Insurance companies are among the market's busiest investors but a new phenomenon taking root is transforming their own business into collateral for securitizations.

Trust preferred securities, or TruPS, have been harnessed as collateral for CDOs in recent years, primarily by the banking institutions which pioneered the process. Issuing these securities raises new sources of funding, provides balance-sheet relief and offers investors the opportunity to capture long-term notes from assets once difficult to access. Five CDOs backed by bank TruPS have been issued already in 2004, totaling about $2.0 billion.

The first CDO of this variety was issued in 2000 through underwriter Salomon Smith Barney. According to Moody's Investors Service, 35 bank trust preferred transactions have been done to date, with approximately $5 billion of rated notes issued last year alone.

With activity surging on the banking side, attention has begun to focus on insurance companies. In a report release earlier this month, Moody's said it has experienced a rise in CDO transactions structured with insurance collateral. Market sources report four deals backed by insurance TruPS in the current CDO pipeline.

Thousands of insurance companies are eligible to issue trust securities and surplus notes (both of which are packaged into collateral pools). Trust preferred certificates are commonly 30-year maturities with interest deferral up to five years and are tax-deductible. Analysts note they contain a non-call period of five to 10 years and are treated as capital by state insurance regulators. Overall, insurance TruPS-backed CDO provide access to the capital markets for small firms in a cost-effective manner.

Yet as Moody's Associate Analyst James Brennan notes, fewer than 10 deals backed by insurance TruPS have been issued to date. "It is taking a little more time to get these deals together. It's still a new product," Brennan said.

As insurance companies are regulated state by state, as opposed to the banking industry, which is under federal oversight, the creation of these securities is a task that involves regulatory approval in all of the states with which the insurer does business. Since it is a more cumbersome process, it appears just a few underwriters have crafted a model for structuring insurance TruPS CDOs, including FTN, Citigroup/Sandler O'Neill and Merrill Lynch.

But just because more structures are being rated in recent months does not necessarily mean investors are ready to bite. Trust preferred certificates are subordinate to and junior to other senior debt, making them a more risky holding. Also, there is not enough data to perform a historical analysis on recovery rates. According to Brennan, the closest proxy on a historical basis is preferred stock recovery rates. A 5% recovery rate for all TruPS and insurance surplus notes is utilized in the Moody's rating analysis.

CDO researchers point out that the two types of TruPS CDOs vary significantly in assumptions, including actual default probability and actual diversity between the two types of collateral. Most important, they said, is the fact that insurance companies are more likely to suffer financial distress, or impairment, than their banking counterparts.

According to a March 2004 report from A.M. Best Co., U.S. domiciled insurance companies rated by the entity had an average annual impairment rate of 0.71%. The study involved 4,936 individual companies from 1977 to 2002 rated by Best during this period; 583 companies became financially impaired during this timeframe. Entities dubbed vulnerable (rated B and below) were largely to blame, racking up an average annual impairment rate of 3.44% as opposed to the 0.23% rate from entities dubbed Secure (rated B+ and above).

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