Will Regulation XXX see life reinsurers focus more on the capital markets? asks Ronald Gift Mullins
Securitisation has benefited banks, mortgage lenders, car rental and leasing companies, credit cards companies, utilities, and aircraft leasing firms to name but a few. Property/casualty insurance companies joined the movement with the creation of catastrophe bonds. Now, life insurers are using securitisation as a means to tap the capital markets for ready cash from life insurance policies and to fulfil regulatory reserve requirements.
Insurance risk securitisation, also called insurance-linked securities or asset-backed securities, transfer insurance-related risk directly to investors in the capital market. With global markets holding trillions of dollars in stocks and bonds, funding for even the most widespread catastrophes or gigantic life securitisations would only slightly dent that source.
Exploiting the capital markets permits insurance companies to reduce counterparty risk and diversify its sources of funds. It also allows insurers and reinsurers to monetise otherwise intangible assets, including the future profits (embedded value) of life insurance policies. Financial instruments resulting from insurance securitisation offer investors high-risk adjusted returns and a means to optimise the spread of their portfolios.
Before the advent of life securitisation, life insurers relied on conventional reinsurance, offshore captive reinsurers, clever policy design and letters of credit from banks to handle reserve requirements. With rising reinsurance rates, regulations requiring higher levels of reserving and less availability of multi-year letters of credit, insurers began exploring the various benefits of securitisation. Because arranging for a securitisation involves a number of steps and several different organisations within a complicated structure, the process can be lengthy and costly. A company has to securitise at least $250m of reserves to make the transaction practical, which leaves out most smaller insurers.
SECOND ONLY TO REINSURANCE
In a CFO survey of the Tillinghast business of Towers Perrin, conducted in mid-2005, only 4% of respondents said they currently use securitisation to address capital needs, but 50% said they would consider it in the next two to three years, ranking it second only to reinsurance. Respondents are currently using or exploring securitisation for managing statutory surplus strain on universal life business associated with Actuarial Guideline 38 (66%) and term life business associated with Regulation XXX (55%).
Reasons cited by the CFOs in the survey for pursuing securitisation transactions include mitigating letter of credit exposure (50%), limiting reinsurer credit exposure (33%), avoiding high reinsurance cost (33%) and raising capital (33%).
From 1996 to the present about $19.8bn of bonds have been issued by P/C and life insurance and reinsurance companies, according to Swiss Re. The breakdown was 42% for several kinds of cat bonds; 25% embedded value, 15% Regulation XXX, 4% extreme mortality and 14% other life securitisations.
From January 2002 to June 2005, Lehman Brothers and Goldman Sachs underwrote securitisations worth about $4.6bn each, followed by Swiss Re Capital Markets with $4.4bn. In 1999, investors in insurance risk bonds were primary insurers (30%), money managers (30%) and reinsurers (25%). In 2005, the major investors in these financial instruments are money managers (40%), dedicated ILS funds (33%) and hedge funds (16%). Primary insurers' share has dropped to 3% and reinsurers' share declined to 4%.
"The transformation of life insurance risk into capital market risks - similar to what we have seen in many other asset classes over the past 20 or 25 years - is inevitable," said Scott Willkomm, CEO of the Scottish Re Group at a Standard & Poor's insurance conference. "There is a lot of work to be done on the part of the issuers, bankers, and rating agencies, so that we create a very robust framework for a long-term, sustainable securitisation market for life insurance products."
One of the oldest forms of life securitisations began in the 1980s with the viatical settlement market. These life settlements were usually individual investors buying life policies at a discount from AIDS patients who, because of the lack of drugs then, had a life expectancy of less than two years.
But as drugs were developed to prolong the life of AIDS patients and thus reduce the life benefit, the purchase of these policies declined.
Rather than leaving that market when it lost its allure, the industry shifted its attention to high-net-worth seniors, usually aged 65 and older with a life expectancy of less than 15 years. These people usually have multiple life policies purchased originally for income protection, or for their heirs to pay estate taxes. Due to changing lifestyles, these wealthy people may not need a specific life policy. Instead of accepting a cash surrender value or lapse the policy, they enter into life settlement agreements. About a third of these people, according to the Viatical and Life Settlements Association of America, using proceeds from life settlements, buy replacement policies that have the advantage of lower premiums.
These life settlement bonds have raised some legal, accounting and tax concerns, and criticism for placing investors in the depressing position of profiting from the deaths of seniors. Yet the market continues strong both for securitisations of the policies and buyers of the bonds.
LIFE SECURITISATIONS EMERGE
Except for cat bonds and life settlements, until 2003 there were few securitisations of life insurance policies. In late 2003, Swiss Re Capital Markets entered into a financial arrangement with Vita Capital to provide up to $400m of payments to its parent in certain extreme mortality risk scenarios. In turn, to fund potential payments under this arrangement, Vita Capital, a special purpose vehicle established by Swiss Re, issued $400m of principal at-risk variable rate notes.
The principal of the Vita Capital notes will be at risk if, during any single calendar year in the risk coverage period, the combined mortality index exceeds 130% of its baseline 2002 level. The bond matures on 1 January 2007. Investors will be paid a quarterly coupon rate of US$ three-month London Interbank Offered Rate (LIBOR) plus a spread of 135 basis points for the principal at risk. "Generally speaking, mortality would have to deteriorate to a very large degree before investors would lose a dollar," explained Judy Klugman, managing director, Swiss Re Capital Markets.
Swiss Re Capital Markets is a leading broker dealer of insurance risks in the US. About 45% of a new issue comes from policies written by Swiss Re, the remaining books of business are arranged on behalf of Swiss Re's clients. "We help other insurers transfer insurance risks into the capital markets, along with our parent," said Klugman.
In early 2005, Swiss Re Capital Markets successfully completed its first securitisation of future profits from five closed blocks of US life insurance policies. The $245m issue benefits Swiss Re by transferring insurance risk to the capital markets. Interest and principal will be paid mostly by future profits from the policies. The securitisation consists of three separate tranches of securities, paying an average pre-tax coupon of 6.96% with an expected maturity ranging between six and 11 years. Investors' return is subject to various factors that reflect the risks of the underlying business, including mortality, persistency and investment risks.
This transaction is unique for life securitisations as it contains "BBB" and below investment grade tranches of securities and it transfers more risk evidenced by the high proportion (87%) of present value of future cash flows from the policies. John Kiernan managing director of Swiss Re Capital Markets said: "We offer a securitisation solution to whatever problem a company has."
Scottish Re began exploring securitisation "in earnest" with the assistance from various Wall Street firms in April 2000, Willkomm said, with the idea of producing a framework that would address both short- and long-term collateral financing needs. He added that the reinsurer now has an in-house group dedicated to securitisation.
LILACS UNDER FIRE
Life insurance and life annuities-based certificates (LILACS) give investors the benefit of inside buildup if they agree to give a small portion to a charity. To date, more than $1bn of LILACs have been sold. These securities are structured to take advantage of the different pricing between life insurance and annuities. This slight difference comes because sellers of the life insurance and annuities use two different assumptions to estimate mortality rates and investment returns. At the conclusion of the life contract, the difference between the two funds, if any, is given to the charity.
These insurance products have come to the attention of the US Senate Committee on Finance. Chairman senator Charles Grassley introduced a bill in May 2005 to block tax-exempt organisations from having an interest in a life insurance contract by taxing acquisitions costs at 100%. "I am very concerned about snake oil salesman taking advantage of tax-exempt organisations to line their own pockets with life insurance schemes," he said. "This bill ... will toll the bell on this scam." President Bush, in his 2006 budget, proposed the excise tax be 25% on distributions from certain investor-owned charitable life insurance contracts.
One proposal to curtail the writing of LILACs is to broaden the definition of insurable interest, thus preventing charities as third parties from benefiting from these life policies. This proposal worries the life insurance industry as it could lead to taxation of inside buildup of all life policies.
LILAC(R) and LILACS(R) are service marks of Capital LLC of Nashville, Tennessee.
In a hearing before the National Association of Insurance Commissioner (NAIC) in June 2005, Capital LLC said it "is proud of the fact that LILAC(R) does not involve speculation or wager policies thereby conforming to the underlying concepts of 'insurable interest,' is neither 'tax driven' nor a 'tax gimmick'. As a matter of public policy, the insurance industry should be proud of a design that permits charities and their supporters to economically use 'off the shelf' insurance products to further charitable goals."
Most states have adopted a variation of the NAIC's Regulation XXX. This regulation allows a life insurance company to use its own mortality assumptions to figure its deficiency reserves expressed as a percentage of a set of 19-year select mortality factors as applied to the 1980 Commissioners' Standard Ordinary mortality table. These percentages are commonly referred to as "X-factors". This regulation applies to most life insurance policies, but in particular, level-premium term, universal life with secondary guarantees, and some whole life plans issued on or after 1 January 2000. However, a negative fallout from this regulation was that life insurers would have to set up non-economic reserves of from $80bn to $200bn, certainly exhausting the capital of US insurance and reinsurance companies. In answer to the call for the increased statutory reserves, the industry turned to XXX securitisations.
The insurers in XXX deals securitise a slice of their book of life insurance, sometimes including policies that will be sold in the next 12 months.
With XXX arrangements, the number of policies that an insurer can securitise is larger than in a LILAC. This makes triple Xs attractive to insurers because they can offload more risk from their balance sheet, while complying with the regulatory requirements without using their own hard capital.
But in a surprise announcement in June 2005, the NAIC proposed a regulatory change that could relieve US life insurers of a portion of the estimated $200bn burden in the form of uneconomic reserves. The proposed regulatory change would involve updating the standard, one-size-fits-all mortality valuation tables that all US life insurers are required to use. "The NAIC had not even hinted that it would take such action since introducing controversial Regulation XXX, which made conservative assumptions about policyholder risk based on those tables," said Standard & Poor's director and senior analyst Jose Siberon.
Siberon believes the proposed regulatory change could substantially reduce statutory reserve requirements for life insurers of some term life policies and universal life policies with secondary guaranteed benefits. However, he cautioned that such a change to the rules would require a number of years to be implemented. "Policies now written will have to follow the methodology at the time of issue," he said. "This change will only help policies after 2007 or whenever the new rule is adopted. While it could have a positive effect on the life industry, it would have a negative effect on the rapid growth of the life securitisation market, as the burden of creating huge redundant reserves comes down."
LIFE SECURITISATION GROWTH?
"In the early days," said Swiss Re's Klugman, "there were a fair number of primary insurers and reinsurers buying bonds. They understood the underlying risk. However, over time as we educated institutional investors they became more comfortable with these types of insurance risks. I feel the market for insurance linked securities is extremely robust."
"Insurers and reinsurers are becoming more expert at finding solutions other than reinsurance as a way to optimise capital," said John Kiernan.
"There is a wide spectrum of risk available for bonds. Investors have appetites for all types of risks." But not to worry: Swiss Re does not believe it is going to cannibalise its business by securitising its policies.
"Securitisation is complementary to our traditional business," he said, "and we intend on extending it to third-parties as well."
"We believe that the growth in popularity of securitisation as a means of financing risks is the confluence of two trends," said John Nigh, managing principal and M&A practice leader, Tillinghast. "The first is stronger reinsurance pricing and the second is the willingness of the financial markets to provide funds for these securitisations."
Standard & Poor's believes compared with cat bonds, life securitisations are growing faster. These transactions are largely fuelled by companies responding to the additional reserving requirements mandated by Regulation XXX and Actuarial Guideline AXXX, which may abate somewhat in the future if new regulations reducing reserving are promulgated by the NAIC. "Although the insurance securitisation market is expected to continue its growth, the total amount of issuance remains small relative to the total asset-backed securities market," said Jose Siberon.
- Ronald Gift Mullins is an insurance journalist living in New York City.
Regulation XXX and Actuarial Guideline AXXX took the life insurance industry by storm in 2000 and 2003, respectively. "Combined, XXX and the more stringent application of AG38 will result in a sizable funding need that will grow to very significant levels over time," said Robert Swanton, head of the life insurance ratings team at Standard & Poor's.
Most XXX reserves are financed by offshore reinsurers, to which the policies are ceded. These offshore reinsurers - most of which are captive affiliates of the life insurer with XXX exposure - are in turn required to post LOCs to meet US statutory requirements.
In 2004, insurers turned to synthetic securitisation, in which an insurance holding company issues senior debt on the market as it would issue any senior debt, with the proceeds earmarked to back the redundant reserves.
Standard & Poor's prefers true securitisation to synthetic securitisation as a form of more closely matched funding. Nevertheless, the synthetic solutions that Standard & Poor's has observed thus far are still preferable to short-term LOCs. "Although not ideal, we deem synthetic securitisation to be far superior to the LOC solutions we have seen because of the enormous mismatch between the duration of instruments and the duration of policies issued," said Standard & Poor's credit analyst Kevin Ahern.
CRITERIA FOR STRUCTURED TRANSACTIONS
Because of Regulation XXX and Actuarial Guideline AXXX, statutory reserves for term and universal life policies will become increasingly inadequate.
By some estimates, the non-economic reserves required by XXX could total $100bn. As a result, US life insurance companies have begun to look to the capital markets to provide both capacity and customised solutions to assist them in solving these problems. Standard & Poor's has developed new ratings criteria to evaluate these burgeoning capital-market structured transactions. While few transactions have actually been completed, proposals abound and are coming from all quarters.
The rating agency will apply a series of deterministic stress scenarios to test the robustness of the cash flows. A team of actuaries, structured finance analysts, and insurance corporate analysts at Standard & Poor's will evaluate:
- The underwriting guidelines;
- The actual versus expected experience of mortality, lapses, and investment performance of the block;
- The company's business profile, earnings capacity, distribution systems, management, and actuarial and underwriting strengths; and
- Other factors that affect the financial strength of the company and the level of reserve redundancy inherent in the underlying block of policies.
In addition, Standard & Poor's requires that a third-party actuarial consulting firm calculate the cash flows used in the deal model.
Source: Standard & Poor's.