Recent Misuse of ModCo to Falsely Reduce Required Capital

[Please note this is not a polished report…this short version is intended to assist you in preparation of a more complete discussion about current day misuse of ModCo to falsely reduce required capital. The brief background below helped me to put the misuse of ModCo in perspective.]

Prior to World War II (WWII) Germany was the primary hub for large, heavily-capitalized reinsurance companies. After WW II large reinsurance companies willing and able to assume large blocks of business from ceding companies became much more available in other countries.

Pre-WWII, U.S. insurance companies turned to the large German reinsurers for their backstop to absorb surges or spikes in claims volume. U.S. insurers and regulators trusted them to honor their commitments. As Hitler’s threat grew, Germany’s volatility made large reinsurance transactions by U.S. insurers with the German reinsurance hub more precarious. The U.S. insurers and regulators’ distrust was not of the reinsurance companies willingness or ability to pay claims; it was Hitler’s insanity. U.S. regulators had no doubt that the long-standing giants (Cologne Re founded 1846) were “willing and able” to honor their reinsurance commitments to U.S. insurers. With Germany war-torn and the threat of German military leaders potentially seizing their assets, Modified Coinsurance became a solution.

Modified Coinsurance is precisely the same as traditional Coinsurance in that the assuming reinsurance company is in fact on the hook to pay all losses that fall under the traditional Coinsurance contract and, of course, to share in the profits. The unique characteristic is that all funds that the ceding U.S. insurer would normally pay (along with the related liabilities) to the reinsurer (in Germany…a wartorn country) are actually held in trust or escrow by the U.S. ceding insurer. While it served its purpose in the instance of World Wars, it has more recently been used with affiliated, underfunded captives, as nothing but a farce for the sole purpose of “sleight-of-hand” accounting.

Note that the mechanics associated with such modified coinsurance (as compared with traditional coinsurance) are a tedious and onerous accounting mess. Ceding insurers must basically account for both ends of the reinsurance contract and exercise considerable fiduciary caution in pulling funds from the escrow account. Upon receipt of a claim, the ceding insurer must not only determine if the claim is or is not covered under the ModCo contract and report the claim to the assuming reinsurer, it must carefully document the propriety of pulling the funds from the escrow account. While the funds in escrow are safekept in the U.S., they are the property of the reinsurer. Also, the results of the ModCo are the same as traditional Coinsurance; hence, the onerous nature of the ModCo only makes sense if it is necessary. If the preferred reinsurers have substantial capital and the willingness to provide a backstop – but are domiciled in a war-torn country, then ceding insurers and their U.S. regulators might find that the additional safety net is worth the hassle.

No one can successfully challenge the reinsurance fundamentals that require bona fide risk transfer and, especially, the ability of the reinsurer to pay. Ceding insurers do not engage in large reinsurance contracts because they want to share their profits with them. But in order to have their commitment to honor claims/losses, they must be willing to share in profits as well. Coinsurance is truly share and share alike…both profits and losses. If the claims experience is especially bad for several periods, the reinsurers are on the hook for amounts which might be far in excess of anticipated claims patterns. In such events, the reinsurer must cough up substantial additional funds necessary to “true up” the higher reserve liabilities. IF THE REINSURER WAS NOT ABLE TO PAY IN THE EVENT OF SPIKES IN LOSSES, THE CEDING INSURERS WOULD NOT CEDE TO THEM VIA COINSURANCE, MODCO OR ANY OTHER FORM. More on point here, because of the onerous nature of the ModCo process, to do so with a reinsurer with insufficient capital would be foolish.

In recent years, I began to take notice that for-profit life insurers were employing a renewed use of ModCo contracts and in massive amounts. Frankly, given that I had already uncovered accounting schemes far in excess of the life insurer’s total surplus, I was not in the hunting mode. More importantly, I was lulled into a false sense of security by the fact that with ModCo contracts, THE FUNDS DO NOT TRANSFER TO THE REINSURER. In fact, when I first focused on the potential problems with these ModCo deals, I called one of the most respected life actuaries in the country who has worked for more than 30 years with Tillinghast and served as a life actuary for more
than 40 years. Jeff had earned my respect and trust when he testified in a large criminal case involving fraudulent reinsurance which resulted in a lengthy prison sentence for the defendant. I testified in that same case with respect to RICO and money laundering which led to a record forfeiture under RICO; funds which went to the benefit of policyholders who had been unable to get claims paid. When I told Jeff that I had uncovered a new scheme involving ModCo, his first comment was “what concern would there be with ModCo, since the funds stay with the ceding company?” That is when I realized how this scheme had a powerful “lulling” effect on regulators and fraud
examiners. When I went on to explain that the scheme was not related to the funds themselves; but rather, it was actually nothing more than a trick to falsely reduce Risk-Based Capital (RBC) penalties, he agreed and suggested that I confirm that the RBC risk factors are transferred to the assuming reinsurer and, if that were the case, I had stirred up yet another hornets’ nest.

I did confirm through multiple channels, including honest regulators and analysts, that ALL of the RBC risks do transfer to the assuming companies. That is what makes this scheme tricky to understand. To be clear, if the assuming companies were independent and well-capitalized, I would never raise an issue. I would question why they would go through the hassle of Modified Coinsurance given that the assuming companies are in blissfully safe domiciles, but if ModCo is their choice, fine. A quick note on RBC: the sole purpose of the complex and all- encompassing risk factors that flow into the RBC formula is to ASSESS LEVELS OF RISK related to investment concentrations, excessive reinsurance with high-risk reinsurers and excessive levels of interdependency on affiliates within the group, is to determine HOW HIGH THE SURPLUS MUST BE AT A MINIMUM. The higher the risks in a company, the higher their surplus must be relative to its size. Unfortunately, the recent use of MASSIVE AMOUNTS of ModCo involving subsidiaries and affiliates is the very type of process which RBC attempts to account for. Ultimately, life insurers are using these ModCo tricks to REDUCE their required surplus, when it ought to increase it.

For purposes of this discussion, I will tell you that all of the relevant ModCo schemes are ENORMOUS in dollar-volume and are ceded to AFFILIATED AND UNDER-CAPITALIZED reinsurers. The assuming companies are in under-regulated venues that permit reserve liability discounting and even allow NON-ASSETS to be carried as ADMITTED ASSETS to support their claims liabilities. Often, they are even wholly-owned subsidiaries of the ceding insurance companies. Based on the forgoing arguments, I consider these so-called reinsurance transactions to be an embarrassment to the U.S. life insurance industry.

Specific Examples:

The most relevant data in assessing these ModCo deals include the amount of the life insurer’s Total Surplus as compared with its total liabilities, the speculative nature of their investment portfolios and the true nature of their reinsurance ceded portfolio. At the core of any large life insurance company, it is essential that their reinsurance genuinely transfers risk to the reinsurer; to do so, the reinsurer must be ABLE TO PAY. Below is a quick snapshot of those elements for several large life insurers. All actual examples below are using the most recent sworn annual statements date 12/31/2018.