chapter 35 (capital management)

[Shani]

Can someone explain the following:

"
Financial reinsurance arrangements have historically been used to improve the balance sheet of a company by crystallising the value of future expected profits. However, the viability of such arrangements is much reduced (or eliminated) under regulatory regimes, such as Solvency II, which take credit for future profits.
Whether FinRe improves the statutory solvency position depends upon the regulatory regime. For example, if the regulatory regime already allows future profits to be included as an admissible asset (as is the case under Solvency II, for example) then the regulatory solvency position will not be improved by using a contingent loan. Such a loan would though still have a role in changing an illiquid asset (future profits) into a liquid asset (the money received from the reinsurer) and so can help with liquidity management."

Thanks!

 

[CapitalActuary]

Example situation
Say I write a brand new policy insuring a space satellite. The policy starts today, 12 December 2020 and ends on 11 December 2021. I’ve been paid a £12m premium for the policy (lucky me!), to provide cover for a variety of perils that could occur over the next year. Let’s also assume I’m expect around £6m claims from this kind of policy, on average, ie an expected 50% loss ratio.

I’m paid in cash, so my assets go up by £12m immediately. What happens to my liabilities depends on the accounting basis. The increase in assets less the increase in liabilities is then the amount of profit recognised.

GAAP accounting treatment
Under GAAP accounting (or the current IFRS regime, before IFRS 17 comes in) I’m not allowed to recognise the future profit on “day 1”. This is because I’m required to record a £12m liability in respect of “unearned premium” - this liability is called the unearned premium reserve, or UPR. The idea is: it’s not fair for me to take credit for the £12m cash I’ve received yet, because I haven’t even been exposed to any risk of claims yet, as it’s only day 1 of the policy.

I’m said to “earn” that premium over the next year the policy lasts for, in line with my exposure to the risk of claims. For most policies you assume this exposure is uniform over the year, ie that claims are equally likely to occur at any point in the year. This means that after 1 month, on 12 January 2021, I’ve earned 1/12 of the premium since I’ve covered 1/12 of the risk.

The way you take credit for earning the premium on the balance sheet is by reducing the UPR by 1/12 of £12m (£1m) each month. After 1 month I reduce the UPR of £12m to just £11m, which will improve my net assets by £1m... and after 12 months the risk is completely earned, and the UPR reduces to £0m. Finally giving credit to my net asset position for all £12m of premium I initially received.

Note, each time I earn a month of premium I also have to set up a new reserve for the claims that happened that month, called the “outstanding claims reserve”, the OSCR (this includes an amount for claims incurred but not reported). The setting up of this reserve each month, and the reduction in OSCR you’ve already set up for previous months, will impact the liabilities too, hence the profit.

Solvency II
Under Solvency II accounting I can recognise day 1 profit! This doesn’t mean I can slide all £12m premium instantly into profit though. It means the liability you set up doesn’t have the be the full £12m (which the UPR does have to be under GAAP). Under solvency II the liability is part of the “premium provision” instead and you only set up a liability for the amount of claims you expect, in this case £6m. This recognises £6m of future profit on the balance sheet as soon as you’ve written the policy because there is a £12m increase in cash from the premium, less a £6m increase in premium provision.

Hope this makes it clear what future profit means, and why it’s recognised on Solvency II basis.

FinRe
Under GAAP accounting you could try to sidestep the fact you couldn’t recognise future profit. For example, on day 1 we pay a reinsurer £7m to take on 100% of claims for the policy. As we have no future liability, the £12m UPR nets down to £0m. Hence we get a £12m-£7m=£5m benefit to the balance sheet.

We’ve effectively recognised the £6m future profit we would’ve had anyway under Solvency II, but we paid the reinsurer £1m for this (since the reinsurer needs to make a profit on the deal) so only end up with £5m benefit.

Of course, the reinsurer then get £7m cash but also a £12m UPR on a GAAP basis - a loss! This will unwind though, as over the year the UPR will disappear, and they expect to incur £6m claims or so, which will leave £1m profit at the end of the policy.

I’ve glossed over details here, but hope this helps.

 

[Shani]

Thanks so much for the detail, it helped me a lot.

 

[Lindsay Smitherman]

Hi - just to expand on this thinking from a long-term (life) insurance perspective:

Fin Re arrangements used by life insurers are typically structured as contingent loans. The arrangements normally transfer minimal risk, but effectively comprise a loan from the reinsurer to the insurer, which only has to be repaid if future profits arise. It can take a long time for the profit margins (loaded within the premiums / charges) to emerge on a life insurance business contract, due to the long-term nature of those contracts. Fin Re basically allows the insurer to take out a loan against the value of those future profits, before they have actually arisen.

The insurer's balance sheet benefits from an increase in assets due to the cash received from the reinsurer (the 'loan'). Because the liability to repay that loan is contingent upon future profits arising (and that might not happen, if experience turns out to be much worse than priced for), it might be the case that the insurer doesn't have to recognise that liability on its balance sheet. Hence its reported available capital position would improve: assets up, liabilities the same.

Whether a specific accounting or regulatory jurisdiction requires the insurer to recognise the liability or not would depend on whether future profits are already allowed for within that approach. If the accounting / supervisory balance sheet recognises (ie 'capitalises') the value of future profits already (like under Solvency II, as has been nicely described above), then the liability to give (some of) these profits to the reinsurer in future has to be recognised - so there is no overall balance sheet benefit (both assets and liabilities increase). However, if the accounting / supervisory balance sheet ignores the value of future profits (as many do, eg various GAAPs), then the fact that those profits will belong to the reinsurer now rather than the insurer is irrelevant - the liability to pass those profits to the reinsurer (as repayment of the initial loan) can be ignored, and so there is a balance sheet benefit.