Reinsurance of a gift annuity involves payment of a premium by the charity to a company qualified to issue annuities in that state.

When a charity receives a gift annuity, it usually has the option to retain the annuity in a designated reserve fund and invest that fund. The charity may make payments from the fund or pay a premium to a financial services company that will then make the required annuity payments. The second choice is commonly called "reinsurance" of the gift annuity.

Reinsurance involves evaluating the factors that will benefit the charity with self-insurance, or the favorable factors that might lead to reinsurance. The primary questions relate to the life expectancy of the donor, the estimated return of the charity's annuity reserve fund and the cost of reinsurance.

Reasons for Reinsuring

There are multiple reasons that charities give for the annuities that have been reinsured. These primarily relate to various strategies to reduce risk. Some Boards of Directors are unwilling to run even modest risks and are willing to pay the cost of reinsurance for that risk reduction.

The primary risk reduction reasons are as follows:

1. Smaller Charity -- Charities have a fiduciary obligation to protect donors. A smaller charity may not have the annual funds, the reserve funds and the expertise to manage the assets and make payments on a gift annuity.

While many gift annuities last seven to 12 years, a donor could live 20 or 30 years. A small charity may be reluctant to undertake an obligation for that period of time.

2. Modest Endowment -- With a modest endowment, a charity is somewhat like a newer business. It cannot afford to undertake any risk with the endowment because that could be very harmful to the organization. While the organization may at some future time have a substantial annual revenue and endowment and reconsider the reinsurance decision, in the initial phases of an organization's life it may be appropriate to reinsure gift annuities.

3. Few Annuities -- Annuity diversification is in some respects similar to equities diversification. If an investor only has one, two or three stocks in a portfolio, the risk is much higher than with 20 or 30 stocks. Similarly, with two, three or four gift annuities, the risk that two or more annuitants may live well past the standard expectancy is appreciably greater. With a small number of annuities, it is more logical to reinsure.

As the number of annuities grows past 20, 30 or 50, the diversification of the annuity portfolio increases and the gift annuity program will be much more stable.

4. Large Annuity as % of Reserve -- Even a larger organization with a good endowment and substantial annuity reserve fund may choose to reinsure a very large annuity. For example, an organization with a $10 million endowment and a $1 million annuity reserve fund may have a prospective annuitant who wishes to create a $500,000 cash annuity. This would constitute a substantial portion of the annuity reserve fund and the organization may choose to reinsure for that reason.

5. Other Organizations Benefit While Parent Runs the Risk -- Many community foundations and religious foundations serve affiliates in their community or within their religious sphere of influence. Some organizations issue annuities and then transfer the residuum to the requested beneficiary. The parent is legally obligated on the gift annuity and must make the payments even if the annuity reserve becomes negative. Because the parent runs the risk while the affiliate receives the benefits, some parents choose to reinsure.

6. Reduced Gift Annuity Reserve Required -- Under the state insurance law of most states, the reinsurance of a gift annuity relieves the charity of the obligation to maintain a reserve fund for that annuity. Because only a portion of the funds are used to pay the reinsurance premium, the balance of the gift is a current benefit to the charity.

Self-Insurance of Gift Annuities

There are multiple reasons why many charities choose to self-insure. The primary benefit for the charity that self-insures is that it receives a larger eventual benefit if it has a good investment plan. Many of the largest charities in the nation self-insure for that reason.

There are several considerations for self-insuring. These are as follows:

1. Large Gift Annuity Pool -- If the organization has hundreds or even thousands of gift annuitants, then the actuarial averages are very likely to be achieved. The high probability is that gift annuitants will pass away with an average expectancy relatively close to that predicted in the selected mortality table. This assumes that the table has been adjusted for typical gift annuity factors. If a high percentage of the annuitants are female, nonsmokers and in good health, then the probable life expectancy may exceed the standard IRA expectancy tables by two to five years. However, with a large gift annuity pool, the averaging should give greater certainty for future projections.

2. Diversification by Age and Annuity Size -- In mid-sized and larger annuity pools, the desired result would be to have 80% to 90% of the annuitants reasonably close to the median annuity size. In addition, it is helpful to have a spread of age ranges from the mid 60's to the 90's in the entire pool. This diversification by age and relative uniformity for the size of the annuity increases the probability of reaching the actuarial averages.

3. Substantial Endowment -- Organizations with large endowments have an advantage -- they can run more risk and can accept larger gift annuities. Some organizations with significant endowments have accepted annuities of several million dollars. While there is some risk with a large gift annuity, there is also great potential reward. Therefore, the organization with a very large endowment can undertake those risks with the ability to pay larger amounts if necessary, but also with the recognition that it probably will receive large benefits. One strategy some organizations use is to retain a substantial portion of matured annuity funds within the reserve so that any future risk on very large annuities is undertaken with the residua from prior gifts.

4. Long-Term Perspective -- If the organization is able to have the long-term viewpoint of some of the charities who had been issuing gift annuities for over 100 years, it is more likely to self-insure. Annuity returns, like all investment returns, will experience substantial variations from decade to decade. However, returns over a period of 15 to 30 years will be more uniform. Finally, returns over 75 to 100 years are very likely to reach bond and stock statistical averages for a century.

5. Capable Investment Committee -- A mid-sized or larger charity may have greater talent in the investment committee. The investment committee is typically a sub-committee of the board of directors and often includes individuals with professional responsibilities for investments and managing funds. With a talented investment committee, there is greater ability to self-insure. The endowment committees that were served in the past by Mr. Warren Buffett did very well. While not everyone has the benefit of his presence on the committee, there are many excellent investment managers who volunteer to serve on investment committees.

6. 100% to Annuity Reserves -- In unregulated states and many regulated states, it is permissible for the charity to spend a percentage of the gift immediately. However, the best practice is for the charity to transfer 100% of the annuity to the reserve fund. For example, a $20,000 cash annuity might have a required state reserve of $12,500, but the charity transfers the full $20,000 to the reserve. This provides a cushion of $7,500 in the reserve. The reserve fund actually becomes part annuity reserve and part endowment fund. Over a period of decades, the annuity reserve fund can be increased significantly. Even if several annuities individually go negative because of annuitant longevity, the overall reserve fund enables the charity to average those losses with gains and have a reasonably high degree of investment security.

How Reinsurance Works

Financial service companies issue billions of dollars in commercial annuities each year. The charitable reinsurance market is a small fraction of the total market.

Large companies will create a structured portfolio for their annuities at the close of the bond markets each day. The financial services company's New York office typically reviews the sales of commercial annuities for that day. It determines the probable duration of payments and structures a bond portfolio to match those payments. The bond portfolio may be insured or there may be an internal insurance method to handle potential defaults of any of the bonds in the portfolio. By the end of that business day, the annuity requirements as estimated by the actuaries are matched with the bond payments. There is an allocation of funds for overhead (the commissions and the home office costs) on the annuity, an allocation to profit and the result is essentially fixed that day.

Because financial services companies have a very high level of success in their actuarial estimates and in their investment analysis for the bond portfolio, the profit is essentially locked in each day.

State Regulation of Reinsurance

Insurance is a very highly regulated industry. Some states permit insurance companies that are licensed to sell annuities in the state to reinsure gift annuities. Other states may have specific licensing for insurance companies with respect to reinsuring gift annuities.

Charities should make certain that a financial service company with whom they enter into a reinsurance contract is qualified not just to sell insurance in the state, but is qualified to issue a commercial annuity for reinsurance of a charitable gift annuity contract. There are a few regulated states in which most financial service companies are not able to issue reinsurance for charitable gift annuities. See GiftLaw Chapter 1.1.7 for specific state insurance requirements.