As structured finance grows , life insurance companies are entering into new terrain and looking into life embedded value securitizations in the U.K., as well as in the U.S. Getting a grip on the accounting issues that surround this asset class is part of the story behind the rise in interest in embedded value securitizations.
"When a life insurance company writes a contract it initially incurs a number of costs, including administration and commission expenses," said David Anthony, a London-based analyst at Standard & Poor's. "The trouble is, because accounting is annual, whether for the regulators or the shareholders, the current years' accounts will only show the loss made today, without giving full credit for the profits the contract will likely bring tomorrow," he added.
Anthony was a co-author of a report published last week by S&P entitled Survey of Life Embedded Value Securitization in the U.K.
The securitization of embedded value, which essentially is a set of future cash flows, provides a way for life insurance companies to avoid the financial issues of new business strain and regulatory solvency. Insurance companies have found that they can take a block of existing business off the balance sheet and effectively securitize the future cash flows relating to that block of business. They give the future cash flows to investors in securitized notes and get an up front cash payment from those investors in the present. "Life insurance companies can turn those future cash flows into cash today through securitization," said Anthony.
Thus far, two life companies based in the U.K. have undertaken embedded value securitizations, according to S&P. The U.S. has seen three value embedded securitizations to date which have been rated by S&P, said Jose Siberon, New York-based analyst and co-author of the report. In 2001, Prudential Financial executed a closed block securitization; in 2002 MONY did the same, and another securitization was also executed by Forethought Life Insurance Company.
In the U.K., the more recent transaction occurred in 2003, when Barclays Bank merged its two life businesses, Woolwich Life Assurance Co. Ltd. and Barclays Life Assurance Co. Ltd., into New Barclays Life and securitized the surplus emerging. The transaction received an unwrapped credit rating of A-' by S&P.
The first embedded value securitization took place in 1998, when National Provident Institution securitized part of its "value of in-force." The notes were split into two classes, with class A1' notes set to expire in 2012 and A2' notes to expire in 2022. These carried an initial rating of A-'. However, the rating of the notes fell to triple-B plus as the financial strength of the company deteriorated. Currently the class A1 notes are rated double-B plus and the A2 notes dropped from B/Watch Neg' to triple-C last week due to insufficient surplus emergence.
"Companies change," said Anthony, said of the change in ratings. "That's a particular risk with very long maturities."
Other risks associated with this type of securitization include investment return risk, which takes into account the fall of valuations and in absolute levels of income; and persistency risk, or the likelihood of increased early surrenders, which not only create an immediate cash call but also deprive the insurer of future profits. Other risks to be aware of are mortality and morbidity risks; expense inflation risks; and reputational risks, such as a loss of confidence or bad press. "Like banking, insurance is a confidence-sensitive industry," S&P analysts note. Additional risks mentioned by analysts were adverse selection risk; bifurcation risk; embedded guarantee and option risk; and surveillance risk.
Even with the risks involved, the S&P analysts do envisage more companies in Europe taking the route of embedded value securitizations. During the 1990s, when the investment markets were strong there was no need to raise additional capital, but the downturn of investment values thereafter caused problems, according to Anthony. "There have been a number of downgrades if you look at our ratings of European life companies as well as some of our ones in the U.S. You'll see that there are a number of companies who may not have had capital problems in the past, but do appear to have capital problems in the present," he said.
There are a number of ways of improving a capital situation, Anthony added, but it's a matter of which is the most cost effective. "Until recently securitization tended to be a very complex, somewhat expensive way to go," said Anthony noting as the capital markets became familiar with embedded value securitizations, these transactions have become cheaper. By comparison, reinsurers are getting more expensive, he said. "The securitization route is becoming increasingly viable and realistic for more and more companies now," said Anthony.
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