As competition in the re/insurance market remains heightened, global property and casualty (P/C) re/insurers are rethinking their business strategies and how best to deploy capital resources. Consequently, they're increasingly using loss portfolio transfers (LPTs) and adverse development covers (ADCs) to de-emphasize their non-core legacy businesses that no longer offer optimal risk-return opportunities.

Re/insurers have relied on these risk management tools to exit lines of business, reduce regulatory capital burdens, minimize earnings volatility, enhance liquidity, shore up their balance sheets, and optimize their administrative resources. These structured solutions go beyond traditional risk transfer covers and combine risk transfer with balance-sheet management considerations.

While LPTs and ADCs remain the preferred options, the introduction of Insurance Business Transfer (IBT) laws in some states in the U.S. expands the solutions available to re/insurers and could serve as a comprehensive tool in the future.

S&P Global Ratings believes that effectively executed LPT and ADC transactions could enhance cedants' overall credit profiles. While the benefits would primarily be in terms of capital relief and improved risk profiles, they would vary depending on the risk transfer dynamics on an economic basis, terms and conditions, and materiality of such transactions.

Exiting Business Through LPTs

Today, to exit a line of business, re/insurers have limited restructuring options. They can novate their business, put their business in a run-off and manage it themselves, or use LPT. Over the past few years, re/insurers have shown increasing interest in using LPT as a means to restructure their portfolios. This is primarily due to the ease of executing such transactions or transfers compared with the other options. For instance, novation typically involves a rather cumbersome process because of the consent required from the policyholders and various regulatory authorities. Thus, in most cases, novating a block of business is less cost efficient than an LPT.

The increased interest in LPTs largely stems from the capital relief for the cedant as the economic reserve risk is transferred to the reinsurer, offset by potential counterparty credit risk and lost investment income from the assets backing the subject reserves. Given the differing treatment under various accounting standards, we consider the economics of these transactions to evaluate whether true risk transfer has taken place.

Additional benefits to the cedants may include:

• Potential financial benefits if the carried loss reserves are adequate, thus helping the cedant negotiate a better pricing for ceded risk;
• Operating efficiencies from resultant savings of claims management and other administrative expenses on the associated portfolio; and
• The potential for better capital allocation and redeployment opportunities.

Table 1

In most cases, we have observed that LPTs involve long-tail commercial liability lines such as asbestos and environmental, workers' compensation, and professional liability. The higher uncertainty around the actual amount and the timing of claim payments prompts cedants to undertake LPTs. Reinsurers typically underwrite such covers on these long-tail liabilities as they price these LPT contracts on a discounted cash flow basis. So, the longer the duration of the contract, the more opportunities reinsurers have to generate investment income from the assets received under the transaction. In addition, reinsurers leverage their expertise in claims handling to enhance the positive payoffs from such transactions.

On the flip side, cedants could face credit and reputational risks in the event of non-payment or inadequate claims handling by the reinsurers. Also, differences in the actuarial opinion on the transferred loss liabilities between the cedant and the reinsurer may increase reinsurance costs for the cedants. Similarly, reinsurers failing to price the transactions adequately may face negative returns from larger-than-expected claim payments. They could also face lower investment income from shortened reserve duration due to faster-than-expected claim payouts.

In our assessment of the reinsurers underwriting such transactions, we also factor in management's expertise and experience in handling LPTs, adequacy of reserves assumed, and claims management, among other things. And we consider the potential risks from the concentration or diversification benefits of long-tail liabilities in the reinsurers' overall underwriting portfolio.

Mitigating Earnings And Capital Volatility Through ADCs

In light of challenging market conditions, generating underwriting profits while maintaining rate adequacy and minimizing earnings volatility remains a key focus for re/insurers. As such, re/insurers have increasingly used ADCs to mitigate earnings volatility.

Table 2

Over the past few years, we have seen re/insurers purchase ADCs, particularly for some of their commercial liability lines. The landmark ADC bought by American International Group Inc. (AIG) from National Indemnity Co. (NICO, a subsidiary of Berkshire Hathaway Inc.) provides 80% coverage of $25 billion in excess of the first $25 billion of subject reserves (U.S. casualty reserves for accident years 2015 and prior). Underpinning AIG's, as well as most of the other re/insurers', purchase of ADC is the intention of curtailing earnings and capital volatility amid weakened operating results.

Apart from stabilizing earnings, ADCs also help facilitate smoother mergers and acquisitions, wherein the acquirer is less concerned about potential volatility from reserve adequacy of the target company's legacy portfolio. This reduces the need for in-depth actuarial due diligence or additional capital infusion requirements. As an example, in May 2019, The Hartford Financial Services Group Inc. purchased a $300 million ADC from NICO during its acquisition of Navigators Group Inc. As part of the ADC, NICO covers any adverse reserve developments in excess of $100 million above Navigators' loss reserves as of Dec. 31, 2018.

ADCs relieve cedants of the uncertainty and potential earnings and capital impact of reserve strengthening. For reinsurers, the benefits and risks of writing ADCs are similar to those of LPTs. For instance, reinsurers underwriting these covers are exposed to pricing risk in case of an unexpected or sudden deterioration in loss reserves trends for the covered lines of business. The impact may be exacerbated if the reinsurer has multiple ADC contracts covering the particular lines of business. Nonetheless, similar to LPTs, cedants retain the risk of default of their reinsurance counterparties.

Insurance Business Transfer, An Emerging Restructuring Option

Although LPTs and ADCs are the two most well-established restructuring solutions available to re/insurers, they do not provide a complete finality or release of liability, and the ultimate policyholder claims obligation remains with the cedants. Increasing demand for restructuring legacy liabilities has also led to the introduction of IBT laws, which provide a more comprehensive solution to the cedants.

However, these laws are still in the nascent stages. Rhode Island was the first state to adopt this law, and multiple U.S. states have since followed suit. But, there have been inconsistencies in the laws these states have adopted. The inconsistencies are typically in terms of the types of business/liabilities that are eligible to be transferred, nature of business (active or run-off), and other requirements around court approvals and disclosure provisions for policyholders. Considering these disparities, the National Association of Insurance Commissioners (NAIC) has formed a Restructuring Mechanisms Working Group and a Restructuring Mechanisms Subgroup to oversee various legal and financial issues related to IBT and district laws.

So far, we have not seen any re/insurer undertake an IBT transaction. We believe that a wider and more consistent adoption of IBT law across all states in the U.S. will take a while. Nevertheless, if adopted, IBT could act as a comprehensive restructuring tool for re/insurers in the U.S. and can be a successful equivalent to the Part VII transfers in the U.K.

LPTs And ADCs Could Be Credit Positive For Cedants

We believe that effectively executed LPT and ADC transactions could enhance cedants' financial risk profiles and overall creditworthiness. For this to be the case, the transaction has to be a true risk transfer, with explicit attachment or trigger points (the point at which reinsurance limits apply) and clear terms and conditions.

As a result, the capital requirements on the subject reserves could be reduced. Thus, our quantitative capital and earnings assessment of a cedant could improve, depending on the structure of the transaction and remoteness of the attachment point being triggered. (The associated increase in counterparty risk slightly offsets these benefits.) Furthermore, these transactions could enhance our view of overall risk exposure, to the extent they mitigate prospective reserves and earnings volatility.

An Example Of Potential ADC Treatment Under Our Capital Model

Here we provide an example of the potential quantitative benefits of an ADC transaction to the cedants under our risk-adjusted capital adequacy model. Given that each ADC transaction is unique and the terms and conditions may vary, our assessment may differ on a case-by-case basis. So this example should not be viewed as guidance.

We assume that XYZ Insurance Co. has purchased a $400 million ADC above its current loss reserves for its U.S. workers' compensation line of business. Under the three scenarios, we have assumed different attachment points. As the attachment points are further away from the covered reserves, the probability of them triggering becomes remote. Thus, the quantitative benefits under our capital model (relief on reserve risk charge) are lower. This is reflected in our example. ADC-1 gets full capital relief of $292 million of reserve charge, while ADC-3 gets only up to $92 million. This is because the ADC-1 attachment is "at the money," while ADC-3 attachment is "out of the money." Offsetting reserve capital relief is an increase in counterparty risk.

Table 3

Substantial Opportunities Lie Ahead

We believe re/insurers will continue to strive to achieve better risk-adjusted returns by redeploying capital to focus on their bread-and-butter business. As re/insurers contemplate mergers and acquisitions, management teams could seek structured solutions to mitigate their exposure to legacy business. In addition, re/insurers may need to prune unprofitable non-core products as the sector is coming out of a soft pricing cycle. As a result, we expect re/insurers to increasingly use LPTs and ADCs.

In our view, by offering structured solutions, reinsurers have the potential to form long-term partnerships with cedants with more tailor-made pricing, compared with traditional risk transfer products. But they also require intense underwriting and claim expertise for the acquired lines of business, and scale depending on the size of the transaction--for example, the ADC bought by AIG from NICO. However, if these structured solutions aren't properly managed, they can weaken reinsurers' creditworthiness.

We could assess ADCs and LPTs as a credit positive for cedants if they are well executed and we view them as true risk transfers. However, these may not be comprehensive solutions, and the ultimate risk of claim payment would still lie with the cedants. A promising prospect is the IBT laws introduced in some states in the U.S. But, a consistent application of the laws across states could take a while, so we may have to wait to see a more widespread use of IBT as a strategic tool.