A secure package: life insurers are becoming more creative in designing securitization transactions to fund a variety of objectives.

Since 2001, more than $12 billion has been raised from capital market investors on transactions involving life insurance risks. These "life securitizations" can be grouped into three categories: redundant-reserve transactions, embedded-value or value-in-force transactions, and mortality-catastrophe transactions.

"Life Securitizations 2001-2006" on page 60 shows the issuing companies, the type of transaction, the year of the transaction and the amount of funds raised. Companies can execute different types of transactions depending on their objectives.

The objective of the redundant-reserve securitizations has been to replace equity funding of excessive (or redundant) statutory reserves with debt funding. By definition, statutory reserves under the U.S. regulatory system for life insurance companies are meant to be conservative. However, because of very conservative statutory valuation mortality rates, reserves on level-premium term life insurance have been viewed as extremely conservative, creating the need for companies to find a less expensive way than the use of equity to fund such reserves. Companies have turned to the capital markets to help fund these excessive reserves. These transactions are known as XXX securitizations after the letters assigned to the model reserve regulation for term and universal life insurance business when it was still in the drafting stage.

Embedded-value transactions are a broader category than redundant-reserve transactions. The Forethought transaction involved the issuance of notes to help finance the acquisition of the Forethought Life Insurance Co. Similarly, the two recent Swiss Re embedded-value transactions helped Swiss Re with its goal of "accelerating the balance sheet." In effect, Swiss Re was able to replace the equity financing associated with various acquisitions under its "Admin Re" business with debt financing. The closed-block transactions done by Prudential and MONY involved the issuance of notes to help those companies release excess required surplus used to support the regulatory closed blocks. At the end of 2005, Hannover Re securitized future profits related to unit-linked life policies issued in Germany and Austria. Wolf S. Becke, chief executive officer of Hannover Life Re, said that this transaction enabled the company "to optimize its capital efficiency, improve its expo sure profile and provide internal funding to support growth."

Broadly speaking, under both the redundant-reserve transactions and the embedded-value transactions, the company is able to "securitize" projected cash flows from its insurance operations in order to raise money from the capital markets. While a true sale of the cash flows cannot happen (as the relationship between the insurance company and the policyholder whose policy cash flows are securitized does not change), what essentially happens is that life insurance cash flows are aggregated into an underlying pool and then sold as an investment package to the capital markets.

The objective of the mortality-catastrophe transactions is to reimburse the issuer (the insurance company arranging the transaction) if an extreme mortality event occurs. Structurally, these transactions are very similar to natural catastrophe bonds, which have been issued for many years now. Under these transactions, investors provide funds, which go into a collateral account, and they receive interest on their monies during the life of the transaction. At the end of the transaction, if no extreme mortality event has occurred, then the investors receive their principal back. If an extreme mortality event has occurred, then investors may lose some or all of their principal. Two reasons to issue such a bond, as opposed to purchasing such coverage in the reinsurance marketplace, include 1) such coverage is not readily available, and 2) the counterparty risk (the ability of the reinsurer to pay claims) increases at the same time that the benefit is most needed.

Ideally, (from the issuer's perspective) to minimize basis risk these mortality catastrophe bonds would be structured so the trigger event would be defined based on the company's actual mortality experience. Such mortality "indemnity" bonds have not been issued to date, but instead, these transactions have defined the trigger event based on certain percentage increases in a population mortality index. While the transactions to date have used weighted population indices (to reflect age, gender and geographic weightings of the underlying issuer's exposure), the use of an index approach does lead to a potential basis risk.

Transactions to Come

We expect to see more XXX transactions along with more mortality-catastrophe transactions. We also expect to see continued growth in embedded-value transactions. Possible areas for growth are discussed below.

Bank Balance Sheet--Aside from the capital market XXX transactions listed in "Life Securitizations 2001-2006," there have been a growing number of transactions in which banks use their own balance sheets to provide redundant-reserve relief to XXX reserves. These transactions may be short term in nature (to be replaced by a capital markets offering) or may provide long-term relief.

Synthetic Transactions--Parties are considering many creative structures to meet different objectives. We have seen some structures in which companies form their own captives and use Letter of Credit arrangements to provide relief to redundant-reserve situations. Evolving rating agency views on the use of LOCs to fund redundant reserves may necessitate changes to such structures.

Warehouse Facilities--We are seeing more situations in which an insurance company enters into a transaction with a bank to provide relief from redundant reserves. Insurance companies use these warehouses as an interim solution until the book of business is large enough to do a securitization. These warehouses can also be established using the synthetic structure described above.

AXXX--Similar to the redundant statutory reserves generated by level-premium term insurance under U.S. statutory reserving requirements, the statutory reserving requirements for universal life policies (commonly known as "AXXX") also have the potential to generate redundant reserves. Because of the complexity and multiplicity of options embedded in these products, it has taken longer to bring an AXXX securitization to the market than it has for the simpler level term products. But several companies are working on trying to develop a securitization structure for redundant AXXX reserves, and we expect that one or more transactions may close this year. Companies are also looking at bank balance sheet structures, synthetic transactions and warehouse facilities for AXXX business.

Embedded Value Transactions--There continues to be a lot of discussion in both Europe and in the United States about embedded-value transactions. Hannover Re has publicly indicated that it intends to do more embedded-value transactions by the end of 2007. Several U.S. companies are currently investigating possible embedded value transactions.

Longevity Transactions--An area generating a significant amount of interest, especially in the United Kingdom and in Continental Europe, is longevity risk. This risk relates to people living longer than expected in the pricing of payout annuity (retirement) products. Credit Suisse has launched a longevity index, under which parties can trade or swap mortality risk for longevity risk. We are also aware of other companies looking into the possible issuance of longevity bonds. We expect to see significant developments in this area over the next several years.

The evolution in the packaging of life insurance cash flows to help insurance companies meet various objectives is still in its early stages. We expect to see more parties investigate various kinds of securitizations, leading to significant growth over the next several years in the use of life securitizations to help companies meet different objectives and goals.

Key Points

* Life securitizations can be grouped into three categories: redundant-reserve transactions, embedded-value or value-in-force transactions, and mortality-catastrophe transactions.

* Significant growth is expected in life securitizations over the next several years.

* Areas for possible growth include bank balance sheet, synthetic transactions, AXXX and longevity transactions.

Contributors: Steven Schreiber and Stuart Silverman are consulting actuaries it, the New York office of Milliman and have beet, involved in many of the transactions described in the article. They can be reached at [e-mail] and [e-mail].

Parties to the Transaction

Many parties participate in a life insurance securitization, with the two most important being the insurance companies structuring the transactions and the investors buying the securities. Other parties include the bankers, financial guarantors, rating agencies, lawyers, actuaries and other advisers.

ISSUERS (INSURANCE COMPANIES)--Any securitization needs to start with an insurance company defining the objective it wants to achieve with the transaction. While the company will likely need to retain external advisers, it will not be able to complete the transaction unless it's willing to commit a significant amount of internal resources (corporate, actuarial, investment, legal, others) to focus on these complex transactions.

INVESTORS--A wide range of investors have invested in life securitizations, ranging from hedge funds to pension plans to corporate treasurers looking for some additional spread to insurance companies. Many of the transactions have been wrapped by a financial guarantor, allowing the investors to rely on the due diligence performed by the financial guarantor. But such wrapped transactions then carry a very high rating, which appeals to some investors but does not provide enough yield for other investors. Several of the transactions have been issued with different tranches, which appeal to investors with different risk appetites. And in late 2005, the industry saw the first issuance of a XXX transaction with both wrapped and unwrapped tranches.

BANKERS--The role of the banker is to help the issuer structure the transaction and to help manage the discussions of the transaction with the regulators, rating agencies, financial guarantors, and, ultimately, the investors. While the banker's structuring role is clearly critical to the process, the banker's most important role is to identify investors who are interested in purchasing the offered securities.

FINANCIAL GUARANTORS--A financial guarantor lends its rating to a security for a fee. In effect, the financial guarantor issues an insurance policy, which requires it to cover interest payments and principal payments to investors (under the terms defined in the policy) if such amounts cannot be paid from the cash flows underlying the transaction. In transactions which are wrapped by a financial guarantor, the investors know that the financial guarantor has performed significant due diligence, which reduces the amount of due diligence the investor needs to perform. Even for transactions in which only part of the transaction is wrapped, investors in the unwrapped tranche can often piggyback on the due diligence effort performed by the financial guarantor for the wrapped tranche.

REGULATORS--The regulators for the insurance company structuring the transaction typically will need to review and approve the transaction. But, because most of these transactions are issued through a captive insurance entity, much of the regulatory discussion is with the captive regulator. The concerns of both the home regulator and the captive regulator need to be addressed as part of the structuring of the transaction.

RATING AGENCIES--Investors will look to the rating agencies for their view on the riskiness of the securities to be offered under life securitizations. To obtain a rating, transaction documents, along with a transaction deal model (which projects the transaction cash flows under various sets of assumptions) need to be provided to the rating agencies. Even for fully wrapped transactions (in which the securities will carry the rating of the financial guarantor) the rating agencies still need to review the transaction so they can provide a shadow rating, which is used by the rating agencies in determining the capital requirements for the financial guarantors.

ACTUARIES--The role of the actuaries in life securitizations is to analyze the subject book of business and to project insurance cash flows and balance sheet items into the future so that the interested parties in the transaction can analyze the risk associated with the transaction. Such projections involve the development of models and, based on a review of the company's experience data, development of assumptions appropriate for projecting the business into the future. The output from the actuarial projections is typically input into a deal model developed by the insurance company or the banker, which applies the terms of the transaction to the projected actuarial cash flows.

LAWYERS--Life securitizations are complex transactions that require a significant amount of legal documentation. Lawyers are also involved in the discussions with the different regulators.

Life Securitizations 2001-2006

Company                       Type    Year              Amount Raised
                                                           (Millions)

RGA                            XXX    2006     $850
Scottish Re            Catastrophe    2006     $155
Scottish Re                    XXX    2006   $1,700
First Colony                   XXX    2006     $750
Hannover Re         Embedded Value    2005      100 [euro]
Swiss Re            Embedded Value    2005     $370
Scottish Re                    XXX    2005     $457
Swiss Re               Catastrophe    2005     $362
Scottish Re                    XXX    2005     $850
Swiss Re            Embedded Value    2005     $245
First Colony                   XXX    2004     $300 *
Banner Life                    XXX    2004     $550
Swiss Re               Catastrophe    2004     $400
Forethought         Embedded Value    2004     $150
Friends Provident   Embedded Value    2004      380 [pounds sterling]
First Colony                   XXX    2003     $300 **
Barclays Life       Embedded Value    2003      400 [pounds sterling]
MONY                Embedded Value    2002     $300
Prudential          Embedded Value    2001   $1,900

* Initially. One subsequent offering totaling $300 million

** Initially. Two subsequent offerings totaling $500 million

Source: Milliman Inc.