In late October, Genworth announced the establishment of a $475 million financing facility to securitize the non-economic portion of AXXX reserves associated with a block of universal life insurance policies with secondary guarantees (ULSG). This marks a milestone as the first securitization to finance the redundancy in statutory reserves underlying ULSG products, where such reserves are calculated under Actuarial Guideline 38, otherwise known as “AXXX.”
Several securitizations have been brought to market over the past few years to reduce the cost of holding statutory reserves associated with level premium term insurance products. These are known as “Regulation XXX” securitizations, based on the name commonly used to refer to the NAIC Model Regulation, the standard that defines the reserve methodology for level premium term products. Up until now, however, companies have been unable to adapt the structure used for Regulation XXX securitizations to an AXXX environment. Now that the first AXXX deal has hit the market, we expect to see more AXXX transactions.
Securitization is an attractive option because it provides an opportunity to boost profitability by converting equity financing to less expensive debt financing (with such debt financing getting “operating” leverage or off-balance sheet treatment if structured properly) while potentially still experiencing significant tax benefits. Because of the complexity and lifetime coverage of ULSG products, there are many moving parts that need to be handled when developing an AXXX transaction.
What follows is an examination of some of the major issues and challenges related to structuring an AXXX securitization that would be considered by various reviewers of a transaction, including regulators, rating agencies, financial guarantors, and investors.
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What is reinsured? Securitizing redundant reserves typically involves a reinsurance transaction with a captive. In an AXXX transaction, either the entire ULSG product risk or just the secondary guarantee risk may be ceded to the captive. The insurer ceding the business needs to make sure that if it cedes just the secondary guarantee risk, it gets the appropriate reserve credit it is expecting.
Determining the level of redundancy in AXXX reserves. While most products will have some non-economic portion of reserves, the level of redundancy will vary significantly based on the product design. Also, the statutory reserve requirements have changed over time. Policies issued after June 30, 2005, are subject to more stringent rules than policies issued prior to that date. For new policies issued in 2007 or later, new rules take effect that will likely reduce reserves for most product designs.
Defining “economic reserves.” The term “economic reserves” has been used in securitization transactions to define the level of reserves that can be funded by policyholder premiums. The excess of the statutory reserves over economic reserves are intended to be financed by the capital markets. There is no generally accepted economic reserve methodology for AXXX transactions, although consistent with this concept for XXX transactions, there seems to be movement towards having the assumptions locked in at issue.
In order to assess risk to investors, the counterparties will need to consider the capital levels in the transaction as well as the economic reserves. Even if assumptions are locked in, however, the methodology must be flexible enough to account for the dynamic relationship between the premium funding levels and the face amount.
Lapse assumptions. The lapse rate should be assumed to fall quickly as the secondary guarantee moves in the money. For fully paid-up secondary guarantees that are in the money, reviewers of the transaction will expect the lapse rate to be zero. For in-the-money secondary guarantees that still require a premium to be paid to keep the guarantee, reviewers will expect a lapse rate of 1% – 2%. Consideration should also be given to potential life settlement ownership of the business, as the expected lapse rate would be zero for such policies.
Mortality assumptions. The impact of mortality depends upon the structure of the transaction. From an investor perspective, higher than expected mortality will be harmful in some transactions while beneficial in others. Several issues should be considered when setting a mortality assumption.
o Consistency of recent experience with mortality assumption.
o Slope of mortality rates, particularly at older attained ages.
o Compliance with risk classification systems, including the effects of any table-shaving programs.