White Paper - Operating a Re/Insurer – Holding Company Structure

Operating a Re/Insurer – Holding Company Structure/Transactions/Financial Condition

Chief Financial and Chief Underwriting Officers should consider the following. The mantra of both new and longstanding insurer groups of four or more insurers should be: “stacking, pooling, dividending and contributing”. Those transactions can: enhance financial condition efficiency, internally finance corporate opportunities, increase shareholder dividends and funding for stock buybacks, provide underwriting flexibility, and provide marketing benefits and optics.

Stacking Ownership (aka “double-counting surplus”). An insurance holding company system (Holdco system) should own its insurers vertically, not horizontally. Insurers owning insurers increases the policyholders surplus (PHS) of each owning insurer because the PHS of each insurer subsidiary is rolled up into the owning insurer’s PHS. If a group had insurers A-D with PHS of 500, 100, 50 and 20 – the Holdco’s PHS would be that total (670) if owned horizontally (i.e. Holdco directly owns each sister company). If stacked and owned vertically, these insurers’ PHS immediately become: 670, 170, 70 and 20 – essentially being an increase in “geographic PHS” at the insurer level, which results solely from ownership of affiliate insurers – while the aggregate PHS at the Holdco level remains the same (670).

Constituents who value size will see substantially larger PHS at all but the lowest insurer in the stack. Holding company regulation is based upon PHS at the prior December 31 for: investments (by kind and class and for a “single name investee”); the size of Ordinary Dividends; when affiliate transactions become subject to prior regulatory approval; the maximum net liability assumable from any one risk; and the calculation of RBC or BCAR ratios. PHS of each insurer can increase overnight via stacking alone.

Some states limit the permitted size of “an insurer’s investment in subsidiary insurers” (e.g. 35% or 50% of PHS under NY Section 1408). However, exceptions exist in the law for acquiring subsidiary’s shares via dividends or contributions to PHS – so that a subsidiary insurer’s size might exceed those percentages. Which makes sense because stacking is accomplished by the Holdco contributing (i.e. “gifting”) the stock of each insurer to its new insurer owner; it is not the expenditure of investable cash by one insurer on a second insurer’s stock (creating a “concentration” hazard); it is a gift of contributed surplus in the form of subsidiary insurer stock. Because of this “relative size of owner and subsidiary” concept, stacking often has affiliates with the highest PHS owning smaller affiliates. For a larger system, 20 or so affiliates could be owned via 4-5 stacks, with each parent insurer at the top of each mini-stack being sisters horizontally owned by the Holdco. But the stacking benefits remain within each stack, especially the creation of additional Net Income via dividends from owning subsidiary insurers – which solves a “limitation on dividend capacity” issue (see Dividending below).

Gross Intercompany Reinsurance Pooling. “Gross reinsurance pooling” is accomplished among affiliates prior to effecting reinsurance by any one pool member. An example of a gross pool’s “firing order” is: each insurer writes business; 100% is reinsured to the Pool Leader (typically the affiliate with the largest PHS); the Pool Leader buys all external reinsurance (for itself, and thus for all pool members); and the net of the external reinsurance is pooled among affiliate members via a retrocession from the Pool Leader. (“Net pooling” is when each member first buys external reinsurance then pools the net of it.)

If the intercompany pool is by US insurers with an offshore affiliate owner (that is not a US taxpayer and is operating “the Bermuda Advantage” of growing tax-deferred investment income on reserves in a lower or zero US tax environment), the firing order can be modified. The US Pool Leader first buys external 3rd party reinsurance for the pool; secondly it cedes a portion of the net to its non-US affiliate (to grow tax-deferred or lesser-taxed investment income); and thirdly the net of both the 3rd party reinsurance and the non-US-affiliate reinsurance is retroceded to each US pool member. The retrocession to each pool member can be based upon its individual PHS as a percentage of the aggregate PHS of all pooling members. Or it can be arbitrary, provided it is prudent.

The starting point for selecting the retrocessional percentage of each pool member can be its PHS as a percentage of the entire pool’s aggregate PHS (e.g. affiliate C with PHS of 50 pre-stacking and 70 post-stacking might have a retro share of 70/670 or 10%; affiliate B with post-stacking PHS of 170 might have a 170/670 share or 25%). Retro percentages can be tweaked from time to time, with regulatory approval. A higher share can grow an affiliate via underwriting income; a lower share can freeze its size. An insurer with low GWP that under-utilizes its PHS can receive a higher share to “untrap capital”.

Gross reinsurance pooling results in many benefits: (1) only the Pool Leader cedes external reinsurance for the group (profit centers no longer buy their own); (2) virtual elimination of Schedule F for all but the Pool Leader (i.e. each member only shows 100% reinsurance to the Pool Leader); (3) there is no RBC charge to members for affiliate reinsurance; (4) each member receives a pooled rating from AM Best; (5) each member can write GWP of any size, since pooling reduces a member’s GWP to a NWP matched to its (stacked) PHS; (6) each member’s underwriting results are a blend of the entire group’s writings; (7) a surplus lines affiliate (fast to market; no rate and form filings; typically without guaranty fund protection of policyholders/claimants) is 100% reinsured by the substantial Pool Leader (comforting brokers and policyholders by reducing its insolvency risk to zero); (8) affiliates can “brand” their own line of insurance (specialty, superior, sub-standard, etc.) at any volume, thus marketing its brand yet reducing its NWP to a prudent size; (9) historical 100% internal fronting arrangements are unwound and replaced; and (10) members can be grown or shrunk by tweaking their retrocessional pool percentage from time to time, thus avoiding “trapped capital” in a member (and re-deploying capital without needing dividend approvals or filings within the Holdco system).

Maximum Annual Dividending (to grow Net Income). Each insurer in a group (on the same Day One) should annually pay its maximum Ordinary Dividend (the statutory amount not needing regulatory approval) to its owner-insurer (which passes up the stack to Holdco) starting on December 1 of any year. If all or a portion of that dividend is needed back as PHS, it can be contributed down to the dividend-paying subsidiary without approval on Day Two – so the dividend-paying insurer is made net neutral on PHS – but the recipient-insurer’s Net Income has increased by the dividend amount it received before contributing it back down. By starting this process on December 1, the group has at least 10 years before the “up on Day One, back down on Day Two” reaches December 31, which is the most critical day for financial condition management. All the subsequent year’s limitations are based on admitted assets or PHS as of the prior December 31.

Why dividend annually, just to return it on Day Two? Paying an “Extraordinary Dividend” requires regulatory approval, but an Ordinary Dividend does not. Each domicile defines Extraordinary. 28 states define it as a number calculated on a rolling 365-day period that is “the greater of: Net Income or 10% of PHS”. 21 states define it as the “lesser of” those two figures. Each group insurer domiciled in a “lesser of” state can increase its capacity to pay higher Ordinary Dividends by constantly growing its Net Income, since that is often lower than PHS. Net Income (Annual Statement p 4, line 20) can be grown by receipt of dividends (Net Investment Income from subsidiary insurers) or underwriting income (from a pool retro share). By starting in early December, a group can manage the 365-day rolling measurement period by all insurers paying an Ordinary Dividend amount one day after that amount ceased to be “Extraordinary” by the passage of 365 days since the prior dividend was paid. This technique manages the rolling period by paying annual dividends one day later each year, but prior to December 31.

Dividends may only be paid from “earned surplus” or “unassigned funds” (Annual Statement p 3, line 35). That figure can be increased by Net Investment Income (from its new subsidiary’s dividends) and underwriting income (from a pool member’s retrocessional share). Pooling (and taking a retrocessional share) is better than 100% fronting by an affiliate (a frequent structure for smaller affiliates), since such fronting freezes the writing insurer’s underwriting income at zero, thus stifling Net Income growth.

Stacking creates additional Net Income for each insurer owning a dividend-paying subsidiary insurer. A group with a number of “lesser of” domestic insurers should definitely be stacked and have the stack pay maximum Ordinary Dividends annually. As dividend capacity increases at each “lesser of” recipient-insurer (via increased Net Income) and “earned surplus” increases from new investment income (from dividends) and underwriting income (from pooling), opportunities open up for the Holdco. Corporate opportunities might be financed internally via dividend income up to Holdco, followed by contributions of surplus down on Day Two (to the dividend-payer or elsewhere in the system). Shareholder dividends can be increased by Holdco or stock buy-backs can be internally financed to boost earnings per share.

Contribution Agreements. If a group insurer is thinly capitalized and possibly needs surplus contributions from time to time, it is difficult to estimate and make the perfect amount of contribution prior to December 31, because underwriting results aren’t calculated until January or later. A Contribution Agreement can be filed in early December with the domicile regulator of the needy affiliate and approved before yearend (don’t wait too long). That agreement obligates the insurer’s owner or affiliate to contribute the estimated amount or range of PHS in January or February, once the appropriate figure is ascertained. This allows the figure determined in mid-February to be contributed then, but receive annual statement credit for having been made as of the prior December 31.

Future articles will discuss corporate reserving for loss and expense and how to calculate the “operating ratio”, which is the true measure of insurer performance.

[Charley Barr is the former General Counsel of General Re, XL Capital, Reliance Life, General Accident and other re/insurers. He is an expert witness, ARIAS-certified arbitrator, and a specialist in holding company structures and transactions. This is one in a series of white papers at: www.CFBarrADR.com]