#219 | The Tangled Reinsurance Web – Part 2 – YRT

If life insurance companies are a prism struck by white light, which represents the combined risks embedded in each policy they sell, then reinsurers specialize in particular parts of the light spectrum splaying out on the wall behind the prism. Their stock and trade are managing the specific risks embedded within life insurance contracts. During my time at MetLife, I sat through more than my fair share of meetings with reinsurance companies and the range in appetite for risk was astonishing. Some reinsurers want straight mortality risk. Some reinsurers don’t want any mortality risk but will take asset risk. Some reinsurers don’t want any risk at all (true story) and just want to make paper trades for “capital management” purposes. Other reinsurers offer up their balance sheets for capital relief, others talk up the advantages of their foreign domicile and still others are hunting for partners in strategic risk ventures. Every risk is different – and so is every reinsurer.

That’s what makes reinsurance so devilishly difficult. But, fortunately, reinsurance does tend to follow some standard forms. There are two big classes of reinsurance – Yearly Renewable Term (YRT) and Coinsurance. YRT is the simplest, by far, and what I think most people envision when they think about life insurers using reinsurance. YRT is essentially the reinsurance equivalent of a Cost of Insurance Charge. Both are an annual charge that increases over time as the client gets older. Both depend on underwriting for rate determination. Both are quoted as a rate per dollar of Net Amount at Risk. It’s a straightforward tool for straight mortality risk management, but don’t mistake simplicity for weakness. YRT is a powerful tool that many life insurers rely on to get mortality exposure scale and smooth out their earnings. Everyone knows that the law of large numbers is what makes mortality pooling effective, but how big does your pool have to be for the law of large numbers to eliminate surprises? Let me illustrate the point with two stories.

I remember one time at MetLife that we got a call from corporate treasury asking why we had an abnormal $20 million hit to earnings for the quarter related to mortality. You wouldn’t think that $20 million would draw much attention at the largest life insurer in the country with something like $1.5B in earnings that quarter, but it did because we’d only recently started to retain full risk on certain policies. The explanation of what happened was a bit uncomfortable. We’d underwritten a woman in her 60s in Florida a year before who was in perfect health but, tragically, was hit and killed by a car when she was out for a run. We were on the hook for the full $20M. People noticed. I’ll contrast that with when another claim for over $60 million came through but we’d reinsured 90% of it – and almost entirely to one reinsurer. It was a bad day for RGA.

This is why even very large companies make strategic use of YRT. Take, for example, MassMutual. Of MassMutual’s $518B in reinsured face amount representing 72% of its total in-force face amount, YRT rings in at $204B in reinsured face. But that’s not what’s interesting about MassMutual’s reinsurance treaties. The interesting part is that the entirety of the YRT treaties cover Ordinary Life, which is Whole Life and UL, and not other product types. MassMutual is clearly using YRT in a particular way and for a particular product. A different pattern emerges at Northwestern Mutual, where YRT makes up $394B of the $564B of the total reinsured face amount, but this time the vast majority of the YRT ($285B) is coded as XXXLO, which is the term rider associated with a Whole Life product. Why would Northwestern choose to do that? Simple – it’s insulating the base Whole Life products from the sheer mortality risk of thin-funded term insurance coverage. That seems like a pretty smart move. The remainder of NM’s YRT is associated with its small block of Guaranteed UL ($5.5B in face) and what is likely Universal Life but coded as OL ($103B). YRT isn’t just for mutual companies, either. Lincoln reinsures a massive $197B of face amount using YRT treaties as well, nearly a third of all of its reinsurance.

So where is all of this YRT reinsurance going? If you were to look at Northwestern Mutual and MassMutual’s list of reinsurers as an indicator of the rest of the market, and there’s no reason to believe that it wouldn’t be, then you’d see that the same 6 names make up more than 92% of the reinsured face at both carriers – SCOR, Munich, RGA, GenRe, Swiss and Hannover, in that order. YRT reinsurance is the bread-and-butter of reinsurance and the biggest players in YRT are the biggest players in reinsurance, representing 6 of the 7 biggest life reinsurers in the world. All of them sport surpluses that would put them at or near the most well-capitalized direct life writers in the US. The same goes for their net premium volumes. These reinsurers are massive by any metric. They have risk pools that would make any direct life insurance writer’s pale by comparison. That’s why YRT works. If you’re doing YRT, you better have a counterparty with a bigger pool than you – hence, the biggest reinsurers are the biggest players in YRT.

That also means that they’re the chokepoint in the mortality transfer system. If all of the direct writers are pushing some level of their sheer mortality risk to the same handful of reinsurers, then that means those reinsurers have an enormous mortality risk liability sitting on their books. To see the problem with that, think back to the metric I used in the first article of face amount to reserves. The most leveraged company on the list, Transamerica, had a ratio of 20-to-1, meaning that their reserves equated (on average) to 5% of their face amount liability. But if you dig into Transamerica’s filing, you’ll see something else you might not expect. Transamerica, although it is a direct life insurance writer, has also assumed $445 billion of reinsurance from 159 other direct writers. Transamerica is a reinsurer itself and the makeup of its reinsured business is very different than its direct business. The average ratio of face amount to reserves for assumed reinsurance is an astronomical 56.5. Both Lincoln and Security Life of Denver have also assumed substantial amounts of reinsurance ($167B and $210B, respectively) and the ratios for their reinsurance business are also sky-high (31 and 33).

The ratios are so much higher for the reinsured business because of YRT. The reason is intuitive. Think about what the ratio of face amount to reserves should be for YRT. It’s just straight mortality risk. The premium paid to the reinsurer is basically a COI rate which, as we know, is then quickly eaten up with actual mortality claims. What kind of reserve would a sufficiently large insurer be required to hold against straight transactional mortality risk? Not much at all – and that’s exactly what you see in Transamerica’s assumed reinsurance block. The face amount to reserve ratio for the YRT deals is 308, or $132B of face amount against $431M in reserves, which is something like 8 months’ worth of premium payments ($755M annually). All of this goes to show that YRT reinsurance is extremely thinly capitalized because it is extremely low risk as long as the overall pool is big enough. Except, of course, in a pandemic.

Hence, the reason why reinsurers are sweating the mortality risks from COVID far more than direct writers. A moderate uptick in mortality would completely wipe out the reserves held against these YRT deals and eat into the reinsurer’s overall capital pool. It would not be a pretty scenario. Reinsurers are acting quickly and clamping down the screws on underwriting at older ages precisely because they’re the ones holding the ultimate mortality risk. This is the hidden risk of reinsurance. Pooling individual mortality risk reduces overall mortality risk through diversification, but that only works if each individual’s mortality risk is independent from another’s. But if there are dependencies or systemic events (like a pandemic), then the benefits of diversification deteriorate and the reinsurer is left exposed to a huge amount of loss. How big? Well, let’s play back the math from the first article. If a 5% mortality event would almost wipe out Transamerica’s surplus, a 0.5% mortality event for just its assumed YRT block would wipe out more than 1.5 times the reserves for the block, guaranteeing immediate regulatory insolvency before even the first 0.1% in excess mortality had hit the books. The margin for mortality error on YRT is vanishingly small.

But what about retrocession, you might say, where reinsurers reinsure to other reinsurers? That should be the saving grace for reinsurers, but I had a lot of trouble finding evidence that retrocession occurs at a volume big enough to make a difference. Make no mistake about it – reinsurers absolutely retrocede to other reinsurers, but almost always it appears that the retrocession is to an affiliated reinsurer. SCOR, for example, has no less than 3 legal entities in the US reinsuring life blocks. In each of the financial examinations conducted by Delaware for these 3 insurers, the vast majority (as in, 90%+ except in one case) of the retrocessions are going to other SCOR owned reinsurers offshore. Every other reinsurer’s examination followed the same pattern with the exception of the US-based reinsurers which generally retained more of the risk. Retrocession serves less to minimize the risk to the overall reinsurer and rather is a way for the reinsurer to “optimize” capital and business flows, which is how it’s described in the Delaware report. But it also allows reinsurers to limit the damage of losses to an individual reinsurance entity, although there are obviously overarching agreements between the reinsurer and the parent. It’s like when a real estate developer uses separate LLCs for each individual project so that if one blows up, it won’t destroy the whole enterprise. The same arguably goes for reinsurers, although to huge and varying degrees between the firms. Reinsurers appear to have a good sense of the risks they’re taking and the strategy is to spread it far and wide, to even the ends of the earth (literally), in an attempt to disperse its consequences.

One of my favorite lines from a movie is from The Firm, when Tom Cruise’s character is about to pin mail fraud charges on the mobsters running his firm and says “it isn’t sexy, but it’s got teeth…ten thousand dollars and five years in prison for each act.” Every time I see something seemingly innocuous that packs a surprising punch, that line comes to mind. YRT certainly qualifies. It isn’t sexy, but it’s got teeth – although, in this case, the teeth are for the reinsurer.

Fortunately, YRT isn’t the only kind of business they’re writing. In fact, it doesn’t even (usually) make up the bulk of the reinsurance trades. For that, there’s coinsurance, and that’s where things really get interesting.