Securitization of life insurance assets and liabilities

Journal of Risk and Insurance, June, 2005 by Alex Cowley, J. David Cummins

INTRODUCTION

Securitization is one of the most important innovations of modern finance. The securitization process involves the isolation of a pool of assets or rights to a set of cash flows and the repackaging of the asset or cash flows into securities that are traded in capital markets. The trading of cash flow streams enables the parties to the contract to manage and diversify risk, to take advantage of arbitrage opportunities, or to invest in new classes of risk that enhance market efficiency. The cash flow streams to be traded often involve contingent payments as well as more predictable components which may be subject to credit and other types of counterparty risk. Securitization provides a mechanism whereby contingent and predictable cash flow streams arising out of a transaction can be unbundled and traded as separate financial instruments that appeal to different classes of investors. In addition to facilitating risk management, securitization transactions also add to the liquidity of financial markets, replacing previously untraded on-balance-sheet assets and liabilities with tradeable financial instruments.

The securitization era began in the 1970s with the securitization of mortgage loans by the government sponsored enterprises (GSEs) Fannie Mae, Ginnie Mae, and Freddie Mac, which were created by the federal government with the objective of facilitating home ownership by providing a reliable supply of home mortgage financing. The securitization process enabled mortgage originators such as banks, thrift institutions, and insurers to move mortgage loans off their balance sheets, freeing up funds for additional lending. In the process, a new class of highly rated, liquid securities was created, enhancing portfolio opportunities for investors. The next major development in securitization was the introduction of asset-backed securities (ABS) based on other types of assets. This market began in 1985 with the securitization of approximately $1 billion in automobile loans and later expanded to include credit card receivables, home equity loans, aircraft-backed loans, student loans, and numerous other asset classes. In 2003, new issue volume of mortgage-backed and nonmortgage-backed ABS reached $2.1 trillion and $585 billion, respectively. (1)

Although the insurance industry in the United States accounts for approximately $4 trillion in assets with corresponding liabilities and equity capital that would seem to be candidates for securitization, securitization has been relatively slow to catch on in this industry. The first U.S. insurance securitizations took place in 1988 and involved sales of rights to emerging profits from blocks of life insurance policies and annuities (Millette et al., 2002). Insurance linked securitizations accelerated during the 1990s with the development of catastrophic risk (CAT) bonds and options and a growing volume of life insurance and annuity securitizations. However, the volume of insurance transactions remains small in comparison with other types of ABS.

Securitization has the potential to improve market efficiency and capital utilization in the insurance industry, enabling insurers to compete more effectively with other financial institutions. Through securitization insurers can reduce their cost of capital, increase return on equity, and improve other measures of operating performance. Securitization offers insurers the opportunity to unlock the embedded profits in blocks of insurance presently carried on balance sheet and to provide an alternative source of financing in an industry where traditional financing mechanisms are often restricted due to regulation. Securitized transactions also permit insurers to achieve liquidity goals and can add transparency to many on-balance-sheet assets and liabilities traditionally characterized by illiquidity, complexity, and informational opacity. Securitization also offers new sources of risk capital to hedge against underwriting risk more efficiently than traditional techniques such as reinsurance and letters of credit.

The objective of this article is to analyze securitization in the insurance industry with an emphasis on the lessons to be learned from prior securitizations as well as techniques that can be employed to mitigate the remaining impediments to the more widespread securitization of insurance risk. Because the securitization of catastrophic property risk has been discussed in numerous prior publications (e.g., Froot, 2001; Lane and Beckwith, 2002; Cummins and Lewis, 2003; Cummins, Lalonde, and Phillips, 2004), this article focuses on life insurance and annuity securitizations. The article begins with an overview and analysis of asset-backed securities. This is

Alex Cowley, FIA, is Senior Vice President within the Insurance Solutions Group of Lehman Brothers and is a Director of Lehman Re & Lehman Risk Advisors. J. David Cummins is the Harry J. Loman Professor at the Wharton School of the University of Pennsylvania. The author can be contacted by e-mail: cummins@wharton.upenn.edu.