial institutions such as investment bankers or commercial banks are providing that need and they're doing that as an alternative to reinsurance, whether it's in South Carolina, Vermont, Hawaii, Bermuda or elsewhere. They are doing special funding through securitizations where you can have security probably for 20 years. When Citibank did the first deal they were Washington National, but obviously as you're all likely familiar, Hannover Re recently had done several life securitizations and others have been done. I'm not suggesting that they're going to be a major player in the very near future, but transactions are being done and so the engineering platform is there and it would not be inconceivable that you think about the whole concept of traditional life mortality, that's a really strong basis for securitization and given the consolidation from the price increases that we're seeing, I see a potential there for some of the banks.
Mel: I don't disagree with the end conclusion, but I might disagree with how you're getting there. Despite the recent publicity received by the P&C companies in the financial reinsurance market, I believe financial reinsurance, done properly, is a better vehicle than securitization. Reinsurance takes the risks specifically on the product involved and the insurance company can take reserve credit for the risks reinsured. A disservice will have been done if the recent publicity results in shrinkage in the financial reinsurance market. Securitization transactions might then become a more viable alternative. But, if securitizers do not find an economic way to deliver their product to a wider audience, despite the intervention of a few state attorney generals, it is my belief that financial reinsurance will eventually experience a rebirth.
Mike: I think that's already starting to occur. I have the view that the rate of development has accelerated from the past, that there was a lot of talk about these kinds of transactions, but I think the time has come because almost every bank I know of has significantly added to its life insurance and actuarial support staff. It's because the banks needed it as a growth opportunity, so the way I look at it, they're investing already to take advantage of an opportunity. They must be offering a product or service that is likely related to financing the XXX reserves. Similarly, every monoline I know has added actuaries to its staff, again, an indication that they're investing to address a need. When you marry this to reinsurance, I see that at least if you're offering mod-coinsurance or co-insurance on XXX reserves, then reinsurers will be providing financing. That's why I said before, I think that companies are looking for a diversity of solutions. Ceding companies are at least entertaining discussions with a variety of banks and monolines and seeking almost any and every alternative rather than relying solely on reinsurers.
Kin: Unfortunately it was I who was pontificating on some of those things, but let me add to it. As to your comment, I do agree. I'm not just making predictions that will necessarily come true, but the technology of doing what you said is actually there. If you look at the whole issue of surplus notes, there are a number of funding vehicles that mix more company issues into a pool, such as technology for securitization insurance versus the traditional form of reinsurance. To add to what Mike has been saying, not only are the monolines, which have become the financial guarantors of the world, they are not only adding insurance expertise–I think it is reasonably well known today they are willing to take certain risks in insurance. The risks are what we would characterize as traditional insurance risks, be it mortality, substandard mortality, lapse supported risk and other things. So it's probably not a big leap of faith that at some point this whole market will settle even quicker, even though we know that this concept has been successful for 20 years or so.
Jay: I think within the past year, Bob, Doug Shair and Bill Burkleigh acquired a funeral insurance company and instead of using reinsurance the way we might have seen it used years back and the way it was used in a number of acquisitions, they securitized the future returns. I'm not an expert on securitization, but they used securitization to provide additional financing, whereas years back we would have probably used reinsurance.
Mike: And I believe they did it in record time.
Jay: In record time, right. So, that is a turn toward using these alternative markets.
Mel: In essence, the providers in these alternative markets are adopting the role of stop loss reinsurance.
Jay: You're right.
Kin: Fundamentally what you have are people who typically, in the past, would never touch this stuff. They're sort of knee deep in it now. Financial guarantee companies write a zero claim/loss ratio all the time and I don't care how much testing they do, they're on the risk as reinsurer.
Mike: And they will be assuming that there's no risk. Then occasionally, no matter how hard we downplay our financial reinsurance, when there's a loss, one wonders what the reaction is going to be.
Mel: I don't know. I have been in discussions with a number of these folks and it's interesting. You can walk into a room full of people, many of whom have come from the life insurance world. None of them have actuarial backgrounds and everyone is talking about mortality like it's a car. The premise is that since people have been dying since the beginning of time, we must have a pretty good understanding of death rates and the stability of it. A lot of them, are almost like they're fooled in some ways, that the law of large numbers applies to like 10,000 folks, 10,000 policies–fundamentally they don't feel the risk in their bones like a life reinsurance professional might. It's pretty fundamental and represents a fundamental change.
Jay: I think it's beyond the talking about these guarantees and investors, have the reinsurers been at all involved in the securities–LILACS–are you familiar with them?
Jay: Are reinsurers at all involved in those? The one I'm familiar with I think involved AIG and Berkshire Hathaway.
Mike: Yes. At one point, I think it was about a year ago, AIG did a whirlwind tour, I think of all reinsurers, attempting to get them interested in the transaction in one form or another. My companies passed on it. I'm not sure they were able to attract any other participants, I think they went ahead on their own.
Gaetano: It's been around now for about five years and to my recollection I don't know of anyone who's actually gone into that arrangement.
Mel: The only one I thought that did was Lloyd's of London.
Jay: The provider of that was a group called Goshawk and to the best of my knowledge they are out of the business and pretty much out of business. To the best of my belief, they are out of the providing of longevity cover.
Mike: I think they had a life expectancy of plus two.
Jay: They did not do well in that business to the best of my knowledge. I know that they're out of it. So I don't know who would be in that market at this point. On talking about the hedge fund business, it seems to be going over every insurance product to find ways to exorcise risk. Clearly, this is something that evidently was done with the variable guarantees. Obviously insurance companies had not priced their optionality to assume that they've got sophisticated investors playing against–they put options in for people to utilize in the course of their life changes. What kind of impact do you think we're going to see if we get a bunch of sophisticated hedge funds trying to find ways to play against the options that are built in? I know the focus would be the lapse supported products and my guess is that since they're going toward the large policies, the impact will fall disproportionately on reinsurers.
Mel: Reinsurers who are in that market?
Jay: Reinsurers who are reinsuring those last supported products.
Kin: I think Mel's comment was to the extent that some of those market reinsurance supporters may have disappeared.
Jay: We're talking about the ones that the hedge funds will be looking to pick up are ones that are in the mature mode now.
Kin: Jay, I could be wrong, but there's been a new generation during the last 12 months that have come into hedge funds, actually now backing not only the mature policies but also the new issues. While going to new issues, what they're trying to do is arbitrage from inception rather than a point in time.
Jay: Yes, but I think that's a different kind of issue. Will that really be attractive? Those policies wouldn't be attractive until further down the road.
Kin: There's always timing. I'm not sure I agree with the economists. These companies' underwriting is worse than their own underwriting that they're relying on for their economics, but that seems to be a harder market now than the traditional reinsurance business.
Jay: You're right. I'm trying to remember what it is that's appealing to them in that market. Do they just believe their underwriting is better?
Kin: I talked to a couple of the hedge funds who approached me to talk about that and I quite honestly couldn't figure it out. When you try to boil it down, almost all these senior settlements involve the same limited number of people that help and advise investors on life expectancy from the underwriting standpoint.
Jay: It's certainly the same message you've got in LILACS. You've got one of the two companies, either the company that's writing the annuities or the company that's writing the life insurance, is going to be wrong. It's an arbitrage between their two mortality rates.
Kin: Exactly. I agree with that and that's my comment from earlier. The guys they use, who by the way have no economics scheme on the table, are more accurate than the underwriters of the issuing insurance companies.
Mel: Are you sure that it's the mortality that you're talking about? I think at least one of the people I'm aware of that was in that market on the annuity end of it just thought they were a better investor.
Kin: What we're talking about is more like traditional life insurance as opposed to the investment side of things. There are other products similar to it. I think that's not what the hedge fund investors are focused on.
Mel: What I was thinking about was the people who were in the single premium annuity with a term life sale.
Kin: This is not that. This is truly better mortality.
Jay: Actually we have only a few minutes left. I'd like to just go around and give everybody a chance to ask their #1 question.
Gaetano: Since we're all actuaries on the call, I'll go with a quantitative question. How long will it take our industry, give me an answer in years, to get back to some level of equilibrium where there is a reasonable expectation between all players in the risk management supply chain leading to a stable, competitive and respectful reinsurance relationship?
Jay: My guess is that will occur for about one month every ten years.
Mel: My feeling is we're all very cynical. But when all of this crazy underwriting that was spurred on by the crazy reinsurance pricing, when that was in its heyday, I would say that, I don't know that it was a majority, but a significant number of companies, underwriters and people who are familiar with their underwriting, would say, "Hey, quit being relatively straight. You reinsurers are supportive of crazy underwriting and when are you going to stop?" So that when the reinsurance started realizing that they were doing something wrong with some reinsurance, the marketplace started getting closed down, those companies that thought they were being relatively straight were thankful. They were saying, "What took you so long?" We're sort of going along into the same pot now.
Gaetano: Mel, give me a number!
Mel: A number for what?
Gaetano: Will it take years, decades or months?
Mel: The response to your question: when will we see an equilibrium? I don't know if there ever is any equilibrium.
Gaetano: That's your answer. That's what I'm looking for–never, right?
Mel: When I first got into this market there were three significant reinsurers and they were all charging a very high price. What I'm trying to tell people today, a multiple of today's direct company term premiums, they charge by the reinsurers–North American Re, Cigna and Lincoln National, back in those days, there was an equilibrium. Now, some of the new entrants, including me, started to say, "We'll just start pricing fairly and we'll become players," and that happened. Once that happened, it was Pandora's box. I'm not sure you're ever going to see what you're asking.
Gaetano: So effectively you don't think equilibrium is possible to see again.
Mel: I doubt it.
Jay: This is one time where I think my perspective in the non-life business is useful, because the cycle of it seems to be shorter. If you look at non-life reinsurance what you see is, it goes from periods of very high returns where we get a number of startups very quickly. In one period we had companies, this was in the 80's, companies like ACE and XL formed. Looking back, fully developed returns that were extremely high, probably in the 40 to 50 percent range, to periods where reinsurers are pricing at a distinct loss. The point at which you run to equilibrium is pretty much when you're at the right fair return. We run through that almost in an instant.
Kin: I would agree with that Jay and we refer to that as the cycle. In the past, I think there was, roughly, a seven-year cycle. We saw it mainly on the property/casualty side, but that cycle disappeared almost in a heartbeat. For example, within six months after the property/catastrophe capacity dried up in 1992, several billion dollars of capital flooded into Bermuda. We saw that right after 9/11 as well. It happened very quickly. I think the capital markets and the way they're working today, that kind of cycle changes very quickly. What has happened, in my opinion is that equilibrium is now a fleeting point, a single point you pass through very quickly and I don't think it's a state in which it could be maintained for a sustained time, sort of what Jay's is saying. It may be one month or so and then new entrants, new forces or something happens that will quickly change that so-called equilibrium.
Jay: I think what happens is, that occurs as the market is moving from adequate pricing to inadequate pricing. In the non-life business you don't usually see a prolonged period where you're getting a sustained price. It usually goes from high to low pretty quickly.
Gaetano: So would you then, we still need to get Mike's answer to the question, but would you say, then, that we might be seeing more similarity in returns from life companies compared to P&C companies down the road, meaning more volatility than we have today?
Jay: The life cycle seems to be so much longer that it's entirely possible that the life business could achieve equilibrium for a period of time. The cycle seems to be quite long. I'm trying to remember when there was equilibrium in the market in the life reinsurance business. I can't remember it, other than many years ago.
Mel: You're going back to what I said.
Jay: Right. I think it's anybody's guess. But if you want a number from me, I'd say 10 years– because by then nobody will ever remember what I said today.
Mike: I think we may have already passed through the inflection point. It seems to me that–let's go back to Swiss Re's repositioning in the market and ING's exit. I think there's market pressure that allows many companies, existing reinsurers, to reconsider a position in the marketplace and attempt to address the ING opportunity as it were, because that freed up a lot of opportunity and almost every one of those companies that had ING, matter of fact, all of them, came to the market for new quoting opportunities. Every single one of those transactions was enormously difficult to prevail in because almost every reinsurer was seeking to get a prudent price. There was margin compression on the direct side that caused them to think a lot about their alternatives whether to retain risk or to raise rates or to do other things that were at their disposal. But in any sense, I think this period, this last year or so, has been a period of sanity in the market. We talked a little bit earlier about the focus on underwriting and claims management, so I would say that's very, very true. There's been, along with looking at the pricing assumptions with every deal, there's been a much greater emphasis on looking at each and every company's underwriting environment in terms of its quality of its manual, the quality and experience of its people, looking at their own control environment, like having they themselves know what kind of exceptions and errors they're making. Transamerica has taken the position that it's focused quite a bit on reaching mutual expectations on that front and so there's been a lot of time and effort thrown at defining things such as errors and defining things such as exceptions and acceptable exception rates so that if you're within it, it's not an audit finding. If you're beyond it, then it's a question. Transamerica focused a lot on administrative concerns because if you look all the way through the organization and you're writing XXX and AXXX type business, which eventually needs to be financed by someone, if you're looking toward that being a mature type of business, at some point you will need to have data standards that are far greater than what the reinsurance community used to accept in yesteryear. I think everything is tightening up on all fronts and so I don't know that, when you look at what might threaten that, if you think banks are competitive and there's a new source of cheaper costing capital, would that threaten it? I don't know. I think that banks probably have a higher standard in terms of operational control than the reinsurance companies demand. I think that won't necessarily hurt. I actually think that banks can either be perceived as competitors and collaborators and I think it will probably go toward the latter. They'll provide financing, but they won't want to keep much of the risk.
Jay: Mel, do you have a question?
Mel: I have the longstanding belief that to be successful in life reinsurance you need to have quality staff. I look around the life reinsurance business today and come to the conclusion that there are not many companies blessed with a large contingent of quality people. And I'm left to wonder, "Where will the future Jay Novick's be coming from?"
Kin: So Mel, are we going to see people who are on the life side become famous and rich doing all this stuff–and then become editors of newsletters, like Jay Novik?
Mel: To be successful in our business you need to have quality people. Where will they be coming from?
Jay: I'm not as involved as I would need to be to answer that question. It is my impression that when I think back on the people who were there when I started and I would include people like Mel. A lot of the people in the business, I did have the highest respect for them and I certainly do hope that there would be a cadre that–I agree with Mel that reinsurance is a difficult business and one would hope that there is a good talent pool that can be developed to deal with it.
Mel: I'd like to go back into some of the earlier conversation. Banks and other financial institutions are getting into the business and seem to believe it's an easier business than I think it is. It seems like a lot of these people are able to enter the market because of capacity needs. A fundamental question remains, will they be successful?
Jay: Oh, I've seen people come and go that thought it was an easy business. Kin, do you have a question?
Kin: Yes, it's an extension of what Mel has said. Obviously execution of a good business would depend on the quality of people you've got. This is fundamental to any successful business. An industry depends on providing a service or product that someone would want to buy and demand. When we look at what's happening in the whole non-insurance financial institution, we see more and more companies have stronger organizations around risk management. My question really is whether there is a need for traditional reinsurance as a tool for risk management and maybe some financing in the future. Maybe not a year or two, but five years or 10 years down the road, when the insurance industry will be dominated by the likes of AIG, New York Life and MetLife, who are very strong financially and have sophisticated risk management, I question whether some of the traditional services and products that have been offered in the last 70 to 75 years will remain unchanged and how will that get effected in the longer term?
Gaetano: Kin, I think you point out to the very real possibility that certain companies will feel encumbered by reinsurance as it is being practiced today and they will set up their own risk management paradigms to deal with these issues that used to go to the reinsurance community.
Jay: Mike, do you have a final question?
Mike: I do. I've been wondering if you were a reinsurer who contemplates denying a claim then how good is the credit for reinsurance?
Jay: This is true universally. On the non-life side its basically the difference between won't pay and can't pay.
Mel: Mike, I don't know how one can respond without disparaging one's competitors. I always find that an unwise practice.
Mike: I forgot to mention it was a rhetorical question.
Jay: I guess, Mike, unlike the life business, our business, these kinds of situations arise very frequently in the non-life business, much more complicated claims and there are legitimate differences of opinion.
Mike: Yes. There was one situation where a client said, okay, we feel that we're at risk, we don't even answer our internal chief risk management officer. How do we know when we buy reinsurance and we continue to give you premiums year after year after year that you'll pay when we have a claim? It seems that you decide after the fact, and we're very nervous that you can never articulate well enough the conditions under which you would or wouldn't pay. So, they're actually struggling to propose a solution that they themselves would know that a line of business was reviewed and once reviewed, it could be, it would simply be, the reinsurance on it would be good, in a sense, and would never after that point in time be subject to the risk that the reinsurer would not pay due to an underwriting error. They knew that the reinsurance was good on that block of business. So every quarter they would produce it, they would reinsure it, the reinsurer would have some method of reviewing all the policies and those that were subject to question would be, those that should get thrown out would be, and the rest made good going forward.
Jay: Thank you very much. Thank you all for your participation.