The allure of securitization: securitizations are a hot new trend as life insurers seek access to cheaper and more reliable sources of capital.

Life insurance securitizations have been on the rise both in the United States and globally, fueled by the availability of ever-increasing amounts of capital chasing deals and returns, the increased regulatory capital requirements for life insurers, and diminished and more costly reinsurance capacity.

In the past, the broader capital markets have been wary of raking on insurance risks. Although some catastrophe bonds were issued on the property/casualty side, securitization transactions in the life insurance market were not common. But in 2005 as many as six life insurance securitization deals were completed, compared with roughly one per year from 1996 through 2002, and the amount of capital raised also reached a new high at $2.4 billion.

An insurance securitization is the process through which an insurer or reinsurer accesses the capital markets by issuing asset-hacked securities supported by the assets and cash flows from a defined block of insurance contracts. Securitizations allow insurers to raise funds from the capital markets at rates that are potentially below the companies' own costs of capital or those charged by external providers of capital.

Securitizations can take a number of forms, such as enabling insurers to redeploy capital that may have been locked up in underperforming lines of business, and to fund acquisitions by releasing capital from their own portfolio or that of the target company. In the area of risk management, a securitization offers advantages over traditional reinsurance, including potentially unlimited capacity, reduced counterparty credit exposure and solutions to multiyear coverage issues.

In the United States, regulatory capital relief deals have been the primary form of securitization used recently, driven by changes to regulatory capital requirements, specifically Regulations XXX (Triple X) and AXXX, which significantly increased the U.S. statutory reserve requirements. Other forms of securitization include closed-block or embedded-value deals, catastrophe risk bonds, future revenue deals and life settlements.

Given the length of time these deals take to come to market and how many constituents are involved, only insurers/reinsurers that have sufficient scale (issuing around $250 million in total) can make securitization a viable solution. Even those that have the scale face risks from management distraction and unpredictable time frames. "Conduit" structures are being developed to allow for the warehousing of business from multiple smaller insurers. If successful, this would open the securitization market for companies lacking sufficient scale to go it alone or for companies that are finding diminished reinsurance capacity.

Many of the deals completed so far have been "wrapped" by third-party financial guarantors to assist in the sale of the notes. These companies typically guarantee, or "wrap," the deals by guaranteeing the investors payment of interest and principal on certain of the tranches. Wrapped notes receive a higher credit rating, allowing companies to raise higher proceeds at lower coupon rates.

As the capital markets become more comfortable with the underlying risks, the need for financial guarantors may decrease. In a number of recent deals, only a small portion of the debt has been wrapped, showing that investors are more willing to assume the risks implied by the higher-yielding tranches.

Despite the attractiveness of these transactions, issuers, investors and financial guarantors are exposed to a number of risks. Investors are exposed to counterparty credit risk of the financial guarantor, while the failure of a financial guarantor or nonpayment of coupons or principal for unwrapped tranches will lead to reputational risks for the issuer and financial guarantor.

Another area of risk to the financial viability of these deals is any reliance on profitability during the post-level-term period, when the policyholder has chosen to renew coverage on yearly renewable terms, or even the assumption of no losses in the post-level-term period. There is little credible data to support post-level-term lapse and mortality assumptions, making it difficult to estimate post-level-term profits or losses. The other looming development that could affect the future of this market is the move toward principles-based reserving, which could reduce the need for regulatory-type securitizations.

At this writing, it appears that 2006 will be an even bigger year for life securitizations than 2005. More issues will feature unwrapped tranches, providing investors with higher yields. There also will be a push to structure solutions that allow smaller players to utilize the capital markets.

Life insurance securitization has brought the capital markets and the life industry one step closer together, allowing each to play to its respective strengths. As this relationship grows, more innovative and comprehensive deals will be structured, and securitization will become a standard approach to the management of life insurers' capital.

Robert W. Stein, a Best's Review columnist, is chairman of Global Financial Services for Ernst & Young. He may be reached at [e-mail]. Richard de Haan and Steven Lash of E&Y contributed to this column.