Adam Robinson and Luca Tres explain the past, present and future of life insurance securitisations
Life insurance linked securitisation (life ILS) is the packaging of life insurance risks and passing them to the capital markets. However, beyond this simple definition, what exactly is it?
Unlike the developed yet standardised role that non-life ILS has played in non-life insurers' peak risk transfer (such as catastrophe bonds), life ILS has long resisted being shoehorned into an easy-to-define yet single-purpose offering.
This lack of standardisation is actually life ILS' greatest strength when considering it as a tool for risk, liquidity and capital management purposes. Whenever insurers have faced new problems caused by regulatory, reporting or demographic changes, life ILS funds have had the capacity to provide solutions.
Pre-financial crisis, life ILS was used by (re)insurers to solve a relatively small set of problems. The first one was to place peak mortality risks - a similar problem to the peak catastrophe risks that non-life CAT bonds were designed for. An example would be Swiss Re's first Vita mortality bond in 2003.
Another use was the AXXX excess reserve financing securitisations (named after the US adoption of Regulation Triple-X) and embedded value securitisations across the US, UK and Europe. These types of transactions - while different in their objectives - had similar effects, placing life actuarial risks, notably mortality and lapse, into the capital markets. It should be noted, however, that issuance was facilitated by monoline insurers providing 'credit wraps' on bonds; the guarantee from monoline insurers enhanced the bond's credit rating (linking it to the insurer's). This made these types of transactions more accessible to conventional capital market investors, as opposed to specialist investors such as life ILS funds, as some of the most complex risks would be effectively transferred to the guarantor funds.
The run-up to Solvency II saw some more innovative transactions. An example of this was Aegon's longevity risk transfer programme, whereby Aegon transferred its longevity risk to Deutsche Bank, which in turn placed it with capital markets investors. This was a novel out-of-the money longevity swap, with attachment and detachment points based on Dutch population indices. This type of transaction was in many ways a precursor to Solvency II-optimised transactions, as it could likely result in solvency capital requirement (SCR) and risk margin relief. The transaction itself was also highly specialised, requiring investors to take a long-term view on Dutch mortality improvements to price and understand the risk. Life ILS funds were a key element in this transaction, as they had the requisite capital markets and actuarial skillset to understand and price the deal.
Solvency II was meant to boost de-risking and capital relief transactions. These are designed to explicitly transfer key actuarial risks from a (re)insurer's balance sheet and, subsequently, reduce SCR for the risk-ceding (re)insurer. Transactions of this type can cover any of the core life actuarial risks; lapse has been a key one, especially mass lapse, but increasingly also lapse down, longevity and, to a lesser degree, mortality.
To date, however, the volume of public ILS transactions has been limited. This is partly due to investment banks' subdued capacity and appetite for structuring these transactions, as well as for the ample availability of cheap capital; medium and large insurers have benefited from thin spreads in the hybrid bond market, enabling issuance of different forms of capital, such as restricted tier 1, tier 2 and tier 3.
Private ILS transactions have been more abundant, notably among mid-sized insurers. Privately negotiated risk-transfer transactions have remained a key focus for life ILS funds in a post-Solvency II world. These funds have stretched beyond traditional lapse, longevity and mortality de-risking transactions, sometimes even helping insurers on the loss absorbing capacity of deferred taxes (LAC DT). This is a Solvency II balance sheet item that allows insurers, under certain circumstances, to reduce the insurer's SCR as a consequence of a loss, getting credit for the lower tax due in the future. This future loss-contingent benefit can be recognised on the balance sheet today, reducing SCR risk capital. A key requirement for an insurer to recognise the LAC DT on its balance sheet is to demonstrate that should a loss occur, it will still be able to meet its capital requirements and make profits in the future. (Profits are clearly required, as otherwise no future tax to offset against the tax credit would arise.) By providing full risk transfer solutions, life ILS funds have been integral in structuring transactions that allow insurers to benefit from their LAC DT.
Beyond explicit risk transfer and Solvency II-motivated transactions, Life ILS funds often help insurers by providing capital to support business growth. For example, commission payments to brokers create cashflow strain upon the inception of new business sourced through this channel.
Traditionally, banks could help insurers with this strain by providing liquidity facilities. However, since the financial crisis, banks have moved away from this business. Life ILS funds have stepped in to fill the gap and offer solutions to this problem, structuring transactions linked to the experience of specific policies, on which life ILS funds take direct lapse and mortality risks. This means that insurers benefit from not only reduced day-one cashflow strain, but also from a risk reduction and, possibly, from lower SCR.
IFRS17, the new accounting standard for insurance contracts that comes into effect on 1 January 2022, will affect the timing of profit recognition for insurance companies. This could shake up the industry and, subsequently, the life ILS market. Life ILS funds will not be affected directly, as they report under different accounting standards. This will permit transactions that leverage accounting differences between insurers reporting under IFRS17 and life ILS funds under a simpler fair value basis. Some life ILS funds are already working on transactions that can impact profit recognition under current accounting rules (IFRS4) and upcoming ones.
When credit spreads begin to widen, issuing new hybrid bonds may become less attractive, encouraging some of the larger insurers to explore alternative solutions to reduce Solvency II capital requirements. This may lead to issuance of large-scale public de-risking transactions (mass lapse and longevity structures are an obvious target), in which most life ILS funds will participate.
Life ILS has evolved over time and changes will continue in the future. The role of life ILS funds has also morphed, from risk-taker to provider of holistic solutions. As insurers become more comfortable with their Solvency II balance sheet and IFRS17 implementation becomes imminent, we expect them to seek further innovative solutions to some of their problems, with which ILS funds can help.
Adam Robinson is investment analyst at Securis Investment Partners
Luca Tres is head of life at Securis Investment Partners