Selling the stream: life insurers are raising new capital by selling projected cash flows as an investment package.

Life insurers have traditionally relied upon the reinsurance market for outside capital. In today's economic environment, however, reinsurers' capacity is being strained. Banks are not looking favorably on long-term credit risks and thus letter of credit costs, which are important aspects of reinsurance agreements, are rising. So where are life insurance companies looking to raise capital for their financing needs?

One increasingly popular avenue for companies is to "securitize" projected cash flows to raise money from the capital markets. In this article's context, securitization essentially means that life insurance cash flows are aggregated into an underlying pool and then sold as an investment package to the capital markets. These marketable securities are then used as a way for a life insurance company to raise capital and potentially optimize earnings.

In order to take advantage of this resource, life insurance companies may have to think outside the box in how they perceive themselves. Life insurers typically view themselves as companies that sell life insurance and/or annuity products. In reality, insurance companies are really investors, investing surplus in up-front costs, such as commissions, underwriting, increase in reserves and required capital, to receive future profits. From an insurer's perspective, investing surplus in the acquisition costs associated with insurance or annuity products is really an investment in a complex financial security. On a similar note, packaging future life insurance company cash flows and selling them to the capital markets (life insurance securitizations) is creating a marketable security for the investor while raising capital for the insurer.

While there is a need for life insurers to find ways to relieve themselves of high acquisition costs, reserve strain and/or capital strain, there is also a need from a lender's perspective. The low interest rate environment is leaving investors in search of an investment with a slightly higher yield. Fund managers are endlessly searching for those elusive additional basis points. Life insurance securitizations are starting to fulfill a very real need in the market for alternative investments.

Life insurance cash flows have many qualities that make them ripe for packaging into marketable securities. Insurance cash flows are generally predictable. For the most part, they are also long term, allowing for reclassification into separate tranches. Furthermore, value can be extracted from the conservative nature of statutory accounting. Different legal requirements in different jurisdictions also can create opportunities.

Case Histories to Date

There are many possible situations where securitizations can be the answer to a life insurer's financing needs. As life insurance companies realize ways to optimize earnings through use of the capital markets and as investors become more comfortable with the nature of the underlying risks, the breadth of securitization transactions will grow. Outlined here are examples of several successful life insurance cash flow securitizations to date.

Two companies have securitized the embedded value associated with "closed blocks" formed when the companies demutualized. Closed blocks are established to protect the dividends on participating individual life policies. In 2001, Prudential securitized the embedded value of its closed block and raised $1.9 billion in capital (described in further detail below). Similarly, in 2002, MONY raised $300 million in capital securitizing its closed block.

In 1999, the National Association of Insurance Commissioners promulgated a change to the Valuation of Life Insurance Policies Model Regulation (commonly referred to as "XXX"), which significantly increased the statutory reserves required for newly issued level term policies and universal life policies with secondary guarantees. Companies are looking to fund statutory XXX reserve strain. One company has structured a transaction to fund statutory XXX reserve strain with surplus notes financed by capital markets. The structure of the transaction incorporated the use of a wholly owned special purpose vehicle that assumed a significant portion of the business through reinsurance and is expected to pay dividends back to the parent company. The release of the redundant XXX reserves is used to repay the surplus notes.

Since a monoline insurer--a credit insurer--is guaranteeing timely payment of interest and principal, this transaction received the highest ratings from the two rating agencies that reviewed the deal. Since XXX reserve strain is a concern for most insurance companies selling term and UL insurance, more transactions of this type are expected.

Companies may look to pass mortality risk to capital market investors. Swiss Re recently entered into an agreement to raise $400 million in principal from investors to hedge against catastrophic mortality exposure. If population mortality deteriorates to certain trigger levels (which was determined to be highly unlikely, Swiss Re will not have to pay back some or all of the principal.

Companies may attempt to realize embedded value of margins built into insurance and annuity contracts. Starting in 1996, American Skandia securitized several tranches of mortality and expense charges and surrender charges on its variable annuity business. The proceeds were used to fund the high levels of initial cash strain.

Banks and other investor groups are financing life settlements and projecting significant returns.

Even broker commission streams have been securitized. Long, Miller, and Associates (LongMiller), which was one of the largest distributors of business-owned life insurance, was acquired by Clark/Bardes Consulting. $305 million of the $403 million purchase price for LongMiller was financed through nonrecourse, securitized debt backed by a majority of the renewal revenues of LongMiller. The securitization was split into three tranches. Moreover, the securitization transaction allowed the insurers who owed LongMiller residual commissions to invest in a security backed by their commission cash flows.

The View From the "Buy Side"

Aside from the perspective of selling off its cash flows, insurance companies are perfectly situated to enter these agreements from the buy side. While traditional reinsurance and acquisitions provide a means of obtaining blocks of business, securitizations can provide access to insurance cash flows with less regulatory and marketing constraints.

>From an investment perspective, the long-term nature of packaged insurance cash flows might be used to enhance asset/liability management techniques. Moreover, insurance companies can further diversify risk by buying into various tranches. For example, a company willing to buy the tail end of a block of cash flows might be able to achieve a superior return relative to other long-term bonds while diversifying risk.

The Prudential closed-block securitization is an excellent example of a transaction in which insurance companies invested in assets backed by insurance company cash flows. All closed-block cash flows not dedicated to the policyholders were packaged and sold to debtholders ($1.75 billion) or Class B stockholders ($175 million). Debtholder cash flows were divided into three tranches (Series A, Series B and Series C). Tranche differences included floating rate interest vs. fixed rate interest and guarantee of principal and interest by a monoline company vs. no guarantee. Life insurers accounted for 6%, 18% and 27% of the principal invested in Series A, B, and C tranches, respectively. Furthermore, Class B stock, which entitles the holder to residual cash flows from the business, was privately placed with American International Group and Pacific Life. The stable nature of the closed-block business, the level of target dividends, and the upside potential after repayment of debt to the debtholders are three possible reasons AIG and Pacific Life purchased the Class B stock.

Key Considerations

There are several things to keep in mind when considering securitization as an answer to a company's particular situation.

Initial cost--The type of securitization will determine the initial startup costs. If the investor is a bank or insurance company looking to purchase packaged cash flows and it does its own risk analysis, the transaction costs should be manageable. If the cash flows are being sold to the capital markets directly, then the deal must be large enough so that it is still economically feasible after reflecting the fees of bankers, lawyers and other consultants. A natural progression might follow the mortgage-backed securities market where blocks of similar business are pooled together so smaller companies can take advantage of this process.

Investors' required level of security--Since these are complex financial instruments, an independent actuarial report is often needed to analyze the risks of the packaged cash flows. An independent actuarial report was included in the investor offering circulars for most of the securitizations listed above.

The role of a monoline insurer--It may be worth an additional premium for a monoline insurer to guarantee timely interest and principal. The additional level of security will allow investors to accept a lower yield on their investment. Obviously, there is a cost associated with that additional level of security. Financial Security Assurance Inc. guaranteed timely interest and principal repayment on the Series A and B notes from the Prudential closed-block securitization. Furthermore, MBIA wrapped the securitization of XXX reserve strain described above.

Existing reinsurance agreements--Does the transaction get wrapped around existing reinsurance policies or not? In other words, who takes on the credit risk of the third-party reinsurers?

Complexity--Deal structures can get quite complex. All parties need to understand the risks involved. Thus, setting up a deal satisfactory to all parties will take a significant amount of time and effort. Some of the deal-specific negotiated items are investment guidelines, tax sharing agreements, special accounting provisions, capital requirements, dividend structures and assumption development.

Avoid the trap of not thinking "outside the box"--When thinking of returns on investments in life insurance, companies tend to compare their products to returns on other life insurance products. Similar to the fact that life insurers are no longer the only competition to other life insurers (mutual funds, banks, etc.), insurance products can't be solely priced against other insurance products. When analyzing the risk/return objectives of the securitization deal structure, companies should compare results with all potential investments.

In the past, investments in life insurance cash flows seemed to be in a black box and companies without expertise were wise to keep their distance. Today, however, transparency is being forced upon the industry from all sides, including educated investors, new accounting rules, upper-level management and regulatory oversight. Higher levels of transparency have produced greater clarity for insurance companies, and hence the potential for greater opportunities. This evolution in the use of life insurance cash flows as capital market instruments is broadening the frontier of investments as well as creating an alternative financing option for insurers.

Stuart Silverman is a consulting actuary in the New York office of Milliman USA.