August 1, 2013
Insurers are contemplating a return to the securitization market to fund what they consider to be excessive reserve requirements for certain life policies.
Doing so would free up capital to put to what they consider to be more productive use. But the modest, albeit safe, returns offered by such transactions, which are structured similarly to higher-yielding catastrophe bonds, could pose a challenge to attracting investors.
The last asset-backed deal to transfer life insurance-related risk was done in the fall of 2010 by Goldman Sachs. The complex, $200 million transaction, through Goldman’s Signum Finance Cayman Ltd special purpose vehicle (SPV), was designed to provide mortality protection on a block of U.S. term life policies.
The deal was done when Wall Street was still struggling to recover from the financial crisis. It was something of a lone wolf in the wake of what had been a robust market in life insurance company-related deals, estimated at $20 billion in annual issuance leading up to its 2009 collapse. Most of those deals were designed to enable life companies to free up capital, especially excess reserves required by Regulation XXX, by transferring policies to a reinsurance SPV that in turn issued bonds to investors.
At that time, Goldman was testing what had become an all but inactive market, and whether the investment bank ever sold the bonds to investors or ended up retaining them on its own balance sheet remains unclear--Goldman did not respond to inquiries by press time. However, no deal securitizing those assets has been completed since then, according to market sources.
Nevertheless, companies writing term life polices and universal life policies have still faced significant capital strain imposed by the excess reserve requirements—universal under Regulation XXX. As a result, transactions continued but under a more private guise, and the risk transfer mostly took the form of bilateral agreements within the insurance holding company, or between insurance companies’ captive reinsurers and bank or other reinsurer counterparties.
More recently, capital markets participants have taken an interest in the asset class’s long-maturity risk which, like catastrophe bonds issued by property/casualty insurers, is mostly uncorrelated with their exposures to corporate securities. That lack of correlation is highly prized, with memories of the volatility during the financial crisis still fresh.
However, the moderate spreads from such transactions, and the steep learning curve required to master their dynamics, pose significant challenges to drawing more capital-markets investors to the asset class. U.S. insurance regulators are also moving toward more principles-based regulation, which could eliminate the need for excess reserves altogether, and a New York regulator just issued a report that was highly critical of insurance companies’ captive reinsurance strategies.
Nevertheless, investors favoring safety and stability over outsized returns, or those able to employ leverage in one form or another, appear to be taking a closer look. And changing market dynamics could soon make the bonds attractive to a wider array of investors.
“Broadly speaking, we think it’s perfectly likely there will be at least a partial return to securitization and trading of this risk in bond form,” said Robert Meehan, senior vice president of financial solutions at Hannover Life Reassurance Co., which is a major buyer of this risk. “We’d be equally happy investing in those bonds or helping structure them, as we do today through reinsurance and derivative forms.”
For now, though, capital markets investors interested in excess-reserve exposure must engage in derivative transactions. After the financial crisis life companies looked to internal solutions that typically involved parent companies guarantying their captive offspring. Then banks entered the market, providing letters of credit to finance the reinsurance SPVs. Within the last few years, credit-linked notes, swaps and other derivative vehicles have been used to transfer risk to mostly other reinsurance companies but also some capital markets investors.
Given excess reserve transactions’ moderate spreads for an alternative investment and long maturities, a major appeal for those investors is the asset class’s lack of correlation with other financial markets, primarily corporate securities. Mortality risk has little to do with the stock market. In that sense, excess reserve bonds resemble their cat bond cousins, although cat bonds are typically noninvestment grade and provide much wider spreads.