The capital markets continue to feel the effects of this summer's sub-prime mortgage situation. Although liquidity is returning to debt markets, equities are not yet out of the woods. With these factors in mind, some might have anticipated that the nascent market for insurance-linked securities would promptly wither and die.
On the contrary: The convergence between the insurance and capital markets continues apace and, in fact, only grows deeper. The sub-prime events of the summer have made investors more interested in risks that are a somewhat rare commodity–risks that are uncorrelated with more traditional investments.
As the sub-prime market's effects are rippling from mortgage lenders to hedge funds to investment banks and beyond, the diversification offered by insurance-linked securities (ILS) investments is more important than ever. In fact, new issuance in 2007 already exceeds that of 2006, with more than $32 billion of total bonds outstanding.
The idea behind these securitizations is to offer industry gatekeepers and investors clarity and transparency regarding the risk profile of a specific block of business so that they can get comfortable with a higher degree of leverage for it.
Life insurance-linked securities have largely been wrapped by financial guarantors, and distributed across a relatively limited investor base. But in their quest for improved diversification, investors will become more familiar with ILS as an asset class, and we can expect to see issues involving unwrapped senior and subordinate securities.
Insurance-linked securities offer compelling benefits and the number of transactions is expected to grow significantly as life insurers look for ways to deal with large regulatory reserve requirements and low returns on equity. In fact, a growing number of life insurance companies are beginning to see the benefits of securitization as an important tool to help them improve capital efficiency. This bodes well for a strong future flow of life insurance-linked deals.
The majority of issuance to date has been regulatory reserve financing transactions more commonly known as Triple-X and A-Triple-X. The drivers for these transactions are the conservative assumptions embedded in the regulatory requirements regarding reserves. These involve outdated mortality information, little or no recognition for the likelihood of future lapses, and interest rate assumptions that are typically out-of-step with prevailing yields. All of these create a degree of redundancy in the level of required regulatory reserves, adversely affecting the insurers' ability to deploy their capital productively. This is particularly true for products such as level premium term life and universal life with secondary guarantees.
Most reserve financing structures have utilized an onshore captive as a reinsurer and as the vehicle for financing the redundant Triple-X and A-Triple-X reserves. This arrangement allows insurers to maintain tax consolidation of the subject block of business, so they can continue to utilize the net operating losses generated by the policies ceded to the captive.
In addition, the downstream captive can finance the redundant regulatory reserves by issuing surplus notes which, although technically a debt instrument, are considered capital by regulators due to the control that regulators have over interest and principal payments. This allows for an efficient financing structure utilizing low cost debt.
The capital structure of a Triple-X Captive is comprised of 4 components:
1–Debt financing redundant reserves (surplus notes).
2–Economic reserves funded from policy cash flows.
