Alex Cowley details the first securitisation success in the life insurance market and explains why securitisation is poised to gain widespread use in the future.
Life insurance securitisation had its first major success with the issuance of nearly $2bn in debt and equity securities for New Jersey-based Prudential Financial Inc, supported by the future release of assets held to satisfy regulatory reserve and capital requirements. The Prudential transaction set an important precedent that will no doubt be followed by other life insurance companies seeking to monetise the embedded value in their life insurance business. This transaction portends well for the future of life insurance securitisation, which will become more widespread with the growing focus on capital management and as insurers seek to expand into a broader array of financial service businesses.
In connection with its demutualisation, Prudential established and funded a closed block of traditional participating life insurance policies with assets sufficient to satisfy the dividend expectations of its mutual company policyholders. In addition to these closed block assets, Prudential set aside surplus and related assets (see diagram) mandated in accordance with US statutory accounting principles. These assets serve as a backstop or cushion in case the closed block assets are insufficient to pay policyholder claims.
While the closed block assets will ultimately be paid to policyholders either as benefits or as dividends, the surplus and related assets are expected to be released to Prudential as regulatory requirements run off over time.
In order to monetize the surplus and related assets dedicated to the closed block, Prudential established Prudential Holdings, LLC, a subsidiary of Prudential that owns Prudential Insurance Company of America (where the closed block resides) and was created for the sole purpose of issuing debt supported by the surplus and related assets. Prudential Holdings issued three tranches of debt, two of which were wrapped with a financial guarantee from Financial Security Assurance Inc (FSA). In addition, Prudential issued additional securities in the form of common stock backed by the residual of the surplus and related assets after servicing the closed block debt.
The future of life insurance securitisation
In addition to closed block securitisation, a number of other areas show potential for securitisation in the current market. Below are some of the most promising lines in which securitisation could soon serve as a valuable tool.
Like closed blocks formed through demutualization, in-force blocks in run-off offer a relatively fixed set of policies that can be isolated and analysed with relative simplicity. For this reason, it would be natural for any redundant (and consequently trapped) capital associated with such an in-force block to be a strong candidate for securitisation.
Surplus requirements for traditional lines of business such as non-profit/non-participating business, term assurance, rider benefits, industrial business, pre-need business, paid-up benefits, etc, can lead to inefficient use of capital due to the conservative nature of reserving and minimum capital requirements.
Securitisation enables an insurer to unlock the trapped capital by monetizing the future earnings on a non-recourse basis and in so doing, raise cash to re-invest in its operations. Such securitisations will transfer long-term insurance risks to investors and thus have certain advantages over traditional surplus relief transactions. Furthermore, with maturities ranging from seven to 25 years, securitisation transactions tend to be longer term than traditional surplus relief.
Transactions involving in-force books in run-off will be similar to closed block transactions, but will not benefit from the formal establishment of a closed block in accordance with regulatory constraints. However, given the non-par/non-profit nature of run-off blocks, this is unlikely to be a major hurdle.
Depending on size, complexity and the robustness of the cash flows being securitised, these transactions may be tranched to allow different investors access to different cash flows with different levels of security.
Another strong candidate for securitisation is so-called mortality & expense fees (M&E fees) on variable annuities, analogous to the 12(b)(1) mutual fund fees securitisation market that already exists in the US. With such transactions, the operating company sells prospective fees and surrender charges in return for receiving what is, in effect, non-recourse debt. The loan-to-value ratio for the debt will reflect the robustness of the cash flows to changes in assumptions concerning primarily asset performance (given that this is an asset-based charge) and secondarily lapsation, assuming the product is designed correctly to immunise the insurer from the impact of early lapses. M&E fees securitisations may lend themselves to being structured at the operating company level.
Keys to securitisation
The Prudential transaction highlights several important considerations that will be key to determining the feasibility and appropriate structure for securitising various types of life insurance business.
The Prudential transaction included a number of mechanisms and incentives for Prudential to protect the release of surplus and related assets through dividends from the operating life insurance company to the issuing company. If Prudential falls too far away from its projected surplus levels (for example, by failing to adequately adjust policyholder dividends after significant investment losses), certain penalties are triggered to provide investors with additional collateral. Other features are in place to ensure that the operating company pays sufficient shareholder dividends to service the closed block debt.
Prudential debtholders have additional protection due to the nature of the closed block. As contemplated by the closed block construct, policyholder dividends are adjusted to reflect the performance of closed block insurance policies and investments, so that the closed block behaves much like a self-contained mutual insurance company. As a result, the risks and rewards associated with the closed block are borne primarily by policyholders and only secondarily by closed block debtholders.
In the securitisation of other lines of life insurance, the mechanisms employed to protect the collateral will depend on the nature of the underlying book of business, the extent of the issuer's existing covenants and creditors, and the ability to separate the collateral from the other business exposures of the issuer and its affiliates.
Life insurance embedded value securitisation is only feasible if the relevant assets and risks can be clearly defined and investors can be granted a legal claim on those assets. The ability to securitise life insurance depends in part on the ability to isolate the risk associated with the securitised assets or liabilities from the corporate risks of the sponsor.
In typical asset-backed transactions, a separate bankruptcy, remote special purpose entity is established to own the assets and issue the debt. In the case of life insurance assets, true sale of capital held for regulatory purposes is in most cases impractical, if not impossible.
Because Prudential's closed block resides within its operating life insurance company, the release of surplus and related assets could be limited by the performance of the ongoing life insurance business, which continues to write policies outside the closed block. However, Prudential Holdings is structured to be bankruptcy remote from the parent company and its other operating subsidiaries. Investors have a perfected security interest in a debt service coverage account, a pool of assets established for the securitisation and maintained by Prudential Holdings for the purpose of servicing the closed block debt.
While a true sale to a separate company would be preferred by investors, they take comfort in the fact that other creditors will not have claim to any assets placed into the debt service coverage account, and the issuing entity has control over their collateral through its ownership of the operating company. At the same time, securitisation through an intermediate holding company does not threaten the solvency of the regulated operating company.
Future securitisations may include specific life insurance risks such as mortality, lapse and investment risk. Securitisation often relies on the ability of investors to model and quantify the risk, which is best accomplished when one of these risks can be isolated and transferred in a single transaction.
In the case of the Prudential transaction, the closed block's policyholder dividend mechanism keeps the risks and rewards of the business with policyholders, which together with the debt service coverage account insulates investors to a large extent from those underlying risk factors.
Only in extreme cases would closed block debtholders suffer losses due to mortality, lapse or investment losses. As a result, analysis of the securities focuses on the ability of the operating company to dividend sufficient funds to Prudential Holdings to service the closed block debt.
Quantitative modeling plays an important role in the rating and marketing process for securities, especially when a specific risk such as mortality or lapse is included in a transaction. Ratings agencies typically undertake thorough analysis of actuarial models used to establish cash flows, and may request stress testing of the model to determine sensitivity under a variety of scenarios. An actuarial opinion will be a vital part of the offering documents for a securitisation when investors lack the tools to perform a full analysis of the book of business themselves.
As a result of the complexity inherent in life insurance lines, financial guarantors will have the opportunity to play a significant role in the development of the life insurance securitisation market. The Prudential transaction was informative in this regard because it included both wrapped and unwrapped tranches. Obtaining a AAA wrap on two-thirds of the issuance proved beneficial to Prudential, especially in December when the events of September 11 and the Enron debacle had precipitated a widespread flight to quality. A financial guarantee is particulary valuable when certainty of execution is of paramount concern, as it was for Prudential because the transaction was connected to its demutualization. The after-market performance of the unwrapped Prudential Class C Notes demonstrates that unwrapped life insurance securities are growing more viable.
Securitisation can be an attractive source of funds for acquisitions, expansion into a new market, or other business objectives. It is often these larger business objectives that create an impetus for securitisation. One advantage of securitisation is that the proceeds may be released to the parent company where there is a great deal of flexibility in how the proceeds may be used. As with any use of capital, securitisation proceeds should be used in a manner consistent with the issuer's overall business plan and rating objectives, as rating agencies and equity analysts tend to focus on the use of proceeds when a transaction is executed.
Closed block securitisation benefits from the relatively fixed nature of the underlying book of business. The well-defined characteristics of Prudential's closed block business helped simplify the analysis of risks in the Prudential transaction. In the future, securitisation techniques could become an important tool in the management of ongoing business. The key to securitising a growing book of business is to establish a set of standards with which all new business must comply in order to be included in a securitisation. For example, underwriting, pricing and investment guidelines would need to be uniform among included policies and assets. This principle has been successfully employed in the master trusts used in securitisation of credit card receivables and other dynamic asset pools.
What lies ahead?
Life insurance securitisation is poised to gain widespread use as both mutual and stock insurance companies seek to become more competitive and deploy their capital more efficiently. Given the amount of capital trapped in life insurance companies for regulatory and other reasons, we believe that Prudential represents only the tip of the iceberg in a market that will grow significantly in the coming years. In addition to the closed block securitisation trend set by Prudential, we expect to see securitisation of traditional blocks in run-off and M&E fees, as well as other areas of life insurance in the near future.
By Alex Cowley
Alex Cowley is senior vice president, Insurance Products Group at Lehman Brothers. He can be reached at email@example.com or by calling, 1 212 526 5465.