UK: Securitisation – A Way of Life?

For both insurers and the FSA, the need to keep the business running within the solvency requirements is paramount. The World Trade Center attack and heavy falls in stock markets worldwide have already led to the relaxation of UK solvency requirements on at least two occasions in the last 12 months (the first on September 11 2001 and the second at the end of June 2002). Although such relaxation has helped, questions are being asked as to the value an insurer can put on intangible assets and the status of inadmissible assets. Ultimately will such reactive measures from the regulator prove enough to support the industry in its current state?

Already, the sector is considering another round of mergers, although currently there is understandable hesitation over undertaking these costly exercises. Nevertheless the FSA will be keen to see weak companies bolstered by the strength of stronger firms. They are also under pressure to implement the new legislation emanating from the EU and the results of the Basel Capital Adequacy Review.

The issue of financial strength has led to some activity in the ART sector and the possibility of accessing the capital markets can rarely have seemed so attractive. Although some saw the industry’s tribulations as the springboard for an explosion of ART, this has yet to materialise and much depends on the attitude of the regulators who earlier this year referred to some of the financial reinsurance written within the industry as being "toxic". The FSA has recently published a Consultation Paper on financial engineering (CP 144). The main aims of the review are to provide (1) for closer control and analysis of the inherent risks in the arrangements; and (2) the market with clearer presentation of the effects of financial engineering on life companies. Emotive headlines reflect the increased scrutiny the regulators are imposing on this area, nevertheless, with the shrinkage of capacity in the reinsurance market, securitisation is likely to become more attractive.

Perhaps the main stumbling blocks to the increased use of securitisation for life companies are (a) the costs involved; (b) the conflict between policyholders’ and bondholders’ positions and the regulatory concerns; and (c) the relative unfamiliarity of the process.

Nevertheless, it seems only a matter of time before (a) the insurance industry embraces securitisation (which will of course, drive down costs and increase familiarity with the format) and (b) the regulator settles and makes clear its priorities.

The only securitisation achieved in the UK life market to date was undertaken by the National Provident Institution (NPI) in 1998. It involved a special purpose vehicle (SPV) registered in Ireland which issued two tranches of bonds. The SPV loaned NPI the proceeds of the bond issue, secured against future surplus. (Because repayments were technically contingent on the emergence of that surplus, NPI did not need to treat it as a liability for regulatory purposes. Indeed the proceeds of the loan could count as an asset for solvency purposes). The surplus emerging was linked to the performance of some of NPI’s unit linked and unitised with-profits business. Finally, NPI set up a reserve account to meet scheduled repayments should the surplus prove insufficient.

The need for the reserve account included in the NPI structure has been seen as a deterrent to companies considering raising money in this way. Its existence reassures the bondholders who are otherwise vulnerable given the need to protect policyholders and satisfy the FSA. It has been suggested that there is no need for the reserve account, if reinsurance can be obtained to cover the possibility that the surplus may not emerge. Nevertheless, the reinsurer’s interests will then need to be taken into account, the policyholders’ interests remain and the rating of the bonds still needs to be approved – this will involve the reinsurer.

Over the past few years, the market has been soft enough to allow financial reinsurance to step in and take the burden of risk at very competitive rates. Such reinsurance has inevitably been cheaper than embarking on the complex securitisation route. Now that market capacity has been reduced and the cost of providing such reinsurance has increased considerably, securitisation may be reconsidered. Swiss Re’s sigma study reported last year, "life securitisation offers insurers an economical way of financing policy acquisition costs". Indeed, with concerns as to companies’ ability to support existing business, a way of meeting the new business strain can hardly seem more attractive.

Some of the issues that arise for a life company looking at securitisation are the same as the normal commercial risks for a loan arrangement. These include the rate of repayment and the period for which the loan advance is outstanding as well as ensuring that sufficient surplus will emerge from the relevant block of business.

A securitisation involves a wide pool of investors and they will need clear, full and accurate information in order to understand the risks they are assuming. It is instructive that many of the NPI bonds were taken up by the insurance industry itself – it being best placed to evaluate the inherent risks of the product.

The securitisation itself needs to fit within the company’s existing reinsurance programme and modelling of the returns should be undertaken in order to ensure that the combination of both reinsurance and securitisation does not adversely affect the life insurer’s solvency. The FSA will be keen to ensure that the life insurer understands its duty towards its policyholders. It is in the very nature of life insurance that its liabilities may last for a very long time. The old requirement that policyholder’s reasonable expectations (PRE) were of paramount importance still remains, even if the terminology has changed to "treating policyholders fairly".

From the point of view of the bondholders and the SPV, the SPV will need to ensure that it is not conducting insurance business, particularly (for UK regulatory purposes) that it has no need of authorisation for the purposes of Section 19 of the FSMA. Investors need to be able to buy the bonds and the SPV needs to be able to sell them! The purchasers and investors will seek protection given the prime importance of policyholders. The SPV needs to be sure that sufficient assets and/or cover are available to meets its payout requirements and in the event of an insolvency (whether of the life company and/or its reinsurer) the bondholders’ position needs to be protected.

These conflict, and the very complexity of a securitisation of assets (which by their nature are not transparent) require specialists to be involved in their evaluation. Specialists will also be required to structure and document the process. It is the investment bank which facilitates access to the capital markets, and which will need to be comfortable both with satisfying the bondholders’ requirements and the insurer’s needs. The bank will also be involved with the insurer in satisfying the rating agencies who will determine the creditworthiness of the bonds.

The rating agencies have traditionally not been close to insurance companies (particularly those writing with profits business) and accordingly err on the side of caution giving lower ratings to the investments.

The reinsurance-wrapper route is of course open to the life insurer to credit-enhance the risk by making a guarantee of bond repayments from a party with a higher credit rating than the life company. Nevertheless the life company’s default and indeed the reinsurer’s position remains key as a risk which determines the credit rating applicable to the bonds issued under the securitisation.

The hard market in reinsurance and the need for life companies to increase financial strength ensures that ART solutions are at the forefront of insurers’ minds. However, the FSA’s concerns have only recently been clarified and consulted upon. Securitisation offers an alternative source of capital in a market where investors’ appetite for such a product is, at the moment, unsated. The early birds may yet capture the worm before the market moves on.