However, while more capital is available now than ever before, opportunities for investing in the MPL market are becoming harder to find, due to consolidation within the market and the greater prevalence of self-insurance for hospital systems.
This growth in surplus has been relatively unique to the MPL line of business. In fact, since 2002, the weighted-average risk-based capital (RBC) percentage has increased nearly 600% for entities with an MPL focus. While the weighted-average RBC percentage for all other insurance writers has increased as well during that same time frame, their increase is dwarfed by that of the MPL writers (Figure 1). The rise of the RBC ratio implies that MPL writers have increased their financial ability to take on more risk at a faster pace than the broader property/casualty market.
In the wake of this surplus growth, it is important for MPL writers to ensure that this capital is working for the organization, its policyholders, and/or stockholders. One relatively common use of this capital is to continue to serve the organization’s mission to their current policyholders through rate subsidization—maintaining current rate levels—or devoting capital to adjacent markets, such as allied health lines or other professional liability segments. However, some companies may prefer a more active approach to capital deployment. What options are available to these organizations?
This article will examine the pros and cons of
a number of capital investment strategies for MPL writers. While some of the methods discussed are relatively well known in the industry, one—the residential mortgage credit risk market—is an emerging area in which organizations might find a new opportunity to deploy their excess capital to the benefit all their stakeholders.
MPL mergers and acquisitions
One of the most familiar applications of capital for MPL writers in recent years has been mergers with, or acquisition of, another MPL company. This well-known strategy is often the preferred option, because it is comfortable for the buyer and allows the organization to rely on already acquired expertise rather than devoting resources toward unknown risks. In addition, acquisitions enable MPL writers to increase their market share.
However, given the balance sheet strength of most companies in the market and the relatively small size of the market itself, opportunities for acquisitions are few and far between. Since 2009, the highest number of MPL transactions in a year has been six. This figure includes both insurance companies and non-insurance companies (Figure 2). On average, there have been roughly three transactions per year over the past decade. Another limiting factor is cost: exploring whether or not to pursue an acquisition can require expensive due diligence, including the resolution of issues that arise when there are different valuations of a target’s overall worth.
Lloyd’s of London
Another strategy that has become more popular in recent years is reinsuring or investing in Lloyd’s of London syndicates. Investing implies taking a stake in the syndicate itself, whereas reinsuring is done as an independent third party, only the latter of which flows through Schedule P, to our knowledge. A Lloyd’s of London syndicate typically specializes in particular markets, but ultimately creates a diversified portfolio of insurance risks, thereby operating as a defacto insurance company. One benefit of doing business with Lloyd’s of London is that the assumption of risk is done via quota share, so companies can determine what percentage of the risk they want to assume. This gives the investor access to a diversified portfolio of the wider insurance market, at a risk level appropriate for the company that takes on the risk.
Doing business with Lloyd’s of London can have a number of benefits. First, it diversifies the risk in an organization’s portfolio. Second, it allows MPL writers to partner with some of the best minds in the insurance industry, which may serve to lower risk. Further, as opposed to other uses of capital, Lloyd’s of London syndicates have a relatively short tail—three years—for any given year of assumed business. Finally, unlike acquisition efforts, there are lower barriers to entry for those looking to participate in Lloyd’s of London syndicates.
There are some potential downsides with the Lloyd’s strategy, however. Like most portfolios in the insurance sector, syndicates typically take on some level of property/catastrophe risk—a risk not otherwise encountered in MPL insurance. Although a syndicate can reduce this risk via diversification, it cannot be eliminated completely, and so it can lead to lower returns. Finally, Lloyd’s of London reinsurers have limited oversight when it comes to underwriting and claims handling. If results begin to deteriorate, it may be difficult to understand the underlying drivers because the syndicate is simply trusted to handle those matters.
Residential mortgage credit risk: An emerging strategy
Relative to the more familiar options for investing capital, one newer approach is residential mortgage credit risks. After the subprime mortgage crisis, Fannie Mae and Freddie Mac were mandated by the federal government to “deleverage” or hold less risk than they had previously maintained. The two entities, known collectively as government-sponsored enterprises (GSEs) in effect package single-family mortgage loans around the United States and sell them to bond investors, or they acquire private insurance to cover the credit risk, thereby spreading the risk of default by sharing it with capital markets and reinsurers.
Currently, residential mortgage credit risk reinsurance is not an option that MPL writers have pursued, at least to our knowledge. However, the wider reinsurance market has seen a steady increase in assumed risk during the past five years. In 2014, Fannie Mae’s Credit Insurance Risk Transfer (CIRT) and Freddie Mac’s Agency Credit Insurance Structure (ACIS) accounted for over a billion dollars of reinsured credit risk. In recent years, there has been around $5 billion of risk transfer per year (Figure 3).
In a typical arrangement, a diversified pool of tens of thousands of mortgages is aggregated. The payments (i.e., principal and interest) on those mortgages are pooled, then contractually apportioned to the bonds purchased by capital-markets investors or reinsurance agreements. The transactions may be standalone reinsurance agreements (CIRT) or may include a reinsurance element (ACIS) such that if credit losses exceed contracted loss levels, the reinsurers begin paying losses (akin to excess- of-loss reinsurance, subject to an aggregate). Therefore, the residential mortgage credit risk market offers two options for participation: bonds and reinsurance contracts. The primary differences between the two options are the collateral outlay and the accounting treatment.
The credit risk transfer bonds could be managed as part of a company’s investment strategy and managed by the investment arm of the organization. Similar to other bonds, these are purchased at a par value, and then earn interest over time until the bond matures. This investment requires a significant capital outlay for purchasing the bond.
On the other hand, if an MPL writer becomes involved from a reinsurance perspective, the premiums and losses would flow through Schedule P nonproportional reinsurance in a manner similar to reinsuring Lloyd’s of London syndicates. As compared with investing in bonds, reinsuring bonds requires a lower capital outlay, but reinsurance companies must be approved by Freddie Mac and Fannie Mae before they can participate in the reinsurance execution.
While this industry is relatively new, loss ratios to date and under baseline economic forecasts are generally less than 50% for those who participate with a low aggregate attachment point, and 0% for higher aggregate tranches. Depending on the participation layer within the transaction, oftentimes a repeat of a drastic 2007-level scenario would be required before there would be any loss in the upper layers.
Regardless of the preference between bonds versus reinsurance, there are relatively low barriers to entry, and participants gain a partnership with established experts similar to those at Lloyd’s. Furthermore, if a company has opted to reinsure these risks, the assumed credit risk is not correlated with the rest of the insurance/ reinsurance portfolio.
There are, of course, potential risks in devoting capital to the residential mortgage credit risk market. An economic crisis poses the biggest risk to investors, with the potential for financial loss if, say, there were another mortgage default crisis. Economic downturns have historically been regional events as opposed to national, and the geographic diversification contained in the risk pools serves to mitigate such risks. The 2007 subprime mortgage crisis, however, demonstrates that countrywide economic downturns are
indeed possible. In addition, because this market is relatively new, it is unfamiliar territory for most insurers to navigate. As with Lloyd’s of London, there is little reinsurer oversight when it comes to claims handling for credit risks, though the underwriting and claims-handling processes are highly regulated.
In summary, MPL writers have a range of options when it comes to making their excess capital work for them—hardly a bad problem to have. Whether MPL companies are looking at tested strategies like rate subsidization or acquiring a company, or new markets like residential mortgage credit risks, there are associated pros and cons that need to be weighed. Regardless of the insurer’s risk appetite, it is important to explore all of the options to ensure that the company’s capital is accomplishing the most for its
policyholders and/or
stockholders.