Hitching a ride: by becoming part of the reinsurance arrangement, life insurance producers can grow sales and long-term profits. (Life/Health: Producer-Owned Reinsurance).

Any producer who earns more than $50,000 of annual commissions on life or annuity business may benefit from a producer-owned reinsurance arrangement. The strategy which is already established in the property/casualty industry especially in the warranty and credit life fields, is becoming an attractive way for leading insurance producers to share in the profits of the business they produce. It also creates wealth by allowing producers to share financial benefits with the insurance companies whose products they sell.

Producer-owned reinsurance is a financial arrangement between insurance companies and their producers. The company agrees to reinsure a portion of the business sold by the producer, and the producer sets up a reinsurance arrangement to receive the reinsured portion of the business. In this way producers can share the long-term profits of the business they write. Customers can benefit from niche products suited to their specific needs, and a long-term relationship with the producer. According to Warren Steinborn, president of Indianapolis-based National Partners Group, "Producer-owned reinsurance creates a strong incentive for agents to produce quality business with high persistency that aligns the interests of consumers, producers, and life insurance companies. This creates a win-win situation for all parties."

When insurance producers look at the reinsurance business, it can seem overwhelming. However, producers can overcome the barriers to entry, and benefit from the long-term value that they create.

Benefits of Reinsurance

Why would a producer want to get involved with reinsurance? The answers are clear from the experience of top producers who have already gone down this path. Reinsurance can create substantial wealth, even exceeding the producer's commission income. Perhaps equally important, however, is the ability of the reinsurance arrangement to transform the nature of the producer's job. Instead of a totally transaction-based compensation system, the producer now has the direct incentive to produce quality business, and the satisfaction of benefiting from the long-term value of the business produced. The high-end producer can also be empowered to create products that cater specifically to his or her market.

Ed McKernan, is president of Global Preferred Solutions, a firm that provides actuarial and management consulting services to producer groups. "Reinsurance helps marketing organizations appreciably increase the value of their business, not only through long-term reinsurance profits but also incentive programs that attract and retain successful producers," McKernan said.

Marketing of life insurance products has traditionally had a short-term focus, with the producer earning most of his or her income at the time of sale. The producer's incentives haven't been tied to the long-term profitability of the business, so the company's and the producer's objectives have been different, or even in conflict. Both insurance companies and producers have seen producer-owned reinsurance as a way for producers to benefit from the long-term profitability of the business. The insurance company and the producer then have similar incentives. The resulting feeling of partnership benefits both companies and producers. Consumers also benefit from a marketing structure that is more efficient, with the potential for more accurate pricing, and from the long-term relationships that are encouraged between producers and insurance companies.

Tom Mathews, senior executive vice chairman of the financial services marketing company World Financial Group, has participated in producer-owned reinsurance for more than 20 years. "A commission-based business is inherently unstable. The reinsurance program creates a long-term relationship between the producer and the insurance company, as well as the customer. Producers look at the business in a totally different way. They spend more time selling quality business to quality customers. And they stay around to reap the benefits," Mathews said.

Getting Started

Producers with a substantial volume of business shouldn't find it difficult to participate in a producer-owned reinsurance venture. Generally, the minimum entry point for participation with a group of producers would be about $50,000 of annual commissions on life insurance or annuities. As a practical matter, the biggest decision for the producer is the selection of a service provider, and deciding the amount of the initial investment. A producer might need an initial investment of $50,000 or more, depending on the type of reinsurance structure selected. The producer's investment also depends on the types of products reinsured, the nature of the reinsurance contract, economies of scale, and leverage created by aligning with other producers. A significant initial investment will allow the producer to receive earlier profit distributions, and perhaps, greater returns on the investment. Producers who don't want to make an investment of this magnitude can still participate, but it will take longer to start receiv ing profit distributions.

The effort involved in establishing and maintaining a producer-owned reinsurance company is justified, because it can add substantially to the producer's wealth. The long-term, tax-favored incentives of the producer-owned reinsurer have succeeded in creating a substantial asset for many top producers. For some, the wealth that has built up in the producer-owned reinsurance company is far more important to their financial success than the transaction-based incentives of sales commissions.

Entry Vehicles

There are four possible routes of entry into reinsurance:

* Establish an independent reinsurance company;

* Participate in a reinsurance company owned by a group of producers;

* Participate in a reinsurance company controlled by an insurance company; or

* Participate with an independent, turn-key reinsurance provider.

Owning an independent insurance company provides the ultimate in flexibility and control, but is expensive, requires substantial management effort, and fails to take advantage of economies of scale.

Participating with a reinsurance company controlled by an insurance company will typically have lower volume requirements for entry, and may have lower capital requirements. This option will probably limit the source of business to policies of the sponsoring company, and may introduce other conflicts, as the reinsurance company tries to satisfy both its owner and the producers. On the other hand, a producer who aligns with a producer-group reinsurance company has the advantage of dealing with peers, and generally has more flexibility in the business placed with the reinsurer. Unfortunately, there are few independent producer-owned reinsurance companies, and they tend to have very high qualification requirements.

Participating with an independent, turn-key reinsurance provider can offer the most flexibility in relation to the products reinsured, and avoid potential conflicts of dealing with the insurance company's own reinsurer. The bargaining power of the producers involved in this type of arrangement in relation to a particular insurance company depends on the volume of business written, or potentially written, by the participants in the reinsurer with that insurance company. There are barriers to entry, but all of them can be overcome, most easily by participating in an established reinsurance arrangement.

Producer-owned reinsurance redefines the relationship between insurance producers and insurance companies. In the past, the producer was stuck with short-term incentives that gave short-term results. The producer-owned reinsurance company provides a way for the producer to have long-term participation in the business. This aligns the incentives of the producer with those of the company and the customer, to the benefit of all three.

RELATED ARTICLE: Producer-Owned Reinsurance Structural and Financial Checklist

There are a number of structural and financial issues to consider before getting involved in producer-owned reinsurance. The process helps to choose a provider of reinsurance services and what financial arrangements to make with the reinsurance provider.

Capital requirements for producers to participate in an existing reinsurance structure may begin as low as $25,000. Some organizations allow a trade-off between current capital investment and the timing of profit distributions. In these cases, a producer can participate with little or no capital in exchange for a less rapid emergence of profits.

Capital: The operation of a reinsurance company requires some form of licensing in every jurisdiction. To obtain a license to write insurance business, the company must have at least the minimum capital required by the domicile's regulations. Once capital has been contributed to the company, however, there are regulatory constraints on the ability to take these funds out of the company as long as the company retains insurance liabilities. This can severely limit the possibilities for raising capital outside the sponsoring group.

Knowledge and Talent: The organizational structure of a typical reinsurance company will include a variety of management, financial, and administrative functions. The writing insurance company will provide most of these functions for the producer-owned reinsurer. For overseas domiciles an essential capability is regulatory compliance in the domicile. Expertise in accounting, actuarial, investment, risk management, and treasury are also needed. The need for outside expertise in these areas will influence the structure and domicile of the reinsurance entity. A reinsurance company also needs various banking services, including international fund transfers, so the maturity of the banking system in the domicile is important. Popular domiciles, such as Bermuda, provide a choice of competent providers of these services.

Timetable: The process of establishing a producer-owned company from scratch can be extremely time-consuming. It's not unusual for the process to take several months before the captive is ready to accept its first business. By participating in an existing reinsurance operation the producer can avoid business delays.

Taxes: Tax issues related to offshore reinsurance companies are complex. Special tax rules apply to any company classified as a controlled foreign corporation, and special rules exist for insurance companies. Reinsurance companies decide whether to elect to be taxed as a domestic company for U.S. taxes. Other tax issues include the possibility of an excise tax on premiums, and a substantial withholding tax on investment income. Recently, the Internal Revenue Service issued Notice 2002-70, which prescribes record-keeping and reporting requirements for certain producer-owned reinsurance companies. The possibility of capital gains treatment for the appreciation of the value of the producer's ownership interest in the reinsurance company is critical to creating the maximum amount of after-tax wealth. Existing companies have developed ways to deal with these tax issues. Producers will need professional advice to deal with their individual tax situation as it relates to the emergence of wealth in the producer-owned reinsurance company.

Economies of Scale: When functions such as regulatory compliance, banking services, and accounting are provided by a larger organization, the producer's costs are lowered with no reduction in profit potential. Participation in an existing company through a mechanism such as a protected cell allows the producer to take advantage of economies of scale.

Sharing Financial Benefits: At one extreme all owners share in the results in proportion to their share of ownership. At the other extreme each producer's business is identified in a separate, protected cell, and each producer receives results only from his or her own cell. The issue of how experience should be shared among owners of the reinsurance company should be carefully decided as it involves trade-offs between stability of the results and the direct linking of a producer's results to the quality of his or her own business.

Risk Management: The producer-owned reinsurance company presents some unique risk-management issues. Because it tends to be much smaller than the typical life insurance company, the ability to absorb random fluctuations in experience is low. In addition, the limited number of sources of business may lead to concentrations of risk in terms of geographic area, employment, or product type that exaggerate certain risks, such as catastrophic claims. As a result, the producer-owned reinsurance company needs a detailed and effective risk management program, and will need to purchase reinsurance itself. Different levels of risk sharing can be arranged among the owners for different components of the risk, such as mortality, persistency, and investment.

Business Quality: The "quality" of a block of reinsurance refers to the business's profitability over the life of the block. While the level of claims might seem to be the crucial element of quality for life insurance business, this is typically not the case. In fact, the most important single determination of profitability is the persistency of the business. Except in unusual circumstances, the average death claims on life insurance business can be expected to fall within a narrow range, while persistency can vary greatly from one block of business to another. Fortunately, producers have a substantial amount of control over persistency risk.

Typically, a producer does not need to be concerned about the profitability of the products he or she sells, provided that, over all, the insurance company is financially sound. Other things being equal, a low price and valuable contract features make the product easier to sell. A new dimension is added when the producer participates in the profit generated by the insurance product. Now the marketing benefits of a low price and valuable contract features must be balanced with their effect on profitability. The producer should consult an actuary; or the reinsurance company's actuarial staff, in projecting life insurance product profit.

Exit Strategy: Life insurance contracts, including related settlement options, can extend, theoretically, for 100 years, or more. According to one study, some policies remained in force for 80 years from the date of issue. This implies the same potential for the related reinsurance contracts. The producer-owned reinsurance arrangement must be designed to provide an exit option, since the producer may wish to exit the business on retirement.

It is important to consider the exit strategy at the outset of the reinsurance arrangement. The potential tax, regulatory; and management issues must be considered. Generally, with careful planning, it's possible to obtain capital gains treatment of the value built up in the block of business. This is a major advantage of ownership that should be preserved. Producers should understand how they will be compensated for the value of future profits if the reinsurance arrangement is terminated. Issues related to exit strategy are complex, and require legal and business advice.

Generally the established reinsurers have already developed exit strategies for participants. A large producer-owned reinsurer with an active program of adding new producers will have more flexibility in providing for exit than a company with a small number of owners and no new entrants.

Producer-Owned Reinsurance Model

Once a producer participates in the ownership of the producer-owned reinsurance company, there are two sources of income for the producer. One is the original flow of commissions from the agency, and the second is the flow of profit from the reinsurance company.

Life Insurance Company

20% ($20) Reinsurance


Benfits and Expenses  $80
Commission            $15
Profit                 $5
Total Insurer Profit   $5

Note: Table made from pie chart

Producer-Owned Reinsurance Company


Benfits and Expenses    $16
Commission               $3
Profit                   $1
Total Reinsurer Profit   $1

Note: Table made from pie chart

Agency


Field Commission                                  $12
Expenses                                           $2
Agency Net Profit                                  $1
Total Agency Profit                                $1

Agency Profit

Agency Profit                                      $1
Reinsurance Profit                                 $1
Total Agency and Producer-Owned Reinsurer Profit   $2

Note: Table made from pie chart

Donald F. Behan is professor of actuarial science, Georgia State University and a consulting actuary.