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 recoverables could be the collateral used for the next wave of asset-backed securities.

When investment bankers 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, $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 and investor relations 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 financing."

"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.

Financial Engineering

Since 1996, more than $9.5 billion of insurance-linked securities has been issued, according to Swiss Re. By far, the most common type of securities is catastrophe bonds, 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 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 traditional insurance or reinsurance any time soon, Hartwig said.

"We see some innovation around the edges, but not a dramatic growth in securitization. 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 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, 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.

"It's similar to buying any sort of asset-backed security," Bredahl said, noting transactions such as mortgage-backed securities 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 ... that would be the natural pace," Bredahl said.

Benfield, an insurance broker and adviser, worked with investment bankers Merrill Lynch and Cohen Brothers to establish two financing pools for insurers called Dekania I and Dekania II. Large investment banks 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 securitizations. Insurers have been able to securitize an established book of life insurance business, where the future profitability of that book is measurable and probabilistic. 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 securitized closed books of business that arose from their demutualizations, said Mike Millette, managing director of risk markets for investment banker Goldman Sachs. 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 lees early, letting investors receive the fees as they roll in, said Jack Gibson, managing principal for the North America life practice of the Tillinghast division of Towers Perrin.

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 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, 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 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 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 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 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 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, 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 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.

Learn More

ProAssurance Group

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 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 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, as well as less severe steps such as supervision, rehabilitation, receivership, conservatorship, license revocation 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 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 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.