Session 113 PD, Capital Management Programs for Disability Moderator/Presenter: Michael David Mulcahy, FSA, MAAA Presenters: Jeffrey E. Babino Richard Leavitt, ASA, MAAA SOA Antitrust Disclaimer SOA Presentation Disclaimer
Guy Carpenter Smith Group Group Disability / Life Specialty Practice SOUTH PORTLAND, ME GUY CARPENTER
Group LTD Structural Designs LTD reinsurance for mature players in the Group LTD space has been PPXOL reinsurance New entrants and LTD writers without scale rely more on turn-key quota share reinsurance with full service support The group disability reinsurance market has not been a hotbed of innovation Reinsurers do not want to cannibalize their inforce business LTD product line is complex increasing the barrier to entry for new reinsurers Primary writers tend to look at what competitors are doing for validation Alternative structures often require more refined exposure data than commonly available 2
Drivers of Reinsurance Product Designs Volatility management Quarterly aggregate volatility Quarterly product volatility High maximum limits Segment volatility / profitability (e.g., doctors and lawyers) Risk tolerance statements giving rise to reinsurance program design Ratings agencies and ORSA driven Capital efficiency / relief Statutory capital Economic capital 3
Capital Efficiency / Relief Capital Relief Reinsurance for Group LTD Lower the amount of capital required bring the Group LTD to market Shortage of capital Opportunities to deploy capital elsewhere Lack of product expertise Wary of long tailed business Normally supported by Private Label quota - share Lower the amount of capital needed to support an existing Group LTD product portfolio Boost ROC relative to profit as a percent of premium Redeploy capital to other lines / new business opportunities 4
Group LTD Capital Relief Risk Based Capital is the primary target for Group LTD capital relief reinsurance increase ROC. RBC C2 5% of reserves for all claim durations Longer duration claims are considerably less volatile RBC protect against insolvency as the result of unusually poor experience Capital relief reinsurance protects downside risk enabling the company to release RBC. Capital Relief reinsurance will not provide desired results if GAAP profit is significantly reduced by the cost of the reinsurance. Capital relief products offer a full experience refund for expected loss variance. Minor reduction of reported profit due to a nominal reinsurance charge (expense + risk charge) for the reinsurance program (+/- 100bps). 5
Group LTD Capital Relief Downside risk protection in the event of unusually poor experience is a collateral benefit of the reinsurance program. Nominal reinsurance premium set significantly higher than expected claim cost (run-out) for longer duration LTD claims (110% expected) Full experience refund if expected claims are less than nominal premium level In the event of a loss in excess of the nominal premium level, the reinsurer carries the loss forward over a negotiated period reducing the reinsurers risk. The nominal premium must be set at an expected claims level that is sufficiently high and out of the money The probability of a reinsurance loss is low, but high enough to qualify as a statutory transfer of risk. 6
Group LTD Capital Relief Key features of transaction: Modified coinsurance (up to 80%) with 100% experience refund Reserves, losses, and investment risk ceded to reinsurer Assets held in trust for insurer Open-ended term with bilateral termination rights Excess of loss (110% loss ratio) transferred to reinsurer Offshore markets have regulatory and tax advantages Quality of the claims data critical modeling Professional claims management team dedicated to reinsured block crucial Reinsurer will require annual audits 7
Group LTD Capital Relief Reinsurance market development Bifurcation by Duration of Claim Unpredictability of LTD claims greatest when reserve is first set up Reserves on seasoned claims tend to be more stable Distinct durations may attract entirely new markets to the LTD space Select reinsurers (Lloyd s) have appetite for short tail risk Offshore mortality/longevity markets have regulatory and tax advantages more advantageous for long duration/tail risk Modeling and quality of data is critical to understanding and presenting bifurcated risks Short Tail Reinsurer(s) Retention Long Tail Reinsurer(s) Retention < 5 year duration 5 year+ durations 8
Group LTD Long-Duration Capital Relief Agenda Simple Reinsurance Modeling Example Scenario Testing: Dependencies on Assumptions LTD Long-duration variance modeling Risk Capital versus Statutory Capital 9
Group LTD Long-Duration Capital Relief Typical Assumptions Annual LTD Premium 500M Ratio of GAAP Reserve Balance to Annual Premium 4.0 Ratio of STAT Reserve Balance to GAAP Balance 1.08 RBC Capital Multiplier 3.50 Percent of Reserves > 5 Years 40% ROC with no reinsurance 8.00% Asset Risk C1 1.5% Premium/Pricing Risk C2 Reserves 5% C2 Prem LT 50M 15% C2 Prem GT 50M 3% 10
Group LTD Long-Duration Capital Relief GAAP Reserve Balance 2,000M Stat Reserve Balance 2,160M C2 Capital on Reserves 378M C2 Capital on Premium 54.8M C1 Capital 143.7M Total Assets 2,638.9M Total GAAP Capital 638.9M <= Assets - GAAP Balance Total Return 57.5M <== GAAP Capital / Return 11
Group LTD Long-Duration Capital Relief Long-Tail Reinsurance Percent 80.0% Risk Charge for the reinsurance Ceded Reserve 691.2M C2 Capital 311.8M C1 Capital 98.7M Total GAAP Capital 519.3M Cost of the reinsurance 6.91M Modified Return on Capital 10.01% ROC Gain 2.01% 1.0% <== Illustrative 25% Gain in ROC: Model is overly simple, but should give approximate range of ROC increase 12
Group LTD Long-Duration Capital Relief Sensitivity to Assumptions 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% Boost to ROC versus Initial ROC 0% 2% 4% 6% 8% 10% 12% Initial ROC The more you earn, the bigger the benefit, due to the fixed cost of reinsurance 13
Group LTD Long-Duration Capital Relief Sensitivity to Assumptions Boost to ROC versus Capital Multiplier 2.20% 2.15% 2.10% 2.05% 2.00% 1.95% 1.90% 1.85% 1.80% 300% 320% 340% 360% 380% 400% Capital Multiplier 14
Group LTD Long-Duration Capital Relief Sensitivity to Assumptions Boost to ROC versus STAT to GAAP Ratio 2.1% 2.0% 1.9% 1.8% 1.7% 1.6% 1.5% 100% 102% 104% 106% 108% 110% STAT to GAAP Ratio 15
Group LTD Long-Duration Capital Relief Sensitivity to Assumptions Boost to ROC versus GAAP DLR to Premium Ratio 2.05% 2.04% 2.03% 2.02% 2.01% 2.00% 1.99% 1.98% 350% 370% 390% 410% 430% 450% GAAP DLR to Premium Ratio 16
Group LTD Long-Duration Capital Relief Sensitivity to Assumptions 2.4% Boost to ROC vs Different Parameters 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% Capital Multiplier STAT to GAAP Ratio GAAP DLR to Premium 1.0% STAT to GAAP ratio is the most important means the new STAT standard may reduce the efficacy of the product 17
Group LTD Long-Duration Claim Volatility Stochastic Modeling: Assume random, independent claim resolutions 140% 120% 100% 80% 60% 40% 20% Estimated Ratio of Standard Deviation of Discounted Cost divided by Reserve by Claim Duration 0% At EP Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Based on GLTD2016 terminations and claim mix Long duration claims are less volatile 18
Group LTD Long-Duration Claim Volatility 1.8% 1.6% 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% Total Expected Percent Standard Deviation by Duration vs Number of Initial Claims 5K Claims 10K Claims 20K Claims At EP Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Percent Survived At EP 100.0% Yr 1 65.0% Yr 2 50.0% Yr 3 39.3% Yr 4 34.1% Yr 5 30.7% Yr 6 27.8% Yr 7 25.2% Yr 8 22.8% Yr 9 20.7% Yr 10 18.7% 19
Group LTD Long-Duration Claim Volatility 12% 10% however, but of the adverse risk comes from changes claim dynamics and not random variance. Percent increase in reserve versus Recovery and Death Rate by Duration 8% 6% 90% Recovs 90% Deaths 4% 2% 0% at EP Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 Early Duration Claims are much more susceptible to morbidity or claim management changes 20
Group LTD Long-Duration Claim Volatility 12% Relative Comparison for 10K Initial Claims 10% 8% 6% 90% Recovs 90% Deaths Random Standard Deviation 4% 2% 0% at EP Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 True Expected volatility is unknown Need scenario testing on possible adverse risk items Still, it is hard to come up with the need for > 15% capital on older claims Modeling generally leaves room for a long-duration capital relief product 21
About GC Smith Group Smith LTD Management Group, Inc. is a disability and reinsurance consultant and a subsidiary of Guy Carpenter & Company, LLC, which is a global leader in providing risk and reinsurance intermediary services. Guy Carpenter is a wholly owned subsidiary of Marsh & McLennan Companies (NYSE: MMC), a global team of professional services companies offering clients advice and solutions in the areas of risk, strategy and human capital. Smith Group provides this presentation for general information only. The information contained herein is based on sources we believe reliable, but we do not guarantee its accuracy, and it should be understood to be general insurance/reinsurance information only. Smith Group makes no representations or warranties, express or implied. The information is not intended to be taken as advice with respect to any individual situation and cannot be relied upon as such. Please consult your insurance/reinsurance advisors with respect to individual coverage issues. Statements concerning tax, accounting, legal or regulatory matters should be understood to be general observations based solely on our experience as reinsurance brokers and risk consultants, and may not be relied upon as tax, accounting, legal or regulatory advice, which we are not authorized to provide. All such matters should be reviewed with your own qualified advisors in these areas. Readers are cautioned not to place undue reliance on any historical, current or forward-looking statements. Smith Group undertakes no obligation to update or revise publicly any historical, current or forward-looking statements, whether as a result of new information, research, future events or otherwise. This document or any portion of the information it contains may not be copied or reproduced in any form without the permission of Smith Group, except that clients of Smith Group need not obtain such permission when using this white paper for their internal purposes. The trademarks and service marks contained herein are the property of their respective owners. 2016 Smith LTD Management Group, Inc.
Capital Management for Disability Michael Mulcahy Hollywood, FL June 14, 2017
Disability Insurance RBC Drivers C1 - assets backing reserves C2 - Pricing Risk - % Premium Claim Run out Risk - % Reserves 2
Pricing Risk Solution Reinsurance structured on a yearly renewable term basis, with quarterly settlement Cover a quota share of all inforce and new business Reinsurance premium initially set at about 100% of gross premium. Reinsurer may have the ability to raise the reinsurance premium rate within certain limits Risk charge set as a percent of reinsurance premium 3
Structure (continued) Reinsurance claims are equal to following: Paid claims + Change in disabled life reserve / (active life reserve also if applicable) + Change in unearned premium reserve (If applicable) Investment income (this could be included in premiums) Reserves on disabled lives are recaptured after a set duration of disability. 4
Additional Structure Details LTD Experience refund of all profits except the Risk Charge Loss carryforward of any losses to reinsurer repaid out of future profits (if they emerge) Reinsurer retains the ability to eliminate Experience Refund under certain conditions Reinsurer retains right to review any change in reserve basis Reinsurer can terminate for new business/renewals (subject to an initial commitment period). Ceding company can recapture (but must pay loss carryforward if it exists) 5
Additional Features May be some level of fixed expense allowance, or a variable expense allowance provided e.g. 25% allowance, decreasing 1% for every 1% increase in Loss Ratio above 70%. Flexibility to modify quota share 6
Example Before Reinsurance 2017 2018 Premium 1,000,000,000 1,050,000,000 Investment Income 152,500,000 160,125,000 Paid Claims 594,000,000 675,000,000 change in ALR 16,666,667 17,500,000 Change in DLR 128,571,429 135,000,000 Change DLR <3 Yrs 77,142,857 81,000,000 Expenses 250,000,000 262,500,000 Reserve Balances STAT ALR 350,000,000 367,500,000 STAT DLR 2,700,000,000 2,835,000,000 DLR <3 Yrs 1,620,000,000 1,701,000,000 Reinsurance Terms QS: 80% Fixed Exp Allowance 5% Var Exp Allowance up to 90% LR Risk Charge 0.75% Ceded 2017 2018 Premium 800,000,000 840,000,000 Inv Income 78,800,000 82,740,000 Paid Claims 475,200,000 540,000,000 Change in ALR 13,333,333 14,000,000 Change in DLR 61,714,286 64,800,000 Exp Allowance 248,552,381 219,940,000 Ceded ALR 280,000,000 294,000,000 Ceded DLR 1,296,000,000 1,360,800,000 Risk Charge 6,000,000 6,300,000 Income 163,261,905 120,125,000 Loss Ratio 83.67% 88.56% Experience Refund 74,000,000 77,700,000 7
Example Before Reinsurance 2017 2018 Total RBC 316,800,000 332,340,000 Capital at 300% 950,400,000 997,020,000 After Reinsurance 2017 2018 Total RBC 210,780,000 221,019,000 Capital at 300% 632,340,000 663,057,000 ROC 17.2% 12.0% ROC 24.9% 17.2% 8
Considerations Benefits C2 RBC for premium and reserve ceded is transferred to the reinsurer Morbidity risk fluctuations will be passed on to the reinsurer Liquidity cover for catastrophic disability claims Disabled lives reserves beyond the recapture date can be ceded elsewhere or securitized Can be terminated by Ceding Company on short notice Improved ROE on the block from Ceding Company s standpoint Administrative Considerations Claim Reserve for new claims must be calculated and reported by policy year May need to maintain ability to calculate reserves on old reserving basis 9
LTD RBC Reinsurance Risk Transfer 33
Risk Transfer for YRT Reinsurance Statutory risk transfer is governed by the Credit for Reinsurance Model Regulation, as codified in A-791 of SSAP 61 Law sets out 11 primary provisions which a contract must follow for a ceding company to take credit for reinsurance. YRT Reinsurance is exempt from 4 of those provisions: Covering renewal expense allowances Including reinsurance payments other than from profits on the reinsured business A list of significant risks that must be transferred Transfer or segregate assets if investment risk is significant 34
Risk Transfer for YRT Reinsurance Significant Risk Transfer Provisions that must be met by YRT: Ceding company can t be deprived of assets or surplus at reinsurer s option Ceding co. can t be required to reimburse the reinsurer for losses. Loss carry forwards and payment of them for voluntary cancelation by the ceding company is specifically allowed. No pre-specified or triggered termination or recapture allowed. At least Quarterly settlements of amounts due No representations or warranties made by the ceding company not related to the business reinsured, or about the future performance of the business reinsured The expected potential liability of the company on the reinsured business must be altered by the reinsurance 35