Capital Solutions
Health Structured Reinsurance
Reinsurance Actuarial Solutions specializes in capital motivated reinsurance for health plans, but these same principles can be applied to other structured reinsurance solutions for health or other insurance products.
For health, structured reinsurance is typically a capital motivated transaction that uses coinsurance with experience refund and loss carryforward features. The coinsurance cedes the risk driving capital requirements, while the experience refund allows the ceding company to retain profit on the business (less a risk charge for the reinsurer) and the loss carryforward allows the reinsurer to recover potential losses through future profit on the reinsured business (if they emerge).
The reinsurance is designed with the expectation of being a multi-year arrangement. Some companies use this reinsurance as part of their capital management strategy; they maintain a certain level of reinsurance for capital financing the same way that they maintain a certain level of long-term debt.
AM Best Health Reinsurance Report - August 31, 2023
More companies are using reinsurance to enhance financial flexibility. Reinsurance allows health insurers to free up capital and use it to cover operational needs, expand vertical integration capabilities, maintain debt service, and return to shareholders.
Structured reinsurance offers an opportunity for capital relief and greater financial flexibility. It can be used to fund part of the capital structure but, unlike debt, does not impact financial leverage.
Primary carriers can use structured reinsurance to write more premium or free up capital for other purposes – M&A, investing in the business, returning to shareholders. Structured reinsurance can also allow the primary carrier to meet risk-based capital requirements without turning to more expensive sources such as borrowing.
Frequently Asked Questions
Evaluating this reinsurance
Purchasing reinsurance, particularly structured reinsurance, involves asymmetrical information, where the reinsurer has more experience and knowledge of the reinsurance solution than the ceding company. An experienced broker with knowledge of these transactions can help balance that knowledge gap for the ceding company.
A reinsurance broker can provide valuable insight, illustrations, and presentations to help the ceding company understand this reinsurance and its application. This may involve working with the treasurer and/or CFO level, but may also involve finance, actuarial, reinsurance administration teams, and/or board approvals.
A reinsurance broker can then prepare an RFP package including all of the necessary data for reinsurance markets to underwrite the transaction. An experienced broker can also support a ceding company on their analysis of admin expenses to confirm what is needed for a ceding allowance to cover anticipated renewal expenses on the business reinsured.
A reinsurance broker can leverage their market knowledge and contacts to create a competitive bid process and drive the best pricing on the transaction. A reinsurance broker with the right expertise can also support the contract and regulatory review process.
A reinsurance broker can also ensure that an existing program stays up-to-date with any improvement in market pricing, any changes in reinsurance market capacity, and any regulatory changes.
Reinsurance Actuarial Solutions provides the highest level of service to our clients on their structured reinsurance solutions.
Most of the time it’s the Treasurer of a ceding company that is evaluating the capital benefit and cost for this reinsurance.
Premium and claims ceded to the reinsurer reduce the RBC calculation for the ceding company. The ceding company should run their RBC model with the net premium and net claims after reinsurance to determine the impact to their RBC. The ceding company then is required to hold less capital to maintain their same target RBC ratio, since they retain less business and have less risk.
Profit is returned to the ceding company through the experience refund, so the cost for the reinsurance is ultimately the reinsurer risk charge. That cost of reinsurance can be measured against the capital benefit and translated to a cost of capital, then can be evaluated versus other capital financing alternatives.
These reinsurance programs can be used across any health product by any health carrier to improve capital management by ceding the underlying risk. Some examples include:
- Capital strain from growth can be supported by ceding risk on that business while still allowing the ceding company to expand operational scale.
- Capital strain from losses in one part of a company’s business can be offset by ceding risk from a different segment of profitable business.
- Large health carriers can often benefit from ceding risk on segments of their business to reallocate capital to other corporate capital management initiatives.
- Non-profit health plans and mutual holding companies can cede risk on their business to provide a flexible alternative capital financing tool.
Reinsurance provides notable advantages over traditional debt financing:
- Capital synchronization vs fixed schedule. If an insurance company is looking to finance capital for growth, quota share provides direct alignment with the ceding company’s RBC capital requirements. Unlike typical debt, with its time-triggered repayment schedule, this architecture not only optimizes capital management but also eliminates interest payments on idled cash, lowering real interest costs.
- Adaptive vs static. Reinsurance can have the flexibility to adjust the quota share, responding to shifts in capital needs. Unlike traditional fixed-amount and fixed-term loans, quota share can be adjusted with a simple amendment, offering a level of adaptability crucial for optimal business results.
- Operational freedom vs restrictions. Reinsurance does not impose the restrictive covenants typically found in corporate loans or venture debt. These restrictions often limit a company’s operational and financial decisions, requiring the maintenance of certain financial ratios or seeking lender approval for specific actions. Reinsurance provides flexible off-balance sheet financing, without the impacts of leverage (debt) or dilution (equity).
- Liquidity cover in a loss event. The reinsurance will pay its portion of claims, providing liquidity during a loss event. Any capital that would have otherwise been needed to pay the quota share portion of claims is being paid by the reinsurance. Whereas a loss in capital would need to be directly recovered to maintain the company’s RBC ratio, the liquidity cover from reinsurance is only recoverable from future reinsurance profit if it emerges.
- Fixed rate vs changing interest rate environment. The reinsurance risk charge is a fixed percent of ceded premium. That risk charge is set when the reinsurance is put in place. It is a function of the capital the reinsurer holds on the transaction and has no correlation with interest rates. There is no renewal process whereby that risk charge would change. The only way the risk charge would change would be through a mutually agreed amendment. Depending on the interest rate environment and economics of the transaction the cost of capital from reinsurance is usually cheaper than traditional debt financing.
There are still benefits to having this reinsurance in place as part of a company’s broader capital management strategy even if there isn’t an immediate need. The flexibility of this reinsurance can allow a ceding company to set it up initially at a low quota share at minimal cost, thereby having it in place to increase the quota share if/when the need arises. This provides the following advantages:
- There is always an internal learning curve for the ceding company management team to understand this reinsurance and its potential applications. Setting up a program at a low quota share allows the ceding company to understand first-hand the mechanics of the reinsurance and financial benefits, with minimal commitment. Having that first-hand knowledge will allow the ceding company to understand how they can take full advantage of the reinsurance within their organization.
- It is a much simpler process to increase the quota share on an existing program than it is to set up a brand-new program. There is work involved in implementing one of these programs, both in terms of having the reinsurer underwrite the transaction, and finalizing the contract (including review with regulator / auditor / legal counsel). It is also beneficial for the reinsurer to have an existing relationship with the ceding company and familiarity with their business. Ultimately these transactions work best as long term partnerships on both sides.
- Reinsurance is a valuable alternative capital financing tool that every insurance company should consider alongside traditional capital financing options as part of their capital management strategy. It provides a diversified source of capital financing that has notable benefits. If an insurance company is not using reinsurance as a form of capital financing, they are likely missing some capital management efficiencies within their organization.
Risk transfer
Each state regulator has adopted laws consistent with NAIC model regulation A791, which lists the risk transfer requirements to use statutory reinsurance accounting for life and health reinsurance. Every company should complete a statutory risk transfer analysis to demonstrate that the transaction meets the requirements for statutory risk transfer and will follow reinsurance accounting for their own internal governance, and it is a good practice to communicate the same with their auditor and state regulator.
Reinsurance Actuarial Solutions has extensive experience with statutory risk transfer analysis and can guide our clients through the process.
It is important to confirm that the experience refund and loss carryforward are not risk limiting provisions. A risk limiting provision is such that it would limit the reinsurer’s losses below the stated reinsurance ceded percentage (e.g. deductible, loss ratio corridor, loss cap, aggregate limit or any similar provisions) which can cause the ceding entity to retain a proportion of the losses which is greater than the proportion of premium and risk ceded.
The experience refund allows the ceding company to retain profit when the program is in a profitable position (less the risk charge and recovery of any prior loss carryforward). The experience refund should be settled quarterly, there should not be any experience account retained by the reinsurer that would contribute to the consideration paid to the reinsurer and therefore mitigate the total loss to the reinsurer.
The loss carryforward should only be recovered through future profits on the reinsured business (or voluntary termination of the ceding company). Recovery of the loss carryforward should only reduce the experience refund and should never limit the reinsurer’s losses below the reinsurance ceded percentage.
For risk transfer, it is important to ensure that the loss carryforward is appropriately handled upon any termination of the reinsurance contract. The loss carryforward should only be repaid at the option (or optional termination) of the ceding entity. Voluntary termination by the ceding entity does not include situations where termination occurs because of unreasonable provisions which allow the reinsurer to reduce risk under the agreement. For example, the reinsurer should not be allowed to increase premiums or risk and expense charges to excessive levels forcing the ceding company to prematurely terminate the reinsurance treaty. The loss carryforward should never be repaid at the reinsurer’s option or automatically upon the occurrence of some event.
No. Every insurance/reinsurance transaction will have a “loss attachment point”. For any coinsurance transaction that loss attachment point is the point where claims exceed premium less the expense allowance. A coinsurance loss attachment point is similar to an aggregate stop loss attachment point, but that does not change the fact that it is still a proportional first dollar quota share in terms of payment of claims. While the experience refund limits the reinsurance profit to a fixed risk charge, a coinsurance contract with an experience refund is still a proportional first dollar quota share in terms of payment of claims.
A coinsurance agreement with a loss carryforward is also a proportional agreement as long as recovery of the loss carryforward will only reduce the experience refund and will never limit the reinsurer’s losses below the reinsurance ceded percentage.
This reinsurance is designed with statutory risk transfer in mind, not necessarily GAAP. Typically, these transactions do not pass GAAP risk transfer and will use deposit accounting for GAAP.
GAAP accounting is focused on the concept of “going concern”, which assumes that the company will continue to operate indefinitely and therefore emphasizes the company’s long-term expected profitability. It makes sense under a going concern assumption to view any loss from this reinsurance as ultimately recoverable from the loss carryforward. Under GAAP accounting, assets and liabilities are valued based on their expected future cash flows. The emphasis is on providing financial information for long-term decision making by investors and other external stakeholders.
On the other hand, statutory accounting is primarily focused on solvency, which means that the company can cover its liabilities and potential losses and is able to meet its financial obligations to policyholders. From that perspective the focus of statutory risk transfer is on ensuring all significant risk is transferred and nothing is limiting the reinsurer’s losses below the reinsurance ceded percentage or causing the ceding entity to retain a proportion of the losses which is greater than the proportion of premium and risk ceded. Statutory accounting emphasis is on providing financial information for regulators on solvency.
While both GAAP and statutory accounting are important for insurance companies, they have different purposes and focus on different aspects of the company’s financial condition. It makes sense for the risk transfer requirements under each framework to differ as well. GAAP risk transfer requirements focus on future expected cash flows whereas statutory risk transfer requirements focus on covering immediate liabilities and potential losses to meet financial obligations for policyholders.