Regulatory capital and asset risk transfer

• Published date: 01 December 2023
• Author: Kyeonghee Kim,J. Tyler Leverty,Joan T. Schmit
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/jori.12441

Received: 25 April 2023

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Revised: 26 June 2023

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Accepted: 28 June 2023

DOI: 10.1111/jori.12441

ORIGINAL ARTICLE

Regulatory capital and asset risk transfer

Kyeonghee Kim

1

|J. Tyler Leverty

2

|Joan T. Schmit

3

1

Dr. William T. Hold/The National

Alliance Program in Risk Management/

Insurance, College of Business, Florida

State University, Tallahassee,

Florida, USA

2

Gerald D. Stephens CPCU Distinguished

Chair in Risk Management and

Insurance, Wisconsin School of Business,

University of Wisconsin‐Madison,

Madison, Wisconsin, USA

3

American Family Insurance

Distinguished Chair in Risk Management

and Insurance, Wisconsin School of

Business, University of Wisconsin‐

Madison, Madison, Wisconsin, USA

Correspondence

Kyeonghee Kim, Dr. William T. Hold/

The National Alliance Program in Risk

Management/Insurance, College of

Business, Florida State University,

Tallahassee, FL 32306, USA.

Email: kkim@business.fsu.edu

Abstract

We explore whether life insurers use a unique reinsurance

arrangement to manage assets tied to their regulatory

capital. Typical reinsurance allows insurers to reduce their

regulatory capital by transferring liabilities (reserves),

and the associated assets, to reinsurers. With modified

coinsurance (ModCo), insurers maintain control of their

liabilities and assets while transferring regulatory capital

requirements to the reinsurer. Holding fixed an insurer's

reported capital, we find that ModCo allows insurers to

report higher risk‐based capital ratios. Insurers with

ModCo are less likely to fire sale downgraded bonds.

We also find suggestive evidence of regulatory arbitrage,

as most ModCo is purchased from reinsurers in countries

with low capital requirements or within the same

insurance group.

KEYWORDS

corporate bonds, life insurance, modified coinsurance,

reinsurance, risk‐based capital

JEL CLASSIFICATION

G22, G23, G28

1|INTRODUCTION

State regulators require insurers to maintain sufficient capital to pay claims. The amount of

required capital increases with insurer risk. In the 2000s, US life insurers began selling riskier

products (Koijen & Yogo, 2016a,2021,2022a) and investing in riskier assets (Becker &

Ivashina, 2015), increasing the regulatory constraints on insurers. The global financial crisis

and the subsequent low‐interest rate environment further increased the regulatory constraints

Journal of Risk and Insurance. 2023;90:1027–1061. wileyonlinelibrary.com/journal/JORI

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(Koijen & Yogo, 2022b). We investigate whether life insurers use risk transfer methods to

manage the regulatory costs of their capital.

In a traditional reinsurance arrangement, an insurer transfers some liabilities, and the

associated assets, to a reinsurer. Life insurers, however, have been turning to a nontraditional

type of reinsurance—modified coinsurance (ModCo). In a ModCo arrangement, the insurer

does not transfer its liabilities or assets to the reinsurer but rather only the responsibility of the

obligations underlying the contract. ModCo contracts are similar to interest rate swaps wherein

the “risk”transfers to the counterparty but not the underlying assets and liabilities.

1

US

insurance regulators assign all the regulatory capital requirements associated with the

underlying assets and liabilities to the reinsurer, even though the insurer retains control of the

risk. As a result, life insurers with ModCo face lower capital requirements than insurers

without it, ceteris paribus.

The use of ModCo has grown rapidly from 2003 to 2019. In Figure 1, we show ModCo

activity by US life insurers from 2003 to 2019. The outstanding value of ModCo increases from

$162 billion in 2003 to $568 billion by the end of 2019, representing 14% of total industry

liabilities (reserves) and an annualized growth of 8%. ModCo activity jumped during the

financial crisis and declined slightly from 2013 to 2015 when various regulations on

reinsurance transactions were implemented.

2

ModCo activity, however, has steadily increased

after 2015.

Most of the growth in ModCo stems from reinsurance arrangements with affiliated

reinsurers (i.e., insurers within the same insurance holding group as the primary insurer) and

with reinsurers domiciled in countries with low capital regulations, suggestive evidence that

insurers are using ModCo for regulatory capital management. ModCo arrangements with

reinsurers that are part of the same insurance holding group as the primary insurer increased

from $52 billion in 2003 to $465 billion in 2019, representing an annualized growth rate of 15%.

ModCo arrangements with reinsurers domiciled in countries with low capital regulations—

such as Bermuda, Barbados, and the Cayman Islands—increased from $78 billion in 2003 to

$293 billion in 2019, an annualized growth rate of 9%.

3

In comparison, total liabilities in the US

life insurance industry only grew at an annualized rate of 5% over the same time period (from

$1.9 trillion in 2003 to $4 trillion in 2019).

We document the impact of ModCo on regulatory capital. The National Association of

Insurance Commissioners (NAIC), the coordinating organization of state insurance regulators,

1

The underlying liabilities (assets) in a ModCo transaction (i.e., the life insurance reserves or investment portfolio) are

similar to the specified principal amount in an interest rate swap and the periodic settlement of changes in the reserves

(investment returns) are similar to the periodic interest payments exchanged in a swap.

2

In 2013, Credit for Reinsurance Model Law—MDL 785 (NAIC, 2016) went into effect requiring all investment income

and capital gains (losses) to be transferred to the reinsurer periodically; before 2013, only investment income was

transferred to the reinsurer. In 2015, Actuarial Guideline XLVIII requiring life insurers to disclose the quality of assets

supporting ModCo reserves for certain life insurance products went into effect. Both regulations went through revisions

since 2015. For example, in 2016, revisions to MDL 785 allow state regulators to apply state‐specific exemption rules for

Actuarial Guideline XLVIII. The revision also makes certain reinsurers, for example, foreign reinsurers that have

sufficient capital, “qualified”for the ceding US insurer to take reserve credit, that is, report lower liability requirements

through reinsurance transactions. See American Academy of Actuaries (2018) for more details.

3

Similar to Koijen and Yogo (2016b), we classify countries with low capital requirements as Bermuda, Barbados, and

the Cayman Islands. In addition, we include the Turks and Caicos Islands, as well as Guernsey, as these are ranked

among the top 20 global captive domiciles during the sample period (Business Insurance, 2007–2021). Regulators can

act against insurers with risk‐based capital (RBC) ratios between 200% and 300% if the insurer's capital is trending

negative (NAIC, 2012).

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uses an RBC system to impose capital requirements. For each insurer, the NAIC determines its

required capital—the amount of capital needed to support its asset, interest rate, insurance, and

other risk exposures. Required capital increases nonlinearly with an insurer's risk profile.

Because required capital is sensitive to risk, insurers can reduce the cost of regulatory frictions

by lowering their risk, for example, by choosing a safer asset portfolio. The NAIC also calculates

a solvency metric, the RBC ratio, for each insurer at the end of each year. The RBC ratio equals

an insurer's statutory capital relative to its required capital. A high RBC ratio indicates an

insurer is well capitalized relative to its capital requirements. In contrast, a low RBC ratio can

trigger regulatory action against an insurer—regulators can act against an insurer when the

RBC ratio is less than 300% and must act when it is less than 200%.

4

Using the details of the RBC ratio, we show how insurers can use ModCo to hold riskier

asset portfolios without increasing their required capital. We then document that ModCo

increases an insurer's RBC ratio. The most remarkable impact is for insurers with low capital

levels. We find that on average, low‐capitalized insurers with ModCo report 14%–21% higher

RBC ratios than low‐capitalized insurers without ModCo. We also find that the increase in the

RBC ratio for ModCo users is associated with a reduction in the investment RBC requirement, a

feature not present in traditional reinsurance arrangements. Our findings suggest a strong

association between the use of ModCo and regulatory capital management.

We next explore whether ModCo is a substitute for other capital management devices. US

life insurers can also manage their risk and capital using asset allocation, traditional

reinsurance, diversification, and so forth. Because ModCo allows for asset risk transfer in

addition to liability risk transfer, we investigate whether ModCo is a substitute for

asset allocation. When corporate bonds become riskier, an insurer can adjust their risk by

FIGURE 1ModCoreserves(in$Bil.).Thisfigureplots(1)themodified coinsurance (ModCo) reserves of US life

insurers (solid black line with circles), (2) ModCo reserves arranged with an affiliated reinsurer (i.e., an insurer

within the same insurance holding group as the primary insurer; dashed blue line with triangles), and (3) ModCo

arranged with reinsurers domiciled in countries with low capital requirements (e.g., Bermuda, Barbados, and the

Cayman Islands; dotted light blue line with squares).

4

Regulators can act against insurers with RBC ratios between 200% and 300% if the insurer's capital is trending negative

(NAIC, 2012).

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