A Primer on Reinsurance Pricing Strategy
“A Checklist for Optimizing Reinsurance Negotiation”
By Larry Warren
This article is written with the assumption that both the reinsurer and the direct writer would each benefit from fully exploring all appropriate assumptions and considerations directly and indirectly impacting reinsurance pricing. Such assumptions and considerations are discussed below. The reinsurer benefits by being able to offer the lowest YRT rates and the most competitive pricing that it can justify, enabling it to win a share in the pool. The direct writer benefits by giving the reinsurer the additional insights and justification for a lower priced quote, thus reducing their reinsurance premiums and increasing bottom line net income. This “negotiation process” should be looked at as more of a useful educational process. With less information the reinsurers may be more conservative in their pricing, while conversely with more information the reinsurer can use a sharper pen. The more knowledge and insights the reinsurer has about the direct writer’s business which may impact current mortality and future mortality patterns, the greater the likelihood that its quote will be more competitive.
Obtaining reinsurance quotes may be a simple matter, but the selection of which reinsurers should participate in the bidding and the negotiation processes calls for special insights. We know that there is often a big disparity in the reinsurance quotes obtained from reinsurers competing for our business. It is necessary to understand the underlying reasons for big disparities in reinsurer pricing. We need to recognize each reinsurer’s methodology and assumptions which are driving its pricing. In most of what follows, I assume that the direct writer wants a first dollar quota share YRT reinsurance arrangement, but similar concepts apply to coinsurance as well.
Outlined below are some of the most important assumptions and associated considerations that impact reinsurance pricing. These items are offered as a checklist for careful joint review by the reinsurer and the direct writer.
Assumption A.
Choice of Mortality Table
Probably the most important assumption (and certainly the one with the largest financial impact) made in reinsurance pricing is the mortality table believed to have the appropriate slope for the client company’s mortality. We place the slope consideration at the top of our list as the paramount feature justifying painstaking research as part of the reinsurance pricing negotiation process. Most reinsurers currently use either the 1975-80 select/ultimate table or the 1990-95 select/ultimate table (2001 VBT) when developing quotes. The former table models relatively flat durational mortality progression, while the latter exhibits the opposite. Mortality rates in this more modern table exhibit marked and steep progression after issue. Once the issue of table suitability has been addressed, the chosen standard mortality table should be fine-tuned to reflect anticipated experience by developing scaling factors to initially assure a perfect fit. The working mortality table to be assumed for pricing purposes will reflect best estimates of the slope of future mortality experience. It may transpire that the table finally adopted is a hybrid of intermediate slope exhibiting features of more than one standard table.
Considerations in Choosing a Mortality Table with Appropriate Slope
1. Underwriting Rules/Guidelines/Practices
Variations in underwriting rules, guidelines and practices obviously impacts future mortality patterns. While underwriting guidelines vary from company to company, the degree to which the underwriters adhere to the guidelines (i.e., the frequency of underwriting exceptions) must certainly be recognized. Special underwriting programs such as table shaving, special credits, etc., must be properly defined and disclosed and can affect the overall slope.
Generally, tighter underwriting requirements and stricter adherence to the underwriting rules and guidelines will produce lower mortality rates on the outset and sharper increments in duration-specific slope.
2. Average Size of Policy (Face Amount)
The distribution of face amount per life insured plays a dramatic role in the overall underwriting screening process. For example, two companies may have identical stringent underwriting guidelines, yet one company (company A) operates in a market where face amounts in excess of $500,000 are the norm, while another company (company B) may be issuing policies with face amounts averaging $100,000. Thus the actual underwriting requirements being obtained by company B would be very limited relative to company A, giving rise to relatively weak selection and an expectation of higher mortality rates with a flatter durational slope.
3. Distribution System
The distribution system of the ceding company or for a particular product can have a significant impact on the degree of potential anti-selection. Anti-selection will likely impact the mortality level and durational slope.
Brokers writing for multiple companies will seek out deficiencies in companies’ product designs, underwriting, or pricing, and exploit these to the detriment of the direct writer and its reinsurers. Career agents writing for only one company will generally produce business with less potential anti-selection.
4. Market Segment (Upscale, Middle America, geographic location, etc.)
It is well known that each market segment will exhibit its own variation in mortality patterns resulting from social, economic, geographic, and cultural differences. Companies underwriting middle market risks with lower average face amounts are likely to experience higher mortality rates, and flatter durational slope.
5. Average Issue Age Distribution
A younger average issue age distribution linked with a low average face amount per life will generally have less stringent underwriting requirements and likely flatter durational slope.
6. Other Important Points
It should be noted that studies have shown that the impact of choosing one mortality table or another in projecting the present value of future mortality can produce a swing of up to 20 percent or more in reinsurance
YRT rates and hence turn a competitive quote into an uncompetitive one. This impact varies by issue age and gender distribution. For additional information, see the author’s article “The Relationship of Mortality Projections and the Underlying Mortality Tables Used” in the August 2002 issue of the SOA publication, “Product Matters!”
It is therefore of utmost importance that you identify and explain all possible characteristics and aspects of your business, including those shown above in Assumption “A” (Choice of Mortality Table) to each reinsurer quoting, that would tend to justify an assumption of a flatter mortality slope than the 1990-95 (2001 VBT) select/ultimate table. The reinsurance quote may be expressed as a percentage of the 1975-80 select/ultimate table even though the reinsurer based its pricing on a steeper scale. In that case, you would still have ample opportunity to convince the reinsurer that a flatter slope is more appropriate for your business and have them improve their quote.
Techniques for generating a hybrid, modified, or redesigned table exhibiting a flatter and more appropriate mortality table can be addressed during the negotiating process. Some techniques are discussed in the author’s article, “Generalized Mortality Table Analysis,” in the March 2003 issue of the SOA publication, Reinsurance News.
If after reviewing the various aspects of your business you cannot find any attributes which could justify a flatter slope, then I would recommend that the following point be raised with the reinsurers to encourage them to assume a flatter slope than the 1990-1995 mortality table (2001 VBT).
The 1990-1995 mortality table was based on intercompany mortality experience from calendar years 1990-1995. It is a known fact that the lapse rates for policies during this period were very high compared to current levels. Therefore, one could argue that the slope of this table is artificially high due to the anti-selective lapses which occur when lapse rates are atypically high. Consequently current mortality slopes should be expected to be flatter than the 1990-1995 mortality table.
Assumption B.
Mortality improvement Factors
Another very important assumption is the extent to which mortality improvement is factored into the pricing (i.e., the reinsurer’s mortality assumption for your business). For example, a one percent annual mortality improvement factor over 20 years produces a decrease in the present value of future claims ranging from 7-10 percent, depending upon issue age. As a result of the fact that reinsurers commonly build future mortality improvements into their pricing, coupled with the fact that projecting future mortality is an art as well as a science, it is not unusual to find reinsurers who will offer a YRT reinsurance premium rate scale (even after factoring in their expense and profit margins) which is lower than the ceding company’s pricing mortality assumption.
Assumption C.
Reinsurer’s Expense Assumptions
The reinsurer’s expense methodology and assumptions (per unit, per policy, percent of premium) can have a significant effect on pricing. For example, the per-unit expense that a reinsurer may assume (unless subject to a reasonable cap) could lead to unrealistically high total treaty expenses where large business volumes are involved and can lead to substantially less competitive or even uncompetitive quotes.
Assumption D.
End of Term Pricing
Another very important assumption and special consideration is the reinsurer’s end-of-term pricing. Studies invariably confirm the severe anti-selection process occurring at the end of each level premium paying period. Severity of anti-selection varies from company to company and product to product. Many factors come into play that influence the end of term anti-selective continuation rate and the resulting anticipated deterioration in mortality experience of the term portfolio. The magnitude of the direct writer’s renewal premium after the initial level term period (typically an A.R.T. ranging from 200-300 percent of the 2001 CSO) impacts the degree of the shock lapse rate and resulting antiselection. The degree of mortality deterioration varies according to a number of factors such as the length of level term period, the magnitude of the renewal premium following the initial level premium term period, issue age, duration, risk class, and gender. Due to the complexity and subjectivity involved in recognizing, measuring, and evaluating each of these parameters in pricing post-level term-mortality, the reinsurers naturally tend to be very conservative in pricing for continuation. This can turn what would have otherwise been an attractive quote into one which is unacceptable. Technical approaches based on tools such as the Dukes-McDonald Method or the Becker-Kitsos approach are valuable in determining the appropriate end-of-term mortality assumption and hence in judging whether the reinsurer’s end-of-term pricing is equitable and reasonable. To address this problem and potentially enhance your quote, it might be prudent for the ceding company to request each reinsurer to provide a quote predicated on the condition that at the end of the level-term period, the reinsurer has the unconditional right to increase premiums and the ceding company has the unconditional right to recapture.
IMPORTANT ADDITIONAL CONSIDERATIONS
1. Reinsurance is not a commodity
Purchasing First Dollar Quota Share YRT Reinsurance is not exactly like purchasing a commodity where reinsurers with the lowest prices are necessarily the best deals. Credit rating, financial strength, services provided, jumbo limits, facultative capacity, and transactional facility (ease of doing business) are some of the important attributes that should be recognized when selecting reinsurers.
2. Treaty Language and Provisions
Treaty language and provisions often vary from reinsurer to reinsurer and play an important role in the amount of effort and manpower which will be needed in the overall administration of the reinsurance arrangement, meeting the expectations of both parties, and the associated costs. Provisions such as Errors and
Oversights and Policy Changes should be crisply and clearly written to prevent potential future disputes. Inclusion in your treaty documents of specific clarifying examples may be helpful in heading off future disagreements, but the examples also work against you if they are not clear and do not take into consideration all possible interpretations and applications.
Writing, defining, and structuring treaty language and provisions is a specialist task requiring painstaking attention to detail that could pay dividends in the event of a dispute. Elaborating on this aspect is beyond the intended scope of this article, but it is worth mentioning two particular treaty provisions that, if not drafted with precision, can have significant financial impact.
Reinsurer Premium Guarantee Provision
The Premium Guarantee language must be clear, effective and have teeth. As we indicated earlier in our discussion, the reinsurer’s choice of which mortality table to assume (i.e., which mortality table they believe reflects the appropriate slope for the particular company’s mortality that they are quoting on) and what level of mortality improvement factors to assume, have the greatest financial impact in pricing. There is clearly a significant amount of judgment and subjectivity involved in these two important assumptions and hence in projecting future mortality which the reinsurer uses in developing their pricing.
In a scenario where the actual claims are following the slope of the 1990-95 mortality table and reinsurance premiums have been based on the 1975-80 mortality table, the mortality claims will increase at a faster rate than the reinsurance premiums. In a few short years, the reinsurers would find themselves in a situation where mortality claims are now considerably higher than the reinsurance premiums. This observation, or shall we say revelation, comes as the experience unfolds, when the reinsured block of in-force business has become quite large and is generating significant losses to the reinsurers. A similar effect would also occur if the mortality improvement that the reinsurer built into their pricing fails to materialize.
In order to avoid or mitigate the recurring impact of significant losses, the reinsurers may attempt to raise rates, especially when the Premium Guarantee Provision in the treaty is weak, unclear or ambiguous, which has very often been the case in YRT reinsurance.
An example of recommended Premium Guarantee language in YRT treaties that should prevent the reinsurer from raising its premium rates on in-force business is as follows:
“We anticipate that the YRT rates shown in this agreement will be continued indefinitely for all business ceded under this agreement. However, because of statutory deficiency reserve requirements, the only guaranteed premiums are premiums equal to the 2001 CSO Mortality Table discounted with the maximum prevailing statutory interest rate according to the issue year.”
AND
“We may only increase YRT rates if we increase rates for our entire class of YRT business with each of our clients. If we increase YRT rates, then you have the right to immediately recapture without penalty or recapture fee, any business affected by such increase.”
The original intent of the first paragraph of the Premium Guarantee provision was to guarantee the current reinsurance premium rates in a way that the reinsurer would not have the ability to raise its rates. If, however, the reinsurer explicitly guaranteed the current rates, it would be required to set up deficiency reserves. Therefore, the actual language was constructed in a way that falls far short of actually guaranteeing the treaty rates.
The first paragraph, although quite common, gives the direct writer very limited protection against the reinsurer actually increasing its rates on in-force business for any reason it considers justified or even for any reason at all. The lack of clarity and ambiguity in this paragraph can lead to disputes and arbitration proceedings with serious financial repercussions to the direct writer.
The second paragraph denies the reinsurer the right to raise the treaty YRT rates unless it also raises YRT rates applicable to all other clients. Thus, by virtue of the second paragraph, a reinsurer experiencing significant losses, as in the scenario alluded to above, can only raise rates if it does so globally across all its YRT treaties, even with respect to clients with favorable experience. Only a reinsurer exiting the YRT business would follow this course of action. Even in such an extreme case the direct writer would have the ability to recapture without fee or penalty.
Clearly, addition of the second paragraph virtually ties the reinsurer’s hands and substantially protects the ceding company.
Recapture Provision
In a reverse scenario from the one discussed in the Premium Guarantee Provision, if the actual mortality claim rates are following the slope of the 1975-80 mortality table and the reinsurance premium rates have been based on the 1990-95 table, then the reinsurance premiums will increase at a faster rate than the death claims. After a few years the direct writer will find itself in a situation where the YRT reinsurance premiums are now considerably higher than its mortality claims. This usually occurs at a time when the reinsured block of in-force business is quite large and is generating significant reinsurance losses to the direct writer. The direct writer will be strongly motivated to improve its situation and will likely attempt to recapture its business.
The Recapture Provisions in most reinsurance treaties are unclear and/or ambiguous for first dollar quota share arrangements, usually to the detriment of the reinsurers. For example, some treaties have no limitation at all regarding the business eligible for recapture. They merely allude to a recapture period (often shown on a separate schedule page). Other treaties refer to the fact that facultative and reduced retention cessions are not eligible for recapture, but never clearly indentify quota share arrangements as reduced retention. In addition, treaty provisions are often silent as to whether an increase in the ceding company’s quota share retention (e.g., 10 percent to 100 percent), represents a true increase in retention scale or not. Of course, the ceding company would assert that it is, in order to strengthen its justification to recapture. Since it is typically the reinsurers’ intent that quota share business not be subject to recapture, the treaty provision language must deal with this issue clearly and unambiguously.
Until such time that the reinsurers revise and clarify the recapture provisions in their treaties, we will find direct writers falling into the scenario above, whose management teams will be compelled to focus on any ambiguous, unclear, or vague treaty language to recapture their business which is experiencing significant reinsurance losses. For additional information and details of the importance of this issue, see the author’s article “The Recapture Provision, Is It Up To Date?” in the March 2004 issue of the SOA publication, Reinsurance News.
Another helpful article titled, “How To Lose A Million Bucks Without Really Trying: Oversights In Negotiating Reinsurance Treaties,” may be found in the January 2011 issue of Reinsurance News.
3. How Many Reinsurers Should be Selected to Participate in the Pool?
There is no universal answer to this question. A higher number of reinsurers participating in your pool (e.g., six to eight) may increase the number of facultative outlets for your underwriters and increase automatic binding limits. It would certainly add stability to the pool in the event that some reinsurers decide to drop out after giving the required notice of termination. These are all important attributes that a pool of many reinsurers would have.
In today’s business environment where most companies are very cost conscious, I suggest that a smaller reinsurance pool be considered.
There is typically an increase in overall reinsurance costs as we increase the number of participating reinsurers in our pool. When a large number of reinsurers participate in the reinsurance pool, there is an added burden and hence added cost relating to managing paperwork and assisting the reinsurers as they routinely and periodically perform on-sight underwriting, administration, and claims audits. Additional costs which can become significant relate directly to higher aggregate reinsurance premiums, due to the fact that in forming your pool typically the lowest priced reinsurers are selected first, and therefore each additional reinsurer will have higher reinsurance premium rates than the previous ones.
Let’s assume that a pool consisting of only three or four reinsurers can be formed which will support both the automatic binding limits and facultative outlets that your underwriting team requires. This should not be too difficult to obtain. Then the remaining attribute that is still lacking is stability; thus we must be able to assure that, if one or two members terminate, there is sufficient time to find replacement reinsurance companies before actual termination takes place.
I am suggesting that establishing stability in a smaller reinsurance pool can be accomplished during the negotiation process by requiring that the customary 90-day notice of termination be changed to a 365-day notice of termination. We now will have produced the same attributes of a large reinsurance pool with stability, lower reinsurance premiums, and a less costly smaller pool.
4. Modification or Changes to Underwriting Guidelines or Requirements
A. Minor Changes in Underwriting
When the direct writer modifies or changes their underwriting guidelines or requirements, there will be no credible mortality experience (reflecting this change or modification) to rely upon for some time afterwards. Without credible mortality experience, the reinsurer will typically be more conservative out of necessity. If the underwriting guidelines or requirements were recently tightened, then the credible mortality experience reflecting the previous underwriting standards could be used as a starting point. A scaling factor recognizing the anticipated improved mortality can then be negotiated with each reinsurer. Some reinsurers will be more optimistic than others in their assumption of the level of mortality improvement resulting from the tightened underwriting, which naturally can provide an opportunity for obtaining a more competitive quote from an aggressive reinsurer. Of course, all of the considerations previously discussed earlier in this article should be addressed in the negotiation process.
When, on the other hand, underwriting guidelines or requirements are to be loosened, the rationale for this modification should be carefully explained to each reinsurer. The direct writer’s underwriting department can be very helpful in communicating to each reinsurer what impact, if any, this underwriting change is expected to have on mortality for new business and hopefully that the mortality experience reflecting the previous underwriting standards can be used without any upward adjustment.
B. Major Changes in Underwriting
Significant changes in underwriting requirements continue to be made over the years throughout the industry. For example, the transition from using blood and urine to oral fluid (subject to age and face amount limitations) was a major change in underwriting. Some reinsurers were initially more cautious than others in determining what impact this would have on mortality rates and how to reflect this in their pricing. Even today there is still a noticeable variation in reinsurer pricing differentials when comparing blood-tested business and non-blood-tested (oral fluid) business. We will address this issue further in our discussion on Flexible Reinsurance Selection Procedure below.
Increasingly companies are moving away from oral fluid testing towards the use of the prescription drug (Rx) database, subject to age and face amount limitations, and often with the incorporation of automated underwriting programs. The objective is to accelerate, simplify, and streamline the agent and customer application and underwriting process.
Exactly what impact this will have on mortality rates and how to reflect this in their pricing is currently a big challenge to both direct writers and reinsurers alike. It should therefore come as no surprise that currently there is a significant variation among reinsurers in their pricing differential between blood-tested and non-blood-tested (using an Rx database) business.
5. Flexible Reinsurance Selection
After discussing and fully exploring all appropriate assumptions and considerations with each reinsurer as outlined in this article, it may be advantageous to consider the feasibility of using a Flexible Reinsurance
Selection Procedure (FRSP), a term which I took the liberty to coin, which will be addressed shortly. Typically on a first dollar quota share arrangement each reinsurer would assume a fixed percentage of the face amount for each and every life reinsured regardless of the risk classification of that life (e.g., Male/Female, smoker/nonsmoker, blood-tested/non-blood-tested, etc.). The ranking of the various reinsurance quotes is then developed by applying weights to the YRT rates of each reinsurer based on an assumed distribution of new issues by underwriting risk classification.
Some reinsurers have very competitive rates for male lives, but are not as competitive on female lives. This typically happens when reinsurers build in aggressive mortality improvement factors for male risks, but little or no mortality improvement factors for female risks. Similarly, some reinsurers can have very competitive rates for blood-tested business, but uncompetitive rates for non-blood-tested business. (This disparity can be especially pronounced in those situations when the use of an Rx database replaces the use of oral fluid and urine.)
In these situations, one should consider using an FRSP by reinsuring the blood-tested business and the non-blood-tested business separately. This would enable the direct writer to choose one group of reinsurers with the lowest prices for their blood-tested business and another group of reinsurers with the lowest prices for non-blood-tested business. Of course some reinsurers will be competitive for both and will be chosen for both risk pools. A similar approach could be employed when and if a large disparity in rates exists between male and female lives.
It is hoped that the ideas touched upon in this article will give the reader additional insights and knowledge into the important pricing concepts and considerations which are called upon in reinsurance pricing, and will serve as “A Checklist For Optimizing Reinsurance Negotiation.”
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Larry Warren is a Reinsurance Strategist and Negotiator. For the past six years, he has served as Chair of LICONY’s Resinurance Subcommittee working directly with the New York Department of Financial Services on actuarial and reinsurance matters. Mr. Warren has also served on the Reinsurance Committee of the Society of Actuaries, the Reinsurance Committee of the ACLI, the Reinsurance Premium Rate Guarantee Subcommittee, the Subcommittee to develop the Life Reinsurance Sourcebook, and have often been quoted in reinsurance literature.
Mr. Warren has written several papers covering both technical and business matters relating to reinsurance appearing in various publications of the Society of Actuaries such as “Reinsurance News,” “Product Matters,” and “The Financial Reporter.” His most recent paper entitled: “A Primer on Reinsurance Pricing Strategy—A Checklist for Reinsurance Negotiation” received high recognition from the reinsurance community.
