Financial evolution: as insurers and investors become more adept at dealing with insurance-related securitizations, they're looking for new ways to tap into the capital markets.

Money may not grow on trees, but many insurers are seeing green when they turn to the capital markets to raise money through securitizations.

Insurers have become well versed in tapping into the capital markets to raise money for catastrophe risk as an alternative to reinsurance. They've also been able to securitize the additional reserves needed under Regulation Triple X. They've been able to securitize closed blocks of business and life settlements.

Now, in addition to small to midsize insurers joining together in pools to raise money through securitizations, some have expanded the pools to include banks and even insurers from other countries. In addition to individual companies securitizing Regulation Triple X reserves, small to midsize life insurers may be able to join pools to securitize their Triple X reserves. And on the horizon, industry experts believe insurers will be able to securitize property/casualty reinsurance recoverables and on the life side, Regulation AXXX reserves.

Everyone in the Pool

The banking industry was the first to band together to raise money through pooled securitization transactions. It allowed small and midsize banks to access the capital markets by forming a pool that issues notes to the capital market, said Rob Bredahl, executive vice president of Benfield Group's Financial Solutions Group. Insurers followed in 2002 by forming their own pooled trust preferred securities transactions. The money raised by the pool is shared with the pool participants, which at that time, tended to be about 25 to 35 midsize insurance companies, each trying to raise up to $15 million.

The notes are purchased by investors, mostly institutional investors, who view the trust preferred securities as a good risk. With so many different insurers in the pool, the risk is spread. Also, the risk isn't linked to other market factors, such as rising or falling interest rates, which can impact other parts of investors' portfolios.

The first insurance company pooled transactions were filled with insurers only. But in 2004, innovative financial engineers realized they could mix banks and even non-U.S.-based insurers into a pool with domestic insurers and still find investors hungry to participate.

"The pools are much bigger now, so the amount that can be raised by each issuer is larger than it was previously," Bredahl said. "If you told us a few years ago that we could mix banks and insurance, and U.S. and foreign insurers, we probably would not have believed you. But investors have become very comfortable with blending. The mixed pools give investors increased diversification."

The pools have doubled in size to $600 million from $300 million. Individual companies in the pools also are able to borrow larger chunks of cash, such as $20 million for a better-rated issuer compared with $15 million a few years ago. By using several pools, individual issuers now can raise up to $100 million at once. Also, it's easier and cheaper to put the transactions together, Bredahl said.

"Spreads in the credit market for this type of structured paper have dropped steadily in the period that the pools have been produced. The market has become more comfortable with insurance paper. By combining bank and insurance company issuers, the banks' lower credit risk spreads have pulled down insurance companies' spreads" Bredahl said.

Banks tend to have better credit ratings, so by mixing banks and insurers into pools, insurers have been able to benefit from lower credit spreads. Due to the mixing, the increased size of transactions and the maturing of the pooled funding product, weighted average credit spreads for insurance companies have dropped by approximately 50 basis points (0.5%) over the past 18 months.

Also, the once tricky issue of coordinating would-be pool participants seems to have been resolved.

"In the earlier days, we had to create a critical mass of issuers. We had to line up companies and get them ready to issue on the same date. Now some arrangers are willing to 'warehouse' issuers. Before the pools are completed, we will warehouse paper and put it into the pool when it is ready to be launched," Bredahl said.

In the past, some transactions never came to fruition because arrangers could not get enough insurers that were able to issue the paper on the same day, Bredahl said, noting Benlield always completed its deals on schedule. "But as we became more and more confident that we could ultimately place the paper, we become more willing to warehouse it," Bredahl said.

X Marks the Spot

Faced with having to increase their reserves to meet the more stringent requirements of statutory Regulation Triple X and Regulation AXXX, life insurers are looking to the capital markets to help. Genworth Financial completed the first such transaction in 2003, and other companies have followed, said Duncan M. Briggs, Towers Perrin princpal and Tillinghast consultant.

Regulation Triple X deals with term life insurance and AXXX deals with universal life insurance. Both require companies to hold additional reserves significantly higher than what they had become accustomed to holding.

When Triple X went into effect in 2000, direct companies faced a huge statutory reserve requirement that they didn't want to insure themselves. Many began ceding 80% to 90% of business to reinsurers to eliminate 80% to 90% of the Triple X reserve that they had to hold.

But the reinsurers weren't crazy about the idea of holding the higher reserves either. Often, the reinsurers, in turn, reinsured the Triple X business to offshore companies that weren't subject to Triple X requirements. But even though the reinsurers had eliminated the reserve requirement by sending it offshore, in order to get credit for the reserve, they had to post collateral for the full amount of the reserve. The offshore reinsurers had to obtain bank letters of credit to guarantee that the Triple X reserve was available to the primary writers.

Letters of credit are not considered "hard capital," Briggs said. "It's just a piece of paper that provides security for the benefit of the direct company."

But the demand for bank letters of credit is so high, that there are now "issues of capacity in that market to continue to provide letters of credit,' Briggs said. "It's not a definite solution."

Typically, letters of credit provided by banks are only issued for one year, so each year, the reinsurers need to ask for one again.

"There's no guarantee the bank will continue to give it, and no guarantee on price," Briggs said. "Prices have been going up. That's another issue that's driving the whole securitization trend."

So reinsurers, feeling the pressure of rising costs of letters of credit, have begun to charge more to direct writers. Direct writers that are big enough have turned to securitizations to fund the needed reserves as an alternative to reinsuring the business, Briggs said.

Reinsurers, instead of relying on letters of credit, are also looking at securitization. In February, Bermuda-based Scottish Re Group Ltd. became the first reinsurer to securitize its Regulation Triple X reserves. The company offered $800 million of 30-year maturity securities from its newly formed, wholly owned subsidiary Orkney Holdings, with the proceeds to be used to fired regulatory reserves for level premium term life insurance policies reinsured by Scottish Re from 2000 to 2003. The securities were guaranteed by MBIA Insurance Corp.

In a statement, Scott Willkomm, president and chief executive officer of Scottish Re, said it's the first securitization of excess reserves arising from Regulation Triple X to be completed by a reinsurer and the first to lock in a certainty of funding as well as a fixed cost for the entire file of the transaction.

While companies need to have a certain size, the Scottish Re transaction may open the door to smaller life insurers, who could follow in the property/casualty insurers' path and pool together to issue securities to cover their Regulation Triple X reserves, Briggs said.

"If you think about how reinsurance works: Scottish Re has taken business from 30 to 40 different companies, many small companies, and pooled together the risks in a single security. There's nothing to stop a group of 10 medium companies to decide to form their own special purpose reinsurance company for their own securitization," Briggs said.

In fact, some primary writers, who had given 80% to 90% of their business to reinsurers, are now looking to recapture some of that business because the small portion they have left isn't enough to securitize, he said.

"It's difficult to recapture business without paying some sort of penalty to the reinsurance company. The reinsurance company doesn't want to give up the profits it's locked in," Briggs said.

However, if their own costs have gone up (because the cost of letters of credit is rising), reinsurers might be more amenable to a recapture," Briggs said.

Investor demand for these types of transactions has been running high, especially if the issuers wrap the transaction in a bond guarantee that gives them a high rating.

"If the bond is guaranteed, investors are not really directly exposed to the insurance risks," Briggs said.

Second Child Arrives

With securitizations for reserves needed for Regulation Triple X becoming more common, next on deck could be securitizations of reserves for Regulation AXXX.

Regulation AXXX, which went into effect Jan. 1, 2003, governs the reserves for universal life policies with no-lapse secondary guarantees and, like Regulation Triple X, requires insurers to carry more reserves than they previously held. Unlike the additional business reinsurers took when Regulation Triple X was adopted, reinsurers have not had an appetite for Regulation AXXX business.

"It's a more complicated risk than term business. Plus reinsurers' letters of credit have been maxed out dealing with the term-life business," Briggs said. "They don't want to use that capacity on AXXX."

Briggs said any company big in the universal life market "is desperately seeking some sort of solution to help manage the AXXX reserve issue. I think we will see a AXXX securitization transaction complete over the next several months, and once one of these occurs, quite a few more will be hot on the heels."

If the transactions come to the market with a credit wrap, Briggs expects investors to bite. "If it's wrapped, then the insurance risk isn't there. There should be the same level of demand [as for Regulation Triple X securitizations]," he said.

Recovering the Recoverables

For many insurers, reinsurance recoverables--or money reinsurers owe them--are greater than their corporate holdings, and could be the next asset insurers attempt to securitize.

Most property/casualty companies, for instance, must maintain the average credit quality of the investment portfolio above a very high level and limit exposure to both single issuers and single industries. Guidelines for managing recoverables are much less stringent despite the fact that recoverables are a bigger asset class for insurers, Benfield's Bredahl said. For example, a per-name concentration is often $25 million and per industry $100 million for corporate bonds, while the same company might have $500 million in reinsurance recoverables to a single reinsurance company and $3 billion or more to the reinsurance industry.

"We continue to work on securitizing recoverables, but as far as I'm aware, no deal has been completed yet," Bredahl said. "It's on the horizon. Recoverables are messy instruments, and it's taken a little more time to develop the securitization structures and get buyers comfortable taking on recoverable risk as opposed to bond or loan risk."

Christopher McGhee, managing director of Guy Carpenter, said there's been more talk than action when it comes to securitizing reinsurance recoverables.

A number of primary insurers, however, have been able to get reinsurers to put up a letter of credit or a trust account to collateralize their reserves. "That's not just a promise to pay, it's a promise to pay supported by dedicated assets? McGhee said. The idea has been around for decades, but has been mostly nonadmitted reinsurers required to put up a letter of credit to cover claims after a loss happened. The new twist is that U.S.-based insurers also have begun to put up the letters of credit.

One step that insurers have taken to limit recoverables risk is to purchase credit derivatives. A third party, such as an investment bank or reinsurer, provides coverage that would kick in if the reinsurer's credit drops, leaving the primary insurer with unrecoverable reinsurance recoverables.

Gaining Speed

Securitizations have become faster and easier to put together, McGhee said, and in fact, don't take more time than traditional reinsurance. In the past, some have said a reinsurance transaction could be put together in a week. It sometimes takes more than a year, however, for the transaction to be fully documented, signed and collateralized.

"The difference is securitizations are fully documented and collateralized in advance. If you compared apples to apples, you might find the time frame in which to get these done is very comparable, and perhaps it's a shorter time frame for securitizations,' McGhee said.

The asset-backed security business is booming even without insurers, but insurance securitizations are continuing to grow at a steady, if not dramatic, pace, McGhee said. While catastrophe bonds continue to dominate the market, there's room for new areas of securitization, he said.

"We continue to see a lot of interest in insurance and reinsurance as a risk capital diversification," McGhee said.

Key Points

* Midsize property/casualty insurers have raised more than $3 billion in the pooled funding market in the past two years.

* In pools that mix banks and insurers, insurers have been able to reduce their weighted average cost of capital by 50 basis points.

* New types of securitizations may include reinsurance recoverables; reserves for Regulation AXXX; and pools formed by midsize life insurers to fund Regulation Triple X reserves.

Securitization

* DEFINITION: The process of funding assets or transferring risk by issuing securities to the capital markets.

* PURPOSE: Funding acquisitions, liquidating assets, funding potential liabilities, satisfying regulatory requirements, transferring risk, satisfying investors' risk appetite, and redeploying capital.

* CHARACTERISTICS: Segregation of assets in bankruptcy-remote special purpose vehicles or protected cells, formation of pools of homogeneous assets, creation of one or more tranches of securities, and transferring risk to investors.

Source: A.M. Best Co.

Recoverables Outpace Investments

While insurers carefully manage their investments in stocks and bonds--for instance, making sure they don't place more than 15% of their invested assets in a single industry--they don't follow those same classic rules in governing their reinsurance recoverables.

U.S property/causalty insurers carried more
in reinsurance recoverables in 2003 than
they held in any single investment class.

($ Billions)

Recoverables                  $171.0
Treasuries                     $69.3
Muni (rev)                    $119.9
Muni (Obl)                    $110.3
Mortgages                     $111.0
U.S. Corp Bonds               $156.6
Cash & ST Inv                  $88.5
Common Stock                  $121.7
Preferred Stock                 $9.3

Source: Benfield Group

Banking on Growth

Midsized insurers have not only followed in the footsteps of midsized banks by pooling together to issue collateralized debt obligations--lately, they've joined them in the same pools.

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Swiss Re Securitizes Future Profits

swiss Re recently completed its first securitization of future profits from a portfolio of U.S. life insurance policies.

"What was transferred to investors was mortality risk, lapse risk, performance of assets risks, interest rate risks ... all the risks that a life insurance company would have were transferred to investors," said Judith Klugman, a managing director of Swiss Re Capital Markets Corp., which facilitated the transaction on behalf of Swiss Re.

Swiss Re was able to raise $245 million by issuing three tranches of securities in January. The securities paid an average pretax coupon of 6.69% with an expected maturity ranging between six and 11 years.

The asset that backed the securities is the expected profits from five blocks of life insurance business acquired by Swiss Re through its Admin Re arm. By transforming insurance risk into a tradeable security, Swiss Re was able to turn intangible assets into cash.

"What makes this transaction unique is that it's one of the first that transfers significantly more amount of risk," Klugman said. Other similar deals were a single risk with a highly-rated credit wrap going out to investors.

In December 2003, Swiss Re obtained $400 million in insurance coverage from institutional investors by issuing bonds to protect against extreme mortality risk.

"It's not just about natural catastrophes or life insurance, it's about all types of risk being transferred into the capital markets," Klugman said.

She said Swiss Re is working on other types of securitizations which could include other types of insurance risk.

"All of our deals are very well received by investors," Klugman said. "Institutional investors are increasingly attracted to insurance-linked securities because of the diversification it can provide them."

Learn More

Scottish Re Group A.M. Best Company # 08928 (Scottish Re Life Corp.)

Distribution: Direct marketing, reinsurance brokers

Swiss Re Group A.M. Best Company # 085010

Distribution: Reinsurance brokers

For ratings and other financial strength information about these companies, visit www.ambest.com.