An Emerging Class of Financial Instruments (original) (raw)

by Alex Krutov

Financial engineers and investment bankers are continually developing new types of financial instruments. Recently, investors are hearing more and more about securitization of insurance risk. Quite a number of transactions involving insurance-linked securities have already been completed. We have also seen the establishment of hedge funds that specialize in insurance-linked securities. This article examines some of the new developments and potential opportunities presented both to issuers of such securities and to investors.

The securitization era began three decades ago with the securitization of mortgage loans, followed by the introduction of asset-backed securities. The current annual new issue volume stands at over 2trillion.Insurancecompanies,however,despitehavingover2 trillion. Insurance companies, however, despite having over 2trillion.Insurancecompanies,however,despitehavingover4 trillion in assets and close to that in liabilities, have been slow in adopting securitization as a tool of capital and risk management. While the insurance industry is one of the largest warehouses of risk, it usually functions as a self-contained entity with very little risk transferred to the capital markets, except in the form of insurance companies issuing equity and, sometimes, debt. Banks try to move risk exposure off their balance sheets, and it stands to reason that insurance companies should do the same. However, until recently we have seen little risk transfer between insurance companies and the capital markets. Now, finally, the situation is changing, and changing rapidly. Insurance companies are seeking to move the risks, as well as certain liability and asset items, off their balance sheets, and securitization is one way to accomplish this goal.

The developments in securitization come from several angles and involve several new types of securities being offered to investors. One type of insurance-linked securities, a catastrophe (“cat”) bond, has existed for over a decade. Tens and tens of cat bonds have been issued. Such bonds are the result of securitizing the risk of catastrophic property and casualty damage. Depending on the specific terms and structure of the bond, this damage could be the result of a hurricane, earthquake or some other catastrophic event. The motivation in securitizing this risk is to transfer to the capital markets the truly catastrophic part of the risk exposure – the far end of the “fat tail” of the loss distribution – so that the insurance company “sponsoring” the bond can avoid bankruptcy or major hits to its bottom line. In other words, it is an efficient way for an insurance company to manage its Value at Risk (VaR).

The rationale of insurance companies in securitizing catastrophe risk is clear, but why would investors be interested in this type of security? In fact, there are several reasons that have led to significant investor demand for cat bonds and other risk-linked securities. One attraction is the relatively generous yields compared with similarly rated fixed-income securities. Another important reason is the low correlation with the returns of traditional securities, leading to the comparison with Kipling’s “cat that walked by himself.” Cat bonds and some other risk-linked securities have even been referred to as “zero-beta assets.” Inclusion of such assets in an investment portfolio could lead to significant improvement in its overall risk-return profile.

A typical cat bond would involve full or partial default if losses resulting from a certain catastrophe exceeded a predetermined amount. It appears that hurricane Katrina has triggered a default of at least one such bond, making it the first default of a public cat bond. Cat bonds generally fall in the non-investment-grade category and are of increasing interest to the hedge funds that have developed an understanding of the risks involved. The three established leaders in structuring the securitization of property-casualty insurance risks are Goldman Sachs, Swiss Re Capital and BNP Paribas, who control the vast majority of the market and are responsible for most of its growth.

While cat bonds and some other property-casualty risk-related securities have been in existence for over a decade, significant developments have started to occur in securitizations done by life insurance companies. Securitization of the so-called XXX reserves is the hottest new trend in the field.

In general, life insurance industry securitizations could fall into a number of categories. Some are driven primarily by the desire to transfer risk to the capital markets, such as the transfer of extreme mortality risk (mortality bonds). Others, while also including the element of risk transfer, are driven by other considerations. For example, a securitization could be undertaken to relieve the capital strain on life insurance companies caused by the regulatory requirements of establishing very conservative reserves for some types of products. Another example is the securitization of the stream of future cash flows from a particular block of business, including the securitization of embedded values of life insurance business or securitization for the purpose of funding acquisition costs.

The major development of 2005 in the insurance securitization market was the growth of so-called XXX securitizations. The term Triple X (or XXX) refers to the regulation specifying the requirements for establishing reserves (setting liabilities) for term life insurance policies with long-term premium guarantees. Adopted a couple of years ago, these conservative requirements lead to sizable “redundant” reserves, representing the excess of statutory reserves over best-estimate reserves. The result for many life insurance companies is that a significant amount of capital is tied up and cannot be used in a more productive manner, thus reducing the overall return on capital. Figure 1 below shows a schematic illustration of the problem, with the area between XXX reserves required by regulations, and best-estimate reserves, representing “excess” reserves. Securitization of some of these “excess” reserves allows life insurance companies to free up capital that could be used for writing new business.

Conceptually, securitization could be performed in the following way: An insurance company would transfer the risk for part of the “excess” reserves to investors, which would enable the company to free up capital. The investors would assume the risk that these “excess” reserves are not in fact excess and that the insurance company will need to make payments higher than its actuaries have estimated. Investors are compensated for taking the risk, with the yield on the securities depending primarily on the risk probability. There are also certain legal and accounting issues involved, such as the need to establish a separate entity (SPV) that will stand between the insurance company and investors in the securities. The actual structures are somewhat similar to those used in the issuance of ABS and MBS securities.

An early transaction of this type was conducted in 2003 when an insurance subsidiary of GE Financial securitized its XXX reserves in a $300 million deal through a special purpose vehicle (SPV), River Lake Insurance Company. It was one of the ground-breaking transactions that opened up the way for life insurance companies to ease the strain on their capital caused by conservative regulatory requirements.

A pioneer in the field, Scottish Re, has already done more than one securitization. The latest happened at the very end of 2005, when the company closed an offering of $455 million of 30-year maturity securities issued by its wholly owned subsidiary Orkney Re II plc. Proceeds are used for the funding of XXX statutory reserves associated with term life insurance policies that have long-term premium guarantees. Scott Willkomm, president and CEO of Scottish Re Group Limited, characterized this transaction as an “important milestone for Scottish Re’s capital markets strategy,” affirming the company’s strong commitment to securitization.

While securitization of XXX reserves is certainly the hottest topic in life insurance-linked securities, other market segments are continuing to develop along similar lines. Embedded value securitizations, which allow insurance companies to monetize the present value of future profits, continue to generate significant interest. Transfer of extreme mortality risk is also an area of strong interest and activity.

Many investors are unsure of how to analyze and price life insurance-linked securities. This unfamiliarity explains why we have seen credit wrapping for the first wave of transactions. A triple-A rated third party such as a guarantee insurance company can provide credit enhancement to these securities, in most cases bringing their rating to AAA, but with yields that are currently higher than those of comparably rated traditional securities. There is a risk that credit-wrapping capacity for life insurance mortality risk might reach its limit, since only a handful of companies are providing this kind of credit protection. This situation could lead to the credit wraps becoming more expensive. On the other hand, as investors become better educated about the risks involved in life insurance-linked securities, the need for credit enhancements will probably be reduced.

The insurance securitizations market is very dynamic, with new products emerging and the role of the old solutions changing. Long-term predictions, with the exception of the trend toward overall growth, are very difficult to make. For 2006, growth on the life insurance side could be as high as 50 percent or more. “We will see some growth in the XXX, from what I am seeing in the pipeline,” says Michael Millette, a managing director in the Risk Markets division of Goldman Sachs. “We may see an AXXX deal emerge, we will see more EV [securitization of life insurance embedded value], and we will see more EV in and around strategic deals. We will see more risk securitization, and we might see more longevity along with the mortality, and we might very well see some life settlements activity resurface in the capital markets.” Shiv Kumar, his colleague at Goldman, adds that while XXX deals tend to be larger and more noticeable, the growth in the EV and mortality/longevity securitization segments might actually be higher in 2006.

Insurance risk securitizations are more difficult to structure than, for example, mortgage-backed securitizations, due primarily to the lack of transparency and to the complexity of insurance risks. With clearer understanding of the risk, as well as the development of structures allowing for better risk modeling, both insurance companies and investors will become more comfortable with the securitization process. Expectations are that 2006 will bring considerable growth in this type of financial instruments.