Fast finance: with the help of investment banks, insurers are cooking up new reasons and ways to tap into the capital markets--and investors are gobbling up the offerings.Key Points
* Insurers are using innovative transactions to raise capital or transfer risk to the capital markets.
* More than $9.5 billion in insurance-linked securities has been issued since 1996.
* Small to mid-sized insurers have been able to bond together in pools to raise $2 billion in capital in the past year.
* Reinsurance The contract made between an insurance company and a third party to protect the insurance company from losses. The contract provides for the third party to pay for the loss sustained by the insurance company when the company makes a payment on the original contract. recoverables could be the collateral used for the next wave of asset-backed securities Asset-backed security
A security that is collateralized by loans, leases, receivables, or installment contracts on personal property, not real estate.
A debt security collateralized by specific assets. .
When investment bankers Investment Banker
A person representing a financial institution that is in the business of raising capital for corporations and municipalities.
An investment banker may not accept deposits or make commercial loans. approached ProAssurance Corp., a speciality insurer, with a low-cost way to raise $13 million in capital in April, the Birmingham, Ala.-based company jumped at the chance.
To ProAssueance, the fourth largest medical professional liability writer in the United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. , $13 million is not a great deal of money. With assets close to $3 billion and $740 million in gross written premiums, the company had just raised $100 million by issuing senior debt notes in 2003.
Yet for each $1 million in capital on its books, the company can write another $1 million in business, said Frank B. O'Neil, senior vice president of corporate communications Corporate communications is the process of facilitating information and knowledge exchanges with internal and key external groups and individuals that have a direct relationship with an enterprise. and investor relations Investor relations
The process by which the corporation communicates with its investors. at ProAssurance.
"We didn't have our backs to the wall. We didn't do this as a last resort," O'Neil said. "We saw this as an opportunity to raise capital and enhance the balance sheet. It was opportunistic opportunistic /op·por·tu·nis·tic/ (op?er-tldbomacn-is´tik)
1. denoting a microorganism which does not ordinarily cause disease but becomes pathogenic under certain circumstances.
"Opportunistic financing," in this case, means participating in a pooled trust preferred securities transaction. It's a pool that borrows money by issuing notes to the capital market. The money that the pool raised is shared with the pool participants--about 25 to 35 small to midsized insurance companies, each trying to raise up to $15 million.
For investors--mostly institutional investors--the trust preferred securities are a good risk, because with so many different insurers involved, the risk is spread out. Also, the risk isn't linked to factors such as rising or falling interest rates, which traditionally impact other parts of investors' portfolios.
For insurers, raising money this way is a chance to strengthen their balance sheets at a low cost. And it's just one of several innovative ways that insurers are enticing investors to lend them money or share their risk.
Since 1996, more than $9.5 billion of insurance-linked securities has been issued, according to according to
1. As stated or indicated by; on the authority of: according to historians.
2. In keeping with: according to instructions.
3. Swiss Re Swiss Re is the world’s largest reinsurer, now that it has acquired GE Insurance Solutions (Ligi 2006). Founded in 1863, Swiss Re now operates in more than 30 countries. General Electric owns 8.9% of the firm. . By far, the most common type of securities is catastrophe bonds catastrophe bond
A debt security with a payoff tied to the relative severity of a natural disaster such as a hurricane or earthquake. Bondholders are paid with insurance premiums but may have to accept reduced principal repayment in the event the specified , which insurers or other entities issue to investors to raise money to cover specific catastrophes. At the end of a certain period of time, if the catastrophe hasn't occurred, then investors receive their original investment back, with interest.
"We're starting to see a little more interest in financial engineering now that we've emerged from the upset of the pricking of the equity bubble a few years ago," said Robert Hartwig, chief economist The Chief Economist is a single position job class having primary responsibility for the development, coordination, and production of economic and financial analysis. It is distinguished from the other economist positions by the broader scope of responsibility encompassing the for the Insurance Information Institute. "Insurers are having to get more creative in how they raise capital."
These types of transactions, however, aren't likely to outpace out·pace
tr.v. out·paced, out·pac·ing, out·pac·es
To surpass or outdo (another), as in speed, growth, or performance.
[-pacing, traditional insurance or reinsurance any time soon, Hartwig said.
"We see some innovation around the edges, but not a dramatic growth in securitization Securitization
The process of creating a financial instrument by combining other financial assets and then marketing them to investors.
Mortgage backed securities are a perfect example of securitization.
May also be spelled as "securitisation. . These deals are relatively unique, and take a long time to put together. You can't pull them off the shelf. They're relatively expensive and time consuming and difficult in a business where you have to put contracts together quickly," Hartwig said.
Institutional investors Institutional Investor
A non-bank person or organization that trades securities in large enough share quantities or dollar amounts that they qualify for preferential treatment and lower commissions. are interested in purchasing insurance-linked securities for the portfolio diversity, Hartwig said. But don't expect them to become insurers' primary source of capital, he said.
"Everyone thought securitization would take over the entire industry seven or eight years ago, and that hasn't happened. Innovation is good. It's healthy in the marketplace. We should continue to see lots of innovation, but it won't take over the marketplace," Hartwig said.
Both life and property/casualty insurers have become active in the world of securitization. Insurers are turning to the capital markets both to raise capital and transfer risk. The newer transactions include attempts to raise pooled capital for everyday business purposes, raise capital to meet increased surplus requirements and transfer mortality risk.
Just about any asset or liability can be securitized securitized
Of, related to, or being debt securities that are secured with assets. For example, mortgage purchase bonds are secured by mortgages that have been purchased with the bond issue's proceeds. , and the industry is preparing to launch additional transactions, such as securitizing reinsurance recoverables.
Into the Pool
Small, regional banks have been raising money through pools issuing senior notes and trust preferred securities for five or six years now, but the concept is still fairly new to insurers, said Rob Bredahl, executive vice president of Benfield Group Benfield Group Limited is a reinsurance and risk intermediary based in London, England. It has been listed on the London Stock Exchange since June 2003 and is a constituent of the FTSE 250 Index. .
"It's similar to buying any sort of asset-backed security," Bredahl said, noting transactions such as mortgage-backed securities Mortgage-backed securities (MSBs)
Securities backed by a pool of mortgage loans. are quite common. "From an investor standpoint, previously they didn't have any way to get exposure to midsized U.S. insurance companies. It's a way for them to diversify their portfolios."
Larger insurers can issue debt on their own, but it's more expensive for smaller insurers to do so.
"When you raise capital on an individual basis, you've got to raise a larger amount of capital to make it work. Here you are leveraging the cost of raising capital among many insurance companies," said Karen M. Spaun, senior vice president and chief financial officer of Meadowbrook Insurance Group, which specializes in alternative risk transfer.
Meadowbrook was so pleased with the $10 million it raised through a pool issuing trust preferred securities in September that it raised another $13 million in April and $12 million in May through similar transactions.
ProAssurance, too, has dipped into two more pools to raise an additional $35 million in May, raising $45 million total through the transactions, O'Neil said.
Benfield, which has participated in a couple of pooled funding vehicles for insurers, said about $2 billion in capital has been raised through such vehicles in the past year or so. "We expect to see continued demand to raise about $750 million to $1 billion per annum Per annum
Yearly. ... that would be the natural pace," Bredahl said.
Benfield, an insurance broker and adviser, worked with investment bankers Merrill Lynch Merrill Lynch & Co., Inc. (NYSE: MER TYO: 8675 ), through its subsidiaries and affiliates, provides capital markets services, investment banking and advisory services, wealth management, asset management, insurance, banking and related products and services on a global basis. and Cohen cohen
(Hebrew: “priest”) Jewish priest descended from Zadok (a descendant of Aaron), priest at the First Temple of Jerusalem. The biblical priesthood was hereditary and male. Brothers to establish two financing pools for insurers called Dekania I and Dekania II. Large investment banks The following is a list of investment banks Financial conglomerates
Large financial-services conglomerates combine commercial banking and investment banking, and sometimes insurance. such as Merrill Lynch have great technology, but don't have strong connections to midsized insurance companies. Smaller investment houses, such as Cohen Brothers, are more familiar with the small to midsized companies that the pool needs, Bredahl said.
"It's quite a trick to get 25 to 35 companies to borrow money at the same time," Bredahl said.
Establishing the pool works like this: Investment bankers approach insurers about participating, and ask them to sign letters of intent for the amount of money they'd like to borrow for the pool.
A special purpose vehicle--a company, usually established off-shore with the sole intent to issue securities for a specific transaction--acts as a "middle man" between investors and the insurers. The special purpose vehicle raises the money for the pool by issuing securities, and then lends the money raised to the insurers involved. Insurers are expected to pay back the loan in 30 years, but can pay it back as quickly as five years, in the case of Dekania, Bredahl said. As the insurers pay back the special purpose vehicle, the vehicle in turn, returns the money to investors, who earn back both their original investment and interest.
The name "Dekania" is a Greek word meaning "guard house." It refers to the transaction's collateral manager, Cohen Brothers, which was not involved in originating or placing notes but acts as a "guard" by approving all insurance companies going into the pool, Bredahl said.
The pool has to have a strong portfolio of companies involved, or investors will view the transaction as too risky to participate.
Investors judge the riskiness of the pool based on how rating agencies, including A.M. Best Co., rate the financial security of the debt issues. A.M. Best Co. sees a growing demand for rating structured finance vehicles, such as the trust preferred pools, said Emmanuel Modu, head of A.M. Best Co.'s new structured finance department. (See "Rating the Issues," page 54.)
These types of deals are having an impact in the reinsurance market, Bredahl said, because the small to midsized property/casualty companies buying into trust preferred securities are using the money raised to increase their reinsurance retentions and buy less reinsurance.
Life in the Market
Life insurers opened the door to securitizations by transactions known as embedded value Embedded Value
A common valuation measure used outside North America particularly in the insurance industry. It is calculated by adding the adjusted net asset value and the present value of future profits of a firm. securitizations. Insurers have been able to securitize Securitize
The practice of a company selling accounts receivables or other debts owed to it. The third party that buys the debt assumes ownership of it and the responsibility for collecting the debts, and keeps the repayments when made. an established book of life insurance business, where the future profitability of that book is measurable and probabilistic (probability) probabilistic - Relating to, or governed by, probability. The behaviour of a probabilistic system cannot be predicted exactly but the probability of certain behaviours is known. Such systems may be simulated using pseudorandom numbers. . The policies are pooled together into a special purpose vehicle, or account, which issues securities using the emergence of profit from the policies as collateral.
Prudential and MONY MONY Mutual of New York (Insurance - Syracuse, NY) securitized closed books of business that arose from their demutualizations, said Mike Millette, managing director of risk markets for investment banker Goldman Sachs The Goldman Sachs Group, Inc., or simply Goldman Sachs (NYSE: GS) is one of the world's largest global investment banks. Goldman Sachs was founded in 1869, and is headquartered in the Lower Manhattan area of New York City at 85 Broad Street. . Prudential raised more than $1.9 billion in capital in 2001 and MONY raised $300 million in 2002 by issuing securities based on closed books of business. The transactions protected the dividends on the individual life policies included.
Millette said a similar type of transaction with another company is in the works now.
In recent years, an annuity writer also has used a securitization to collect funds for variable annuity Variable Annuity
An insurance contract in which, at the end of the accumulation stage, the insurance company guarantees a minimum payment. The remaining income payments can vary depending on the performance of the managed portfolio. lees lees
Sediment settling during fermentation, especially in wine; dregs.
[Middle English lies, pl. early, letting investors receive the fees as they roll in, said Jack Gibson
It was established 1 March 1934 as Towers, Perrin, Forster & Crosby. The umbrella name of Towers Perrin was adopted in 1987. .
A new type of securitization has been used related to the statutory regulation XXX and regulation AXXX. The related regulations--the first of which primarily applies to term life insurance, the second, to universal life insurance--require companies to hold additional reserves significantly above what they have become accustomed to holding.
Instead of holding additional assets to back these increased reserve requirements Reserve Requirements
Requirements regarding the amount of funds that banks must hold in reserve against deposits made by their customers. This money must be in the bank's vaults or at the closest Federal Reserve Bank. or using reinsurance letters of credit, one company was able to issue securities to raise some of the capital needed to cover the additional reserve.
While only one such transaction has taken place to date, "There's a large number of companies in various stages of pursuing this. I expect there to be a number of deals that occur in the second, third and fourth quarter this year," Gibson said.
Catastrophe Mortality Risk
Catastrophe bonds have traditionally been an option for property/casualty insurers and large corporate interests looking to secure capital in case an extreme event causes an extremely large claim. Life insurers have also harnessed securitizations to tap into the capital market, but have traditionally used the transactions to securitize future cash flows from expected premiums related to the underlying portfolios.
Swiss Re, a master of cat bonds, has found a way to apply the lessons it learned issuing those securities to transfer "extreme" mortality life risk from its life book of business to the capital markets.
In the fourth quarter, Swiss Re completed a $400 million securitization called Vita Capital, which would provide Swiss Re with the funds raised if an event occurs that results in an annual mortality rate increasing dramatically.
As is the case with a cat bond, a special purpose vehicle was set up to issue bonds that were purchased by institutional investors. The transaction allowed institutional investors to take the risk if mortality exceeded a certain amount from year to year in Swiss Re's business. For instance, if mortality increased by more than 30%, then investors would lose some of their principal. If mortality increased 50%, investors could lose all of their principal. If mortality didn't increase to the point where the bonds were triggered, investors would be rewarded with the return of their principal, plus interest.
A 30% increase in mortality--which was weighted toward middle-aged men, the most common life insurance purchasers--has only happened one time in recent memory--the 1918 influenza epidemic influenza epidemic
caused 500,000 deaths in U.S. alone (1918–1919). [Am. Hist.: Van Doren, 403]
See : Disease , said Judy Klugman, a managing director of Swiss Re Capital Markets Corp., which facilitated the transaction on behalf of Swiss Re.
Investors were hungry to buy into the issue, Klugman said. The transaction was originally slated to raise $250 million, but was bumped up to $400 million due to the strong demand for the notes. "And there was interest beyond that. Hopefully, we'll see more deals like this going forward," she said.
Such transactions are quite a bit different from reinsurance, Klugman said. Reinsurance is subject to counter-party credit risk. This is, when an insurer purchases reinsurance, it has to trust that when a reinsurance claim is filed--perhaps years later--that the reinsurer re·in·sure
tr.v. re·in·sured, re·in·sur·ing, re·in·sures
To insure again, especially by transferring all or part of the risk in a contract to a new contract with another insurance company. will not only still be around to pay the claim, that it will agree to pay the claim.
Money raised through a special purpose vehicle could be easier to access. "You know when an event happens that the money will be there. It's very straight forward on what will trigger the capital. It's very clear-cut," Klugman said.
Also, an insurer who sponsors a multiyear securitization could have longer control over the risk, as opposed to a reinsurance contract, which often expires in a year.
The downside Downside
The dollar amount by which the market or a stock has the potential to fall.
You might hear someone say that the downside on stock XYZ is $10. What that means is that the stock could fall by this amount if things got bad. of such transactions is that it takes time and effort to bring the deal to the market, Klugman said.
Life Settlement Transactions
Most recently, institutional investors have found a new collateral to issue asset-backed securities: life insurance policies collected through life settlements.
In several transactions now in the works, bankers are pooling together a few hundred million dollars in face-value life settlements--life insurance policies purchased from individuals with life expectancies Life Expectancy
1. The age until which a person is expected to live.
2. The remaining number of years an individual is expected to live, based on IRS issued life expectancy tables. ranging from three to 10 years. The policies are purchased from elderly people who are not terminally iii, but have one or more medical conditions See carpal tunnel syndrome, computer vision syndrome, dry eyes and deep vein thrombosis. requiring ongoing medical treatment or attention.
The plan is for the pools to be securitized and issue asset-backed bonds, using the life insurance policies as collateral.
"The insurance companies aren't involved at all, except they wrote the underlying policies," Modu said.
Modu explained that life insurance policies are considered an asset, and policyholders have many reasons to want to sell them to a life settlement aggregator. Perhaps the premiums have become too high, or sometimes a policyholder views the sale of the policy as a financial planning Financial planning
Evaluating the investing and financing options available to a firm. Planning includes attempting to make optimal decisions, projecting the consequences of these decisions for the firm in the form of a financial plan, and then comparing future performance against move.
Policyholders can sell their policies to a life settlement aggregator to get cash immediately for the policy. In return, the aggregator pays the premium and collects the payment when the policyholder dies.
By pooling these policies and selling them to investors, a life settlement aggregator can pass off some of the mortality risk to investors. It's not unlike mortgages being bundled together and sold to other investors, Modu said.
"It's created a secondary market for life insurance policies," Modu said.
On the Horizon
The next potential wave of securitizations could come from insurers seeking to securitize their reinsurance recoverables, said Bredahl of Benfield Group.
"The raw asset going into the pool could be recoverables. We are working on that now," Bredahl said. "It's an enormous asset class. If you add up all the recoverables that insurers have on their balance sheets, it's billions and billions of dollars."
Insurers already have been successful securitizing their reinsurance recoverables as part of a pool that also included banks securitizing accounts receivable accounts receivable n. the amounts of money due or owed to a business or professional by customers or clients. Generally, accounts receivable refers to the total amount due and is considered in calculating the value of a business or the business' problems in paying , Goldman Sachs' Millette said.
"That's not just theoretical--real transactions have been completed," Millette said.
The uncertainty with reinsurance recoverables, however--the timing and the amount of the eventual payout--could lead to "substantial discounting" that may undermine the potential for major deals coming to the market, he said.
"There are four sources of uncertainty: you don't know Don't know (DK, DKed)
"Don't know the trade." A Street expression used whenever one party lacks knowledge of a trade or receives conflicting instructions from the other party. how much [the reinsurance claims will be worth]; whether reinsurers will contest the claims; the credit worthiness of the reinsurers; and when the claims will be paid," Millette said. "That will make a lot of investors scratch their heads and think whether it's worth the investment."
The insurance-linked security market is "bigger than most people think--approaching $10 billion--but it's growing and broadening slowly," he said.
A.M. Best Company # 18559
Distribution: Independent agents, direct marketing, agents affiliated with the company
Meadowbrook Insurance Group
A.M. Best Company # 18132
Distribution: Independent agents, managing general agents, reinsurers and reinsurance brokers.
Swiss Re Group
A.M. Best Company # 85010
Distribution: Reinsurance brokers
For ratings and other financial strength information about these companies, visit www.ambest.com.
Rating the Issues
A.M. Best Co., which has traditionally rated insurance companies' financial strength, is now actively rating insurance-linked securities, and the demand for such ratings is increasing, according to Emmanuel Modu, head of A.M. Best's new structured finance department.
"We expect these types of transactions to continue to become more common as investment banks devise new ways to securitize insurance-related assets and liabilities," Modu said. "We're getting calls about new securitizations almost every day." The securities issued attract various institutional investors, and the highest-rated notes are typically purchased by companies including banks and insurers.
A.M. Best looks at the credit quality of insurers issuing insurance-linked securities, and rates the securities based on their credit worthiness and other factors, Modu said. Best's Long-Term Credit Ratings, which are assigned to debt and preferred stock Stock shares that have preferential rights to dividends or to amounts distributable on liquidation, or to both, ahead of common shareholders.
Preferred stock is given preference over common stock. Holders of preferred stock receive dividends at a fixed annual rate. issues, range from "aaa" (exceptional) to "d" (in default). Best's Short-Term Credit Ratings, which are opinions as to the issuer's ability to meet its obligations having maturities generally less than one year, range from "AMB-1+" (strongest) to "d" (in default).
It's not appropriate to assess the risk of insurance-linked securities by using general statistics on corporate bond defaults, because insurance credit risks are unique due to the regulatory and accounting environment in which insurers operate, Modu said. Also, relatively few insurers issue public debt, so there's not an extensive track record to compare new issues with, he said.
To gain appropriate information, A.M. Best recently conducted an in-depth study to estimate rates of financial impairment Impairment
1. A reduction in a company's stated capital.
2. The total capital that is less than the par value of the company's capital stock.
1. This is usually reduced because of poorly estimated losses or gains.
2. for insurance companies that can serve as the basis for estimating the likelihood of defaults on financial obligations made by those companies.
Financial impairment includes more than the traditional concept of issuer defaults. A financially impaired company still may be able to meet its policyholder obligations, even though insurance regulators have become concerned enough about the company's future viability to have intervened.
A.M. Best designates an insurer as financially impaired after the insurance department in the company's home state takes an official action. Such state actions include involuntary liquidation The collection of assets belonging to a debtor to be applied to the discharge of his or her outstanding debts.
A type of proceeding pursuant to federal Bankruptcy , as well as less severe steps such as supervision, rehabilitation rehabilitation: see physical therapy. , receivership receivership
In law, state of being in the hands of a receiver, a person appointed by the court to administer, conserve, rehabilitate, or liquidate the assets of an insolvent corporation for the protection or relief of creditors. , conservatorship Conservatorship
A circumstance in which the court declares an individual unable to take care of legal matters and appoints another individual, known as a conservator, to do so.
This is sometimes referred to as "LPS Conservatorship. , license revocation The recall of some power or authority that has been granted.
Revocation by the act of a party is intentional and voluntary, such as when a person cancels a Power of Attorney that he has given or a will that he has written. or other action that restricts a company's freedom to conduct business as normal.
The study, "Best's Impairment Rate and Rating Transition Study--1977 to 2002," shows that as financial strength ratings of insurers fall, the impairment rate increases. The lower the rating, the higher the impairment rate; the higher the rating, the lower the impairment rate.
During the past 25 years, the Years, The
the seven decades of Eleanor Pargiter’s life. [Br. Lit.: Benét, 1109]
See : Time average annual impairment rate for U.S. insurers rated by A.M. Best was 0.71%, according to the study. Of the 4,936 U.S. life/health and property/casualty operating insurance companies that carried an A.M. Best financial strength rating during this period, 583 companies became Financially impaired.
The average annual impairment rate for secure companies--those with financial strength ratings of B+ (Very Good) and above--was 0.23%.The annual impairment rate for vulnerable companies--those with financial strength ratings of B (Fair) and below--was 3.44%.
The 15-year cumulative average impairment rates for secure companies was 8.01%, while the same rate for vulnerable companies was 34.63%. The 15-year cumulative average impairment rate for all companies was 12.08%.
Impairment rates also varied across time, as insurance companies with highest financial strength ratings--A++ or A+ (Superior)--had the lowest impairment rates, ranging from 0.06% over a one-year period to 4.86% over a 15-year period.
By contrast, insurance companies with a financial strength rating of D (Poor) had the highest impairment rates ranging from 7.20% over a one-year period to 50.94% over a 15-year period. The one-year to 15-year impairment rates for the insurance companies with A/A-(Excellent) ratings, which constitute the greatest percentage of A.M. Best's ratings Best's rating
A rating A.M. Best Co. assigns to insurance companies based on the company's ability to meet its obligations to its policyholders. over the period, ranged from 0.24% to 8.69%.
Also, there is a strong correlation between a financially impaired company's initial rating and the time it took to become financially impaired. On average, financially impaired companies initially rated A++/A+ took 13.4 years to become impaired, whereas financially impaired companies initially rated B/B- took just 8.8 years on average.