The popularity of value of in-force securitisation as a source of alternative capital is set to continue, but watch out for the regulatory hurdles that await, warns Franz Lathuillerie

From a shareholder's perspective, value of in-force (VIF) securitisation compares well with alternative sources of financing such as subordinated debt, equity or financial reinsurance. Life companies are increasingly looking at VIF securitisation as part of their overall capital management.

In the UK, from a statutory perspective, VIF securitisation can be appealing as "implicit items" are to be phased out and therefore securitising the VIF would enable life companies to maintain or increase their level of regulatory capital.

The additional source of financing that VIF securitisation provides is positive for the insurance industry and is likely to become increasingly popular in Europe, improving both regulatory capital and liquidity. The greater transparency that the VIF securitisation process brings to the underlying books of policies, as well as the deeper understanding of the risks that can be derived from these transactions, have been widely appreciated.

However, there are three main hurdles that may slow down the progress of VIF securitisations. First, changes in the regulatory or accounting framework - such as the introduction of International Financial Reporting standards (IFRS) or Solvency II - could make these transactions less efficient.

Second, the regulatory and economic value obtained from securitisation should be weighed against the high structuring and legal costs of these complex transactions as well as the premium on yield required initially by investors to take on insurance risks. The experience on the first catastrophe bonds seems to illustrate this phenomenon since initially larger spreads were required by investors. Finally, the recent flurry of regulatory investigations and censure with regard to the use of financial engineering in the non-life insurance and reinsurance markets (led by the US), that affected large companies such as AIG and Zurich, may make life insurers more cautious about being seen to indulge in similar practices.

A PRUDENT APPROACH

VIF arises because GAAP accounts are generally based on prudently calculated reserves, usually resulting in understated (on a pure economic basis) numbers being reported for both annual profit and net assets. GAAP profit emergence is indeed slower due to the need to maintain prudential margins, and net assets are lower due to the conservatism of insurance reserves.

VIF can be thought of as a quantification of the degree of prudence in the reserves, as it is the discounted value of the reserve releases expected to come through in future years based on a realistic set of assumptions.

Hence, it is possible that the concept of VIF could become less useful once IFRS for insurance are fully implemented, as life insurance liabilities on the balance sheet are unlikely to require the same level of prudence.

If the margin for prudence above best estimate were small, the amount of VIF in the life companies would be too small for VIF securitisation to make economic sense. Insurance practitioners will need to wait for the wording of Phase II of the IFRS to get a clearer view on the issue, as the development of the standards is still in its very early stages.

While securitisation has grown substantially in other sectors, it is still relatively rare in the life insurance sector with only one public transaction recorded in Europe in 2004 by Friends Provident. This is partly because the rationale for securitisation is much less clear for insurers, given their regulatory constraints.

RUNNING RING-FENCES

One of the characteristics of the securitisation process that contributed to the success of this instrument is the ability to achieve a higher credit rating on the issue than the issuer's counterparty rating. For a securitisation other than for a life company, it is possible to divert a specified stream of cash flows from the primary company, thereby delinking the security of the special-purpose vehicle (SPV) from that of the primary company.

A VIF securitisation, however, depends on statutory profits emerging from a regulated life insurer and it is extremely difficult to structure the transaction to ensure that the regulator would continue to permit servicing of the issue if the insurer were not meeting its minimum solvency requirements.

Consequently, the rating of a VIF securitisation is going to be tied to the financial strength rating of the life company, unless some credit enhancement mechanisms are put in place.

Regulators will not allow, purely for the purposes of a securitisation, a book of policies to be ring-fenced from the other policies for various reasons. Ring-fencing of policies securitised, which represent a more stable and secure profit stream than the rest of the company, would be detrimental to the other policyholders, as the security offered to the remaining policyholders has deteriorated. Ring-fencing of policies securitised which represent a less stable and more volatile profit stream than the rest of the company would harm policyholders, leaving them cut off from the insurance company and unable to benefit from its funding anymore.

In addition to the use of credit enhancement mechanisms, and in order to comply with the insurance regulation, a more complicated and costly structure must be put in place than for a regular securitisation. A structure will be deemed acceptable to the regulators if, and only if, all policyholders are at least as well off, if not better off, after the transaction.

The very strict current UK regulation applicable to loss portfolio transfers in the non-life sector highlights the regulator's position in that respect.

The more recent transactions used a special purpose reinsurance vehicle (SPRV). The SPRV is generally set up to separate these future cash flows from the primary risk carrier. This step is necessary since the policyholders of the books within the risk carriers are well protected by the local regulation. Thus, the assets securitised are really the cash flows arising from the reinsurance contract. The "securitised" policies are thus not ring-fenced from the rest of the book. Note that the debt securities will be issued by a separate SPV in order to leave the investors free from any insurance regulation; again this adds to the structuring costs.

Other regulatory constraints arise from the type of products sold, which attract different set of rules. It is difficult to securitise UK with-profits business, because of the significant uncertainty regarding the bonuses the company will pay, which depend partly on the evolution of the company estate as well as the policies' own experience, and the fact that the bonus decision is made at the company's discretion. This situation could change, however, now that with-profits offices are required to publish their Principles and Practices of Financial Management (PPFM), thus reducing the degree of discretion and uncertainty. However, PPFM documents generally still leave the company management a significant amount of discretion in running with-profits funds.

In the past, there has been no obvious advantage in a securitised issue compared with plain vanilla subordinated debt of the type that the regulators allow for solvency purposes. Moreover, the transaction costs are much higher. Consequently, securitisation has been, until recently, more appealing to those insurers who have already utilised their maximum permitted capacity for subordinated debt from both a regulatory and a credit rating agency perspective.

LOW QUALITY OR TIER 1?

At the present time, VIF securitisation could represent an interesting alternative for these companies since such transactions would normally qualify as Tier 1 capital, as did the Friends Provident transaction in December 2004. Fitch recognises the capital raised through a VIF securitisation, although it considers it to be of a lower quality than traditional equity capital. As is the case with the regulatory regime, Fitch sets limits on the maximum amount of alternative capital, other than equity capital, that is assessed within its measurement of capital adequacy. The capital raised through a VIF securitisation is thus assessed within these limits.

The success of VIF securitisation is closely tied with the evolution of the accounting and regulatory framework, which represents a hurdle to clear as well as a major source of uncertainty for the life companies that have decided to use this new tool. However it can also be a major driver for new transactions as illustrated by the phasing out of implicit items, or the fact that VIF securitisation has been recently recognised as Tier 1 capital.

- Franz Lathuillerie is an analyst in Fitch's insurance group.