Hannover Re Life's innovative life securitisations, transacted through the Dublin office.
It is three years since Hannover Re first completed its quest to transfer acquisition costs of life reinsurance treaties to the international capital markets. Pioneered in April 1998, Hannover Re has since followed its first deal up with two more transactions, and received industry plaudits for its innovation. Other, similar, deals are in the pipeline, with several close to being finalised.
Hannover Life Re is one of four strategic business segments within the Hannover Re group, and recorded forty-fold growth in the 1990s. In fact, in 1999 alone premiums increased almost 60% to reach E2.2bn. This growth stems primarily from so-called financing transactions. For the most common types of financing reinsurance, the reinsurer assumes the technical risks such as mortality and lapse, and also relieves the primary insurer of the immense acquisition costs originated by its new business strain.
As a second type of financing concept, Hannover Life Re has specialised in the reinsurance of ‘block assumption transactions' (BATs). In these transactions the reinsurer assumes existing portfolios against the payment of a single initial commission. These transactions can be considered as asset swaps through which future earnings potential and liquidity streams are converted into current cash.
According to German accounting rules, acquisition costs from life and health reinsurance business have to be written off in the year in which they are incurred. Thus they produce not only a liquidity drain but also impose a heavy burden on the profit and loss account of a rapidly growing life reinsurer like Hannover Life Re. The traditional way of retroceding financing business to other reinsurance companies could not provide Hannover Life Re with the necessary relief for its balance sheet taking into account the substantial growth and volume of the business and, furthermore, the competitive situation. But by transferring such acquisition costs to the capital market, Hannover Life Re is able to continue its growth and to position itself as one of the leading reinsurers in life and health business.
In the past, Hannover Re had already been a pioneer in its use of alternative methods of risk transfer in the non-life sector. A securitisation deal for natural catastrophe risks was concluded in 1994 and in 1996 a portfolio-linked swap took place. Indeed, the securitisation of natural catastrophe risks now forms part of the everyday business of investment banks and reinsurers. Hannover Re's transactions in the field of life and health reinsurance are, however, the first to apply securitisation techniques to non-natural catastrophe re/insurance risks.
The prevailing differences to non-life securitisations are the longer duration and nature of risks in these transactions. In life and health reinsurance, the policies of one underwriting year will generally remain in force until natural expiry, which may extend more than 20 years. The negative result of the first policy year – due to financing – will be amortised over this period by the reinsurance results of those years that are, of course, volatile depending on real lapse and mortality experience.
In contrast to non-life securitisations where the capital lent by the investors generally is at risk only if a predefined catastrophe occurs before the maturity date, in life securitisation deals the investors have to provide the capital at the beginning of the transaction and the repayment, including interest, is at risk following the (volatile) cash flow of the underlying business.
It is indispensable for all transactions that the reinsurer arranges a retrocession agreement with another reinsurance company, either an existing one or a special purpose reinsurance vehicle (SPRV) newly founded for this transaction. The retrocessionaire should be located in a regulatory environment allowing it to defer the acquisition costs, comparable to US GAAP accounting, thus avoiding negative impacts to the bottom line.
Only this procedure provides the original reinsurer with the necessary balance sheet relief. If the reinsurer gets a loan directly from a bank, it would have to show the obligation for the outstanding repayment in its balance sheet, completely destroying the advantage of the transaction.
The SPRV then takes over the lapse, mortality and morbidity risk of the retroceded portfolio. In a second step, a bank involved in the transaction provides the SPRV with the necessary liquidity by means of an asset-backed loan.
All of Hannover Life Re's finalised securitisation transactions are multi-year and multi-currency deals. Multi-year means that Hannover Life Re may draw parts of the initially agreed upon financing volume of a transaction within a certain specified period – usually three years – according to its needs. It is not necessary to specify in advance the explicit amounts to be drawn and the time of drawing. On top of that flexibility, security for future planning is given as the refinancing conditions for the total transaction are negotiated in advance.
The retrocession agreement is a master treaty for various individual original treaties, falling into a predetermined class of business such as geographic origin, type of business and expected repayment duration. Thus Hannover Life Re is able to cede specific treaties to the master agreement without further negotiation with the SPRV. Furthermore, the flexible design of various put options makes it possible to withdraw individual tranches of the transaction, enabling Hannover Life Re to actively financially steer its profit and loss account.
The advantage of this structure for an investor is the chance to participate in an investment form which is uncorrelated with the general development in the capital markets, as the risks originate from lapse and mortality.
Up to now, Hannover Life Re has finalised four securitisation transactions, reflecting its core markets. The first transaction of Hannover Life Re is known as ‘L1' (‘L' standing for life). Reinsurance treaties from a number of Western European countries for new business production can be included, and the geographical scope may be extended or the transaction volume increased by mutual agreement without delay, should this prove necessary.
In contrast to its L1 predecessor, the second deal, L2, includes the above-mentioned BATs from Western Europe and North America. As well as pure life business, accident and health business originating from these countries may be covered.
The third transaction, L3, is a mixture of new business financing treaties and BATs for so-called special markets, particularly Southeast Asia, South Africa and Eastern Europe.
The most recent transaction, L4, concentrates again on traditional financing for new life business production from certain European countries. This time only a specific product, unit-linked policies, is covered.
To date, Hannover Life Re has been able to refinance E430m of its life and health business via the capital markets, and other transactions with international financial institutions will surely follow.
From a strategic perspective, the completion of these transactions secures Hannover Life Re's ability to continue offering its clients the desired financial capacity for new business growth and other specific business objectives.