Securitization: Buzz Or Real Solution?

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.