In an already capital intensive business, the additional pressures on United Kingdom life offices of stakeholder charge limitations, the low inflation environment, the costs of pension mis-selling, guarantees and endowments all increase the need to utilise capital efficiently. Coupled to this is the sense that now is an era of opportunity for the sizeable life offices to grow, as central governments, at least in the developed world, address the need and cost of caring for their ageing populations. This will lead to life offices focusing on rapid growth to capture market share. The financing of new business growth is almost always a concern for insurers as the costs in the early years of a policy significantly outweigh the charges recovered in that time. Life offices need to feel confident that they have adequate capital backing to support an expansionist strategy.

Use of future profits

One asset of a life office, sitting there relatively untapped (save in a small way and, indeed, intangibly as an implicit item for solvency purposes), is its future profits. The future profits of a life office are the commission element on its portfolio of policies. The charges it will prospectively levy on its existing book, less costs incurred in servicing that business, are capable of being prudently estimated over the lifetime of the relevant policies. Securitisation is one way of releasing value immediately from the embedded value of the long term fund. It may be particularly attractive to a mutual insurer which, by definition, will not have access to equity markets. Indeed, the sole example of a securitisation of embedded value surplus has been carried out by the UK mutual, National Provident Institution (NPI) which successfully held a bond issue in April 1998.

A particular non-public life transaction, also from 1998, that has been variously described as a securitisation, but would seem closer in fact to a form of quota share reinsurance, is Hannover Re/Rabobank's “L1” deal. Hannover Re entered into a quota share arrangement with Rabobank under which it ceded certain percentages of life treaty business. Rabobank benefits from a share of future earnings, although it, in turn, has passed on the risks and rewards to its own Dublin-based reinsurer, Interpolis Re. Rabobank itself provides liquidity financing, while Interpolis Re absorbs reassurance risk.

NPI 1998 embedded value securitisation

Through an Irish special purpose vehicle (Irish SPV), NPI issued £260 million of bonds, listed on the London and Irish stock exchanges. The principal investors in the bonds were UK insurers, pension funds and banks. The Irish SPV on-lent the proceeds of the bond issue to NPI. The crucial feature of the transaction from NPI's point of view was its ability to structure the transaction so that its obligations under the loan agreement with the Irish SPV were only a limited recourse obligation of NPI. The recourse is limited to profits emerging (emerging surplus) on a specified block of NPI's life and pensions business. Without limited recourse, NPI would have liabilities matching assets and thereby lose the solvency benefit of raising that additional capital. The Financial Services Authority (FSA), as insurance regulator, and the rating agencies which rated the issue, were prepared to treat the proceeds of the transaction in the hands of NPI as available assets.

The £260 million raised by NPI is to be repaid over 25 years. NPI would have liked at the time to have raised slightly more than this amount, but prevailing market conditions militated against it doing so. NPI did, however, grant itself the option to issue further bonds pari passu at a future date. The subsequent AMP take-over and demutualisation of NPI in 1999 did not affect the transaction and leaves the securitisation in place. The close proximity of the securitisation and, then, subsequent demutualisation of NPI have perhaps not been particularly helpful in terms of publicity for the cause of promoting the concept of life sector securitisations. There is possibly a perception, quite wrongly, that securitisations may be a sign of financial weakness. Certainly NPI's innovative financing in 1998 was driven at the time by ambition and not by any fundamental financial weakness.

The Irish SPV issued £140 million of Class A1 bonds repayable over 15 years (from 1998 through to 2012) and £120 million of Class A2 bonds repayable in years 15 to 25 (ie from 2012 through to 2022). The Class A1 bonds pay a fixed coupon of £1.4% above the rate of a gilt of a comparable term and, to reflect the slightly greater risk and delay in principal repayment, the Class A2 bonds pay a fixed coupon of 1.7% above the corresponding gilt rate. The bonds initially received a Standard and Poor's rating of A-, and a rating of A3 from Moodys.

NPI's emerging surplus

The emerging surplus is broadly the net amount earned by NPI in its management of the investments supporting the specified life and pension policies, and is calculated by deducting estimated expenses from the management charge NPI receives on those investments. The emerging surplus from that block of business by which the interest and capital is funded is not identical to the actual surplus arising in the business of NPI, as emerging surplus excludes, for example, pensions mis-selling liability. If, in any year, insufficient emerging surplus accrues to meet the scheduled repayments, there are other sources available, principally a special reserve account. However, if a shortfall still persists then repayments are deferred and become due in the following repayment period.

Calculations of the amount of the loan, and of the scheduled repayments of capital each year over the 25 year period, were derived from actuarial projections of the amount and pattern of the emergence of surplus, using a variety of assumptions. The underlying book of NPI business comprises half a million unit linked and unitised with-profits policies, worth at the time of the transaction upwards of £4 billion. NPI excluded conventional with-profits business, not for any reason of fundamental legal difficulty in its use, but because it was simpler in the time available for NPI to underpin the securitisation with its unit linked and unitised with-profits policies.

The NPI “base case”, set out under a central set of assumptions (and described in the offering circular), shows emerging surplus of approximately twice that required to meet capital and interest repayments on the bond. NPI is generally able to retain any excess of emerging surplus over scheduled loan repayments. Although repayments are scheduled to end in 2022, further surplus should emerge after that time which would be available to service the loan if emerging surplus has been insufficient in earlier years. Since the block of business being securitised by NPI did not represent all of NPI's business, it was necessary to specify how certain items would be calculated over the 25 year period in order to arrive at emerging surplus. Key defined terms were investment return, expenses, mortality and lapse experience and a basis for calculating reserves and tax.

Security underlying the transaction

A particular security feature for the benefit of bondholders is the special reserve account, initially credited with £40 million by NPI. The special reserve account does, exceptionally, in the transaction represent a direct full recourse obligation of NPI. This account is principally designed to smooth liquidity shortfalls which may arise from repayment period to repayment period between the amount of emerging surplus and the scheduled capital and interest due. In the absence of any such reserve or other appropriate mechanism, a default might easily be triggered under the loan, because of the potential for variance in emerging surplus from time to time. The special reserve account in normal circumstances remains at £40 million if not drawn down upon and, if it is drawn down upon, it reduces accordingly. It can, however, be supplemented back up to the original £40 million amount from excess emerging surplus.

Under certain adverse circumstances, constituting “trigger events” under the terms of the bonds (ie the insolvency of NPI, loan default, other inability to pay debts, loss of regulatory authorisation, certain misrepresentation, a significant re-rating and certain other adverse regulatory actions), the special reserve account is supplemented by all excess emerging surplus, even if this results in the account increasing beyond the £40 million.

In addition, NPI provided some collateral security with a fixed charge over certain “custody accounts”. These custody accounts contained, at the outset of the transaction, property of only nominal value. In the event of the occurrence of the trigger events, NPI is obliged to transfer into the custody accounts, and charge by way of first fixed charge, certain eligible securities of a specific value. In certain circumstances where events giving rise to the trigger event alter, the payment into these accounts is capable of being reversed. In yet severer default circumstances (ie default on scheduled capital and interest repayment, and material misrepresentation), NPI may be obliged to repay the loan in full, together with an amount representing the discounted value of all of the excess future interest above the corresponding gilt rate. Any such repayment on these terms would be penal and is designed to enable the bondholders to achieve their required rate of return by reinvesting in UK government stock.

Legal issues relating to a life sector securitisation

  • Regulatory compliance

    As mentioned above, first and foremost, the key to an embedded value securitisation is to secure the appropriate regulatory treatment. Since the rationale for such a securitisation is likely to be to maximise regulatory capital or free assets, it is essential that the regulator recognises the limited recourse nature of the underlying loan and does not seek to treat repayment obligations as immediate liabilities of the insurance company.

  • Non-assignability of life premiums

    It might, at first glance at least, seem surprising that life policies issued by an insurer, carrying the right to emerging surplus, cannot be treated in the same vein as any other pool of trade receivables capable of being packaged into securities, and that the right to future surplus is not capable of being securitised in the same way. However, a policyholder always retains the right to surrender his life policy at any time. Assignment, as a legal device, can only be used when there is an actual right to receive the premiums or surplus, ie if the life assurer could sue in respect of premium payments not made when due. The legal analysis is that payments by policyholders in respect of their life policies are of a voluntary nature and the life assurer therefore has no “chose in action”, or right to receive premiums, which is capable of being assigned to the lenders. The loan route used in the NPI securitisation avoided this issue since the securitised asset was the right to receive payments under the loan and not the emerging surplus income from the policies concerned.

  • Section 16, Insurance Companies Act 1982

    Section 16 of the Insurance Companies Act 1982 imposes the requirement that an assurer may only enter into transactions which constitute, or are either for the purposes of or connected with, its insurance business. Financial engineering of the nature and scale of an innovative transaction such as a securitisation is certainly not conduct of insurance business by the life insurer concerned. However, the restructuring and management of its insurance business brought about by the securitisation should be in connection with and for the purposes of its business. The release of current funds to support new business growth is certainly evidence of this.

  • Long term fund liability

    In the event of a proprietary life company proposing a securitisation, it should be required to warrant in the appropriate documentation that it will apply the loan which is granted to its long term fund. Principally, in order to obtain preferential regulatory treatment, the obligation to repay the loan must be an obligation of the long term fund. Even though it is such an obligation, the appointed actuary does not need to treat it as a liability in compiling the regulatory returns since it is a liability which can only be met out of future rather than existing assets and only if such future assets materialise. As the returns do not take any credit for future surplus, the loan obligation is effectively offset by something outside of the return. Such treatment is preferable to it being treated as a shareholder liability which would potentially appear on the balance sheet as a liability making the transaction ineffective in terms of increasing available capital.

    Secondly, on a winding up, as a creditor of the long term fund, the lender's claim will rank pari passu with the claims of policyholders. Under section 45 of the Insurance Companies Act 1982, the FSA has very widely drawn powers to take all necessary action to protect policyholders. This includes the FSA requiring the insurer to take such steps as it, the FSA, considers appropriate to fulfil policyholders' reasonable expectations. In theory though, these powers could include the ability to “subordinate” the claims of non-policyholder creditors.

    Thirdly, ensuring that the loan is a liability of the insurer's long term fund should also have tax advantages as, although the loan is repaid out of emerging surplus, the surplus does not pass into shareholders' funds which would normally trigger a tax charge.

  • Policyholders' reasonable expectations and directors' duties

    How a life office handles potential future surplus clearly raises policyholder reasonable expectation (PRE) issues. In theory, a loan could be raised secured on all future surplus of a book of business. However, to place all of policyholders' future surplus at risk would, in normal circumstances, be inconsistent with PRE unless, exceptionally, this possibility had been explained to relevant policyholders at the outset when they purchased their policies. If the assurer were to lose the proceeds of the loan, then a large proportion of future policyholder surplus might accrue to the lender, leading to very low bonuses to policyholders. Clearly, this would be well outside of what would normally be expected of a with-profits policy.

    The issue of what level of financing can be achieved without adversely affecting policyholders' reasonable expectations is a matter of fine judgment. The FSA has the powers mentioned above under section 45 of the Insurance Companies Act 1982 to intervene to protect the interests of policyholders. Additionally, under Schedule 2A of that Act and the sound and prudent management criteria therein, a life company will be regarded as infringing the requirement to conduct its affairs in a sound and prudent manner if it fails to conduct its business with due regard to the interests of policyholders and potential policyholders.

    Indeed, in determining whether and to what extent to securitise emerging surplus, the board of the insurer will need to have due regard to its duty of sound and prudent management. In particular, as stated above, the directors will need to be satisfied that the arrangement does not damage policyholders' reasonable expectations and that the risks involved in securing an advance by effectively disposing of a future asset are outweighed by the advantages that the additional capital brings to the business; for example, the ability to pursue a more aggressive investment policy or the acquisition of a new company or business.

    Protection for investors regarding operation of the underlying portfolio

    Finally, since the amount or timing of emerging surplus can be affected by the way in which the life assurer deals with the underlying portfolio and the rest of its business, the loan documentation and the bonds will need to address this issue. It is likely that extensive warranties and covenants will be needed in the loan documentation coupled with events of default. Further, certain aspects of the emerging surplus calculation may be predetermined rather than depending upon actual experience. A balance needs to be struck here between protecting the investors and allowing the insurer some degree of flexibility to operate its business. A further protection will be the involvement of an independent firm of actuaries as calculation agent to approve the calculation of the emerging surplus at the end of each repayment period and to determine the amounts due for repayment.

    Further life securitisations?

    Notwithstanding the surmountability of legal and regulatory obstacles, it must be stressed that effecting any life securitisation will be complex and time consuming. In many circumstances, some form of financial reinsurance or contingent loan type arrangement may be more easily organised and entered into. However, the long term nature of a securitisation, the size of the amounts capable of being raised and the keenness of the rates capable of being achieved, coupled with the ability to relieve pressure resulting from rapid growth strategy, may all entice other life offices to follow the NPI lead.

  • Tim Page is a partner in Clifford Chance's financial institutions M&A group.