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 In The Deal NewsWeekly Nicholas F. Potter and Michael McDonnell of Debevoise & Plimpton LLP explain how for life insurers, embedded value transactions may provide the steady cash flows private equity investors crave.
Although private equity firms have shown increasing interest in financial institutions in recent years, specific interest in life insurance companies has remained muted, in part because the life insurance business is quite capital intensive. Strategic efforts by life insurers to manage capital efficiently are not new. However, of interest to private equity firms and hedge funds looking to diversify are "embedded value securitizations," a relatively new technology permitting the monetization of future life insurance cash flows. The securities issued are designed to provide highly rated and predictable cash flows.
The market for structured financings has been severely dampened in the current credit crisis, and in particular assets that do not have a readily realizable market value are very much out of favor. However, the economics of these transactions for both sponsoring life insurers and investors give reason to believe that more of these deals will get done.
There are typically two fundamental legal elements for a securitization: the creation of a bankruptcy remote "special purpose" financing vehicle, and a "true sale" of assets from the originator to the vehicle. Life insurance, however, is different from assets that are frequently the subject of securitization transactions. Life insurance, unlike bank loans or mortgages, involves a promise by the originator that is not performed at the time of origination. This feature gives rise to a key risk that is not present in other securitizations. Specifically, the securitized assets are not "sold" to the financing vehicle, but instead are subject to a prior lien in favor of the securitized policies. This is mitigated by capital maintained at the financing vehicle, and by the volumes of actuarial data that accompany each transaction, but in extreme mortality scenarios assets may be used to pay policy claims rather than service debt securities. As a first step in an embedded value securitization, a life insurer identifies a suitable block of life insurance business. The life insurer then forms a special purpose captive reinsurer. A number of U.S. jurisdictions, including Delaware, South Carolina and Vermont, have enacted legislation contemplating the establishment of captive reinsurers for purposes of securitizations. Off-shore jurisdictions may also be selected. The life insurer enters into an indemnity reinsurance contract with the captive under which the life insurer "cedes" to the captive assets and liabilities, and profit and loss, relating to the securitized policies. The reinsurance balance will be collateralized for the benefit of the ceding life insurer in order to comply with state "credit for reinsurance" rules. In addition to the reinsurance transaction, the ceding life insurer or an affiliate remains responsible for the administration of the policies, thereby playing a role analogous to a servicer in other securitizations. Typical capital structures involve either the issuance of subordinated "surplus notes" by the special purpose captive, or term securities by a parent holding company of the captive, payments on which are dependent on receipt of dividends. In either case, payments from the captive, whether in the form of payments on surplus notes or dividends, are subject to prior approval by the domestic regulator of a captive domiciled in the U.S. Given the complex actuarial analysis underlying these securitizations, it is not realistic to expect that investors will necessarily have the expertise required to assess the risks of each transaction on the basis solely of the characteristics of the subject life insurance business. Accordingly, various types of credit enhancement are commonly incorporated into the structure. For example, the securities may be guaranteed by a holding company parent or another affiliate of the ceding life insurer. Other forms of credit enhancement are also possible, including capital maintenance arrangements with affiliates or the issuance of subordinated tranches of securities. The current credit crisis, coupled with execution risk and other issues associated with the creation of a new asset class, have caused the embedded value market to get off to a slow but steady start. There is every reason to expect that the compelling need of life insurers to manage capital efficiently, combined with interest in deploying buy-side capital into diverse asset classes, will lead to growth in this market. Nicholas F. Potter is a partner and Michael McDonnell is an associate in the New York office of Debevoise & Plimpton LLP. A version of this article originally appeared in Debevoise & Plimpton's Winter 2008 Private Equity Report. Categories Deal Video
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