Swiss Re, a reinsurance company in Switzerland, provides reinsurance to US life insurance companies, among other insurers.  Last month, Swiss Re divested itself of a portion of its US life insurance onus because returns on it were lower than the company’s benchmark of 14%.

Why did Swiss Re pass on their business?

Presumably, the American life insurers who purchased reinsurance from Swiss Re have not fared so well as anticipated.  Indeed, over the past year, most carriers in the industry have suffered financial losses.  One ramification of this poor performance is the possibility of a hike in reinsurance rates for US life insurers.

Regardless of the cause of the lower-than-expected returns, Swiss Re’s ultimate purpose in selling to Buffet was to free up money currently held in reserve, expecting that it could invest the freed funds for a better return than the US life insurance reinsurance was providing.

How does getting rid of business free up money?

Insurers (and reinsurers) cannot be certain of the volume of claims they will have to pay over a certain period.  Therefore, using their best guess (and adding some wiggle room) they keep a reserve of liquid assets with which to pay claims.  By divesting itself of responsibility for some of its reinsurance contracts, Swiss Re enabled itself to reduce the assets held in reserve and invest the difference for profit.

Who holds the bag now?

In name, Swiss Re retains the business in question, but it is now investor Warren E. Buffet who stands to gain or lose depending on its performance.  Buffet paid 1.3 billion Swiss francs for the exchange.  This is quite a lot of risk shifting:

Americans bought life insurance to protect their survivors.  The life insurers bought reinsurance from Swiss Re to protect themselves against loss.  Swiss Re passed on a portion of the reinsurance to Buffet in order to free up its reserve.  This chain of transactions calls to mind the notion of “borrowing from Peter to pay back Paul,” for after all,  insurance products resemble (and in some cases mimic exactly) debt securities.

In that light, this series of transactions resembles leveraging of investments.  In theory it’s one way to make substantial returns on comparatively little capital, but it’s also a substantial contributor to credit crunches (such as the crash of 2008).