Making the move: regulatory changes have forced life insurers to explore new ways to fund reserves.

The U.S. life insurance securitization market has grown in recent years, driven by a combination of higher reserving requirements and growing expense and capacity issues associated with more traditional reinsurance alternatives. Securitization gives life insurers access to capital markets trading for certain statutory reserves, thus freeing capital for other uses. This flexibility to adapt to various product reserving and regulatory requirements continues to garner interest among life insurers and market participants alike.

Regulation XXX 'Excess' Reserves

The National Association of Insurance Commissioners' Valuation of Life Insurance Policies Regulation of 2000--or Regulation XXX--sets statutory reserve requirements for level term insurance business. Similarly, Actuarial Guideline 38 sets forth reserving requirements for universal life insurance policies with secondary guarantees. The required term insurance reserves, called XXX reserves, and universal life insurance reserves, called AXXX reserves, are widely believed to exceed the economic reserves actually needed to fund future policy obligations.

Historically, these "excess" reserves were reinsured on a coinsurance basis in traditiorlal life reinsurance markets, usually via cessions to offshore reinsurers collateralized by letters of credit. This effectively released the capital held as excess reserves--the ceding insurer took a reinsurance reserve credit in its statutory financial statements.

However, U.S. bank consolidation led to fewer letter-of-credit issuers. Consequently, letters of credit became increasingly costly, and concerns grew regarding capacity and credit exposure. Moreover, rating agencies recently instituted policies that penalize insurers that engage in reinsurance transactions using short-term letters of credit. As a result, life insurers began to explore other solutions, including XXX and AXXX securitizations and captive reinsurance involving long-term letters of credit.

XXX Securitizations

One increasingly common alternative is to securitize XXX reserves by issuing nonrecourse debt securities in the capital markets. Though transaction structures may vary from deal to deal, XXX securitizations generally involve the formation of a new captive reinsurance company by a life insurer. These captives are usually domiciled in a "captive-friendly" jurisdiction such as Vermont or, more frequently, South Carolina. The life insurer then reinsures the excess XXX reserves to the newly-formed captive reinsurer, often via a 100% coinsurance agreement.

For example, a captive reinsurer can issue surplus notes to a special-purpose vehicle, which in turn issues notes to investors via a private offering. The captive's domiciliary regulator must give approval prior to each payment of principal or interest on the surplus notes. However, approval is not required in connection with payments on the notes sold to investors (see "Structure One:' right).

Another commonly used structure interposes an intermediate holding company (usually organized as a limited liability company) between the life insurer and the captive reinsurer. The captive pays dividends to the intermediate holding company, which in all cases are subject to the prior approval of the captive's state regulator. This is true even when payments might not otherwise qualify as"extraordinary dividends" within the meaning of the state's insurance holding company laws. These dividends fund the payment of principal and interest on investors' notes issued by the intermediate holding company (see"Structure Two" on page 70).

In these two structures, a single beneficiary reinsurance trust, often called a "Regulation 114" trust, is established so that the ceding insurer can take statutory reserve credit. Any notes or sup plus notes issued in connection with the transaction are nonrecourse to the ceding life insurer. They are treated as "operational" rather than "financial" leverage by rating agencies.

Cash from investment earnings, and the release of excess reserves over time, fund payments by the captive reinsurer, either on the captive's surplus notes or as dividends to the holding company. These payments, in turn, fund payments of principal and interest to investors.

To enhance credit quality, an AAA-rated financial guaranty insurer typically issues a guaranty policy that "wraps" the notes issued to investors.

This wraparound ensures that investors will receive principal and interest payments regardless of whether the captive's regulator approves payments on the surplus notes or dividends to the intermediate holding company. The notes can then be issued with an "AAA" credit rating, rather than a lesser grade. (These "wrap" guarantees are important-none of us are aware of either a XXX or a AXXX securitization ever going completely without a financial guaranty.)

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AXXX Securitizations

In 2006, life insurers began to use this structure to securitize AXXX reserves related to certain universal life products with secondary guarantees. The reserving requirements for these secondary guarantees are similar to those for term life insurance under Regulation XXX. They result in "excess" reserves that can be supported by third-party borrowing via a securitization transaction.

AXXX transactions, while generally structured like XXX deals, sometimes employ more complex reinsurance arrangements. One example is a coinsurance/modified coinsurance reinsurance structure. Here, risks relating to secondary guarantees are reinsured on a coinsurance basis, and the underlying universal life risks are reinsured on a modified coinsurance basis. In this way, the reserves for the secondary guarantees are held by the captive reinsurer, while the underlying universal life insurance reserves are held by the ceding insurer, where to some extent they remain unaffected by the transaction.

Other reinsurance structures could be used as well, including structures combining coinsurance with YRT reinsurance on the underlying mortality risk. Under these structures, the captive reinsurer directly or indirectly borrows funds to support the excess AXXX reserves and deposits these funds in a reinsurance trust in order to support its coinsurance obligations.

AXXX securitizations present issues not raised in XXX transactions. For instance, AXXX reserves involve significant investment risk, beyond the mortality and lapse risk associated with XXX reserves. Financial guarantors and investors may not want this risk, so the captive reinsurer may need additional support. And, while XXX reserves are limited to the typical level-term period of 10 to 30 years, AXXX reserves generally have a longer tail, which can make AXXX transactions all the more challenging.

Given the current state of flux in the reinsurance regulatory arena,

the direction of the U.S. life securitization market in the coming years is unclear. State insurance regulators continue to develop a principles-based approach to reserve requirements for life insurers. In fact, the NAIC adopted an interim reserve proposal in 2006, specifically designed to reduce the conservative statutory reserve requirements applicable to term and universal life insurance products with secondary guarantees. The impact of a full principles-based reserving system, if finally adopted, remains to be seen.

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Additionally, proposed revisions to the U.S. reinsurance credit rules may impact the life securitization market. In a XXX or AXXX transaction, the captive reinsurer typically is licensed only in its domiciliary state. Collateral is necessary for the ceding insurer to secure reinsurance reserve credit in its statutory statements, and new collateralization rules could well alter the economics of securitization transactions.

Nonetheless, the flexibility of the securitization structure may allow it to adapt to evolving regulatory and market constraints. Time will tell how securitizations will evolve in the coming years.

Key Points

* Securitization gives life insurers access to capital markets funding for certain statutory reserves.

* Securitizing XXX reserves releases capital held in excess reserves.

* Life insurers began to securitize AXXX reserves, related to certain universal life products, in 2006.

RELATED ARTICLE: The Ins and Outs of Securitization.

SINCE SECURITIZATIONS frequently take place over a long time--30 years or longer--they can function as a long-term funding solution. They are also complex transactions, involving a number of parties and regulators.

REGULATORY APPROVALS typically are required from multiple jurisdictions, including the ceding insurer's state of domicile. Multiple rating agencies generally are involved, along with a financial guaranty insurer.

LEGAL ISSUES almost always involve not only insurance and reinsurance law, but also securities, corporate, structured finance, bankruptcy and tax law.

Type of Securitizations

The recent wave of XXX and AXXX securitization transactions is by no means the first in the insurance industry. Others include:

Closed block securitizations that securitize future cash flows associated with closed blocks of life insurance business, often following the demutualization of a life insurer.

Other embedded value financings, securitizing the embedded value of a block of life insurance business.

Catastrophe bonds, or cat bonds, that transfer certain low-frequency, high-severity property and casualty risks to capital market investors.

Mortality bonds, which transfer catastrophic life insurance mortality risks to capital market investors.

Securitization of variable annuity fees to finance initial new business cash strain.

Contributors: Nicholas E Potter is a partner;John Dembeck is counsel; and Elizabeth K. Brill is an associate in the New York office of Debevoise & Plimpton LLP. They can be reached at: [e-mail]" [e-mail]; and [e-mail].