Fair Share.

Many insurance company executives are using finite quota-share reinsurance as an alternative source of capital.

The chief financial officer of a midsized insurance company is faced with an interesting quandary Pricing is clearly firming in many of the company's market segments, and by all rights, it should be able to increase volume for the first time in several years. Unfortunately, the CFO realizes that underwriting leverage (premiums to surplus) will begin to strain surplus by year end. Worse yet, the company's commercial bankers, who have been relatively lenient on pricing and terms for its credit lines, are suddenly uninterested in lending to the company, and Wall Street hasn't had an appetite for property/casualty insurance stocks since 1998. In the past, the CFO has used traditional quota-share reinsurance to manage leverage, but giving up increasingly profitable business just doesn't Sit that well. The alternative, however, might be to miss a great opportunity.

In this environment of tight capital for insurers, many insurance executives are faced with this type of dilemma. This situation, coupled with hardening market conditions and perhaps increased opportunities, makes it even more imperative for insurance companies to have access to additional sources of capital to support their business. Many insurance company executives are using finite quota-share reinsurance as an alternative source of capital.

Not-So-Easy Money

In the mid-1990s, insurance companies were going public at an unprecedented pace. Between 1995 and 1998, favorable valuations (approaching two times book value) enabled about 30 property/casualty insurance companies to go public. Since that time, valuations have dropped below book value in many cases, and the market is generally unreceptive to new insurance issues. As one investment banker put it: "You just can't bring a medium-sized insurer to market right now. There is virtually no story that will make an investor listen." Besides, the thought of selling the franchise below book value sits very poorly in most insurers' board rooms.

On the debt side, up until recently, banks were quite eager to lend to insurers at lenient terms and pricing that was barely above the banks' cost of funds, as long as there was the hint that banks could make money from fees. Some high profile bankruptcies and losses have changed most banks' view of lending to insurers. Said one banker: "Most major banks are pretty much full up on insurance lending. If they lend at all, they will extract a pound of flesh." For most companies, managing leverage using the capital markets is no longer a viable option.

Quota-Share Reinsurance

Historically, one of the most common tools used by small and midsized insurance companies to manage their underwriting leverage has been quota-share reinsurance. Quota-share reinsurance is a traditional form of reinsurance, and it is also known as either proportional or pro-rata reinsurance. As implied by its name, the reinsurer shares a proportional part of the original losses and premiums of the ceding company. An important aspect of quota-share reinsurance is that the reinsurer also shares in a proportionate amount of the economic profit or losses on the business, depending upon the circumstances. The reduction in net premiums retained, coupled with the reduction in net acquisition costs due to ceding commissions, helps insurers reduce underwriting leverage.

An Irony

This proportionate share of economic profit aspect of quota-share reinsurance highlights an irony of quota-share reinsurance that is unlike other traditional forms of reinsurance: the better the experience of the underlying business, the higher the economic cost of the reinsurance to the buyer.

Usually, the net pretax cost of a reinsurance transaction increases when more losses are ceded during the current year as additional premiums are paid or as higher rates are charged in subsequent years (i.e., experience rating), and the converse is frequently true. But the pretax cost for the buyers of quota-share reinsurance generally increases when the loss experience is favorable. This is because fewer ceded losses mean more profits ceded to the reinsurer. The justification for such increases in the cost is that the opposite is true when loss experience is not favorable. The reality, however, is that even traditional quotashare reinsurance may have risk-mitigating features, such as a variable ceding commission, mainly for the reinsurer's benefit. The ceding commission payable to the ceding company may be reduced based on a contractual formula tied to increases in ceded losses. Thus, the reinsurer often does not share in a proportionate amount of the losses in exchange for a proportionate amount of the pro fits. There is a solution that gives ceding companies the desired leverage relief as well as certain economic protection without giving away all the profits. Finite quota-share reinsurance is the solution on which the ceding company and reinsurers can both agree.

Managing Costs

Finite quota-share reinsurance provides the ceding companies with the alternative source of capital to finance growth without giving up all the profits. One of the primary features of finite quota-share reinsurance is that the reinsurers' losses are capped at an aggregate limit or specified amount. The reinsurers, in exchange for this aggregate cap that limits their economic downside, will accept a stated or contractual maximum profit potential. This stated maximum profit is called a margin. Thus, in today's world of managing costs, the concept of capitation, or negotiating a fixed fee, is now being applied to the reinsurance. In an environment where the profitability of the underlying business is increasing, if done properly, finite quota-share reinsurance will avoid an increased reinsurance cost (i.e., ceding away more margin), and will provide capital to the buyer at a reasonable cost.

Another important cost mitigator is to execute the quota-share reinsurance on a funds-withheld basis. The ceding company retains the ceded premium, net of the reinsurers' margin, and the related investment income. There are numerous benefits to funds-withheld reinsurance, the most notable of which is elimination of the hidden margins or costs (i.e., investment arbitrage).

Accounting Rules

The aggregate limit, by definition, limits or mitigates risk. It is imperative to have sufficient limit to meet the risk requirements under the current accounting rules (i.e., Statement of Financial Accounting Standards No. 113, Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts and Chapter 22/Statement of Statutory Accounting Principles No. 62, "Property and Casualty Reinsurance," of the National Association of Insurance Commissioners' Accounting Practices/Procedures Manual). Also, the limit needs to be adequate to protect the ceding company's financial results with a reasonably high degree of confidence. Otherwise, the quota-share reinsurance will not have the desired net impact on the company's financial statements. It is important to consult with your auditors to ensure not only the proper accounting treatment, but also adequate disclosure on the terms and structure in the notes to the financial statements.

Alternative Source of Capital

Another favorable financial statement benefit relates to any ceding commissions received in respect of year-end unearned premium balances. Statutory accounting requires acquisition costs to be expensed in the year a policy is written (i.e., no deferred acquisition costs). This accounting requirement exacerbates the capital strain of new business, as the initial acquisition costs must be expensed immediately. In the example (page 60), if it is assumed that the subject ceded business is written pro-ratably throughout the year, then about 50% of such business or $50 million will be unearned at year end. The ceding commission rate of 30% will provide $15 million of statutory expense relief at year end (i.e., 30% multiplied by $50 million unearned premium). Thus, the finite quota-share reinsurance also will provide an efficient and effective means to finance growth. The pretax cost of the $15 million of statutory benefit is relative to only half of the margin (i.e., the margin that relates to the unexpired ceded premium) or, say, $1 million. Thus, the cost-benefit ratio on a pretax basis for the unearned premium cession is 1 to 15. The $15 million of surplus relief for one year equates to an effective annual rate of about 6.7%, or 70 basis points over risk-free. For the vast majority of small to midsized insurers, a 70 basis-point annual spread compares quite favorably with the effective annual interest cost of a bank loan or debt transaction (equity would be more expensive). Additionally, the surplus relief does put pressure on an insurer's debt-to-equity ratio, unlike debt.

While it isn't a solution for everyone, finite quota-share reinsurance is providing small to midsized insurance companies with a solution for financing growth without giving away all the profits in their business. For the company with a growing, profitable niche, finite quota-share reinsurance often will be an efficient capital alternative.

Edward S. Hochberg is senior vice president at PMA Re. Hugo Kostelni is vice president at Pegasus Advisors-Towers Perrin Reinsurance.

Example: XYZ Co. Buys Quota-Share Reinsurance

Suppose XYZ Insurance Co. buys a quota-share cover on a certain casualty line of business. Assume that the quota-share represents $100 million of gross ceded premium and $70 million of ceded losses on a budgeted basis. XYZ Insurance Co. receives a minimum and provisional ceding commission of 30% of gross ceded premium, which equals $30 million. Thus, in our example, XYZ Insurance Co. could recover, on a budgeted basis, $70 million of ceded losses under this quota-share treaty plus $30 million of expense relief in the form of a ceding commission.

In this example, assume that the losses subject to the quota-share treaty are expected to settle over a 10-year period with an average settlement date of four years (i.e., half of the ceded losses are paid in the first 48 months, and the balance of the ceded losses are paid over the remaining 72 months.)

The accompanying chart compares at varying loss ratios the present value net ceded premium relative to the present value ceded losses at a riskless rate of return of 6% per annum. This rate approximates the yield to maturity of a U.S. Treasury rate that is consistent in terms of duration with the nature of the underlying ceded losses. The difference in the present values is the estimated present value pretax profit or loss earned by the reinsurer on the transaction which corresponds with the ceding company's present value pretax cost or profit, depending upon the circumstances.

The cost of the quota-share in this example could be $13.8 million at the expected loss ratio on a present value basis. Alternatively, assume that the ceding company offers to cap the reinsurers' ceded losses at 100% loss ratio. In exchange for this aggregate limit, the reinsurer is willing to write this finite quota-share for a stated margin of, say, $2 million, as the approximately 1:5 upside-to-downside ratio makes sense for the reinsurers (i.e., $2 million margin relative to present value loss of $10.3 million). This net cost compares favorably to the estimated expected cost of $13.8 million at the budgeted 70% loss ratio. Furthermore, now the residual funds implied by the above present value cash flows will inure to the benefit of the ceding company by virtue of the 100% profit-sharing terms. Thus, the client is able to obtain the net leverage benefit of ceding the $100 million of business off of its books without giving away all the profits.

                  XYZ Co.'s Present Value Cost or Profit
                        Under Various Circumstances
                  A comparison at varying loss ratios of
                    the present value net ceded premium
                    relative to the present value ceded
                   losses at a risk-free annula rate of
                        return of 6%. ($ Millions)
                 A            B           C=A-B      % of
             PV of Net    PV of Net     Buyers PV    Ceded
Loss Ratio Ceded Premium Ceded Losses Cost (Profit) Premium
110%            $70         $88.4       ($18.4)     (18.4%)
100%             70          80.3        (10.3)     (10.3%)
 90%             70          72.3         (2.3)      (2.3%)
 80%             70          64.8          5.2        5.2%
 70%             70          56.2         13.8       13.8%
Pv = present value