#237 | The Tangled Reinsurance Web – Part 6 – Through The Maze

At last, we’ve come to the end of this series that attempts to untangle the tangled web of reinsurance. It seems like an eternity since the first article was published at the end of April. What have we discussed so far? Here’s a quick overview of the pertinent conclusions:

  1. COVID isn’t likely to be a material mortality hit for life insurers but, if it is, then reinsurers are going to be the ones picking up most of the tab. That’s a real problem for reinsurers who were doing a lot of YRT because YRT is thinly capitalized, which creates a very low margin for mortality deviations (Part 1 and Part 2 – YRT)
  2. For most insurers, however, YRT makes half or less of their reinsurance. The rest is coinsurance, which is a different animal because the full liability and reserve (usually) flows through to the reinsurer. (Part 3 – Coinsurance)
  3. The direct impact of the coinsurance is a stronger capital position at the ceding life insurer because of the historical (and potentially even current) gap between formulaic reserves and so-called “economic” reserves, particularly for Guaranteed UL and Term. For captives, economic reserves are satisfied with hard capital and the remainder can be “soft” capital like letters of credit or trust agreements (Part 4 – Coinsurance & Capital)
  4. As a result, most of the biggest writers of Term and Guaranteed UL reinsure those blocks to captive reinsurers, which pushes more hard capital up to the ceding life insurer on the rationale that the capital isn’t required to support the liabilities. (Part 5 – The Power of Coinsurance)

Now, why does this matter in the time of COVID? I wrote in the original article for this series that “even if [COVID] isn’t a mortality crisis, it’s still a reinsurance crisis.” Should COVID impact mortality experience, the tangled web of reinsurance is going to dictate where that blow lands and, in all likelihood, it’s going to mostly concentrate up to the third-party reinsurers. But that’s hardly the end of the story. COVID has the potential to be a mortality crisis, but it is already an economic crisis – and that’s where reinsurance really comes into play.

Think about the setup of these complex reinsurance structures. How can captives transform reserves into capital? By holding less reserves against the liability and plugging the gap with financing tools or off-balance sheet parental guarantees. These lower reserves are based on “economic reserves,” which is a view of the future liabilities of the product under certain lapse, mortality and asset yield assumptions. As I wrote at the end of the last post, captives magically transform formulaic reserves into deployable capital, but only on the assumption that the true liability is less than the formulaic liability. What happens when interest rates drop, lapse rates drop or mortality goes up? The economic reserve will also increase. A captive suddenly needs its capital back.

But where did all the capital go? Up to the mothership life insurer, where it was then deployed to write new business, pay stockholder dividends, make an acquisition, shore up the overall capital position, you name it. It’s accounted for. A casual observer might look at a life insurer’s balance sheet and see, say, $5 billion in the “unassigned surplus” account and think that it’s free-and-clear cash, but that’s obviously not the case. Life insurers hold capital to keep their financial strength ratings. Even “unassigned” surplus is assigned. If it wasn’t, it would have been distributed to policyholders or stockholders in the form of a dividend. Even life insurers in a very strong capital position can’t afford to just dip into their surplus to shore up new economic reserve requirements cropping up at their captives. It has to come from somewhere else.

That’s why life insurers have to use “soft” capital to fund the difference between the economic reserve and formulaic reserve in the captive. What is soft capital? The definition is, well, a little bit soft. It could be a letter of credit from a major financial institution. It could be an agreement with a separate trust with an unclear asset mix. It could be some form of securitized note. Or, as is the case with the vast majority of these deals, soft capital could come in the form of a “parental guarantee” where the non-life insurer holding company (think MetLife, Inc) guarantees the liability. That’s like an arrangement where someone is taking out a second mortgage on their house uses their husband as the co-signing guarantor. The husband and wife might not have perfectly comingled assets but, at the end of the day, the family unit is still on the hook.

In an environment like this one, where it would be rather difficult for anyone to argue that the economic reserves for these products haven’t gone up, soft capital has to become hard capital. These structures will be put to the test and, for some insurers, in a very serious way. We just don’t know which insurers and we don’t know to what degree. The odd thing about captives is that you really have no idea what’s in them and why they’re capitalized they way they are. Some insurers might have used more conservative economic assumptions to set their reserves and, therefore, are prepared for a situation like this one. Other insurers might have used really aggressive economic assumptions and are staring down a huge capital hole. Who knows? I certainly don’t. And neither do you. And, very likely, neither do the rating agencies or state regulators.

Captives might have magically created capital on the front end, but now they’re potentially going to magically suck it back up. The problem isn’t just for life insurers selling Term and Guaranteed UL, either. It’s also a problem for third-party reinsurers. The assumption that most folks have, including myself prior to writing this series, is that third-party reinsurers also have retrocession agreements with other reinsurers to offload the risk. Technically, that’s true. They do have their own reinsurance agreements to offload the risk to other reinsurers. But practically speaking, retrocession in life insurance is actually pretty rare. Instead, those retrocession agreements are to captive insurers established by the reinsurance company and usually in friendly jurisdictions because reinsurers tend to be truly global enterprises. The tangled web of reinsurance isn’t just about direct writers. It’s also about the reinsurers themselves and their own tangled web of captives and capital.

There’s also something of a myth going around that captives aren’t really important anymore. There was a lot of industry attention on captives back in 2013 arguably kicked off by then-NYDFS Superintendent Ben Lawsky’s white paper on “shadow insurance.” The New York Times ran an article in 2015 on captives that clearly detailed how life insurers were using capital to game reserves. But that was 5 years ago. Now, life insurers use Principles Based Reserving (PBR), which is theoretically reflective of an “economic” reserve, so there shouldn’t be a need for captives anymore. Right? Not necessarily. Captives are still growing because of recurring premiums whether the life insures like it or not. These are long-term liabilities and long-term structures. But captives can even come into play in a world of PBR because there is a floor scenario for the reserve that might still be higher than what the life insurer deems as the true economic reserve. The margin to reinsure won’t be as big, for sure, but it may still be there. Captives are still very much a pressing issue for life insurers, regardless of whether or not they’re in the news.

Now, here’s why you should care. Captives are immensely important to the life insurance industry. That much is clear. What is also clear is that their capital contributions have fueled an immense amount of growth at life insurers. Witness the simple example of PennMutual on a small scale – just a couple of billion in reserves. Imagine that same fuel being dumped on the fire at Prudential with a gargantuan $40 billion of reserves in captives backing Guaranteed UL and Term. What happens when the flow is reversed? Imagine a fire burning back up into the fuel line. What happens next?

That’s why COVID is a reinsurance crisis no matter what. If it results in a significant but manageable mortality event for life insurers, it will be a catastrophe for third-party reinsurers where hundreds of billions of dollars of thinly capitalized YRT reinsurance sits. But if COVID ends up being primarily a significant economic event where Treasuries drop to zero and credit losses abound, then thinly capitalized captives relying on soft, contingent capital like parental guarantees will become black holes into which life insurers will have to throw money to keep them solvent. The reality is that virtually every major stock company and a few scattered mutual companies are propping up their financial strength with captives. Now is the first real test of the strategy. No time in the past 12 years since the financial crisis have life insurers been faced with a current economic environment like this one or anything even close to it. Will this captive strategy survive? Will the companies that are relying on captives be able to stem the losses? Only time will tell.