A.M. Best States Position on Insurance-Linked Securitizations/Monetizations.

OLDWICK, N.J. -- For several years, insurance industry experts have been discussing the convergence of insurance and the capital markets. Although early predictions of the velocity of such convergence have not materialized, a steady drumbeat of securitization/monetization transactions, especially by large insurance and reinsurance companies, appears to be paving the way for the insurance industry to regularly tap alternative sources of capital, according to A.M. Best Co.

A.M. Best is increasingly looking more critically at how these transactions, in general, can affect the financial strength ratings (FSRs) of insurance companies it evaluates. Within these analyses, A.M. Best takes into consideration the structural integrity of the transactions and the analytical rigor applied by various experts and advisors, such as actuaries, modelers and investment banks. These factors are critical components in determining whether the transactions' stated objectives will strengthen, weaken, or have no effect on the FSRs of the participating insurers and reinsurers.

A.M. Best groups insurance-related securitizations/monetizations into broad categories of transactions designed to:

--Monetize the economic value of blocks of insurance business (as in closed block/value-in-force/embedded value transactions);

--Augment statutory reserves (as in Regulation XXX and potential Regulation AXXX transactions);

--Provide capital relief (such as with efforts to securitize reinsurance recoverables);

--Increase equity capital (such as with the securitization of trust preferred securities and surplus notes);

--Transfer catastrophic and high-frequency/low-severity risks (such as with cat bonds associated with natural-catastrophe/mortality risks and with transactions that transfer risks associated with working layers of a cedant's business).

It is important to note that with some of the insurance securitizations/monetizations, there is some level of recourse to the ceding companies. In this sense, "true sale" (i.e. de-linkage from the ceding companies) is not completely achieved, unlike with the traditional non-insurance transactions in the asset-backed securities market. This is especially true of closed block/value-in-force and risk transfer transactions. In these transactions, it is critical to understand specifically which risks are being transferred and what type of agreements are in place to shield investors from risks associated with pandemics, catastrophes and terrorism. In addition, these transactions may have special servicing and systems requirements that may tax the capacity of the originating insurance/reinsurance companies.

As more securitizations are undertaken by sizeable players in the insurance industry, insurance and reinsurance companies will increasingly become originators of risk as opposed to warehousers of risk. This raises issues about how the enterprise risk emerging from this change in the insurance business model will affect the FSR of insurance companies. Some of the questions that A.M. Best will ask with regards to the securitization/monetization transactions are as follows:

--How accurate is the data gathered on the likelihood of regulatory intervention for transactions that rely on credit risks of insurance/reinsurance companies?

--What is the level of granularity employed by actuarial or catastrophe modeling agencies in modeling the transactions?

--How have the various scenarios applied by the actuarial and catastrophe modeling agencies been determined? What are the results of the scenarios?

--Are policyholders subject to the risk of anti-selection if the better risks are transferred to investors?

--Will becoming a risk originator mean lower underwriting standards in order to maintain product flow?

--If books of business are being acquired for the sole purpose of monetizing cash flows, will market forces press companies to exercise less due diligence and thus, be forced to retain less profitable portfolios if the monetization market unexpectedly evaporates?

--Will the fact that risks in acquired blocks of business may not be as transparent as risk in "home-grown" portfolios mean more risk for policyholders (even if for a short period of time until the monetization occurs)?

--What risks can be put back to the originating insurance companies under scenarios of extreme adverse developments in mortality, lapse rates, interest rates, expense ratios, loss ratios and interest rates?

--For Regulation XXX and potential Regulation AXXX transactions, to what extent are reserves truly redundant and to what extent is the debt raised recourse or non-recourse?

--For risk transfers involving working layer risks (as opposed to catastrophic risks), how much empirical data exists to support data on loss ratios and recoveries for any specific business line being reinsured or hedged?

--For transactions based on parametric triggers (such as cat bonds), how is the probability of an event occurring tied to the probability of a trigger being activated?

The answers to these and other questions can be determined through a thorough evaluation of the securitization/monetization transactions and the subsequent rating of the securities.

A.M. Best also is aware that failed securitization/monetization transactions may have an indirect effect on the insurance companies that originate them. Because some of these transactions are not totally de-linked from the insurance companies that originate them, bad investor experience could make it harder or more expensive for the insurance companies to raise funds in the future. The prospect of failed transactions is heightened in insurance related securitizations/monetizations because regulators have the power to control cash flows from insurance companies, unlike the case with cash flows from unregulated special purpose entities in traditional securitizations such as mortgage-backed or asset-backed securities. Insurance regulators will always protect policyholders, even if it is to the detriment of investors or bondholders. With some of the transactions so far, several regulators have been involved, thus increasing the prospect of prolonged regulatory intervention that may ultimately reduce cash flows to investors and cause a transaction to fail or cause payments to investors from financial guarantors.

A.M. Best's interest is to follow the evolution of enterprise risk that insurance companies are undertaking or defraying. A.M. Best will publish rating opinions, where appropriate, on all new insurance-related securitization solutions that are taken into consideration in the overall FSRs of the interactively rated insurance and reinsurance companies.

A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.