Optimal use of capital has become a regular and key feature of (re)insurance company agenda across the management spectrum.
The impetus, driven heavily by Solvency II (SII), has created the need for innovative solutions to more efficiently deploy capital and maximise risk adjusted shareholder returns.
Loss portfolio transfers (LPTs), combined with Adverse Development Covers (ADCs), can be a relatively uncomplicated way for risk carriers to reduce their solvency capital requirements, and enhance liquidity to invest in more profitable activities.
A well-established form of finite reinsurance, businesses typically look at these structures when they want to smooth out the peaks and valleys of claim payments. By spreading financial risks out over scheduled premium payments, they can better budget these expenses. Furthermore, firms looking to discontinue a product/business operation, going out of business (or into run-off), or merging with another, may seek such a transfer to eliminate liabilities that it no longer has the desire nor capability to manage.
Why Loss Portfolio Transfers?
Loss portfolio transfers were originally developed to allow primary insurers to reinsure a limited layer of liability for specified blocks of reserves. After the transfer, liability for the losses incurred need no longer be shown on cedants’ balance sheets, strengthening them without necessarily transferring underwriting risk. The impact of LPT contracts on incurred losses can be assessed under SII’s Standard Formula.
Solvency II is in many ways driven by the concept of volatility around best-estimate cashflows, and deal design needs to be framed around this, to demonstrate to all parties that the benefits are real.
Stakeholders include the cedant, the reinsurer, the Actuarial Function Holder (AFH), the auditors, the regulators, and, not least, the reinsurance broker who is facilitating the deal. Depending on the answers to the questions above, we are able to model the impact of the deal appropriately on all aspects of the SII technical requirements and ensure that the post-deal position does not violate the rules governing the Pillar 1 calculation concept.
Depending on the agreed structure, the reinsurer assumes risk transfer, timing, and/or investment risk, but usually has a commutation clause for unexpected claims development. Today, even some of that risk is removed as deals are now often structured on a funds-withheld basis.
Well-considered and properly designed Loss Portfolio Transfers/Adverse Development Covers treaties are typically a good deal both for buyers and sellers. As a result, traditional risk carriers are increasingly favouring these structured solutions as an active capital management tool. The non-linear nature of the Pillar 1 Solvency II calculation means that further efficiencies can be found by combining it with other structures, such as subordinated debt, traditional reinsurance and reduced risk assumption, among others.
Key considerations of the contract
- Is the deal on a risks-attaching or losses-occurring basis?
- Will funds be ring-fenced or transferred to the reinsurer?
- Are the parties planning to commute the deal at some point in the future?
- Does the deal add or reduce uncertainty on the cedant’s balance sheet?
- What is the added value, and how is it demonstrated?
When modelling the benefit of these deals, cost is a very clear consideration to take account of. Working with the right broker, the design of LPT/ADC treaties can be optimised to achieve maximum capital benefits at a minimal cost, whilst ensuring auditors and regulators are satisfied with the deal structure.
For example, an LPT deal written on a risks-attaching basis can provide not only reserve-risk reduction, but may also yield benefits under the premium-risk measure. That is certainly worth considering when the business involved is volatile in nature.
It is also worth noting that SII’s Standard Formula risk charges still apply after the deal is in place. When an loss portfolio transfers leads to a reduction in volatility, scope may exist to consider Undertaking-Specific Parameters (USPs).
When all parties involved cooperate to create a balanced LPT/ADC structure, the deals can add immense value by providing additional profitability for all stakeholders. That, in turn, should help the insurance sector to flourish.