A pick-up in structured finance transactions from life insurance companies based in New York is likely to happen soon because the state recently decided to stop testing a new framework for calculating reserves.
Through the National Association of Insurance Commissioners (NAIC), state insurance regulators have been developing a new framework, referred to as principles-based reforms (PBR), anticipated to be adopted nationwide. The PBR would make reserve requirements less rigid and more reflective of the underlying risk, meaning insurers would have less need for structured finance transactions.
But in September, New York State pulled out of the framework test that focused on universal life policies. Benjamin Lawsky, New York’s financial services superintendent, argued that the proposed rules don’t work; he pointed to a sample of 16 insurers that under PBR were expected to increase reserves by $10 billion but instead added less than $1 billion, with some adding no reserves at all.
No Relief from Reserve Requirements for New York Insurers
Reverting back to the previous rules, which insurers view as rigid and overly conservative, will require New York providers of universal life policies with secondary guarantees to add upwards of $4 billion to their reserves.
Although that is bad news for insurers, the need for additional reserves may prompt more structured finance transactions, which are used to finance universal life assets that the insurer has placed in a reinsurer it controls, known as a captive. The strategy allows insurers to free up capital that would otherwise have to support excess reserves under Regulation AXXX.
“There certainly ought to be an impact on the AXXX market, since all of a sudden New York’s universal life guarantee writers will have to apply the existing rules, increasing their reserve requirements,” said Dan Knipe, who manages Leadenhall Capital Partners’ insurance-linked securities (ILS) funds related to life insurance. “So they, of all people, should be keen to do these financing transactions.”
Funding Via Structured Transactions Expected to Resume
The market for structured excess-reserve transactions has slowed down in recent months. One likely reason, according to Steve Kinion, captives director for the Delaware Department of Insurance, is the regulatory uncertainty. PBR would likely reduce, if not eliminate, the need for captives and structured finance transactions, but it’s unlikely to become effective anytime soon.
“The operative date of PBR would be six to 18 months after 42 states representing at least 75% of premiums adopt the framework as law,” Kinion said, adding that New York’s withdrawal complicates matters, and California has also raised concerns about the proposal. Nevertheless, he said, some states have already adopted PBR as law, and several others, including Delaware, plan to introduce the legislation. Delaware is one of several states that licenses and oversees captive reinsurers.“We’ll probably be addressing this over the next three to five years; it’s going to be a long and arduous task,” Kinion said.
In the meantime, structured finance remains the primary way for life insurers to free up capital supporting excess reserves. Those requirements — imposed by Regulation AXXX as well as Regulation XXX, covering term life policies—once prompted insurers to issue through captives upwards of $20 billion annually in asset-based securities. The ABS market disappeared in the wake of the financial crisis, but insurers have since used captives to do other types of nonrecourse transactions to free up capital, including letters of credits provided by banks, credit derivatives and swaps.
Securitization is Price-Dependent
Leadenhall and a handful of other specialty funds, as well as large money managers and pension funds, partake in those transactions and would likely consider securitizations stemming from excess reserves, should the economics become more favorable. Major providers of universal life polices include Sun Life, John Hancock, and Genworth.
“Right now the primary reason we’re not seeing asset-backed securities is pricing,” said Keith Andrushack, a partner at Mayer Brown. “ABS investors that might consider the life space are demanding a spread of at least 300 basis points, while the cost of a conditional LOC or other contingent capital facility tends to settle below 200 basis points.”
Andruschack said that regulators have expressed the desire to see more “funded” solutions, or “real money” backing up assets in the structured transactions’ special purpose vehicles, rather than unfunded financial contracts. “If that desire gets legs and/or we see enough of the contingencies stripped away from current solutions, then ABS should be poised to return.”
Ironically, the proposed regulatory framework from which New York withdrew aims to create more straightforward reserve requirements than current regulations, under which the use of captives has been viewed by some, including Lawsky, as problematic.