#220 | The Tangled Reinsurance Web – Part 3 – Coinsurance

For all of its subtleties, coinsurance is exactly what it sounds like – co-insurance. Both the direct writer and the reinsurer are on the hook for the liability, the reserves and the capital in proportion to the coinsurance agreement. But, of course, the acquisition and maintenance costs are not distributed in the same proportion. The direct writer incurs all of the commission payouts, underwriting costs, policy administration and any other associated expenses. To offset these expenses, the reinsurer pays expense reimbursements back to the life insurer. In some cases, the reinsurer even tacks on a ceding commission to the direct writer as an upfront payment. These are the core ingredients of coinsurance – risk transfer, expense reimbursement and ceding commission. Voila.

Coinsurance might sound like a pretty innocuous arrangement, but it’s an incredibly powerful tool for direct writers. Short on capital but have big growth plans? Coinsurance allows you to borrow the reinsurer’s balance sheet. Want to sell a risky product without blowing yourself up? Coinsurance lets you offload most of the risk to someone else. Want to get the advantages of offshore taxation or regulatory relief? Coinsurance allows you to get the economics of an offshore domicile without actually redomiciling, thanks to a ceding commission. Want to tap into higher yields from riskier assets without directly making the investments? Coinsurance can reflect those higher yields through experience payments. The power of coinsurance is practically limitless and, equally as important, the degree of customization within a coinsurance deal is also limitless. It’s a contract between two companies. There are some standards, sure, but plenty of room to tailor deals for particular ends. To use the analogy from the original post, coinsurance can handle every color in the rainbow – and then some.

Which is why life insurers love to use it and in much more strategic ways than YRT. As I wrote in the previous post, Northwestern Mutual reinsures the mortality risk from its Guaranteed UL, Universal Life and term blends in Whole Life through YRT and the total amount makes up $394B of the $564B in reinsured face amount. The rest, about $170B, is coinsurance and it’s entirely for a single product – term insurance (coded as XXXL). MassMutual does nearly the same thing. Their coinsured face amount is actually bigger than their YRT reinsurance face amount – $299B to $205B – and virtually all of it is on term insurance. Both firms are also reinsuring to the same general group of companies, with Swiss, RGA, SCOR and Munich taking the lead but also, strangely enough in the case of Northwestern Mutual, MetLife ($53B in face). And you might also not be surprised to hear that Guardian employs almost the same strategy, although with a bit more coinsurance for the term blends in Whole Life.

Why would these companies use YRT for the term blend in its Whole Life but coinsurance for their true, level premium term insurance products? Because true term insurance products represent a very different risk than term blends. A term blend is straight mortality risk. A term insurance product is a guaranteed premium product with a cocktail of risks that requires a triple pour of initial capital to write. It’s fundamentally at odds with the concept of mutuality, but mutual companies recognize that they have to write term to get customers covered and have a shot at future conversions. Coinsurance solves the problem. Now, they can retain a bit of the risk but push a lot of it off onto a reinsurer with a totally different set of economics and incentives. That’s the magic of coinsurance. It allows a life insurer to access, on a limited and defined basis, some of the benefits of being a completely different type of life insurer without actually becoming a completely different type of life insurer.

Which is not to say that mutual companies are the only ones using coinsurance to borrow the benefits of being a different type of life insurer. Of Lincoln Financial’s $696B in reinsured face amount, $420B is structured as coinsurance. A few interesting things stand out about how Lincoln uses coinsurance. First, there’s $102B face amount term insurance deal with Munich Re, which is one of the biggest reinsurance trades I’ve seen on any life insurer’s books. A major piece of Lincoln’s coinsurance ($178B) is for Universal Life and Whole Life, of which $56B is with Swiss Re and $97B is with Claret Re. Wait. Claret Re? Who’s that? There’s no website for Claret Re. I couldn’t find anyone on LinkedIn who works for Claret Re. When I googled Claret Re, I got a bland corporate information page from a third party. The address where Claret Re is registered is also home to thousands of other companies, according to this article. The administrator for Claret Re is Marsh Management Services. So what is Claret Re?

It turns out that Claret Re appears on the corporate organizational chart for Swiss Re as a wholly owned subsidiary. Claret was incorporated in 2014 which, probably not coincidentally, is the year when Lincoln initiated the big reinsurance trade with Claret. But learning anything else about Claret is nigh impossible. Claret is domiciled in Vermont and is an unauthorized insurer, which means it is not licensed in the state of Indiana where Lincoln National Life is domiciled. Why would an insurer choose to not be licensed in another state? To avoid the oversight of that state. Vermont is a hub for captive reinsurers that want privacy. Although Claret Re files financial statements with Vermont and you can see them on the NAIC site, they’re marked confidential and cannot be accessed by anyone other than regulators. It seems as though Swiss Re stepped up to take on a large block of risk from Lincoln but, instead of using the mothership of Swiss Re Life & Health America, they opted to use an obscure captive reinsurer. This move both shields Swiss Re from the economic fallout of losses at Claret Re but, more importantly, gives Claret Re the full suite of benefits of using a Vermont captive insurer.

Lincoln is very familiar with these benefits, which brings us to the most interesting part of the Lincoln story – its own captives. Buried in Lincoln’s tangled web of reinsurance are six Vermont captives labelled Lincoln Reinsurance Company of Vermont (LRCV) I-VII, with LRCV II dissolved sometime between the 2015 and 2016 statutory statements. These captives, along with Lincoln National Reinsurance Company Barbados and Lincoln Reinsurance Company of South Carolina, are used for the express purpose of offloading the risks of term insurance (XXXL) and Guaranteed UL (AXXX). Captive reinsurance accounts for about $170B in face $11.2B in reserves, or roughly a quarter of Lincoln’s retained life reserves. Most of these reinsurance treaties were put into place prior to the changes to AG38 back in 2012 and regulators clamping down on the use of captives, but the business ceded to those captives was grandfathered. Something like $500M of premium is still flowing into these captives and their reserve balances are still growing.

Captives were a hot topic back in the day, but they didn’t just disappear overnight. They’re still a major part of how life insurers manage capital for legacy blocks and, in some cases, new business premium. To put that into perspective, if you include the Claret Re trade, Lincoln is pushing off about $13B of life reserves into captive insurers, dwarfing Lincoln’s $8B in capital surplus. How much capital relief comes from those captives? Where would Lincoln be without them? That’s a question we won’t be able to answer by looking at Lincoln’s books. There’s just too much going on and these reinsurance treaties have been in-force for too long. If we want to see clearly how captives have changed the capital position of a life insurer, we need a test case where we can see the before-and-after effects. A small life insurer, preferably, and a mutual.

Fortunately, we have a perfect case study.