Small- to medium-sized life insurance writers in the US are apparently disadvantaged relative to their larger rivals because they are being hit by rising letter of credit (L/C) costs, and according to an insurance ratings agency they could be further disadvantaged if demand for L/Cs results in a lack of capacity.

Future scenarios for the L/C-reliant smaller life insurers look risky and A M Best, the world's oldest insurance rating and information source, says it would look favourably on less L/C-reliant term life writers.

Regulation Triple X

Demand for L/Cs amongst term life writers has risen since the introduction by most US states since 2000 of Regulation Triple X, which requires direct writers to hold increasingly high levels of redundant reserves on certain products.

Many companies are relying on reinsurers to secure these additional reserves, and much of this business has been placed offshore. But to meet statutory requirements, offshore companies need to secure reinsurance reserve credits, typically with L/Cs, which according to A M Best have been getting more expensive.

Growing demand

Additionally, the insurance ratings agency says that as the demand grows for L/Cs, so capacity will shrink. These factors it says are potentially very troublesome, as increased pricing in the L/C market will ultimately translate into lower earnings.

Moreover, A M Best says that since reserves on new business increase for approximately 10 to 11 years after issuance, companies could become increasingly L/C dependent.

As the need increases over time, and if prices continue to rise as expected or availability becomes scarce, the insurance ratings agency believes company profits can be reduced or, in more extreme cases, result in a capital crunch.

Diversified strategy

Large companies have a better ability to manage risks by diversifying away from L/Cs dependence according to A M Best. It says it will look favourably on companies that execute a diversified strategy in managing Triple X reserves.

Companies that remain dependent on L/Cs may encounter challenges due to L/C pricing/capacity issues that could emanate in the future as Triple X reserves continue to mount for the term life industry, A M Best concludes.

This article represents the views of the author and not necessarily those of the ICC or any of the other partners in DC-PRO.