SECURITIZATION OF INSURANCE PROFITS
We conclude this chapter with a discussion of an interesting development in the securitization arena: securitization of the embedded value of insurance contracts. While risk securitization has been around for a while and securitization of future annuities or endowment contributions is also near routine, a new asset class of the securitization market has recently been introduced: securitization of value of in-force life insurance policies, or the embedded value of life insurance.
Unlike other alternative risk transfer devices, this securitization is not essentially a risk transfer device; it is predominantly a device to monetize the profits inherent in already contracted life insurance policies. It is comparable to the securitization of the servicing fees of a servicer, the residual profits of a business, or the fees of asset managers.
In life insurance business, the key cash flows of the insurer consist of:
• Inflows
• Premiums
• Annuities
• Investment income and capital receipts
• Fee income (for specific insurance contracts only)
• Outflows
• Policy benefits
• Annuity payments
• Investments
• Surrenders
• Expenses, both origination and continuing
• Capital expenditure and investments
• Taxes
The value of in-force life insurance policies tries to capitalize the net surplus out of these cash flows. Sometimes also known as block of business securitization (as the early usage of such funding was to refinance the initial expenses incurred in acquiring new blocks of policies), this funding method is based on structured finance principles whereby the residual income of the securitized block is monetized up front.
One of the early examples of this method is American Skandia Life Assurance Company (ASLAC). From 1996 to 2000, ASLAC issued 13 securitization transactions designed to capitalize the embedded values in blocks of variable annuity contracts issued by ASLAC. The trusts issuing the notes are collateralized by a portion of future fees, expense charges, and contingent deferred sales charges (CDSC) expected to be realized on the annuity policies.
Motivations for Insurance Securitization
One of the basic motivators for insurance securitization has been capital, as indicated by the declining free asset ratio. The free asset ratio measures the market value of the insurer’s assets, minus its policy liabilities, essentially the economic capital or solvency of the insurer. The free asset ratio includes the implicit value of in-force policies (VIF). The implicit value is actuarially assessed net present value of future profits inherent in the current book of business. The embedded value of the insurer is said to be the total of the existing capital plus VIF.
The essential motive behind securitization of embedded value is to monetize the VIF. Under emerging insurance accounting rules, the VIF will not be considered as a part of the insurance capital in the future.47
On the other hand, the monetization of the surplus of in-force policies may be considered a part of capital if the repayment of the funding, raised by way of the transaction, is unambiguously linked to the surplus on the defined pool of policies. While the clean implicit item, unmonetized, requires regulatory clearance to be counted as capital, the funding way of the securitiztion of a surplus is a more definitive part of capital. Hence, the quality of regulatory capital improves as a result of the securitization.
Transaction Structure
The crux of structuring the transaction is to look at residual profits from a pool of insurance policies; hence, the transaction is fairly similar to the whole business transactions discussed earlier in this chapter. However, there is understandably no need to put the kind of financial covenants required in whole business transactions.
In addition, to have clean impact on regulatory capital, these transactions may use either a reinsurance vehicle or a contingent loan.
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