Full speed ahead: insurers shouldn't fear the roadblocks currently inherent in securitizing Triple-X reserves. They can be crossed, and the trip is worth the effort.

Triple-X securitization has generated a strong interest among structured finance professionals because of a potentially large opportunity in the life insurance industry. Application of securitization technology to the funding of Triple-X reserves could transform the current modus operandi of the industry just as it transformed the mortgage banking industry.

Not too long ago, banks used to originate mortgages and finance them permanently, and thus retained the underlying risks. But with the advent of securitization, banks finance mortgages only temporarily, and transfer the underlying risks permanently to the capital markets. As a result, securitization transformed banks into mortgage aggregators, and enabled them to deploy their capital more efficiently elsewhere.

With linkage to the capital markets through securitization, the life insurance industry could go through a similar transformation. Insurers would become policy aggregators, and securitization would become the vehicle for the transfer of the underlying risks to the capital markets. This transformation has begun already in that some insurers are aggregating policies under a third-party warehouse funding facility until a permanent takeout of the funding is achieved through securitization.

Many life insurance and reinsurance companies are hesitant to embrace securitization transaction as part of their capital management strategy because of the burden of the initial capital contribution to the transaction, upfront costs, difficulties in obtaining letters of credit, investors' concerns about repayment of debts and the time-consuming process for the completion of the transaction. These and other related issues are currently perceived as roadblocks to Triple-X securitization. If the history of securitization is any guide, as more and more Triple-X securitizations are completed, the process will become more standardized and thus efficient. As a result, these roadblocks will be less of an impediment for companies to embrace securitization as part of their capital management strategy.

In the meantime, there are ways insurers can cross the roadblocks and achieve the desired efficiency. Companies should not be ambivalent in exploring securitization as a solution to funding Triple-X reserve.

Securitization Structure

Triple-X securitization is a securitization of the business as an enterprise, whereas traditional securitization is a securitization of only the assets of an enterprise. Description of the two frameworks is summarized in

* "Traditional Securitization vs. Triple-X Securitization" on page 79.

Traditional securitization is a device for leveraging the return on investment through a non-recourse funding of assets. In the framework of this securitization, a company transfers assets as a true sale to a special purpose vehicle in an onshore or offshore jurisdiction of convenience. The special purpose vehicle funds the purchase of the assets through a combination of debt and equity securities. The debt securities, in a single class or multiple classes, are sold in a public or private transaction. The equity securities either are sold or retained, in part or full, by the company. The holders of the debt and equity securities rely solely on the performance of the assets for their expected return on investment.

Triple-X securitization is a device for leveraging the return on investment in a block of term life policies through a non-recourse funding of redundant statutory reserve of the block. In the framework of this securitization, a company transfers a policy block as coinsurance to a special purpose reinsurance vehicle (SPRV) in an onshore or offshore jurisdiction of convenience and makes an initial equity capital contribution to the SPRV. Pursuant to the terms of coinsurance, the SPRV deposits assets in a reinsurance credit trust in an amount equal to the statutory reserve amount for the benefit of the company. The SPRV funds the economic portion of statutory reserve through net cash flows from its coinsurance operation, and the redundant reserve portion of statutory reserve through the issuance of debt-like securities (surplus notes). The debt securities are sold in a private transaction, and the residual interests (equity securities) in the SPRV are retained by the company.

The holders of debt securities (as well as equity securities) rely primarily on the performance of the policy block, and to a smaller extent on the performance of the investment assets, of the SPRV for their expected return on investment. To credit-enhance the debt securities, a highly rated financial guarantor guarantees the timely payment of interest and ultimate payment of principal on the debt securities (although the guarantee is not intrinsic to the structure of the securitization).

Capital Contribution

In Triple-X securitization, the company makes an initial capital contribution in the form of equity to the SPRV. The size of the capital contribution depends primarily on the characteristics of the policy block and the terms of the SPRV's liabilities, and equals the greater of the amounts determined by the state insurance regulator of the SPRV, the rating agencies and the financial guarantor, if any. The methodology employed by these three parties in determining the required capital contribution differs because of their differing exposure to the transaction. The key aspect of their methodology affecting the capital contribution to the SPRV is outlined below:

State insurance regulator: Maintenance of a formulaic minimum risk-based capital (solvency capital) for the SPRV at all times during the life of the transaction is the main consideration in determining the initial capital contribution to the SPRV as if the SPRV was an insurance operating entity, and not a traditional securitization vehicle.

Rating agencies: Performance of the policy block to support the SPRV's liabilities under a variety of quantitative and qualitative risk considerations forms the basis for the initial capital contribution to the SPRV. The quantifiable risks affecting the performance of a policy block are mortality, a somewhat predictable risk; persistency, an unpredictable risk, and investment, a controllable risk. The capital level determined by the rating agencies to support a rating on the debt securities is further subject to the maintenance of a minimum solvency capital by the SPRV set forth by its regulator.

Financial guarantor: "No-risk-of-loss" constitutes the basis for a financial guarantor to provide its guarantee on the debt securities, subject to compliance with the capital requirement of the rating agencies and the regulator. The no-risk-of-loss approach together with the rating-agency-type methodology employed by the financial guarantor generally tends to impose capital maintenance level and operational covenants for the SPRV in excess of those required by the rating agencies as well as the regulator.

If the solvency capital falls below its target level set by the regulator, payments on the debt securities cease until the solvency capital is restored to its target level. This restriction on the servicing of the debt securities results in a higher capital contribution to the SPRV to support a rating on the debt securities. But if the SPRV is treated as a traditional securitization vehicle with the sole purpose of posting assets in the reinsurance credit trust pursuant a reinsurance agreement, the level of capital contribution would be less burdensome, and would then be more in congruence with the traditional securitization methodology employed in the determination of such capital.

It is therefore recommended that the SPRV's regulator consider the application of the traditional securitization framework, without treating the SPRY as an operating insurance entity, as the sole basis for the determination of the capital requirement for the SPRV. Alternatively, companies should explore establishing the SPRV in a jurisdiction where such treatment of the SPRV would be available, resulting in a less burdensome capital requirement. A reduction in capital contribution would improve the capital efficiency of securitization and may make it more affordable to a broader range of companies to access the capital markets to address their Triple-X funding needs.

Upfront Cost

Triple-X securitization embodies a new asset class--the SPRV's business--in the context of funding (securitizing) its redundant reserve assets. The upfront cost of securitization of a new asset class is generally higher than that of an old asset class. The key components of the upfront cost of Triple-X securitization include the company's legal and actuarial costs, the SPRV's legal and setup costs, the banker's legal and underwriting costs, the financial guarantor's legal and actuarial costs, the rating agencies' costs and the trustee's legal and setup costs.

The size of Triple-X securitizations completed to date has been approximately $400 million or higher. Companies with smaller securitization needs ($200 million, for example) may find securitization unattractive. But, as more and more securitizations are completed, the upfront cost would be less of a factor for companies with smaller funding needs because the structure, documentation, regulatory approval and rating process would be standardized, and would be more in the public domain than they are now.

Companies with smaller funding needs should view securitization as an investment in a funding technology of their business, provided, however, that they use securitization as an ongoing capital management strategy. Ongoing usage of securitization would reduce its upfront cost significantly, and make securitization the preferred vehicle for funding the redundant statutory reserve.

Collateralized Letter of Credit

Reinsurance regulations provide for two permissible funding alternatives for statutory reserves: deposit of liquid assets in a reinsurance credit trust for the benefit of the company, and an unconditional letter of credit (LOC) from a qualified bank in favor of the company. In a Triple-X securitization transaction, a draw under the funding arrangement for the redundant statutory reserve (through liquid assets or LOC) is made only after the assets representing the economic statutory reserve of the SPRV are exhausted. The draw amount may be repaid then through the performance of the policy block.

The LOC alternative should be more efficient for funding the redundant statutory reserve because, unlike the liquid assets funding alternative, the LOC is not marked-to-market, thus eliminating the funding volatility risk to the transaction, and there is no investment management fee associated with the LOC. To the author's best knowledge, banks have not issued to date LOCs in a rated Triple-X securitization. In view of the efficiency of LOCs, banks should entertain issuing long-term LOCs in Triple-X securitization, because there is no regulatory prohibition that restricts banks from issuing such LOCs and, more importantly, the LOCs will be collateralized with highly rated debt securities issued in the structure. The structure that enables a bank to collateralize its LOC exposure with highly rated debt securities either as a direct investor or to support an investor in the transaction is described below.

Two basic forms of Triple-X securitization structures use a domestic SPRV: a surplus-note-based structure, wherein the SPRV issues surplus notes that are used then as collateral by a special purpose trust for the issuance of highly rated notes based on the guarantee of payments on the notes by a highly rated financial guarantor; and an equity-interest-based structure, wherein the SPRV issues equity interests that are used then as collateral by a special-purpose limited-liability company (owned by the company) for the issuance of highly rated notes based on the guarantee of payments on the notes by a highly rated financial guarantor.

In either structure, the bank issues for its own account or for the account of an investor its LOC for the ultimate benefit to the company in exchange of the highly rated notes (which, in turn, function as reimbursement obligation for the LOC). The economic terms of the LOC mimic the terms of the notes, subject to the regulatory and rating agency provisions of the transaction. (*See "Triple-X Securitization With Letter of Credit," page 80.)

Investors' Repayment Concerns

Securitization continues to create capital markets investment opportunities. The growth is attributable, in part, to the fact that securitization is a rule-based funding device and is not subject to the discretionary risk of its operating jurisdiction. Triple-X securitization is also rule-based but is subject to the regulatory risk of interruption of the cash flows to investors if the SPRV is domiciled onshore. That is, the regulator of the SPRV can, in its sole discretion, interrupt (or even stop permanently) the cash flows otherwise required to service investors in the transaction. This adds an element of uncertainty in the transaction which deters a broad participation of investors in funding the transaction. As a result, the cash flows required to service investors in Triple-X securitization are guaranteed by a highly rated financial guarantor to eliminate the exposure to investors of this regulatory risk.

Removal of the discretionary risk from the structure is central to the framework of securitization and is imperative to broad participation of investors in Triple-X securitization. The regulator should therefore consider implementing rules which it cannot override so that the SPRV can be a self-functioning entity, subject solely to the rules set forth at the inception of the transaction like those in traditional securitization. A failure in doing so may force companies to explore off-shore structural alternatives which do not expose investors to the discretionary risk of the regulatory jurisdiction.

Time-Consuming Process

Triple-X securitization follows the same process for the execution of a transaction as traditional securitization except that Triple-X securitization requires approvals by the regulators of the company and the SPRV engaged in the securitization. For a company's first-time transaction, Triple-X securitization could take nine or more months to complete because of the newness of the process to the company and the requirement for comprehensive information on the policy block, valuation of the policy block under rating agencies' criteria, the SPRV's regulatory approval process and documentation of the transaction. As a result, many companies have not been enthusiastic about securitizing their policy blocks to manage statutory capital.

Overcoming lack of comprehensive information on a policy block and historical performance information of such a policy block is the most time-consuming factor for securitization. It is therefore necessary for companies to have an information management and reporting process in place for a timely and efficient execution of a securitization transaction. As more and more Triple-X securitizations are completed in the industry, the legal, regulatory and rating processes will be standardized and thus will take the same amount of time as they do in traditional securitization. Therefore, for a company equipped with the information management and reporting system necessary for securitization, the process should not take more than four months to complete, like most traditional securitizations.

Key Points

* Triple-X securitization is a device for leveraging the return on investment in a block of term life policies through a non-recourse funding of the block's redundant statutory reserve.

* As more Triple-X securitizations are completed, the process will become more standardized and thus efficient.

* Insurers would gain efficiency by selecting the most advantageous domicile for an SPRV and establishing an information management and reporting process for securitization.

Contributor Shanker Merchant has more than 20 years of experience as a banker in structured and corporate finance businesses with major financial institutions in New York. He can be reached at [e-mail].

Crossing Triple-X Securitization Roadblocks

             Roadblock Issue              Crossing Suggestion

Capital      Burdensome capital contri-   Application of the framework
             bution                       of traditional securitization
                                          or the use of an offshore
                                          jurisdiction for securitiza-
                                          tion
Expense      High upfront cost for a      Standardization of process
             smaller transaction          and documentation for securi-
                                          tization
Funding      Unavailability of letter     Banks to provide LOC collate-
             of credit (LOC) for          ralized by highly rated debt
             securitization               securities through a finan-
                                          cial guarantor.
Regulatory   Capital markets investors'   Domestic regulator to remove
             concern about the            its discretionary power of
             repayment of debt            interrupting cash flows
             securities in a domestic     needed to debt securities
             securitization
Execution    Time-consuming process for   Clean and comprehensive
             securitization               policy level information and
                                          repeat securitization tran-
                                          saction

Traditional Securitization vs. Triple-X Securitization

            Traditional Securitization     Triple-X Securitization

Purpose     Non-recourse funding of        Non-recourse funding of
            assets for GAAP balance        statutory reserves for SAP
            sheet management.              balance sheet management.
Mechanics   Transfer of assets as true     Transfer of policies as co-
            sale to a special purpose      insurance to a special
            vehicle (SPV).                 purpose reinsurance vehicle
                                           (SPRY).
Funding     Multiple classes of debt       Single class of debt secu-
            securities and a single        rities and equity securities
            class of equity securities     of the domestic SPRY
            of the SPV
Execution   Public and private placement   Private placement markets
            markets.                       only.
Repayment   Cash flows from the assets     Cash flows from the assets
            of the SPV                     of the SPRV.