Life securitisation is approaching make or break time and as Dan Ozizmir reveals, it is likely to become an increasingly attractive risk transfer option.
The life reinsurance business is at a crossroads. Standard financial measurements, such as projected growth rates and return-on-equity ratios, indicate the sector is no longer as attractive to investors as it was in the past. The solution to increasing sector performance, and thereby attracting investors to recommit their capital to life reinsurance, requires a certain amount of creativity, financial dexterity, and a dash of what business strategists classify as "out-of-the-box" thinking.
Securitisation, which dramatically improved the financial metrics of the commercial banking industry, may have the potential to revitalise the life reinsurance market by introducing significant financial changes to the sector's structure. Certain changes would of course need to be made to the bank securitisation model, but these enhancements could help the life reinsurance industry address its challenges to create more cost-effective products while improving return-on-equity ratios.
A brief history
The mortgage sector created the securitisation market in the 1980s to find better ways to spread credit risk across the financial markets after large losses from the thrift crisis. After packaging loans, banking institutions sold the securitised assets to investors. The proceeds from the sale were used to underwrite new loans thereby increasing the volume and scale of the operating units.
As the business matured, securitisation products were standardised, investors grew increasingly comfortable with the product, and the traditional bank/business model evolved. The historical buy and hold structure evolved into a more dynamic model in which products were warehoused, sold, and the risk was conservatively hedged. Now, after leveraging capital markets solutions, banks are experiencing higher growth rates, improved returns on equity, and, perhaps most importantly, an improved financial ability to withstand market downturns.
At a recent industry meeting, the consensus among reinsurance executives was that 20% to 50% of the life insurance business will be securitised within five years. The benefit of securitisation is that these structured products enable more efficient capital funding, while transferring mortality risk and minimising funding redundant reserves, all of which ultimately improves capital efficiency. This means reinsurers and insurers are getting better at running their business and can expect higher returns as their reward.
The classic definition of securitisation is the combination of similar assets into a securitised product, and carving projected cash flows from individual assets into tradable securities that are sold to investors. In a process similar to traditional life insurance underwriting, the securities are typically tailored to fit the risk profiles of various investors. Indeed, in the life insurance business, the primary companies source new business and then, in exchange for a fee, transfer future economics. Unlike bilateral reinsurance contracts, securitisations generally involve a single contract covering a pool of underlying collateral, which transfers the economics to multiple investors over dozens of years.
In general, the life securitisations completed thus far fall into the following three categories:
Reserve funding - Much recent attention has focused on Triple X solutions for structures that provide cost-effective funding for the long-duration and non-economic reserves associated with term products. Although similar o the banking model in that they provide funding, the structures have low levels of risk transfer. Using low risk, low cost capital to fund the long-term reserves should ultimately allow for a more cost-effective product. Minimum size for issuing such a security is $300m.
Mortality bonds - The catastrophe bond concept has grown exponentially in the non-life sector. There is now more than $5bn of cat bonds outstanding, covering a diverse range of non-life risks. These bonds provide collateralised protection against extreme events, often on a multi-year basis. In the life sector, this concept has been applied to mortality bonds, which provide the issuer protection against extreme mortality due to events such as pandemics. In theory, if executed correctly, mortality bonds could help to limit volatility. Those wishing to issue such bonds will need a minimum size of $100m to $150m.
Embedded value - These transactions are the closest to traditional mortgage securitisations, where projected cash flows from a closed block of business, ie embedded value, are sold to investors. As in banking, the transactions are viewed in terms of advance rates, or what percent of the perceived value is raised through the transaction. The first life insurance transaction of this nature targeted about 50% advance rates; recent transactions pushed rates beyond 80%.
Embedded value transactions, which begin around $250m, have several positive financial implications. They provide funds to reinvest in new business and reduce capital requirements. The transaction is similar to selling a closed block of business, although the capital markets may provide a lower cost of capital, but will require the sponsor to retain administration requirements and certain risks.
Why isn't securitisation more popular?
Several reasons explain why the life sector is only just starting to use this capital management tool.
First, securitisation is not a trivial undertaking. A material transaction can take up to a year to complete as it requires the review and input of a wide range of stakeholders. Furthermore, post-issuance administration can be cumbersome and time consuming.
Second, because insurance, unlike loans, is a liability and not an asset, transferring the economics in a clean sale is not feasible and requires traditional reinsurance technology. Advanced structures often include complicated regulatory rules and compliance issues. These factors require substantial investor education and often greater involvement from insurance regulators. Finally, to transfer any risk to the capital markets, the sponsor needs to be able to explain the nature of the risk and provide clear historical and expected performance. Such transparency requires reliable data, which the industry often has been unable to provide.
As a result of over two decades of evolution, banks have become proficient at managing data and creating the financial and reporting infrastructure necessary to administer transactions. For life securitisation to occur on a larger scale, insurers must follow suit and improve both the quality of their information and their ability to track it in a timely manner. These improvements will increase transparency and foster a broad and dependable investor base.
Dan Ozizmir is managing director of Swiss Re Capital Markets.
Life Securitisation Q&A
- What is the role of a reinsurer in a securitisation?
Making the model work will require a new level of cooperation between primary companies and reinsurers. Primary companies will need to standardise products and upgrade their IT infrastructure to make the products more "securitisation friendly". This may require new policy terms and sharing data at more granular levels. In exchange, reinsurers will need to share any economic benefits in a transparent way through lower prices.
The model also requires that larger reinsurers educate regulators and potential investors, spend research and development money to optimise the structures and allow prototypes to be copied by others as everyone gains with increased efficiency. As in other securitisation markets, some larger players will do their own transactions. Others will sell the raw assets to another party who will bundle them. In either case, the ultimate risk/reward will go to capital markets investors.
- Should I sell a closed block or do a securitisation?
Either solution could work, depending on the company's strategic and financial needs. Selling a closed block means a more complete exit from a line of business than completing a securitisation. Although the cost of funds used in sale transactions may be higher, the buyer will usually take on all obligations of the block, including administration, thus providing a more holistic answer for a company that wants to monetise embedded value and eliminate ongoing administration.
On the other hand, an embedded value securitisation typically may result in a lower cost of funding to the seller. However, in exchange, investors generally require the sponsor to maintain the risk of ongoing administration, certain other non-insurance risks such as misselling lawsuits and large policies, and asset-management responsibilities. The company also retains any upside in the block after the notes have been paid off, and therefore any benefits of scale, if strategically important.
- Are there real economic benefits from securitisation?
Undoubtedly, just look at banking industry results. By selling risks to investors, insurance companies will no longer need to hold as much capital. Furthermore, being able to write more new business for each dollar of capital can dramatically affect financial returns. If the industry can share these economic benefits with the client, increased market demand could result. A look at current credit card or mortgage rates show they are far lower than if there was no securitisation.
- Who invests in securities?
The beauty of a securitisation is that it can match investors with particular risk appetites - hence return hurdles - to the appropriate securities. Some notes have little risk and tend to attract large money managers or even financial guarantors such as Ambac, XL and FGIC. Other securities involve more risk and are purchased by asset-backed securities investors or sophisticated hedge funds. In general, if a sponsor can accurately describe a risk, then there should be investors who will provide a price.