With growth prospects and return-on-equity ratios below most of their peer group, what can the life (re)insurance industry do to improve its standing with investors? One answer might be to look at what the banks have done to improve their performance, which means looking at securitizations.
The mortgage sector created the securitization market in the 1980s to find better ways to spread credit risk across the financial markets after large losses from the thrift crisis. By packaging a diverse set of loans, banking institutions could “sell” the pools to investors and recycle the proceeds back into new business.
Over time, products became standardized, market acceptance increased and the entire banking business model changed from a “buy and hold” to a “source new business, warehouse, sell/hedge” approach. Driven largely by capital markets solutions, banks now report higher growth rates, significantly improved return on equity and, most importantly, the proven ability to withstand downturns in the marketplace.
Most parties agree that the banking model cannot be emulated fully in the life insurance sector. But there are lessons for the life sector. As we all know, the industry is challenged to produce more cost-effective products while simultaneously improving return-on-equity ratios. Is the answer securitization?
Securitization and life insurers: misnomers and variations
Typically, the term securitization has meant packaging assets, carving the projected cash flows from the assets into tradable securities and then selling the securities to investors. Securities typically are customized to fit the needs of various investors according to risk profile.
This process is remarkably similar to traditional life reinsurance: Primary companies source new business and then, in exchange for a fee, transfer future economics. Unlike bilateral reinsurance contracts, securitizations generally involve a single contract covering a pool of underlying collateral, which transfers the economics to multiple investors over dozens of years.
In general, the life “securitizations” completed thus far fall into three categories:
Reserve funding. Much recent attention has focused on Triple-X solutions for structures that provide cost-effective funding for the long-duration, non-economic reserves associated with term products. Although similar to the banking model in that they provide funding, the structures have low levels of risk transfer. Using low-risk, low-cost capital to fund the long-term reserves should ultimately allow for a more cost-effective product. Minimum size for issuing such a security is $300 million.
Mortality bonds. The catastrophe bond concept has grown exponentially in the non-life sector. There are now more than $5 billion of “cat bonds” outstanding, covering a diverse range of non-life risks. These bonds provide collateralized protection against extreme events, often on a multi-year basis. In the life sector, this concept has been applied to mortality bonds, which provide the issuer protection against extreme mortality due to events such as pandemics. In theory, if executed correctly, mortality bonds could help to limit volatility. Those wishing to issue such bonds will need a minimum size of $100 million to $150 million.
Embedded value. These transactions are the closest to traditional mortgage securitizations, where projected cash flows from a closed block of business, i.e., embedded value, are sold to investors. As in banking, the transactions are viewed in terms of advance rates or what percent of the perceived value is raised through the transaction. The first life insurance transaction of this nature targeted about 50% advance rates; recent transactions pushed rates beyond 80%.
Embedded value transactions, which begin about $250 million, have several positive financial implications. They provide funds to reinvest in new business and reduce capital requirements. The transaction is similar to selling a closed block of business, although the capital markets may provide a lower cost of capital but will require the sponsor to retain administration requirements and certain risks.
Why has it taken so long?
Several reasons explain why the life sector only now has begun to use this capital management tool.
First, a securitization is not a trivial undertaking. A material transaction can take up to a year to complete as it requires the review and input of a wide range of stakeholders. Furthermore, post-issuance administration can be cumbersome and time-consuming.
Second, because insurance, unlike loans, is a liability and not an asset, transferring the economics in a clean sale is not feasible and requires traditional reinsurance technology. Advanced structures often include complicated regulatory rules and compliance issues. These factors require substantial investor education and often greater involvement from insurance regulators.
Finally, to transfer any risk to the capital markets, the sponsor needs to be able to explain the nature of the risk and provide clear historical and expected performance. Such transparency requires reliable data, which the industry often has been unable to provide.
As a result of more than two decades of evolution, banks have become proficient at managing data and creating the financial and reporting infrastructure necessary to administer transactions. For life securitization to occur on a larger scale, insurers must follow suit and improve both the quality of their information and their ability to track it in a timely manner. These improvements will increase transparency and foster a broad and dependable investor base.
A look ahead
It appears the road toward more securitizations will be heavily traveled. At a recent industry meeting, the consensus among reinsurance colleagues was that 20% to 50% of life insurance business will be securitized in five years. These vehicles can more efficiently fund capital strain, transfer some of the mortality risk and fund redundant reserves, which will ultimately make life (re)insurers more capital efficient. Such improved capital efficiency means (re)insurers are getting better at running their business and can expect higher returns as their reward.