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  • December 2019
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Why Coinsurance?

Coinsurance double exposure of handshake and businesspeople
In Brief

Insurers are entering into coinsurance treaties with reinsurers in markets around the world to help them mitigate asset and liability risks. In Asia Insurance ReviewRGA’s Simon Armand-Smith discusses this strategy’s use in Japan and its benefits.

Reinsurers have a variety of structures available that can help life insurers cede risk. Traditional structures such as yearly renewable term transfer biometric risks – mortality, longevity, and disability. Non-traditional structures, on the other hand, transfer investment and reinvestment risk as well as biometric risks. 

Coinsurance, also known as full-risk reinsurance, is one of the simpler non-traditional ways to transfer risk. It enables life insurers to turn over to a reinsurer the risk of either a portion of or an entire block, whether the block be new or in-force. This strategy removes the negative impact of this risk from the insurer’s balance sheets and income statements while also reducing the amount of regulatory capital it must hold. 

There are several strategic benefits coinsurance can provide for insurers. Here are a few: 

  • By reducing risk, coinsurance can help insurers reduce the amount of capital they need to hold, enabling them to return capital to shareholders (via dividends or share buybacks). 
  • It can enable insurers to release surplus margins and reduce statutory reserves, thereby improving overall capital management. 
  • It can facilitate benchmark arms-length pricing for transactions such as intra-group cross-border transfers. Insurers might be required by local tax or other regulatory authorities to show a fair market price for such a transaction. This can be done by co-insuring a small tranche (5% or 10% quota share) of the intended transaction.
  • It can also ease new business strain financing. A new type of product backed by a coinsurance treaty can inform an insurance market that a third party (namely, a reinsurer) has confidence in the future of that product. Also, if an insurer seeks to undertake a line of business in which it lacks expertise or which might involve considerable financial risk, coinsurance can pre-emptively cover that risk. 
  • Coinsurance can give an insurer the ability to send positive signals to its market. A treaty that restructures poorly performing legacy blocks, for example, can inform a board of directors, regulators, and rating agencies that positive steps are being taken to improve the performance of those blocks. 

Coinsurance’s effectiveness in addressing risk can clearly be seen by examining some recent transactions. In one case, a US-based insurer sought to release capital for deployment into alternative markets and geographies. Credit risk and investment risk had arisen for the insurer due to its investments in corporate bonds and other non-government fixed-income securities, as fixed-income investments that could match the duration of their liabilities were increasingly difficult to find – a risk which has grown given the decade-plus low interest rate environment. 

The cedant also had a block of individual payout annuities that was exposed to growing longevity risk as well. Coinsurance was able to reduce the cedant’s credit risk, reinvestment risk, and longevity risk exposures. In a second case, an insurer successfully utilized coinsurance’s full-risk transfer capability to mitigate the impact of the increase in credit, reinvestment, and longevity risk it was experiencing due to Solvency II requirements.

Japanese utility

In Japan, coinsurance is being used to help cedants enhance yields cost-effectively on negative-spread yen-denominated blocks. These are primarily older blocks of whole life payout annuities with high and unhedged guaranteed interest rates. Many Japanese insurers have such blocks. Under Japan’s economic solvency ratio framework for market risk, insurers must have high amounts of capital in order to use investment strategies that incorporate higher-risk asset classes. 

Coinsurance can ease the risk of negative spread blocks in three ways:

  • Leverage a reinsurer’s investment strategies, using instruments with a broader range of risk, to create additional yield and therefore reduce the economic cost of the block.
  • Transfer long-duration liability risk to a reinsurer, which would reduce the risk of further interest rate reductions and lower the amount of regulatory capital needed for the asset and liability duration mismatch.
  • Cede longevity risk, which reduces the risk of future mortality improvement and with it the need for increased regulatory capital.

Since in Japan coinsurance transactions generally receive full reserve credit, any positive difference between the statutory reserve valuation and the reinsurance premium is a net benefit to the cedant. As mentioned above, regulatory capital held against the block can be released, and usually more than offsets any additional capital required for reinsurer counterparty credit risk.

Another reinvestment risk reduction strategy that can benefit Japanese insurers is co-insuring two insurance blocks in a single treaty. The basic idea is to reinsure a block containing products where the bulk of future premiums are still to be paid (reinvestment risk) and a block containing products that are mostly paid-up and therefore will provide future cash outflows.

In Japan, a good example of this strategy would be to co-insure a profitable regular-pay block, such as whole life medical policies, and a mature paid-up block, such as a negative-spread whole life or annuity block. The profitable regular-pay block will have significant reinvestment risk due to the future premium inflows, while the paid-up negative-spread block will pay an initial consideration to the reinsurer, and future outflows will consist only of claims and expenses. 

The future cash outflows would help offset the cash inflows, reducing the future reinvestment risk, which in turn would reduce the capital the reinsurer needs to hold and the reinsurance premium the cedant has to pay. 

There can be positive tax implications for this strategy as well. Profits from the regular-pay block can be used to reduce the initial consideration required for the negative-spread block, which would reduce the need for a cedant to sell assets with unrealized gains in order to fund the coinsurance transaction.

Reasonable terms

When assessing how best to structure a coinsurance transaction, a good watchword for insurers and reinsurers is ‘reasonableness’. As these treaties often remain in place for a very long time – 50 or more years can be possible – entering into one with both prudent and flexible terms and investment guidelines can benefit both parties. 

With investment market volatility rising sharply, investment guideline flexibility is more important than ever. Investment guidelines determine the types of assets that can be held in the trust account that holds collateral for the treaty, and given the long terms of some of these agreements, it helps to have guidelines that will be effective for a broad range of possible economic scenarios. 

Optimising return on capital 

From the US to Europe and in markets around the globe, coinsurance transactions are helping insurers with their asset and liability risks. In Japan in particular we have recently been seeing more of these transactions, illustrating that coinsurance is becoming more recognised as a capital management tool which is suitable for a wide range of life insurance needs. 

Coinsurance transactions work best for both cedant and reinsurer when the two work together in partnership. When done well, using appropriate collateral requirements which allow the reinsurer to provide favourable pricing, coinsurance can be an effective tool for capital management as well as a part of a cedant’s overall strategy for optimising return on capital.  

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Reprinted with permission of Asia Insurance Review (AIR)