In reserve: Triple-X securitization represents an emerging class of structured products for life insurers.

Triple-X securitization can be characterized as the "securitization of the business of an enterprise," in contrast with traditional securitization, which is the "securitization of assets of an enterprise." A securitization structure provides nonrecourse and permanent financing for the Regulation Triple-X reserve through the capital markets, whereas nonsecuritization structures provide recourse and temporary financing for the reserve through the bank market. As a result, life insurance companies have begun to seek the capital markets for a permanent solution as well as for capacity.

Notwithstanding the benefits of a permanent solution, insurers are ambivalent toward securitization as part of their capital management strategy, because it is more costly and cumbersome to the company. But, when analyzed as a risk-adjusted cost of capital, the benefit far outweighs its cost compared with that of a nonsecuritization solution.

Within the past two years, four Triple-X securitizations have been completed: two by First Colony Life Insurance Co.; one by Banner Life Insurance Co. and William Penn Life Insurance Company of New York; and one by Scottish Re Group Ltd.

These transactions have established the groundwork for future securitizations. If history is a guide, securitization transactions will become more efficient and cost-effective as more are completed. That may ease insurer ambivalence in selecting securitization as a solution for funding the Regulation Triple-X reserve.

Reserve Rules

Triple X applies to the valuation of all life policies with guaranteed premiums for at least some period during the life of the policies. This rule was promulgated by the National Association of Insurance Commissioners officially as the Valuation of Life Insurance Policies Model Regulation (XXX).

Triple X requires the use of a prescribed mortality table and discount rate to determine the "statutory reserve" based on a present value methodology. The statutory reserve calculated by this method significantly exceeds the economic reserve, which is based on the insurer's realistic actuarial assumptions. This excess amount is referred to as the redundant--or excess--reserve. The redundant reserve represents the need for additional capital that a company must allocate to support the statutory reserve requirement. The need for this capital puts strain on the company's earnings and capital. The statutory reserve profile is asymmetric around the midpoint of policy and is commonly referred to as the "humpback" reserve.

Current Structures

The framework for Triple-X securitization (See "Securitization Framework for Funding Triple-X Reserve" on page 70.) differs from traditional securitization because the company's liabilities under Regulation Triple X exceed the liabilities supported by the underlying policy premiums (assets), unlike the traditional securitization wherein the company's liabilities are supported by the underlying assets. Two structures for Triple-X securitization have been deployed to date: the surplus note structure and the secured note structure.

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Surplus Note Structure: This alternative (See "Securitization Through the Issuance of Surplus Notes" below.) involves the issuance of subordinated, unsecured notes linked to the performance of a policy block, with no recourse to the company. These notes are treated as surplus notes for regulatory purposes, on-balance sheet financing for GAAP purposes, and debt securities for tax purposes. The basic structural aspects of a transaction are as follows:

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* Special Purpose Vehicle: A ceding insurer establishes a wholly owned special purpose financial captive insurance vehicle (the "captive reinsurer") in a state that provides for it such as South Carolina, and capitalizes it with an amount necessary to support the reinsurer's operations.

* Reinsurance Agreement: The ceding insurer enters into an indemnity reinsurance agreement with the reinsurer for a portfolio of term life policies (the "policy block"). The ceding insurer pays the captive reinsurer an initial payment equal to the economic reserve amount. During the term of the transaction, the ceding insurer receives expense allowance and death benefit claims under the policy block from the captive reinsurer. The premiums, net of the expense allowance and claims, are used by the captive reinsurer to maintain the economic reserve and transfer the balance, if any, to the ceding insurer in the form of an experience refund, subject to the terms of the reinsurance agreement.

* Surplus Notes: The captive reinsurer issues surplus notes in an initial principal amount, and then periodically in additional amounts (or all upfront, depending on the terms of the securitization), and receives, in exchange, proceeds which it uses to satisfy the statutory reserve requirement of the ceding insurer. The source of payments of both principal and interest on the surplus notes consists principally of the following:

* earnings on the investment of proceeds from the issuance of the notes and the net premium from the policy block; and

* the release of assets from the reinsurance trust (as described below) resulting from a decrease in the reserve requirement.

* Reinsurance Trust Agreement: The captive insurer establishes a trust (the "reinsurance trust") and transfers to the reinsurance trust for the sole benefit of the ceding insurer some or all of the proceeds, as necessary, raised from the issuance of the surplus notes in an amount equal to the redundant reserve, plus proceeds required for the economic reserve.

The proceeds in the reinsurance trust are invested hi eligible securities (the "trust assets"), pursuant to the investment guidelines under the statute. The trust assets are marked-to-market at least quarterly and the market value of the trust assets is maintained at a level at least equal to the statutory reserve requirement of the policy block.

Secured Note Structure: This alternative (See "Securitization Through the Issuance of Secured Notes" on page 72.) involves the issuance of senior, secured notes linked to the performance of a policy block, with no recourse to the company. These notes are treated as obligations of the issuing vehicle, on-balance sheet financing for GAAP purposes, and as debt securities for tax purposes. The basic structural aspects of a transaction are as follows:

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* Special Purpose Vehicles: The ceding insurer establishes a wholly owned special purpose limited liability vehicle (the "company") in a state where it is provided for, such as Delaware, and capitalizes it with an amount sufficient to support its operations. The company, in turn, establishes its wholly owned special purpose financial captive insurance vehicle (the "captive reinsurer") in a state with enabling legislation such as South Carolina for the sole purpose of entering into a reinsurance transaction with the ceding insurer, and capitalizes it with an amount necessary to support the captive reinsurer's operations.

* Reinsurance Agreement: Same as the surplus note structural alternative.

* Secured Notes: The company issues senior, secured notes initially, and from time to time thereafter in additional amounts (or all up-front, depending on the terms of the securitization), and invests most (if not all) of the proceeds in the captive reinsurer, enabling it to satisfy the statutory reserve requirement of the policy block, pursuant to the terms of the reinsurance agreement.

The noteholders have a perfected security interest in the collateral consisting of a debt service coverage account; the company's rights to receive payments under a tax allocation agreement (if any) among the ceding insurer, the captive reinsurer and the company; and a pledge of the company's ownership interests in the captive reinsurer. The source of payments of principal and interest on the notes consists of the collateral and dividend distributions to the company by the captive reinsurer.

* Reinsurance Trust Agreement: The captive insurer establishes a reinsurance trust and transfers to it for the sole benefit of the ceding insurer some or all of the proceeds, as necessary, raised from the issuance of its equity interests in an amount equal to the redundant reserve, plus proceeds required for the economic reserve, management of trust assets is the same as described under the surplus note structure.

* Dividend Distribution: The captive reinsurer makes a periodic dividend distribution to the company based on a formula pre-agreed upon with its regulatory authority. The major sources of funds for the dividend distribution consist of earnings on the captive reinsurer's assets including the reinsurance trust assets and the release of assets in excess of the required balance in the reinsurance trust.

Evaluating the Alternatives

These structural alternatives for Triple-X securitization have advantages and disadvantages, as outlined below:

* Secured notes represent senior obligations of the issuer, whereas the surplus notes are unsecured and represent subordinated obligations of the issuer. As a result, the attributes of the secured notes are closer to those of asset-backed securities, which make them more marketable to traditional asset-backed investors.

* Payments on the surplus notes require the approval of the insurance department of the issuer's state of domicile, subjecting them to regulatory risk of a temporary or permanent interruption in such payments. Payments on the secured notes are subject to dividend distribution from the captive reinsurer. The dividend distribution amount is based on a formula reflecting the earnings and surplus of the captive reinsurer. Therefore, the regulatory risk on dividend distribution is, in theory, less than the regulatory risk on payments on the surplus notes.

Characteristics of the Notes

Generally, the notes have an average life in the range of 15 years and maturity of 30 years and are rated investment grade with a low probability of default. Interests on the notes are indexed to the London Interbank Offered Rate, payable monthly (or quarterly) in arrears. The notes amortize based on release of assets from the reinsurance trust in an amount equal to the decline in the statutory reserve, and are subject to redemption at the issuer's option, like asset- and mortgage-backed securities.

The notes are credit-enhanced to triple-A through a guarantee by a triple-A rated financial guarantee company, which guarantees the timely payment of interest and ultimate payment of principal of the notes. The guarantee eliminates two key risks in the transaction--mortality risk and regulatory interruption risk on the payments on the notes. Thus, the guarantee makes the notes more suitable to traditional asset-backed investors. The credit enhancement structure involves transferring the notes to a special purpose trust, which, in turn, issues pass-through notes guaranteed by the financial guarantee company, as illustrated in "Credit Enhancement for Surplus Notes" on page 74.

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Ways to Execute the Securitization

There are several capital markets execution alternatives for the notes, which can be classified into two groups: the funded alternative and the unfunded (synthetic) alternative. The execution alternatives for the notes would evolve as more transactions are completed. The cost of execution of the notes depends on, among other things, the execution alternative, the credit structure of the notes and market conditions.

The Funded Alternative: Funding for the transaction is generated through the placement of the notes on either a full-term basis or on a short-term basis through a Dutch auction or tender option process. The selection of a placement mode for the notes has its advantages and disadvantages to the issuer.

* Term Notes: The notes can be placed for the full-term of the transaction to pre-fund the maximum level of the redundant reserve required during the life of the transaction, known as the "pre-funding scenario." Or, the notes can be placed to fund the transaction periodically to support the redundant reserve as it grows to the maximum amount during the life of the transaction, known as the "'periodic funding scenario."

The advantage of the pre-funding scenario is that it transfers future funding risk to the capital markets at the inception of the transaction but has the disadvantage of reinvestment risk (negative carry) until the funds are fully deployed in the reinsurance trust. The periodic funding scenario, on the other hand, carries very little reinvestment risk but does carry funding risk of the notes.

* Auction Rate Notes: The notes are placed generally as 28-day notes in the Dutch auction market, subject to a maximum coupon set forth at inception of the transaction, based on the maturity and rating of the notes. In the event of a failure of the auction, the investor continues to hold the notes at the maximum coupon until the next auction date.

* Tender Option Notes: The tender option securities are long-term securities with a short- or medium-term put attached to them. The put is issued by a counterparty, which enables the holder thereof to tender the securities to the counterparty at the put maturity. The securities bear the rating of the counterparty providing the put. The notes can be structured as money market securities with a put maturing within 13 months. Such a put makes the notes 2a-7 securities under the Investment Company Act of 1940, eligible for investment by money market funds. The rating on the money market securities will be the same as the short-term rating of the put counterparty, as illustrated in "Issuance of Money Market Securities for Secure Notes" below.

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The Synthetic Alternative: A synthetic transaction is described here as an unfunded transaction, wherein an investor purchases the notes in exchange for posting a clean letter of credit with the reinsurance trust for the benefit of the ceding insurer. The letter of credit is irrevocable and unconditional for the same face amount and maturity as the notes.

In the event of a shortfall in funds otherwise available to pay for claims under the policy block, the ceding insurer draws under the letter of credit the shortfall amount to pay for the claims. A draw under the letter of credit triggers a payment obligation of the notes for the amount drawn. The investor then reimburses the letter of credit issuer for the amount drawn, and is repaid this amount over the remaining life of the notes, pursuant to the terms of the notes as illustrated in "Transaction Schematic of the Synthetic Alternative" on page 75.

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Investment Perspective

In the absence of triple-A credit enhancement through a financial guarantee company, the notes would be subject to some level of mortality risk of the policy block, and could then be considered as mortality risk notes. The mortality risk level would equal the amount by which mortality under Regulation Triple X exceeds the threshold level for the economic mortality, as determined by the rating agencies.

The notes without the guarantee should be classified as alternative assets, because mortality risk is uncorrelated to risks underlying traditional assets, such as stocks and bonds. Furthermore, the notes are subject to low price volatility risk, because their returns are indexed to the London Interbank Offered Rate.

As a result, the notes should be attractive to market neutral portfolio managers. Furthermore, it is the author's opinion that fixed-income asset managers in life insurance companies should be natural investors for the notes, because they ought to be comfortable with mortality risk above the economic threshold level. As a result, such investors should be able to invest in single-A or double-A rated notes, without the need for a financial guarantee to credit-enhance the notes to triple-A.

Key Points

* The benefit of securitization far outweighs weighs its cost and complexity compared with the cost and simplicity of a nonsecuritization solution.

* Two structures for Triple-X securitization have been deployed to date: the surplus note structure and the secured note structure.

* Triple-X securitization can be executed as a funded or unfounded (synthetic) transaction, and investment in the transactions should be classified as alternative investment.

Contributor Shanker Merchant of Wachovia Securities has more than 20 years of investment banking experience in structured and corporate finance businesses with major financial institutions in New York.