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Pain relief: structured reinsurance may be the remedy for risk-based capital issues.

During the past two years, many insurance companies have experienced a decline in the risk-based capital ratio arising from higher C1 risk factors on assets that are reclassified into below-investment grade NAIC3-6 assets.

Structured securities assets, in particular residential mortgage-backed securities and collateralized debt obligations, constitute a significant portion of this reclassification. These assets, referred to hereinafter as "toxic assets," have been a major source of risk-based capital decline, or "strain," for life insurance companies. A captive reinsurance solution may provide full relief from risk-based capital strain.

A resecuritization--often referred to as a real estate mortgage investment conduit or re-remic--of a toxic residential mortgage-backed securities portfolio provides a gain in the risk-based capital attributable to the portfolio. But this gain is more than offset by a loss in the surplus (therefore risk-based capital) because of mark-to-market of the portfolio, pursuant to the statutory accounting treatment of the re-remic transaction. As a result, insurance companies have not embraced re-remics to reduce the RBC strain arising from toxic portfolios.

NAIC Relief

To reduce risk-based capital strain arising from a toxic portfolio, the National Association of Insurance Commissioners recently adopted a new approach to value C1 risk factors for residential mortgage-backed securities. The new approach abandons the long-standing "credit rating-based C1 risk" approach, and instead uses a "credit loss-based C1 risk" approach.

An application of this credit loss-based approach is expected to reduce the risk-based capital strain for a toxic portfolio. However, the NAIC does not currently have such an approach to reduce the risk-based capital strain arising from other classes of toxic structured securities, such as commercial mortgage-backed securities, which many suspect could pose risk-based capital strain similar to those posed by residential mortgage-backed securities.

This article provides a reinsurance framework for relief. The framework applies to all classes of assets, not only to residential mortgage-backed securities.

It uses the existing NAIC-based risk-based capital approach and statutory accounting principles. The benefits of the proposed framework to a company include:

* 100% reduction in the risk-based capital requirement for toxic assets.

* Retention of the full profit of the reinsured business.

* Improvement in the financial strength ratings of the company.

The Strain

Insurance companies, regulators and rating agencies use different methodologies to determine the required risk-based capital. The NAIC-approved model provides the framework to determine the risk-based capital derived from the company's statutory financial statements.

Common risk elements in the model include balance sheet asset risks, insurance underwriting and pricing liability risks, interest rate risks, and off-balance sheet risks. Generally, the C1 asset risk constitutes the dominant risk factor attributable to risk-based capital.

The requirement for an asset, as measured by its "C1" risk factor, is a constant number for AAA, AA and A rating classes which are grouped into NMC-1 class. The C1 risk factor increases significantly and non-linearly for ratings from BBB (NAIC2) to C and below (NAIC6) rating classes, as shown in Figure 1.

For example, the risk-based capital requirement for an investment grade A-rated (NMC1) asset increases by more than 1000% if the asset falls to a non-investment grade BB-rating (NAIC3) class. In the case of residential mortgage backed securities assets, since the vast majority of the assets have been reclassified as toxic, it has caused considerable risk-based capital strain for companies.

The Traditional Approach

Insurance companies have traditionally adopted one or more of these approaches to risk-based capital relief:

* Capital infusion from parent: The parent of the insurance company, generally a non-insurance holding company, downstreams capital into the company from internal funds or issuing equity.

* Surplus notes: The insurance company raises capital through the issuance of surplus notes to supplement the desired level of risk-based capital.

* Third-party reinsurance: The insurance company reinsures a block of business to achieve relief with respect to assets transferred in the reinsurance with a third party.

Captive Reinsurance Approach

In addition to these traditional approaches, a company should also explore a captive reinsurance course of action. It is more capital/ cost efficient than capital infusion from the parent, issuance of surplus notes by the company or third-party reinsurance.

The framework of this reinsurance is based on three important considerations:

* Identifying a block of business with significant embedded value.

* Allocating a portfolio of toxic assets with high C1 risk factors to support the reserve requirements of the business.

* Reinsuring the business with a captive reinsurer in a jurisdiction that allows GAAP or modified statutory reporting flexibility for the business. In such a reinsurance transaction, the company will not allocate risk-based capital relating to the assets supporting the liabilities for the business. Furthermore, the insurer on a consolidated basis will retain profits associated with the business.

[FIGURE 1 OMITTED]

For example, if the reserve for the business is supported by a toxic (NAIC3-6) residential mortgage-backed securities portfolio, the reinsurance of the business would enable the company to reduce the risk-backed capital associated with the toxic portfolio, as both the business and the portfolio would no longer be on the company's statutory books. This is illustrated in terms of relief in Figure 2.

The risk-based capital amount is based on the NMC formula. Figure 2 provides risk-based capital as a simple multiplication of the C1 risk factor with the carrying value of the asset to illustrate the risk-based capital strain and relief concepts discussed herein.

The key requirement for relief associated with toxic assets is to reinsure a business with a domestic or foreign captive that either establishes a risk-based capital requirement by business plan or provides flexibility to select GAAP or modified statutory accounting for reporting purposes.

The jurisdictions for such domestic captives include Vermont, Delaware, South Carolina and Arizona; and for such foreign captives include Bermuda, the Cayman Islands and Ireland. Each of these jurisdictions has advantages and disadvantages from statutory, financial and tax reporting perspectives, and therefore requires a careful examination of the advantages and disadvantages in selecting a jurisdiction for reinsurance.

Potential Structure

The structure of a reinsurance transaction for risk-based capital relief depends on a number of factors, including the redundancy contained in the risk-based capital factors relative to the underlying economic risk, characteristics of the embedded value of a block of business, captive jurisdiction and financial strength of the company and the parent. The following summarizes the potential structure of a transaction to reinsure a block of business with low volatility and the associated assets as major sources of the strain. Figure 3 illustrates certain structural aspects of the risk-based capital relief transaction.

[FIGURE 3 OMITTED]

Captive reinsurance: The parent of a life insurance company forms a captive reinsurer in a jurisdiction that enables the captive to use either GAAP or modified statutory accounting methods of accounting for reporting purposes.

Reinsurance agreement: The insurance company cedes, on either a modified coinsurance plan of reinsurance or coinsurance with a funds-withheld plan of reinsurance, a block of policies with embedded value to the captive. The toxic assets supporting the reinsured block of business are legally segregated. Risk-based capital relief:

Terms of the reinsurance agreement are structured to be in compliance with statutory accounting risk transfer requirements and acceptable to the domiciliary regulator of the company, pursuant to which the toxic assets are then no longer included in the calculation of the insurance company's risk-based capital requirement.

Capital markets protection: The reinsurance transaction is designed to pass the investment performance risk of the toxic assets to the captive. The risk of deterioration in the market value of the toxic assets is guaranteed through a capital markets transaction with the captive.

Keep-well agreement: In the event that the captive has insufficient funds to support losses on the toxic assets in excess of the amount supported by the capital markets transaction, the parent company pays for the insufficient funds through a surplus account under a keep-well surplus maintenance agreement with the captive. The agreement is structured in a manner that mitigates adverse GAAP and rating impacts on the parent company arising from its payment obligation under the agreement.

Experience refund: Depending on the profitability of the reinsured block of business, the captive may pay the insurance company a share of the profits in the form of an "experienced refund."

This proposed reinsurance framework is the most cost-effective approach to risk-based capital relief for insurance companies. That's because the implied cost of such relief can be designed to be relatively minimal compared with the cost of relief through: capital infusion by the parent; surplus note issuance by the company; or third-party reinsurance.

The framework is based on two important considerations: the captive reinsurer has flexibility in maintaining capital requirements for the toxic assets; and the reinsured business has a low volatility and significant embedded value. The principal benefits to the insurance company of the framework are threefold: cost-effective risk-based capital relief from toxic assets subject to high C1 risk factors; no leakage of profit to a third party; and transfer of the toxic asset risk to the capital markets.

Key Points

* At Issue: Toxic assets have been a major source of risk-based capital strain for life insurance companies.

* The Significance: During the past two years, many insurers have experienced a decline in their risk-based capital ratios.

* Possible Solution: In addition to traditional approaches for risk-based capital relief, insurers can explore a captive reinsurance approach.

Contributor: Shanker Merchant is managing director of NewOak Capital in New York. Jeffrey Altman is senior actuarial consultant at Bartlett Actuarial Group in Charleston, S.C. Merchant can be reached at smerchant@newoakcapital.com; Altman at aitmanjeffrey@gmail.com.
Figure 2: Risk-Based Capital Relief Example

Attributes             Original   Current   Change

RMBS Rating Class      NAIC 1     NAIC 4    Downgrade
RMBS Carrying Value    100,000    100,000   0
RBC: C1 Risk Factor    0.40%      10.00%    9.60%
RBC Allocation Amount  400        10,000    9,600
RBC Strain Amount      n/a        9,600     n/a
RBC Relief Amount      n/a        10,000    Full Relief
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Article Details
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Title Annotation:Reinsurance/Capital Markets: Risk-Based Capital
Author:Merchant, Shanker; Altman, Jeffrey
Publication:Best's Review
Geographic Code:1USA
Date:Aug 1, 2010
Words:1637
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