What It Is, What It Isn’t, When It Works and When It Doesn’t
With so much economic volatility over the last 15 years, charities are increasingly exploring reinsurance as a risk management strategy for gift annuities. While it is a relatively simple concept, charities and advisors have erroneous preconceived notions about the viability of reinsurance for better and worse.
Last year, Charitable Solutions helped charities reinsure 81 gift annuities representing $25 million in market value. In particular, multiple, extremely large gift annuities ranging from $3-15 million would have been declined without reinsurance. Mitigating concentrated risk is one key outcome of this strategy.
Risk Management 101. Risk is defined as actual outcomes being worse than expected. Simply, that something bad may happen. Once a risk is identified, the next step is to quantify the probability it could occur – how likely is it, and the severity of the negative event – how bad is it? For gift annuities, this might mean early investment losses (or even no gains) or long-lived annuitants. The development maxim of “take out a gift annuity and live forever!” always elicits a laugh until it actually happens.
There are only four strategies to manage risk:
- Risk Retention – Self-insuring the risk in total or to a certain threshold (e.g., a deductible). If a loss occurs, the risk is borne by the person or entity exposed. For gift annuities, this simply means that the charity is self-insuring.
- Risk Reduction – Reducing the risk by changing either the probability or severity of the loss (e.g, stop smoking, using seat-belts, etc.). For gift annuities, this may mean that the charity reduces the ACGA payout rate, has a minimum age above 65, has a maximum gift size and/or may have a less aggressive asset allocation.
- Risk Transfer – Transferring risk by contract or other practical means to a third party. Generally, this connotes using insurance, but it also includes any other risk shifting via contract (e.g., real estate contract where seller is still liable for environmental issues, insurance contract making payments for any amount over the deductible, etc.). For gift annuities, this usually means reinsurance, but it can also include when other funds/charities remain obligated to pay for any future losses.
- Risk Avoidance – Avoiding any of the activities that give rise to risk. For example, a person may just choose not to drive at all or sky-dive or take any medications. For gift annuities, this may mean not offering a program or referring all prospects to a third party (e.g., a community foundation-type charity or National Gift Annuity Foundation).
Three key tenants of risk management:
- Don’t risk a lot to make a little.
- Don’t risk more than you can afford to lose.
- Know the probability/odds.
CGA Reinsurance Defined. Charitable gift annuity reinsurance is simply a financing technique whereby a charity chooses to purchase a commercial single premium immediate annuity (either an individual or group contract) as an asset to back its contractual life-income liability owed to the donor.
This contract typically precisely matches the terms of the charitable gift annuity (e.g., the same payout, timing, life-only payments, etc.). Further, the contract becomes an asset of the charity and the charity is also the payee unless it directs the life insurer to make payments to the annuitants.
The term "reinsurance" is both incorrect and unfortunate in that it usually has no resemblance to true reinsurance — where one insurance company cedes excess risk to another insurance company for a premium. The term continues to confuse the insurance industry and regulators, but has become ingrained as part of the charitable lexicon.
Want to dig a little deeper on this topic? Join us for our March webinar. This session will dispel some of the myths and clarify the actual costs and benefits of various reinsurance applications.