Necessity: The mother of invention Life insurers use securitization to meet increased reserve requirements By Michael J. Moody, MBA, ARM
Some things in life are certain—death, taxes, and insurance company reserves. All insurance companies are required to maintain reserves. And, while there are any number of definitions for the word “reserves,” in essence, they are the amount of money that must be set aside from surplus to pay for future financial obligations. Since they represent future obligations for an insurance company, they are classified as a liability on an insurer’s balance sheet. As a result, reserves are one measurement of an insurance company’s financial health. That is why when the National Association of Insurance Commissioners (NAIC) advanced its Regulation XXX in 1999, it had such a profound effect on many term life insurance companies. Regulation XXX requires life insurance companies to hold reserves significantly higher than what they had been accustomed to holding. Many industry experts said the additional amount required by Regulation XXX was really a reserve redundancy that was going to result in major premium increases for term life insurance customers. And indeed, there were pricing increases as a result of XXX implementation, but they proved to be smaller than anticipated and were generally short-lived in duration thanks to some creativity on the part of life insurers. And, that creativity was indeed needed as the normal routes for handling increased reserve requirements were experiencing their own problems. Problems multiply In the past, life insurers had, for the most part, resolved reserve issues by either using available reinsurance or letters of credit (LOCs). However, term life insurance companies soon found both strategies had serious flaws. Shortly after XXX was implemented, the reinsurance market began to contract. The results of this contraction were higher pricing and more stringent underwriting. This combination resulted in higher reinsurance rates for the life insurers. The status of the LOC market was even more difficult. Several issues soon materialized that called into question whether LOCs would continue to provide the reserve solutions needed. To begin with, LOCs are typically considered short-term solutions, and XXX requirements could extend for 30 years. Further, the LOC market was also getting stretched due to the newly enacted Basel II regulations, which introduced new capital requirements for banks. These requirements increased the reserves that banks had to hold to support the LOCs they issued. Additionally, there was significantly more demand for LOCs as a result of XXX. Moody’s Investor Services estimates that the demand for LOCs to comply with XXX would exceed $45 billion by 2007. As a result, many industry experts anticipated affordability and availability issues arising from LOCs. To make matters worse, in 2002, the NAIC advanced similar increased reserve requirements (Regulation AXXX) that would apply to universal life carriers. So carriers that had been struggling to comply with the XXX requirements for term now had twice the problem if they had a book of universal life business. While the LOC option was available to assist in resolving the AXXX issue, the reinsurance market had little interest in providing support for this line of business. As a result, life insurance companies found compliance with AXXX more difficult than the earlier requirements of XXX. A time for creativity It was clear that the life insurance market could not continue to count on reinsurance or LOCs to meet their increasing reserve requirements. A new approach was needed. Among the ideas that surfaced was securitization. Securitization was gaining increased acceptance by the investing public, and more creative applications were being introduced all the time. For example, the property insurance market was already using securitization to offset some of their catastrophic exposures via CAT Bonds. Additionally, the life insurance industry was no stranger to securitization since it was frequently used during the early to mid-1990s to assist them in demutualization projects. In those cases, life insurance companies could utilize securitization to finance ongoing operations after they decided to close a book of business. As a result of some research that was completed, several life insurance companies began looking at the feasibility of using securitization to resolve their growing reserve requirements. Most of the securitization approaches centered on the concept of starting a captive insurance company to be used as a repository for the funds that were available from the securitization. Originally, most of the securitization activity was centered in the Cayman Islands; but over the past few years, the South Carolina Insurance Department has become involved with these as well. The department drafted—and the state legislature passed—the South Carolina Special Purpose Captive Insurance Company Act in 2002, thus quickly setting into motion the state’s involvement in the securitization arena. The Act allows organizations to form special-purpose financial captives that take advantage of the favorable features of securitization, while being able to do so through an onshore domicile. To date, South Carolina primarily has been involved with resolving issues related to the reserve requirements of XXX and AXXX, but observers believe there is greater appeal for this product. According to Michael A. Molony, partner at the Charleston, South Carolina, law firm of Young Clement Rivers, “We are certainly trying to ramp up our involvement with life insurers who need solutions for their reserve problems.” Molony notes that the state has become very active in this area and wishes to do more as the opportunity grows. The future At this point, it is clear that securitization has just scratched the surface of the life insurance market, and many are wondering where this is headed. A recent report from Tillinghast titled “Life Insurance CFO Surve,” may provide some insight into securitization’s future. The survey, which included responses from 70 North American life insurance company CFOs indicated that only 4% of the respondents are currently using securitization in their companies. However, a more telling statistic is that over 50% said “they would consider using securitization to address their capital needs over the next two to three years.” Among the key reasons given for the growing interest in securitization was the higher pricing of reinsurance and the continued favorable reception by investors. It would appear that South Carolina is well positioned to take advantage of this increased interest by the life insurance community. The department has an experienced staff that has gained valuable lessons about how to structure securitization captives. Further, it has had an opportunity to fine-tune the legislation to better match captive owners’ needs. Young Clement Rivers’ Molony says, “We have just touched the tip of the iceberg.” He notes that there are many other applications for the securitization process. For example, he says, “It allows life insurance companies to go directly to the capital markets and bypass some of the traditional intermediaries such as banks and reinsurers, so that they can have a more efficient method of borrowing capital. Securitization,” he adds, “can work for many different industry segments. It can provide a better, more cost-effective method of deploying a company’s capital. How better to use the captive platform?” wonders Molony. It remains to be seen whether securitization catches on with the life insurance industry or spreads to other industry segments. However, one thing is clear: Should it become an industry trend, South Carolina will have a leg up on its competition as the domicile of choice for this creative solution for the increasing reserve requirements. * |
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