Insurance firms gain a sense of security

The asset class is gaining acceptance among both traditional money managers and specialised hedge funds, and allowing insurance companies to diversify their funding sources.

‘Value-in-force’ and ‘new business strain’ transactions have broadened ILS away from traditional catastrophe bonds linked to hurricane or earthquake risk, or more recently mortality-linked bonds, which protect insurers from the effects of extreme events such as a global bird flu epidemic.

Value-in-force (VIF) deals take books of life insurance business and crystallise the future expected profit streams from these policies, thus turning intangible assets into cash, which would otherwise only emerge over time. New business strain (NBS) is defined as the initial costs incurred by the insurer of effecting policies, before they become profitable.

More VIF transactions are expected out of the UK before the year end, following the £400m deal from Gracechurch Life (a subsidiary of Barclays Group) in late 2003, and the £380m offering in late 2004 for Friends Provident Life and Pensions.

Meanwhile, insurers are expected to emulate the late 2004 deal for Norwich Union Life and Pensions (NULAP). The £200m NULAP deal was placed into the Thames Asset Global Securitisation conduit run by Royal Bank of Scotland. RBS Financial Markets acted as arranger.

“Conduit financing can be used to provide a capital efficient means of relieving new business strain for a life insurer,” explains David Sullivan, partner at law firm Lovells in London.

“New business strain is created when certain costs are incurred when the policy is written, including the cost of selling the policy (in particular the broker’s commission), the cost of establishing reserves for the liability under the policy, and the cost of proving extra capital resources to meet the increase in the capital requirements attributable to the policy,” says Mr Sullivan.

In January 2005 Swiss Re also launched a VIF transaction, backed by closed blocks of US life insurance business. Bankers say that a couple more transactions are likely out of the US before the end of 2005, as well as a non-life deal out of the UK.

Improvements for insurers

“Value-in-force and new business strain deals are new ways of accessing capital for insurance companies that improve financial flexibility and are cost effective compared with other forms of capital,” comments Riz Sheikh, associate director in the financial institutions securitisation group at Barclays Capital, which arranged both the Gracechurch Life and Friends Provident deals.

“A similar process took place 10 or 15 years ago for mortgage lenders, who began to use residential mortgage-backed securities regularly as a way to finance themselves,” he says. “Today insurance securitisations are being seen by insurance company treasurers as a potentially valuable addition to the financing toolkit.”

In the US, Swiss Re has been at the forefront of developing the investor base for various types of ILS. Its Queensgate Special Purpose transaction launched in January was backed by closed blocks of US life insurance business, and comprised a $175m tranche rated A1 by Moody’s, a $45m Baa1 tranche, and $25m worth of Ba1 rated notes.

The average blended coupon was 6.96% for maturities ranging from six to 11 years.

“Over the past five years there has been a significant broadening of the different classes of investors who are participating in the sector, and that is a reflection of the fact that the type of insurance-linked securities being offered span the risk spectrum from single B all the way to triple A wrapped,” says Judith Klugman, managing director at Swiss Re capital markets in New York.

“As the insurance-linked securities product itself has evolved and grown, the investor universe has grown along with it, with participation from some of the largest multi-strategy hedge funds at the riskier end, and global fixed income managers who are interested in the less risky tranches,” she says. “Some investors gravitate more towards natural catastrophe risk, while others prefer embedded value life risk, and some buy both.”

Market conditions

Although its deals have thus far all been denominated in dollars, Swiss Re sells its paper heavily to the European asset-backed securities investor base, as well as into the Asian market.

In April, Swiss Re transferred $362m worth of mortality risk into the capital markets with the sale of three tranches of synthetic notes, rated single A or triple B. Investors will face pre-set losses on their principal should the average mortality in the US, UK, Germany, Japan and Canada move above annual norms for two consecutive years.

“With the Vita Capital programme all the legal documentation is in place, similar to a medium term note programme, and this allows Swiss Re to opportunistically take advantage of market conditions,” Ms Klugman explains. “Tranches with different ratings can be sold separately so, depending on where pricing is, Swiss Re can tap into the tranche that is most economically attractive to them at that time, to buy protection against mortality events.”

Sophisticated customers

So far, deals in the UK have featured support from a monoline. For example, Ambac Assurance wrapped both the Gracechurch Life and Friends Provident transactions to triple A.

A number of sophisticated investors have indicated that they would prefer to get some extra yield for taking on extra risk, rather than letting the monoline take most of the reward. However issuers are attracted to the certainty of execution for wrapped deals, and some may prefer to negotiate with a monoline, rather than take the added risk of coming to market with triple B or single A rated paper.

“Some sophisticated investors would like to pick up yield, rather than buying triple A wrapped paper, and we have had some reverse inquiries about unwrapped bonds,” comments Mr Sheikh at Barclays Capital. “The market may not yet be ready for a public £300m-£400m unwrapped transaction, but the next logical step in the development of the investor base may be to include a small unwrapped piece alongside the wrapped tranche.”

Regulation pressure

In the UK, the market is being partially driven by regulatory changes, notably the Solvency 1 directive, which will bring about a phased reduction in implicit items between now and 2009. The Financial Services Authority in the UK has moved faster than its continental European counterparts to introduce more onerous capital requirements, which is why the UK is leading the way with value-in-force transactions.

Previously, UK insurers could show the FSA the future profits that will be thrown off by insurance policies, and receive an allowance against the amount of solvency capital they need to set aside – known as an implicit item.

“Clearly, insurance companies want to plan ahead, and are already replacing implicit items with other forms of regulatory capital using hybrid debt, securitisation, or raising additional equity,” explains David Harrison, credit analyst at Standard & Poor’s in London.

“Securitisation may attract a different investor base to hybrid debt such as Innovative Tier 1 debt, and so widens the financing options for the insurance sector,” says Mr Harrison. “The optimal financing tool will vary from one company to another, but insurers may value the flexibility of being able to tap the capital markets in different ways.”

Additional benefits

In addition to regulatory change, insurance companies are also simply looking for new sources of capital, or new counterparties to lay off risk with. Direct access to the capital markets reduces their reliance upon reinsurance. However, putting together an ILS transaction remains a complex and time-consuming process for issuers, with high costs in terms of management time, and fees for arrangers, lawyers and rating agencies.

And from the investor point of view, ILS remains a complicated asset class that requires sophisticated analysis. Each VIF transaction to date has been structured differently to the last, and the market is still a long way from a standardised structure.

Not surprisingly, the hedge funds have become the bedrock of the ILS investor base for unwrapped tranches, since they are willing to do the complex analysis necessary. Hedge funds have set up dedicated ILS funds, and are in turn able to tap into the pension fund community, managing money for those investors who do not have the resources to be experts in the ILS asset class.

All the signs point to continued growth in ILS issuance, and continued tightening of spreads. The possible exception is hurricane risk, where investors may demand a higher spread as fears grow that the world has moved into a period of climate change that has fundamentally altered the risks associated with more frequent and bigger hurricanes.

The pricing of the next hurricane-linked catastrophe bond will be closely watched for any change in investor sentiment. But for VIF deals, the generally solid performance of previous transactions makes arrangers confident.