In most asset-backed securities (ABS) transactions there are several classes or tranches of securities, which often have differing degrees of seniority with respect to the underlying cash flows.
It is common for the special purpose vehicle (SPV) to enter into a swap transaction, either over-the-counter or through an exchange, whereby the assets' fixed rate of interest is swapped for a floating rate tied to a widely used index such as LIBOR.
In a purely theoretical world, transferring cash flows to a SPV and apportioning them in various ways among tranches of security holders would have no impact on the overall economic value of the flows. Because securitization is costly, ABS transactions would not be undertaken in frictionless and complete markets.
The perfect markets model does not allow for the existence of taxation and regulation, both of which can provide motives for securitization. Even when the costs of structuring and credit enhancement are considered, securitization may represent a relatively attractive way for the originator to raise capital.
Investors can improve portfolio efficiency by adding these securities to their portfolios.
Insurers make an investment to put policies on the books and then amortize the acquisition costs out of the premiums, investment income, and fee income received over the policies' lifetime.
Mortality risk traditionally has been considered relatively unimportant by life insurers because of long-term secular trends towards lower mortality and the ease of diversifying mortality risk by issuing policies to large pools of insured risks.
For example, as discussed below, term insurance reserve requirements under Regulation XXX in the U.S. have motivated at least one important securitization transaction.
As discussed below, demutualizations often are accompanied by the securitization of blocks of insurance business previously written by the mutual insurer. Investors typically do not have the option of investing in particular cash flow streams originated by the insurer as in the case of securitization transactions. Securitization is most likely to occur where the capital efficiency and financing benefits are sufficient to offset the value of private information lost during the securitization process.
Securitization and SPVs represent an important step away from the intensively managed, complex, and opaque institutions that presently dominate the insurance industry.
Life insurance risk transfer securitizations designed to protect life insurers or reinsurers against deterioration in mortality or conversely to protect writers of annuities against increases in longevity.
One motivation for life insurance securitizations is to reduce leverage and obtain immediate access to the "profits" expected to emerge from a block of life insurance policies.
From 1996-2000, American Skandia Life Assurance Company (ASLAC) issued thirteen securitization transactions designed to capitalize the embedded values in blocks of variable annuity contracts issued by ASLAC. An interest rate swap could be arranged with a swap counterparty to insulate investors from interest rate risk.
We first discuss the motivation for forming a closed block and then focus primarily on the securitization transaction. In an open block securitization of life insurance policies, a SPV is established to make a loan to the operating unit of an insurance company in return for the right to the surpluses expected to "emerge" on a specified block of life insurance policies.
National Provident Institution (NPI) in the United Kingdom realized $ 220 in funds it could use in its continuing operations, and the loan to value ratio was about 45% after netting out the reserve account (220/487).
The ratio of the bond proceeds to embedded value is 47% gross of the debt service coverage account (DSCA) and 35% net of the DSCA, providing a significant degree of over-collateralization, at least on the basis of the estimated embedded value.
The Series A and B notes were insured through a financial guarantee insurance policy issued by Financial Security Assurance (FSA).
The funds in the SPV are pledged as collateral for the term insurance policies issued by the life insurer, reducing the insurer's required reserve.
Risk Transfer Securitizations The final type of securitization transaction that will be considered in this paper consists of pure risk transfer securitizations.
Another approach to a mortality risk securitization is a new product, which can be called the mortality risk bond, and covers the insurer for higher than expected mortality.
The Swiss Re transaction is noteworthy because it focuses directly on mortality risk and is much simpler to model and understand than transactions involving all of the cash flows on whole blocks of life insurance policies. Securitization can increase the efficiency of insurance markets by utilizing capital more effectively reducing the cost of capital and the cost of insurance, for any given level of risk-bearing capacity and insolvency risk.
One important conclusion is that regulation should be restructured to facilitate securitization transactions that have the potential to enhance market efficiency, while providing less intrusive mechanisms for protecting policyholders against insolvency and management conduct risk.
Most extant insurance securitizations have been heavily over collateralized and also have required the purchase of third-party guarantees.
A final concluding comment is that life insurance and annuity securitizations will not achieve the level of success of mortgage-backed securities and other types of asset-backed securities until a substantial volume of transactions reaches the public markets.
