Insurers are contemplating a return to the securitization market to fund what they consider to be excessive reserve requirements for certain life policies.
Doing so would free up capital to put to what they consider to be more productive use. But the modest, albeit safe, returns offered by such transactions, which are structured similarly to higher-yielding catastrophe bonds, could pose a challenge to attracting investors.
The last asset-backed deal to transfer life insurance-related risk was done in the fall of 2010 by Goldman Sachs. The complex, $200 million transaction, through Goldman’s Signum Finance Cayman Ltd special purpose vehicle (SPV), was designed to provide mortality protection on a block of U.S. term life policies.
The deal was done when Wall Street was still struggling to recover from the financial crisis. It was something of a lone wolf in the wake of what had been a robust market in life insurance company-related deals, estimated at $20 billion in annual issuance leading up to its 2009 collapse. Most of those deals were designed to enable life companies to free up capital, especially excess reserves required by Regulation XXX, by transferring policies to a reinsurance SPV that in turn issued bonds to investors.
At that time, Goldman was testing what had become an all but inactive market, and whether the investment bank ever sold the bonds to investors or ended up retaining them on its own balance sheet remains unclear--Goldman did not respond to inquiries by press time. However, no deal securitizing those assets has been completed since then, according to market sources.
Nevertheless, companies writing term life polices and universal life policies have still faced significant capital strain imposed by the excess reserve requirements—universal under Regulation XXX. As a result, transactions continued but under a more private guise, and the risk transfer mostly took the form of bilateral agreements within the insurance holding company, or between insurance companies’ captive reinsurers and bank or other reinsurer counterparties.
More recently, capital markets participants have taken an interest in the asset class’s long-maturity risk which, like catastrophe bonds issued by property/casualty insurers, is mostly uncorrelated with their exposures to corporate securities. That lack of correlation is highly prized, with memories of the volatility during the financial crisis still fresh.
However, the moderate spreads from such transactions, and the steep learning curve required to master their dynamics, pose significant challenges to drawing more capital-markets investors to the asset class. U.S. insurance regulators are also moving toward more principles-based regulation, which could eliminate the need for excess reserves altogether, and a New York regulator just issued a report that was highly critical of insurance companies’ captive reinsurance strategies.
Nevertheless, investors favoring safety and stability over outsized returns, or those able to employ leverage in one form or another, appear to be taking a closer look. And changing market dynamics could soon make the bonds attractive to a wider array of investors.
“Broadly speaking, we think it’s perfectly likely there will be at least a partial return to securitization and trading of this risk in bond form,” said Robert Meehan, senior vice president of financial solutions at Hannover Life Reassurance Co., which is a major buyer of this risk. “We’d be equally happy investing in those bonds or helping structure them, as we do today through reinsurance and derivative forms.”
For now, though, capital markets investors interested in excess-reserve exposure must engage in derivative transactions. After the financial crisis life companies looked to internal solutions that typically involved parent companies guarantying their captive offspring. Then banks entered the market, providing letters of credit to finance the reinsurance SPVs. Within the last few years, credit-linked notes, swaps and other derivative vehicles have been used to transfer risk to mostly other reinsurance companies but also some capital markets investors.
Given excess reserve transactions’ moderate spreads for an alternative investment and long maturities, a major appeal for those investors is the asset class’s lack of correlation with other financial markets, primarily corporate securities. Mortality risk has little to do with the stock market. In that sense, excess reserve bonds resemble their cat bond cousins, although cat bonds are typically noninvestment grade and provide much wider spreads.
Dan Knipe, who manages Leadenhall Capital Partners’ insurance-linked securities (ILS) funds related to life insurance, said the derivative transactions, typically $500 million or more in size, are syndicated to at most a handful of investors. They can include specialty funds, such as Leadenhall, as well as large money managers and pension funds. His fund, one of at most a handful that invests in life ILS, also looks at embedded-value transactions common in Europe, in which counterparties effectively lend money against the future statutory surpluses that will emerge from an insurance company’s book of mortality business, as well as deals covering extreme mortality exposures.
“The difficulty is that when you move to Regulation XXX securitizations, you come very far down the return scale. From a risk-adjusted perspective, it makes sense, but the deals are slightly esoteric and it’s a nascent market,” Knipe said.
That means expertise is required and firms must devote resources to gain it. There is likely to be little existing expertise among capital markets investors, because the pre-crisis ABS deals were all wrapped by monoline insurers, which did the due diligence. Nevertheless, insurance companies must still finance these assets. In February actuary firm Milliman published its annual life ILS review and outlook, in which it estimated at least $12 billion in reserve financing and embedded value transactions took place in 2012, as well as at least $625 million in transactions transferring catastrophic morbidity or mortality risk. And until the rules change, that should continue.
The Regulation XXX excess reserve requirements came about in the late 1990s, prompted in part by the unexpected and highly publicized insolvencies of major life insurers, including Executive Life Insurance Co. and Mutual Benefit Life Insurance Co. The regulation imposes substantial additional reserve requirements on life insurers who write certain types of policies, primarily term life with level premium guarantees.
“The regulators were concerned by the relatively flat reserve development that life insurers attributed to these policies under then-existing statutory accounting regimes, given that the risks under these policies clearly change over time,” said Keith Andruschak, a partner at Mayer Brown.
Freeing Up Capital for More Productive use
“So the new regulations required life companies to adopt more conservative assumptions and valuation methodologies that regulators believed would cause statutory reserves to more closely resemble the actual risk profile of these products.”
Andruschak added that the higher reserves mandated by Regulation XXX can tie up significant amounts of life companies’ capital that could otherwise be put to more productive use.
Enter the banks. Investment bankers anticipated the excess-reserve issues that Regulation XXX would cause and marketed funding and financing products to free up insurers’ capital and provide a return. Insurers jumped at the opportunity, and for good reason. Using the catastrophe bond model developed for property/casualty insurers a decade earlier, insurers could issue “principal-at-risk” debt securities backed by the cash flows of portfolios of insurance policies subject to Regulation XXX. The proceeds of the sale would fund the excess reserves.
“Since the XXX notes could be linked exclusively to the excess reserve band—the amounts attributable solely to the new regulations—they were perceived by investors as a very low risk opportunity,” Andruschak said.
Today’s non-securitized transactions accomplish the same goal, and there are indications the market is inching toward a revival of securitizations, or at least the conditions are becoming more favorable. Milliman noted that a “substantial portion” of the financings in 2012 involved nonrecourse letters of credit (LOCs) or other nonrecourse transactions in which, like securitizations, lenders rely on income from the captive SPV’s assets and not the credit of the parent company.
Steve Kinion, captive insurance director for the Delaware Department of Insurance, one of a handful of states that licenses and oversees captive reinsurers, estimated that derivative transactions made up a third of transactions his office has reviewed recently. Parental guarantees made up another third and bank LOC’s the remainder, he said.
Kinion said parental guarantees are the least costly way to fund captives. However, he’s seen a migration from those guarantees to credit-linked notes and other derivative structures.
In addition, Kinion said, his office has seen the price of bank LOCs increase significantly. “In a recent transaction I handled, the LOC was replaced by a credit-linked note that was issued by an unaffiliated third party. So yes, there is a migration,” he said, adding that Dodd-Frank rules are increasing the cost to do business with banks, further prompting a shift away from more expensive LOCs.
Dodd-Frank Rules Provide Further Incentive
Kinion has overseen captive reinsurers since 2009, and no one has suggested pursuing an ABS deal since then. Nevertheless, the derivative form of these transactions opens the door to institutional investors that would be shut out of the other current methods.
Knipe said assets devoted to life ILS at Leadenhall have nearly doubled over the last year and a half, to $650 million, and the majority of those investors are pension funds.
An obstacle for many institutional investors investing directly in the derivative transactions is their sheer size. They typically range from $500 million to as big as $2 billion, and dividing even the smallest among a handful of investors presents them with a major commitment. Knipe said Leadenhall can invest in more of these ILS than its capital may suggest by trading on margin, an approach unavailable to most pension funds and money managers.
Hannover Re’s business is taking on risk from insurer clients, but sometimes the risk a client is seeking to transfer is so large that the reinsurer acts as a “first participant,” structuring the deal and taking a large piece of it, and then the client sells the remainder separately to other market participants, according to Meehan.
Hannover Re benefits from the diversification of its international business that is split between property-casualty and life insurance. Its primary regulatory focus is Europe’s Solvency II regulations, which credit its diversification and lower capital requirements, providing a type of regulatory leverage.
“It’s fair to say that the international diversification of our business and different lines of business permit us to assume this risk on a more efficient basis than many of our client companies,” Meehan said.
Such a strategy isn’t available to capital markets investors, and outright leverage is impermissible for many of them. And yet excess-reserve transactions’ relatively tight spread, typically between 100 and 150 basis points, makes leverage almost necessary for some to achieve acceptable returns. Pascal Koller, a partner on the ILS team of Switzerland’s LGT Capital Management, said the returns of excess-spread transactions are so low that “unless you can employ leverage, which we cannot in our fund structures, it is difficult if not impossible to achieve the returns that our investors are generally looking for.”
Nevertheless, the asset class’s uncorrelated nature and long maturities, typically 15 years today with some stretching out to 20 years, may appeal to investors such as pension funds and firms underwriting annuities.
“You’re making annuity payments to a group of individuals for a very long time, so you have this long-dated, non-callable capital that may be suitable to invest in something like this,” Knipe said.
Matching long-dated capital with long-dated investments reduces refinancing risk. The rationale is similar for pension funds, which also have long-dated liabilities they must fund to make payments far into the future. “Pension funds don’t need to shoot the lights out every time with their investments; they just need to make a consistent, stable, low volatility, low correlation return,” Knipe said.
In addition, the longevity risk pension funds face is directionally opposite to the excess reserve deals’ mortality risk, allowing them to offset each other partially. Donald Thorpe, a senior director in Fitch Ratings’ insurance group, noted that “natural hedge,” adding that the risk for term life insurance is policy holders dying sooner than anticipated, and for pension funds the risk is people living longer.
“So those two risks, mortality risk and longevity risk, are on opposite sides,” Thorpe said. “It’s not a perfect hedge, because it’s not the same group of people.”
Leadenhall has focused on European pension funds, but Knipe said the excess-reserve transactions are even more suitable for U.S. pension funds, since the risk offset is more precise because those assets are exposed to U.S. life-policy risk.
For now, funds specializing in ILS, such as Leadenhall, are the main way to access this type risk for most pension funds and other institutional investors, which are wary about investing in illiquid markets. Consequently, they’re hesitant to devote resources to learn about the market. When a tipping point is reached to escape that chicken-before-the-egg conundrum is anybody’s guess.
“Several of the pension funds we’ve spoken to have raised this same issue; they’re not going to spend the time to learn about a new asset class unless they know there’s going to be a lot of recurring issuance,” said Steven Schreiber, principal and consulting actuary at Milliman.
And nobody said life ILS is a quick learn. Prior to the financial crisis, “There were a number of risks embedded in [excess reserve ABS] transactions, and you had a monoline in between the insurance risk and investors that was considering these various risks,” Thorpe said. “There would have to be a willingness on the part of investors to become educated about those risks.”
Many institutional investors are restricted to investing in securities, so there may be unrealized demand for the type of stable, safe, uncorrelated risk that low-yield excess-reserve bonds would provide. A few securitizations, in the wake of Goldman’s Signum deal, that successfully sell more edible chunks of risk to a broader swathe of investors could create momentum that feeds on itself.
Meehan sees the success of today’s market participants potentially drawing new liquidity to the market. A second driver, he said, may come from the insurers themselves.
“As the market evolves, some of our client companies may reach a point in the future where they’re filled up from a risk exposure perspective regarding us or our reinsurance competitors, and it may be natural for them to encourage a broadening of the market.”
The most obvious way to do that is to widen spreads. In fact, cat bonds once offered more attractive returns than the comparable reinsurance, but the tables have turned in recent years. Now cat bond spreads are more competitive, which in turn has made reinsurance pricing more competitive. Whether excess-reserve deals follow a similar path is a difficult call, given the significant differences between the two markets. Catastrophe bonds and reinsurance are mostly noninvestment-grade and their spreads reflect it, while transactions involving excess-reserve assets are probably safer than their ratings suggest.
Safer, and Lower Yielding, Than Cat Bonds
Most excess-reserve deals “are structured so that a credit-linked note is triggered only if there’s a catastrophic event such as a pandemic. They’re extremely conservatively structured,” said Kinion.
In addition, Knipe said, the rating agencies typically look at the quality of the underlying policies, the collateral put up to fund the obligation, and the credit rating of the insurance or reinsurance company sponsoring the transaction, and then base the rating on the “weakest link.”
Because that’s usually the insurance company’s rating, deals are generally stronger than transaction ratings imply, he said. “That’s a deficiency of the rating agencies’ weak-link methodology. If the deal is well structured, you’ll end up with a significantly better risk profile than the rating might otherwise suggest.”
Meehan clearly has insight into where reinsurers’ capacity for this risk stands, but whether that limit has already arrived or remains several years away is only an educated guess at this time.
“In theory it sounds reasonable, but there is no public reporting of these numbers, so no one knows how much has been placed with reinsurers or what their capacity is,” Schreiber said.
Insurance Rules Could Reduce Need for Structured Finance
In the meantime, the biggest threat to botht prospects for securitizing excess-reserve assets and using derivatives and other methods to take them off-balance-sheet may be the brouhaha unfolding at the National Association of Insurance Commissioners (NAIC). It has developed principle-based reserving (PBR) rules that could replace formulaic excess-reserve requirements with broader ones focusing more on what individual companies are seeking to accomplish.
Such an approach could lessen the need for structured transactions to free up capital. Thorpe said the eventual rules—whose adoption is not anticipated anytime soon—will likely end up somewhere between the PBR approach and today’s requirements. In addition, he said, besides financing reserves, some transactions are done because an insurance company, for example, may want to exit a line of business.
“You can’t sell life insurance policies, because as an insurance company those are your policies and you always have to pay them. But insurers sometimes reinsure a closed block of discontinued products by putting the policies in a captive, ‘ring fencing’ them, if you will,” he said.
The bigger risk may stem from a white paper by the NAIC’s Captive and Special Purpose Vehicle Use Subgroup that was first published last November, after a 15-month investigation. It reiterated allegations, first reported by the New York Times about a lack of transparency, questionable structures to help insurers move assets off-balance sheet, and a lack of oversight that created a “shadow insurance industry” with weaknesses resembling those that brought down the banking industry five years ago.
David Provost, deputy commissioner of the Vermont Department of Financial Regulation’s Captive Insurance Division, said that a revised version issued June 6 still expressed concerns about issues such as transparency, but references to a shadow industry and the recent financial crisis were largely removed. “Now it’s more balanced. Here are the concerns and here are the things that should be done,” he said.
A few days after the subgroup whitepaper was finalized and the NAIC proceedings were wrapped up, Ben Lawsky, New York State’s first superintendent of financial services, released a report that repeated much of the language in the NAIC’s first white paper and called for a nationwide moratorium on these types of transactions. It claims that insurance companies are diverting policies to captive reinsurers, which the report calls shell companies, to take advantage of lower reserve requirements that at times result in the parent insurer actually paying itself a commission when the transaction is complete.
Provost said it’s unclear whether the inflammatory report will impact the subgroup’s whitepaper, but he said it may positively impact the NAIC’s larger PBR initiative.