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The Actuary The magazine of the Institute & Faculty of Actuaries

Life: An option for capital efficiency

UK life insurers are increasingly considering value of in-force (VIF) business securitisation as part of their capital, financing and risk management toolkit. As the market for these transactions develops, simpler structures, together with a more sophisticated investor base, are improving the efficiency of the execution process while at the same time incorporating features, such as the ability to add new business, which maximise the benefits for issuers.

Transactions to date have been executed primarily to create Core Tier 1 (equity-like) capital at a cost below that of equity. If correctly structured, VIF securitisations can also provide unencumbered cash that does not contribute to the financial leverage ratios used by rating agencies. The cash and capital raised can be used for a wide range of business uses, for example, reinvestment in higher margin business, used to finance new business, or returned to shareholders. The basics of the transactions are very simple — investors provide cash to the insurer, which is repaid out of future surpluses as they emerge on specified blocks of business, or the entire business. If surplus does not emerge, investors do not receive interest payments, and principal is not repaid. The size of the loan is determined by stressing the future cash flows — for example, an increase in lapse rates and mortality rates — to the targeted risk level. The greater the stress, the greater the security to investors and the lower the price, but the smaller the amount of financing raised and risk transferred from the insurer.

VIF securitisations are particularly useful in managing capital for insurers, where the regulatory capital requirements exceed the management’s view of the economic capital requirements. There are compelling economic arguments as to why an insurer should fund any excess of the regulatory capital above the economic requirements with non-equity capital, namely to maximise the return on equity and minimise the cost of capital. This type of capital management has been widely used by banks to optimise their capital positions. Transactions can be tranched comprising varying degrees of risk. On an economic capital basis, this can provide significant benefits, but the costs increase.

Market developments
Early transactions, such as Gracechurch Life Finance, used relatively complex structures (see Figure 1). This structural complexity, together with the associated costs of onerous due diligence required by the regulator, monolines, rating agencies and investors, are key reasons why the market for VIF securitisation has not grown at the rate predicted following the inaugural NPI Mutual VIF securitisation in 1998. However, as key parties have become more comfortable with the regulatory and legal frameworks and the risk proposition, the costs of a transaction to an insurer both in terms of expenditure and resources have fallen.

The emergence of simpler structures, like the recent AEGON transaction (see Figure 2), has been key to this development. These simple structures have additional benefits, such as allowing issuers to receive the cash without restriction. The early transactions gave capital benefits to the issuer but placed restrictions on the use of proceeds by effectively trapping the cash in the structure. A simple structure also increases speed of execution and reduces third-party costs.

Recent transactions have given issuers the option to add new business to the transaction on an ongoing basis as surplus emerges on the initial pool of policies. This allows the insurer to maintain the quantum of financing outstanding at the initial level for several years, thereby providing cash and capital benefits for longer and effectively reducing the all-in financing costs. For investors, this additional feature also has benefits. The bespoke nature of the risks in each transaction means that investors dedicate significant resources to analyse the risk and the longer duration also allows them to reduce this cost. Another important development recently has been to show that portfolios within an open book can be securitised, rather than a whole fund, without the need to transfer the business, through reinsurance, out of the fund. Although this is usual in traditional reinsurance agreements, capital market investors have been hesitant to rely on an issuer’s administrative systems unless the robustness of these systems can be demonstrated.

The market is still developing, and the holy grail of a transaction blueprint that can be followed by all issuers is some way away. While it is certainly feasible, and expected, that the legal structures will standardise, it remains unlikely that a pre-defined set of stresses will be used to determine the financing amount relative to the VIF for a certain policy type. Investors, like insurers, also analyse the risks in different ways, focusing on different elements of the risk, which also makes harmonisation of the transactions more difficult. This should come as no surprise given the variety in product design, the level of subjectivity in the analysis of experience, and the differing experience between insurers.

The investor base
The insurance-linked securities (ILS) market has grown rapidly over the past few years. On the life side, VIF securitisations have generally been targeted at the investment grade debt market, although some transactions have included a sub-investment grade tranche. The reason for this is that most of the earlier transactions included a monoline to guarantee the timely payment of interest and ultimate repayment principal. This enhanced ratings to AAA and allowed the transactions to be widely distributed beyond those investors with specific insurance expertise.

In the absence of a monoline that would centralise the due diligence, today’s VIF investors need to be much more sophisticated with in-depth knowledge of the life insurance sector. In particular, investors need to get comfortable with the risks of such transactions and are making their investment decision based on their own analysis. The investor analysis is focused not only on the robustness of the underlying cash flows, but also the overall structure of the transaction. As a result, there is also growing demand for sub-investment grade or unrated VIF securitisations from investors who seek the higher returns, but with a clear understanding of the risks which this entails.

Selecting policies and sizing a transaction
Any policy type can be securitised, although for some types the process is much more straightforward. With-profits business, in particular, is challenging because of the asymmetry in the shareholder profits, to date no transactions have included any with-profits business. Non-profits business is comparatively straightforward, with unit-linked policies ideally suited, primarily due to the relatively simple products and the relatively stable, or at least predictable, cash flow profile. Annuities are more difficult because of the significant judgment required in setting the reserves which can materially reduce surpluses, but it is possible to include them in a transaction and there are several examples of this.

Determining appropriate stresses for the risk level is the most important element in sizing a transaction. For risks, such as market risk, where there are liquid markets, it is usually straightforward to determine the appropriate stress for the risk level. The non-hedgeable risks are more subjective. For risks where there is plenty of historic data such as lapse risk, it is possible to determine appropriate stresses. However, for risks such as mortality improvements, which are highly subjective, agreeing a stress level acceptable to both issuers and investors can be very challenging.

Solvency II and VIF securitisation
The eventual implementation of Solvency II could provide both a significant boost to the number of insurers actively using VIF securitisation as a capital tool, and potentially increase the size of the investor base. Solvency II is expected to give regulatory capital credit for VIF securitisations by European insurers, and this is likely to involve greater sub-investment grade issuance than has been seen previously. Through using VIF securitisation, insurers could also significantly reduce their cost of capital post-Solvency II by exploiting the apparent discontent between the proposed stresses used to calculate the solvency capital requirement, and those stresses used in the capital markets to size transactions, particularly for unit-linked business.

Solvency II also represents a move towards a more economic capital-based view of the regulatory capital requirements for insurers. This is likely to increase the comfort that investors take over the appropriateness of the liabilities of the insurers, particularly as the Solvency II methodology should mirror that which other stakeholders, including rating agencies and investors, take in analysing the underlying risks.

Jeff Wood is a member of the insurance capital markets team at Barclays Capital