Insurance securitizations have been slated to be the next big thing among European insurers for sometime now, but as the preferred reinsurance market continues to impose more difficulties, insurance companies are more aggressively investigating what the best way to incorporate this tool will be.
"Reinsurance is generally becoming more expensive following the WTC event last year," said Simon Harris, vice president and senior credit officer of European insurance at Moody's. "Also, the FSA has said that it's looking into the use of financial reinsurance. This is something that was once intensely used in the U.K. but may be more limited in the future.
"On the supply side there are problems," Harris continued. "I think insurance companies would still like to use reinsurance, but are finding it to be too expensive or simply unavailable - this is one of the factors propelling securitization as an option."
Despite the market's roots lying in the U.K. - with U.K.-based National Provident Institution (NPI) issuing the first securitzation of a block of its life insurance business - it has been U.S. companies that have continued the initiative in recent years. To date, there have been two public deals recently completed by the U.S. arm of Prudential, and a number of other deals completed through the private placement market.
European life insurers are now largely regarded as warming to the possibility of securitization as a funding tool. Royal & Sun Alliance said that it is presently exploring a possible securitization to see if it might be more helpful than reinsurance.
In 1997-1998 there were a number of areas into which NPI wanted to expand, and the company needed to raise financing in order to do so. After considering a number of options, the group opted to securitize future profits from a block of its business.
At the time, European market perception interpreted the deal as a sign of NPI's financial weakness. And investors, used to more traditional methods of financing, echoed disdain for this complicated structure. "What NPI found when they did their securitization is that many of their distributors, as well as their brokers, did not give the company credit for its improvement in regulatory capital," said Harris. "In fact, they gave it discredit. About one year later, NPI was forced to demutualize because - even after the securitization - the company still did not have sufficient capital. Many used that situation as fuel and believed that only companies that are really financially weak need to use securitization," Harris continued.
Meanwhile, the late 1990's were a time when many life insurers were benefiting from strong investment markets, so there was not much need to think about additional sources of financing. Securitization was quickly stored at the bottom of the capital markets drawer.
Now, the evolution of the European insurance industry has left many life insurers in need of more capital than what they have at the moment. This shortage is attributed directly to the demise of the equity markets, and has compromised many insurers' regulatory solvency position. At the same time, however, there is an even greater need for regulatory capital than there was five years ago.
"In the U.K., for example, you have the new stakeholder pensions which are issued at very low costs with low margins," said Smith. "The volumes generated to date have been pretty small, but the end game is that there will be large volumes of business which will have to be sold at low margins as a result of government product guidelines. Therefore, the capital you need to underwrite the new business has actually gone up while regulatory capital has come down."
According to Harris, the German market is experiencing similar pressures. There, this pressure is propelled by a major reform of German pensions called the Reister. This reform is expected to drive substantial growth in the life pension insurance business over the next years, and means that German life insurers will also need more capital to underwrite a surge in new business while dealing with a lack of regulatory capital.
This situation has motivated investment banks to investigate different sources of capital. Of these, the most obvious - but least attainable - is the equity market. Another option is traditional debt, but many of the major players in the market have issued all the debt they can without adversely affecting the company's rating, said Smith.
Reinsurance has typically provided a viable alternative method of effectively minimizing the cost of underwriting new business. Post Sept. 11, however, reinsurance costs across the board are going up. For U.K. insurers, there is also the issue that regulators - given the life insurer's exposure to the reinsurers' bankruptcy risk - are becoming more uncomfortable with this funding tool.
And while sources said that the regulator's preference for securitization is largely attributed to the fact that the assets are collateralized up front, it is still far from being the most efficient method of funding.
In the NPI transaction there is a complicated structure in place for the bonds. NPI established a special purpose vehicle (Mutual Securitization plc) that is the actual bond issuer and bond trustee, and which looks after investors' interests. Understandably, as few people outside the life insurance industry understand how profits emerge on life policies, it is necessary to have independent actuaries confirming that what the company is doing is correct. All of NPI's calculations for the emerging profits were checked by Watson Wyatt, the calculation confirmation agents. The trust deed dictates what payments are due when and in what circumstances, what can and can't be done that will affect the policies, and how to calculate the emerging profits each year.
"In retrospect, this securitization probably happened at the wrong time," said Nick Rose at NPI. "The fixed interest rate was set before yields fell in 1998, and now looks high compared with current levels - and it did not raise enough financing to enable NPI to continue independently. Events since have combined to make this a less satisfactory way of raising finance than was originally envisaged," he continued.
Securitization does not affect a company's financing from a ratings perspective, since it is technically not raising any new financing as in, for example, an equity raising. "All it does really is it says you have established some claims reserves, and within these claim reserves there are margins because the regulator says you must be prudent in reserving," explained Smith. "So within these claim reserves you have these surplus amounts of money that, as the business matures each year, emerge as profit. Securitization takes all those future margins out and translates them into cash.
"There is an immediate regulatory benefit as a result of that, but at the end you really have not done much in terms of creating or injecting new capital," Harris continued.
The success largely depends on the type of securitization that is being done, the status of the company before the transaction is done, and what the company intends to do with the proceeds. If it is distributed among shareholders or applied to higher-risk investments it could be negative for the company's risk profile.
What's needed for securitization to take hold as the next big thing among life insurers? One of the things that Moody's looks at is delinking the rating of the insurance company and the rating of the bond. In the case of NPI there was a clear linkage of two notches. If this continues to be the case for future transactions, there is always going to be bonds that are two notches below the financial strength rating of the company.
Banks would like to create a structure that allows the top tranche to be triple-A rated. In such a case, said Moody's, it would be looking at a structure that has no link between the cash flow of the securitization and the financial strength rating of the life insurer.
But in the U.K., for example, the latest move for companies is a switch from their historical line of business with profit policies to unit-linked policies. The most difficult business to securitize is probably that with profit policies; the easiest is unit-linked, where a policy is written and a stream of income is received that comprises the difference between what is charged for managing assets and what this management actually costs. There are many risks associated with profit policies - especially in the U.K. - that are a result of potential legal and regulatory intervention and are likely to make such business harder to securitize.
Securitization could be a tool used to move the capital generated from the old line of business to the new lines of business, said Harris. He expects that going forward, more insurers will look at it as a means to effectively move capital around. In the short-term, however, it is unlikely that securitization as a funding vehicle will achieve a triple-A rating efficiently enough to make it cost effective for both issuers and investors.