They could be a match made in heaven – life insurance companies and the financial engineering that is securitisation. Certainly, structured finance and asset-backed bankers have been touting the technology to insurers and their parent companies since the late 1990s, but few capital market transactions have emerged so far. The industry’s multi-billion-dollar balance sheets remain largely untouched by securitisation.
But with life insurance companies more desperate than ever to raise capital, that may be about to change. Royal & SunAlliance (RSA) has publicly stated that it wants to sell off its closed-book life insurance businesses, and securitising the future cashflows is a possible way of freeing capital. Other insurers are looking at similar moves.
A ground-breaking transaction last November has made it all the more possible. UK bank Barclays’ £400 million reinsurance-based securitisation of the future profits of its life insurance business may provide a template.
The deal, in the name of special-purpose vehicle Gracechurch Life, is the first in which a European bank has used the capital markets to refinance an investment in a life subsidiary, and is only the second time in which investors have bought bonds backed by a life insurer’s emerging surplus. Barclays Capital lead managed the transaction that, crucially, was wrapped by triple-A rated Ambac Assurance (see box).
The financial implications for the participants concerned and the industries involved could be huge. Barclays is able to reduce the amount of regulatory capital it has to maintain at the bank level to cover its life subsidiaries (formerly Barclays Life and Woolwich Life, now just Barclays Life), while Barclays Life also gains capital benefits.
“The transaction raises high-quality solvency capital for Barclays Life, which is likely to be treated as similar to equity under CP195 regulations [the rules set by the Financial Services Authority to determine how much capital should be held by life insurers] and may also increase distributable reserves,” says Craig Stewart, managing director, balance sheet advisory at Barclays Capital. “In addition, it enables Barclays Group to reduce its investment in the life assurance business and achieve regulatory capital relief.”
No financial institution needs capital quite like life insurers. Their capital levels dictate the kind of products they sell, their operational scale and any expansion plans – not to mention their solvency requirements. Also, many large funds are closed to new business at a time when the regulators are moving in. Anything that can free capital or make more efficient use of their balance sheets should be welcome.
“The UK insurance market contains a number of large life funds, many of which, like Barclays Life and Woolwich Life, are closed to new business,” says David Sullivan, a partner at law firm Lovells in London, which specialises in insurance finance and alternative risk transfer. Lovells advised Barclays on the rationalisation of its life insurance business, culminating in the bond issue.
“Current investment market conditions provide limited opportunities for life insurers and their parent companies to raise funding,” Sullivan says. “At the same time, recent regulatory developments appear set to further increase the funding strain faced by life insurance companies.”
Sullivan believes there could be several similar transactions. “The success of the Gracechurch transaction has already generated considerable enthusiasm among life insurance groups, and investment banks eager to assist them, seeking to adapt the Gracechurch technology to meet their own particular needs,” he says.
“The key objective for insurers is to carve out the risk from their balance sheet, and by securitising their future profits actually have the cash in hand,” says Fiona Macnab, vice-president and fixed-income insurance analyst at Morgan Stanley in London. “They want to fund new profitable businesses, company growth and acquisitions, but at the moment they are pretty tied in terms of funding themselves.”
The UK life industries’ median required minimal margin (RMM) – the capital kept on a regulatory basis versus the amount the regulator thinks the company should have – has fallen significantly since 2000. Take Prudential, for example: in 1999 its RMM was 7.1x, falling to 2.1x in 2002 and only back up to 2.8x last year.
At the same time, funding options are narrowing, says Macnab. The amount of debt that companies can issue is running out, especially under rating agency criteria. Nor is the equity market looking appealing – potential shareholders are largely fed up with the industry and its paltry dividend levels.
“Earnings could be a source of replenishing capital but that is a long road,” says Macnab.
Assets minus liabilities equals capital – that is the restrictive regulatory code that insurance companies operate under. In determining liabilities, they have to include all debt and all shares except ordinary shares and, within certain limits, perpetual and dated preferred shares or subordinated debt.
In addition, changes to EU regulations are making things more difficult, and there is more in store. In 2009, the EU will introduce Solvency II, the industry equivalent of Basel II. And all this follows a three-year bear market and difficult trading conditions in which a number of life companies need to increase their capital.
No wonder life insurance groups are looking to find new ways of raising additional capital that could provide attractive alternatives to subordinated debt and equity issuance. The Gracechurch experience has demonstrated that there is considerable interest from investors and the monoline community for properly structured transactions.
Getting the right structure that appeals to all parties is of course not easy, especially in what is more or less virgin territory. Gracechurch is after all the first embedded-value deal in the UK since 1998, and a glance at that previous transaction will highlight the dangers in deals secured on future projections. The transaction by National Provident Institution (NPI) was also flagged as a ground-breaker at the time.
NPI issued a full, public securitisation that enabled Mutual Securitisation (MutSec) to raise £260 million by securitising the embedded value of a block of pension and life policies. But that deal has since performed badly and perhaps muddied the waters for other life insurers thinking of following suit.
“Although they have been looking at it for years, emerging surplus or embedded value or whatever you call it has proved to be a difficult item to monetise for insurance companies,” says Andrew Dennis, executive director, structured finance and asset-backed finance research at UBS in London. “Securitisation was particularly attractive to NPI because it was still a mutual, which meant its access to equity capital was limited to issuing long-dated subordinated debt.”
Back in 1998, insurance was regarded as something of a safe haven, but even then the transaction was laden with what looked like over-cautious and remote provisions. But those provisions have proved absolutely necessary.
Although securitisation helped NPI’s capital position, its overall finances deteriorated. The surplus failed to emerge, falling behind its estimates each year. The parent was downgraded and taken over by Australian insurance company AMP.
How badly is the deal performing? It’s hard to say, says UBS’s Dennis. “When the deal was done there was a lot of information – thereafter each year the investing public got one report in September with the estimates of the future emerging surplus that actuaries think will come off the portfolio. There are not a lot of numbers but they have diminished significantly because of, first, the lower investment returns on the underlying policies and, second, the increase in surrender rates across the life insurance industry.”
Actuarial science deals with uncertainty. Given all the relevant information, predicting when people will die is one of the easier exercises; surrender rates are trickier. The actuaries in the MutSec deal mis-estimated the correlation between poor investment returns and people surrendering. They misunderstood how it can get worse and worse.
Could it happen again? The climate is more difficult for insurance companies six years on, and much more protection is required if investors are going to bite. Gracechurch Life had a different structure – a shorter average life, for example, and the benefit of a triple-A wrap.
“The structural modifications were necessary, I suspect, to entice investors to buy because investors’ experience with MutSec is not particularly positive,” says UBS’s Dennis.
“To improve the transaction’s viability and cost, this deal needed the assurances from the parent, a liquidity provider, and a monoline wrap,” says Manish Bakhda, insurance analyst at Barclays Capital. “After all that, they are only securitising £400 million out of the $750 million underlying net present value of the future surplus emerging.”
It is usually the restrictive conversion rate and transaction costs that have prevented deals from being brought to the market. Rating agencies would opine on many potential insurance securitisations, but most do not get past the initial conceptual stage, says Bakhda, who was previously an analyst covering the sector at Standard & Poor’s. Achieving a good conversion rate was usually the first thing that scuppered the deal, he says. A second factor was the high cost of doing it. “A £100 million deal probably wouldn’t even get off the ground,” says Bakhda. “I think £400 million is probably the lower end of what is needed.”
“The key problem is segregating the securitisation from the insurance company,” says Morgan Stanley’s Macnab. “If you looked at the NPI deal, it is not segregated from NPI – the ratings are linked to NPI so the special-purpose vehicle (SPV) is downgraded when there is a change in NPI’s rating.”
Simeon Rudin, a partner in structured finance at Freshfields in London, who worked on both the NPI and Barclays transaction, says: “There are two methods that can be used by a life insurance company to increase capital – either you lower your liabilities or you boost your assets without increasing your liabilities.”
Gracechurch Life effectively uses reinsurance, thus removing the liability reinsured and increasing capital, he says. NPI did it the other way: it was effectively funded upfront; the SPV on-lent the money to NPI and repayment was limited to future surplus from a defined block of policies. For regulatory purposes, cash was coming in, which meant increasing assets, but the liability was ignored, resulting in an increase in capital.
“The whole industry is going to need to look at embedded value securitisation, and any deal will be a variation of one of the two structures,” says Rudin.
Bankers and lawyers are working on a number of transactions that mirror the Barclays technology, but are being understandably coy about who they are doing them for. What criteria would qualify a life insurer to be able to do a deal?
“The potential of any life insurance company to effect a securitisation of its future surplus will, of course, depend on many factors, for example, its market reputation, the exact status and mixture of business underwritten by it, and the nature and amount of support that its (existing) parent company is capable of providing,” says Sullivan at Lovells. “However, the Gracechurch transaction has shown that where such factors are favourable, securitisation of future surplus offers an efficient, effective and achievable means to monetise a substantial, but generally unrecognised, asset.”
“A variety of insurance companies are looking at it – not all with the same aim,” says Freshfields’ Rudin. “For some, it is a way of managing their capital position generally – that is, for the sophisticated end of the market; embedded value securitisation is more likely to be used once embedded value becomes better known as an established asset class.”
Another type of company likely to look at securitisation is a group with closed life businesses, where the capital is locked up and cannot be used. Embedded value securitisation can be used to raise external capital, allowing internally provided capital to be released and deployed elsewhere.
A third candidate might be a private equity investor who is buying a portfolio of life companies. Such a transaction would allow him to use the future profits of the target company to fund the acquisition.
This is what RSA is looking to achieve with its closed life business – applying the securitisation techniques used by Hugh Osmond, the ex-Pizza Express entrepreneur who did a big deal for Punch Taverns pubs, to the more sober world of insurance. But it will be a hard trick to pull off, not least because of the possible reluctance of a monoline insurer to provide a wrap. Dealing with a private equity investor looking for an exit is not exactly the same as dealing with Barclays Bank.
In many ways, then, monoline insurers could be key players at this stage of the fledgling market’s development. How much appetite do they have? Could a deal be done without them? “If there was enough internal structural protection, if it was not leveraged, if there was a lot of information, you could coax back people into doing unwrapped deals but then it might not make sense for the insurance company financially,” says UBS’s Dennis.
Bankers clearly envisage a market of some depth and width, with a variety of issuers and structures. “There will be more issues that emerge from the insurance sector, although they may differ slightly in structure from the Gracechurch Life transaction,” says Stewart at Barclays Capital. “Bancassurers, proprietary insurance groups and mutuals have all got different corporate structures – and possibly a different set of objectives – for an embedded value securitisation.” Securitisation structures may therefore vary accordingly, he concludes.
|How Barclays chose the securitisation route|
The question facing Barclays ahead of its reinsurance securitisation in 2003 was stark – how do you withdraw your investment in the life insurance business without alienating your existing customers?
The answer emerged gradually over a couple of years, culminating in its £400 million securitisation in November through lead manager Barclays Capital.
In 2001, Barclays Life and Woolwich Life were closed to new business, with Barclays having decided to distribute Legal & General products through its branches. “While no new policies would be written into the life companies, there were still some 900,000 Barclays customers with existing policies underwritten by Barclays Life and Woolwich Life, and Barclays’ capital requirement in respect of the life business was significant,” says Craig Stewart, managing director, balance sheet advisory at Barclays Capital. “Barclays wanted to merge the two businesses and extract the bank capital but didn’t want to sell and risk loss of control of important relationships with customers. The transaction’s structure enabled Barclays to reduce its investment in the business by £400 million and retain interest in the customer relationships.”
“The objectives for Barclays were to accelerate the future surplus, and minimise the remaining obligations for Barclays Bank,” says David Sullivan, a partner at law firm Lovells in London. There were various alternative solutions considered: a syndicated loan was one option but regulatory capital costs would have made it relatively expensive for banks to provide the finance, says Sullivan.
A sale of shares in the two life insurers was also mooted, but it would have been hard to find a single purchaser willing to pay an acceptable portion of a surplus of $750 million, and there would have been a risk of policyholders surrendering their policies, reducing the potential sale price.
Securitisation became the answer. The interlinked nature of Barclays Capital and the Barclays group was a factor in the deal coming to a virtually non-existent market, Stewart acknowledges. “The strength of the relationship between the two obviously helps in the development of any new product,” he says. “However, the most important feature was Barclays’ motivation to complete a transaction that would enable it to reduce its financial investment in the life business in a very efficient manner.”
Barclays also gives what the rating agencies call “implicit support” to the deal: “The notes are truly non-recourse to Barclays, although Barclays has given some representations and warranties, for example, in respect of mis-selling liability,” says Stewart.
Barclays’ involvement in the future in turn provided extra comfort for Ambac Assurance to provide the wrap. The wrap made the transaction work much better, says Stewart, providing access to traditional triple-A investors. “The 10-year maturity, expected life of 6.7 years and average life of two, three, four years is a typical profile of mortgage-backed securities but backed by insurance capital flows instead,” he says. Ambac assumed the burden of due diligence as well, providing a stamp of approval for investors who were unfamiliar with insurance business risk. “I wouldn’t say they were esoteric, but they are not cashflows like credit cards or mortgages,” says Stewart.
Investors clearly relished the chance to get something extra on something new: “You have a triple-A rated cashflow paying Libor plus 40 basis points and are giving investors the chance to diversify away from UK mortgage risk,” says Stewart. “With those deals typically priced at around 10bp to 20bp over Libor, that represents a 20bp pick-up, rewarding investors for doing their due diligence on a less well-known asset class.”