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Securitization comes to life
Life insurers increasingly are looking to asset-backed securities to hedge their risks and realize future profit streams.
The use of asset-backed securities as an alternative to reinsurance has become well established since 1992, when property/casualty companies, looking for new hedges in the wake of Hurricane Andrew's devastating run through the Caribbean Islands and southeastern U.S., began issuing catastrophe-linked bonds to protect themselves against losses on other natural disasters.
Now life insurers and reinsurers are waking up to the possibilities of hedging risk through securitizations. In the past two years, three life insurers and one reinsurer have tapped the capital markets with asset-backed bond deals that either protected the issuer against losses from a surge in death rates or securitized a future stream of life insurance profits. Bankers and insurance industry executives expect the flow of deals to increase.
Swiss Reinsurance Co., Europe's largest life reinsurer, is at the forefront of the new market, both in terms of volume and of innovation. In November 2003 the Zurich-based company issued the first, and to date only, issue of mortality-linked bonds, effectively transferring the risk of a sharp rise in death rates from its balance sheet to bond investors. Market watchers expect Swiss Re to return with a similar issue in the coming months to securitize more of its mortality risk, helping to develop a bond market that investment bankers estimate could grow in size to $2 billion a year.
Swiss Re Life & Health, the company's London life subsidiary, issued $400 million of mortality-linked bonds in a deal lead-managed by affiliate Swiss Re Capital Markets. The structure of the offering closely mirrored most recent catastrophe bond issues in that it created a prefunded reinsurance vehicle, Vita Capital, with a payout profile determined by an independent index of industrywide losses.
John Fitzpatrick, chief executive of Swiss Re Life, says the attraction of the deal for Swiss Re was the rock-solid, triple-A-rated reinsurance that the bond issue effectively provides. The company doesn't reinsure its life exposure because it doesn't like the additional credit risk that reinsurance entails. Any circumstances that might cause it to make a claim, such as a global epidemic, a war or a large-scale terrorist attack, would likely cause losses at other reinsurers, raising the risk that they couldn't cover their exposure to Swiss Re.
The securitization complements rather than threatens Swiss Re Life's core business of reinsuring the exposure of primary life insurers, Fitzpatrick says. The company's large size -- it had Sf13 billion ($11.5 billion) in life revenues last year -- and the geographically diverse nature of its exposure mean that it is better suited to issue mortality bonds than a life insurer with more-concentrated exposure to national or regional markets would be.
"That's what bond investors demand," Fitzpatrick tells Institutional Investor. "We are able to give investors a more diversified mix of risks and therefore a lower risk profile."
The four-year bonds pay interest of 135 basis points over LIBOR. Repayment is linked to an index of mortality rates in Canada, France, Italy, the U.K. and the U.S. If actual mortality in any given year exceeds the index by 30 percent, Vita Capital will divert part of the proceeds of the bond issue to Swiss Re and investors will lose part of their principal. If mortality exceeds the index by 50 percent, investors lose all of their principal.
The chance of either trigger being hit appears remote. According to Swiss Re's data, the last time mortality rates spiked 30 percent above prevailing death rates was during the worldwide influenza epidemic of 1918.
Although Fitzpatrick expects other large reinsurers to follow Swiss Re's lead and issue mortality-linked bonds, some industry executives have their doubts.
Chris Stroup, chief executive of Wilton Re Holdings, a Bermuda-based life reinsurer that was launched last year, contends that such deals won't take off because they don't adequately transfer risk from the reinsurer to the capital markets. The use of mortality indexes rather than an insurer's actual mortality rates creates so much basis risk that it renders the deal worth far less in terms of prudent risk management, Stroup argues.
Fitzpatrick and other market participants are reluctant to predict how big the mortality risk securitization market could become, but they say mortality risk reinsurance is a growing market. To protect against a sharp rise in mortality rates, roughly 60 percent of all life insurance is reinsured, up from 30 to 40 percent a decade ago, estimates David Bruggeman, a life reinsurance underwriter at Munich America Reassurance Co. in Atlanta. Some $1.1 trillion of life insurance policies were reinsured last year, he says.
Swiss Re also has followed three U.K. insurers -- Barclays Life Assurance, Friends Provident and Norwich Union Life -- in issuing asset-backed bonds to guarantee future profit streams from its life business. These deals replace conventional life reinsurance coverage, which protects life companies from shortfalls in projected profits on their policies. Murray Wood, a director at Barclays Capital, which structured two of the recent issues, estimates that there is well in excess of £10 billion ($19.2 billion) of future profit streams that could be securitized at U.K. life insurers alone.
Issuing asset-backed securities can be a low-cost alternative to reinsurance, contends Geoffrey Maddock a partner at London law firm Herbert Smith. Maddock advised Friends Provident on its recent £380 million issue of bonds backed by life policies with a total value in force, or projected future profits, of £700 million. The offering, made in December, was designed to help the company finance the continued strong growth of its life underwriting business.
Insurers incur heavy up-front costs in writing new policies -- commission payments to independent brokers and financial advisers, administrative expenses and the establishment of mortality reserves to back up the policies. As a result, it generally takes about four to five years for an insurer to begin to make a profit on the premium stream from policyholders, estimates Earl Lancaster, a life insurance analyst at Standard & Poor's in London. Insurers also run the risk that policyholders could redeem their policies early or stop making premium payments, eliminating or sharply reducing insurers' profits.
"Even good business brings with it new strains when the cash received and the initial margin being taken as profit are considerably lower than the cash being paid on commissions and administration," says Lancaster, adding that the cost of commissions to financial advisers -- the single biggest expense for insurers -- continues to grow. "It's terribly competitive. It's a broker-driven market right now."
FRIENDS PROVIDENT HAS SEEN ITS NEW LIFE business grow by about 10 percent a year since the former mutual company floated itself on the London Stock Exchange in 2001. That growth, however, has strained Friends Provident's balance sheet, explains Vitor Ferreira, director of corporate development. "Securitization has to a large degree reversed the negative aspects that arise from underwriting new business," he asserts.
Norwich Union Life, an arm of Aviva, the U.K.'s biggest insurer, spends some £500 million a year to fund its new business, says Howard Kew, Norwich's director of capital management. "It's a very significant amount of money," he notes. "And it's growing." Last October the company raised £200 million through the issue of commercial paper backed by life policies sold through independent financial advisers. Barclays Life, a unit of Barclays Plc, also has issued asset-backed bonds to realize future life profits.
The estimate by Barclays Capital's Wood that U.K. insurers have more than £10 billion of expected profits that could be securitized may be conservative: Aviva alone had £4.6 billion of value in force on its balance sheet at the end of last year.
Continental Europe's big life insurers could generate an additional £30 billion or more of deal flow if they were to take the securitization route, estimates Wood. Although many large European life companies, such as Allianz and AXA, are in good financial health and may not need to free up capital, tighter insurance regulations in Britain and Europe are likely to spur more life insurers to consider securitization, industry executives and analysts say.
In January the U.K.'s Financial Services Authority introduced new rules governing how insurers can account for different forms of capital. The Integrated Prudential Sourcebook, as the rules are known, differentiates between tier-1 capital and several lower categories of capital, giving insurers greater flexibility. "Under the U.K.'s old regulatory regime, an insurer either had excess assets or it didn't," says Herbert Smith's Maddock. The new rules, mirroring the tiered approach to capital used by banking regulators, are more sophisticated. Debt raised through the issuance of asset-backed securities counts as tier-1 capital, which improves the creditworthiness of the insurer and allows it to use tier-1 equity capital to generate new business.
Adrian Eastwood, deputy chairman of the Life Board of the U.K. Actuarial Profession and an actuary at Lloyds TSB's Scottish Widows unit, says uncertainty about the FSA's regulatory treatment of securitizations previously discouraged deals. The new rules, he says, "have lifted the cloud of uncertainty. Now everyone knows where they stand."
Other European Union countries must implement similar capital rules by 2009 to meet the EU's new regulations for life insurers. "The U.K. stands at the vanguard of regulatory change," says Barclays Capital's Wood.
The EU directive also will phase out a practice, common in many European countries, known as the "implicit item waiver," which allows an insurer to recognize as much as 50 percent of its expected future profits as part of its asset base. Friends Provident, for example, includes £600 million of future profits among its assets. It will need to raise other capital as it scales back the implicit item waiver in coming years.
The cost of securitization is very attractive compared with alternative means of raising capital, bankers and industry executives say. Friends Provident paid an all-in cost of 5.5 percent on its recent bond issue, including swap and advisory fees to underwriter Barclays Capital and to Ambac Assurance Corp., which backed the deal with its triple-A credit rating. The company also benefited from the fact that coupon payments on the bond issue are tax-deductible.
By contrast, securities analysts estimate that it would cost Friends Provident more than 10 percent to issue new equity. A subordinated debt issue costs the company about 7 percent, says corporate development director Ferreira.
To date, reinsurance has been the most common means of guaranteeing future profits. Herbert Smith's Maddock says the cost of reinsurance can be as much as one percentage point higher than the cost of issuing asset-backed bonds; Norwich Union's Kew contends that the costs are broadly comparable. He says his company will continue to use both methods to guarantee its future profits. "It's important to remain flexible and keep open as many routes to market as possible," Kew says.
The shrinking cost and growing maturity of recent asset-backed deals testify to the market's rapid development. When Barclays Life issued £400 million of floating-rate notes backed by life policies in November 2003, the issue had an average life of 2.1 years and was priced at 40 basis points over LIBOR. Friends Provident's December 2004 two-tranche issue had average lives of 2.9 and 5.8 years, respectively, and the tranches were priced at tighter spreads -- 20 and 23 basis points, respectively, over LIBOR.
The market also is rapidly developing its capacity to absorb risk. Barclays Life and Friends Provident backed their bond issues with credit guarantees, or wraps, but Swiss Re Capital Markets took a more aggressive stance earlier this year by issuing $245 million of life insurancebacked bonds without a credit wrap. The decision was strategic rather than cost-motivated, says Dan Ozizmir, head of insurance securitization at Swiss Re's securities division in New York. "Credit-wrapped deals don't create a new investor base," he explains. "They look like any other monoline deal. There's nothing wrong with that. But educating investors is important to us, as we want to create a new market."
Swiss Re also was able to raise more capital relative to the amount of future profits it was securitizing. Whereas the bond issues from Barclays Life and Friends Provident realized 50 to 60 percent of future profit streams, Swiss Re was able to realize 87 percent of its value in force, according to Ozizmir. "What we wanted was true risk transfer," he explains.
The asset-backed market, with its growing appetite for risk, is only too happy to oblige.