Resetting the reinsurance market back to its core business

Claude du Plessis. Picture: Supplied.

Claude du Plessis. Picture: Supplied.

Published Jun 28, 2023


Claude du Plessis

Capital optimisation for the insurance sector has never been more important than now as industry players seek to hedge themselves against risks imposed by the prevailing local and global macroeconomic headwinds.

Unlike the risk associated with debt or equity financing, South African life insurers optimise the use of reinsurers to support their operations, and this way, reinsurers fulfil a critical support role in the healthy functioning of the life insurance sector.

Defined reinsurance as “insurance for insurance companies” by the Insurance Information Institute, reinsurance is simply a model of transferring some of the financial risks that insurance companies assume in insuring, for example, deaths, disabilities and critical illnesses, among others to another insurance company - the reinsurer.

Typical of all binding agreements, this becomes “a contract” between a reinsurer and an insurer. Under this arrangement, the insurance company, known as “the cedant”, essentially hands over part or all of its risk to the reinsurance company.

The latter then assumes all or part of one or more insurance policies issued by the cedant, who pays a reinsurance premium in return.

Often life insurers will source conventional reinsurance of various kinds, primarily to reduce their risk, thereby decreasing the volatility of earnings and improving solvency levels.

Proportional reinsurance can be on a quota share basis, where a fixed portion of the risk is reinsured, or on a surplus basis, where the excess of the sum assured over a fixed rand level is reinsured, or a combination thereof. Other options involved when structuring reinsurance are using the insurer’s premiums and sharing them, which is called “Original Terms Reinsurance”.

The other option is for the reinsurer to provide risk premium rates to the insurer, known as “Risk Premium Reinsurance”.

Non-proportional reinsurance only pays out in extreme events, such as an accumulation of claims from a single incident, a catastrophe, or a mass lapse by policyholders who give up their policies.

Financial Reinsurance (Fin Re), or Alternative Risk Transfer reinsurance (ART), is another form of reinsurance with various uses.

Uses of Fin Re include the release of embedded profits in a book of policies, freeing up capital requirements for a book of policies, or providing upfront financing to cover acquisition costs of the insurer (such as commission paid to brokers/agents, marketing, system/call centre set up costs, and so on).

When looking at an insurer’s balance sheet following an in-force embedded profit release Fin Re treaty, the insurer’s future value of profits and cost of capital would both drop, but their net asset value would increase. That frees up cash to fund projects or dividends to shareholders.

ART can see a set of fixed pension (annuity) payments being swapped for a set of payments that depend on the survivorship of the pensioners. This is called a longevity swap. Or, a level book of pensions being swapped for one that increases with inflation. These sorts of reinsurance arrangements remove risk from the insurer.

By sourcing reinsurance, the insurer can get support across multiple areas from the reinsurer. These areas include Life insurance product development, pricing of products, underwriting (the processes to accept a Life onto the books and/or the processes to assess claims on the Life insurance policies), and experience studies (such as the disability experience across the Life insurance market).

Reinsurers may retrocede, that is, pass on some of the risks, to their parent company offshore or to other reinsurers in the same group. Some risks are also unusual or large and can be retroceded to Lloyds syndicates in London.

Insurers can benefit from premium rebates, also called reinsurance commission, which is designed to cover the higher level of costs at the insurer compared to the reinsurer when assessed on an expense-to-premium ratio basis.

Reinsurers may also offer a profit share (reinsurance profit commission) whereby profits on the reinsurance placed with them are partially shared with the insurer.

South African reinsurers report financial results on various bases. Local requirements are IFRS 4 and Solvency and Assessment Management (SAM) bases. A significant number report on Market Consistent Embedded Values basis (as prescribed by CFO Forum in Europe).

The liabilities in the balance sheet often show significant levels of Incurred But Not Reported (IBNR) claims reserves due to delays from end policyholder claim event to insurer notification and delay to reinsurer notification. There is a need for estimates (pipeline estimates) of income and outgo as reinsurance accounts prepared by insurers take time to prepare after a period end or are bi-annual or annual reinsurance accounts requiring intra-period estimates.

Reinsurers value their books using valuation systems (examples being MoSes and AXIS), Excel spreadsheets, databases/in-house systems.

Enter the IFRS 17, a new accounting standard for insurance contracts that applies to the financial year ends starting from 1 January 2023 or later. Many reinsurers have spent significant resources preparing to transition from IFRS 4 to IFRS 17. Most are in the testing or post-implementation phases.

*Claude du Plessis is an actuary at The Shard with over 19 years of experience in the Life insurance sector, covering financial reporting, capital modelling and pricing, including extensive reinsurance experience.

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