LOSS PORTFOLIO TRANSFERS AND CAPTIVES

Captive Review: Loss Portfolio Transfers and Captives - Q Akbar

With Solvency II now a firm feature of the European insurance landscape, insurers, reinsurers and brokers have looked for ways to enhance risk management systems, pricing processes and to develop new and innovative ways to generate profitability and ultimately manage their capital more effectively.

Easier said than done most of you are thinking… but wait (he asks) – how can loss portfolio transfers help?

Although a subject that doesn't often come up, LPTs are a valuable vehicle for risk carriers in certain situations.

LPTs were originally developed as a type of reinsurance, through which primary insurers could transfer liability for specified blocks of reserves to a reinsurer, thus enhancing the ceding company’s balance sheet without necessarily transferring underwriting risk.

As the financial liability for the losses are transferred to the reinsurer, the insurer does not have to show it as a liability on the balance sheet.

Reinsurers are normally left with risk transfer, timing or investment risks from these deals depending on the comparison of the treaty limit with the amount of reserves being transferred; however many of the new deals we are seeing are typically on a funds withheld basis.

Given the challenging capital environment faced by many insurers, the reinsurance market is ripe for carefully structured LPT deals.

Can a Loss Portfolio Transfer (LPT) contract be a solution?

Properly considered, LPT reinsurance is a winning deal for buyer and seller.

How they work

More and more, we are finding traditional risk carriers employing LPT contracts to manage their capital as opposed to alternative approaches such as sub-debt, buying traditional reinsurance or reducing business volumes.

Why would you do this?

Let’s suppose you’re a motor insurer looking to release capital to explore a new product range, or you have other growth plans. Ultimately, motives for employing such a contract range from reducing risks and freeing up resources to simplifying corporate structures and making administrative savings.

From ceding losses from insurers’ balance sheets to providing capital relief under Solvency II, LPT contracts appear to be increasing and for good reason.

What’s more…if the reinsurer is of a strong credit rating then the security of the policyholders can be strengthened.

Designing the deal?

The story goes something like… “There was once an insurer, a broker and an (actuarial) consultant…….and a reinsurer, another (actuarial) consultant, a regulator and an accountant…”

Whilst each of them was unclear about the overall picture, the broker thought of portfolio transfers as just adverse development covers, whilst the regulators views focused on policyholder protection and the actuarial consultant was busy wielding her sorcery to model the impact of the deal. Through the rigmarole of toing and froing to agree on a price and mutually acceptable contract, the virtuous cycle continues until all parties converge on the terms and makeup of the deal.

Small to medium sized insurers are faced with the choice of sticking with a standard formula which (potentially) inadequately reflects their risk profile and thereby overstates their required capital, and the expensive choice of a (partial) internal model for a bespoke calculation of their capital requirements.

A properly structured LPT contract could be a nice compromise. Effectively borrowing the balance sheet of a mainstream and well rated reinsurer, insurers are potentially able to lower the volatility of the premium and reserve risks (and associated volume measures) to reduce the capital required under the SII standard formula.

But wait (again) - sounds a bit too good to be true? The caveat to this sophistry is that there can be no “gaming” of the system. Insurers and reinsurers must demonstrate that the deals they enter in to provide sufficient risk transfer and are considered firmly against the background of the Solvency II standard formula.  

Furthermore, a well-designed LPT deal may bring some risk aspects that do not fit within the standard formula into line with standard formula requirements, thereby avoiding the need for regulators to apply a capital add-on.

What about modelling these deals (under Solvency II)?

Key Contract Features

Without getting too technical, we recognise that the standard formula assumes that losses conform to the so-called lognormal distribution.

So, in order to stay on the right side of the standard formula, losses faced by an insurer can be simulated using the standard formula guidance to assess the impact of the LPT contract.

Some key considerations of the contract include:

• Is the deal on a risk attaching or loss occurring basis?
• Will funds be ring-fenced or transferred to the reinsurer?
• Are you planning to commute the deal at some point later?
• Does the deal add or reduce uncertainty on your balance sheet?
• What is the added value and how is it demonstrated?

Depending on the answers to these questions, we are able to appropriately model the impact of the deal on all aspects of the standard formula and ensure that the post-deal position does not violate the standard formula concept.

Solvency II is in many ways a ‘volatility around best estimate cash flow’ driven concept and deal design needs to be framed upon this concept in order to demonstrate to all parties that the benefits are real.

Stakeholders include the likes of the cedent, the reinsurer, the Actuarial Function Holder (AFH), the auditors, the regulators and, not least, the reinsurance broker who is facilitating the deal.

Win-win for all as I mentioned earlier!

What do you need to think about when modelling these deals?

Clearly the cost of the deal is a consideration but equally the potential benefits and requisite structure and design of the LPT contract is a key factor.

For example, an LPT deal on a risk attaching basis can not only provide reserve risk reduction but also benefits under the premium risk measure. Certainly worth considering where the business is volatile.

It is worth noting that the standard formula risk charges still apply after the deal is in place. Where you find there is volatility reduction, there may be scope to consider undertaking specific parameters (USPs).

How does all this help Captives?

Corporations began considering portfolio transactions as risk volatility started to mount for self-insuring organisations in the 1970s and 1980s. By the 1990s, these organisations had realised that they had taken on risks that they had not bargained for and as such, they went to the loss portfolio transfer market to cede these liabilities.

Despite the low-interest rate operating environment, properly designed loss portfolio transfers are still a valuable risk management option for companies that have assumed a significant amount of risk over a long period of time, built up large loss reserves or taken on risk subject to significant volatility.

Businesses typically look at finite risk contracts when they want to smooth out the peaks and valleys of claim payments in a self-insured program. By spreading out their financial risks over scheduled premium payments they are able to better budget these expenses.

Firms looking to discontinue a product or business operation, going out of business (or run-off), or merging with another may see such a transfer as a way to clear out liabilities that it no longer wants to or can manage.

Some of the key questions asked by insurers and captive managers include:

• How can we minimise the cost of financing our company – are there capital relief options available?
• How can we create optimal diversification options in our captive – can we balance the level of risk we’re taking?
• Do we fully understand the insurance risks we’re facing and do we have the expertise to manage them?
• How much capital do we need in our captive?

LPT contracts offer a solution to the above questions if they are designed and structured correctly.

Retroactive reinsurance arrangements are a normal and healthy part of this dynamic and competitive insurance market offering many benefits to insurers and policyholders.

Where all concerned parties work together to provide a balanced structure, the deals can add great value in achieving profitability for all stakeholders and allowing the insurance industry to flourish.

“The information contained in this article does not constitute advice. The author will not accept any responsibility for decisions taken or not taken on the basis of the information presented.”