Demystifying

Capital Management

> in the

Life Assurance Industry

Presented to the Staple Inn Actuarial Society10th October 2000

John Gemmell

Graeme McAusland

Himesh Shah

Nigel Silby

What this paper is about

According to the latest statistics produced by the actuarial profession, 37% ofactuaries work within a life office environment, and many more have done so atsome point in their careers.

However only a limited number of us understand, let alone have experienced, therole of managing capital within a UK life office. A role that demands at least someknowledge of all of the “normal” actuarial issues such as the valuation andembedded values. A role that involves ensuring that the company has sufficientsolvency and cashflow to enable its future growth aspirations to be possible, letalone to be met. And a role that, often, also involves maximising the reported profitsof the company. All at the same time.

Here, we have tried to put together a paper that demystifies a selection of financialtools currently available to UK life offices to help them meet these responsibilitiesand achieve their goals. Many are in common usage, whereas some are rare orrelatively new. At the very least, we hope that this paper provides some interestingreading for anybody interested in the capital management of a UK life office.

What this paper is not about

But first, a few notes on what this paper is not about. While we have included asection on the future, this paper does not reveal the very latest technology, currentlybeing developed by fiendishly clever (or just fiendish) actuaries within the bankingand reinsurance world – the authors were not prepared to reveal to each other theirlatest secrets. Also, this paper is not for the grammatical pedant (as should beobvious from this introduction) – we wanted this paper to be informal and light, not aheavy, long-winded insomnia cure. To this end, we have included a short (two page)version of the entire paper for those who can’t be bothered to read the whole thing.

Acknowledgements

We would like to thank all friends and colleagues who have provided us with helpand advice during the production of this paper – we are grateful for their assistance.

This paper contains the views of one or more of the authors, not necessarily of ouremployers. We would like to have somebody else to blame for any remaining errors,but we don’t.

Contents

Section 0 The Short Version

Section 1 Introduction and Background

1.1 Purpose of Paper

1.2 Definition of Capital

1.3 The Role of Capital in the Life Industry

1.4 The Impact of Regulation in the UK

1.5 Current Issues Impacting Capital

Section 2 Products and Techniques for Managing Capital

2.1 Financial Reinsurance

2.1.1 Surplus Relief2.1.2 Asset Admissibility2.1.3 Virtual Capital

2.2 Securitisation

2.2.1 Securitisation of Embedded Value2.2.2 Securitisation of Policy Loans and Other Assets

2.3 Subordinated Debt

2.4 Banking Products

2.5 Derivatives

2.6 Equity

2.7 Internal Reorganisation

Section 3 Perspective

3.1 Non-Life

3.2 Banking Industry

Section 4 Future Trends

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Section 0 - The Short Version

Capital Management is becoming more important in life assurance because:-

• Consolidation continues – capital is needed for acquisitions.• Guaranteed Annuity Options are putting a strain on solvency.• New Business needs to be funded, and the newer level load products create extra

strain.• New valuation regulations may put a strain on solvency.

You can get capital in lots of ways. Here are some of them:-

1. FinRe

Financial Reinsurance uses the reinsurance industry to provide capital, usuallythrough regulatory arbitrage. There are several different types, and here are someexamples:-

• Surplus Relief takes future profits within non-profit business and turns them intoregulatory assets.

• Asset Admissibility structures involve reinsurers taking assets that you’re notallowed to count as regulatory assets anyway in return for reducing liabilities.

• Virtual Capital is a new way of improving solvency by removing a chunk of with-profit liabilities without taking lots of assets.

2. Securitisation

Securitisation involves taking an asset that it may not be possible to fully recognise inthe regulatory returns (such an Embedded Value or Policy Loans), converting it intotradeable instruments and selling it to the capital markets.

Such transactions are structured with an element of risk transfer relating to the valueof the assets so that accounting and regulatory off balance sheet treatment may beachieved.

3. Sub-Loan debt

This involves getting loans from the capital markets, where the repayment of the loanonly happens if policyholders get their money first. This allows a life office not to showthe liability to repay the loans in their regulatory returns.

4. Banking Products

It is possible to enter into contracts directly with banks that will have a similar effect asFinRe (with a reinsurer) or Securitisation or Sub-Loan debt (with the capital markets).

5. Derivatives

Derivatives can help to manage exposures that a life office may have to certain marketmovements. For example, derivatives can hedge against the risk of increasedliabilities as a result of a fall in interest rates.

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6. Equity

An obvious source of capital is simply to increase equity, which increases assetswithout increasing regulatory liabilities. The equity may come from a parent companyor directly from the market. A mutual cannot raise equity without demutualising first.

7. Internal

There may be ways to simply reorganise the existing financial structure of anorganisation in a more efficient way. Funds could be merged, assets could bechanged, or the valuation basis could simply be weakened, each potentially improvingthe regulatory position.

Perspective

It is interesting to compare how a life office manages capital with how other financialindustries manage capital. For example:-

• Non-life companies have similar issues in general, but the detail is different. They alsooften go to reinsurance companies for help with improving their solvency or raisingcapital, but the form of the treaties is different.

• Banks also must show to their regulators that they are maintaining certain levels ofsolvency, but again, the measures are different. A bank also has a range of options formanaging its capital, but reinsurance is not one of them.

The Future

We think that pressures on capital in a life company will continue to increase. Continuedconsolidation, shareholder demands, product designs (especially stakeholder pensions),valuation regulations and the potential for lower investment returns in future may all taketheir toll.

Life companies will have to continue to seek new and innovative solutions to thesechallenges, and reinsurance companies, banks and the capital markets will have to playtheir part by developing and providing these solutions.

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Section 1 - Introduction and Background

1.1 Purpose of Paper

The purpose of this paper is to explore a range of alternative financial products thatlife assurance companies can access to assist in the management of their capital.

Our reasoning for writing the paper is based on two key facts:

• Capital management is becoming an increasingly important issue for lifecompanies.

• The range and sophistication of financial tools to assist capital management hasgrown considerably over recent years.

The paper has deliberately been written with the intention of helping those new to thesubject area to become familiar with the basic ideas.

In the rest of this section we begin with a brief definition of what we mean by capitaland why it is important to life assurance companies (and other businesses).

The main content of the paper is in section 2 where we consider some of the productsand techniques available to life insurance companies to help them manage theircapital.

Section 3 considers some of the contrasts that exist between the capital managementissues in life assurance and the non-life / banking sectors.

Finally, in section 4, we provide a concise view of some of the future issues weenvisage emerging in relation to capital management for life assurance companies.

As noted above our aim has been to provide a practical paper that is capable of beingread by a wide range of people. By doing so we genuinely hope to be able to“demystify” some of the suspicion and intrigue that surrounds the use of some of thetechniques and products described in section 2.

The consequence of having such an aim is that we have not gone into the level ofdetail that undoubtedly some readers would wish and we have not focussed on areassuch as financial economics which are being discussed in a number of other papers atpresent.

1.2 Definition of Capital

As a starting point for defining capital we believe it is helpful to consider the concept ofEconomic Capital and Regulatory Capital.

• Economic capital can be thought of as the capital required to ensure that thecompany has sufficient assets to deliver the ongoing strategy of the business. Forwith-profits business this could be thought of as being sufficient capital to meetPolicyholders’ Reasonable Expectations (PRE).

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• Regulatory capital is required to protect against the risk of statutory insolvency, i.e.having sufficient capital to demonstrate solvency under the company’s regulatoryregime.

In other words, Economic Capital is what you need to keep your foot on theaccelerator, Regulatory Capital is what you need to stop the regulators pressing thebrake.

Depending on the company and its regulatory regime, either of these capitaldefinitions may drive the need for capital. In the UK our expectation would be thateconomic capital would, generally, be more of a driver for with-profits business.However, the relatively strong regulatory requirements for non-profit business makethe relationship less obvious for this type of business.

To meet the need for either economic or regulatory capital, various types of capitalcould be used. In broad terms these can be split into three main categories: -

• Equity where an individual or body provides access to funds in return for a share in the profits of the company.

• Debt where an individual or body provides some form of loan

arrangement, repaid over time with interest. • Hybrid where an individual or body provides access to funds and

receives a return through a combination of interest and profit sharing.

The cost to an organisation of the various forms of capital will depend on the level ofrelative risk exposure to the investor and to the availability of capital at any point intime in the market. We do not cover cost of capital in detail here but have tried to giveindicative costs for the different capital arrangements that we discuss later in thepaper.

1.3 The Role of Capital in the Life Industry

It is worth considering reasons why the life assurance industry needs capital. For alife assurance business (like most other businesses to a greater or lesser extent),there are a number of key reasons why access to capital impacts the way thebusiness operates. In particular:-

• The level of a company’s capital will have a key role to play in achieving its overallstrategic direction. For example, capital levels will impact acquisitions, mergers,demutualisations and new ventures. This is particularly relevant given theconsolidation currently going on in the industry.

• The timing mismatch of expenses and charges in most life assurance contracts

means the life office needs access to capital to fund a cashflow strain from writingnew business. This issue has taken on increasing prevalence following theelimination / reduction of heavily front-end loaded contracts. The impact ofinitiatives such as the ABI’s SALTR scheme may have a further impact on thecharging mechanisms that will be acceptable in the market.

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• The levels of guarantees in a product impact the level of solvency margins acompany has to hold and will therefore impact capital requirements. For example,a capped charge on stakeholder pensions could require a 1% of reserves solvencymargin to be held for unit-linked business.

• The level of free capital in a with-profits fund will have an impact on the investment

strategy of the fund. This reflects the concept that if you have less free capital (i.e.less of a cushion), then you should be investing in less risky investments (e.g. giltsrather than equities).

• The financial strength of life companies is significant in determining new businesslevels. For example independent financial advisers rate financial strength as oneof the key determinants of deciding whether or not to place business with anyparticular company.

1.4 The Impact of Regulation in the UK

In the UK the valuation regulations impose reasonably strict constraints on the level ofreserves and solvency margins that companies have to hold. These regulations havedeveloped over time and with the professional judgement of the Appointed Actuaryshould ensure that policyholders (and companies) are protected against adverseexperience. Historically this framework has helped ensure that companies have hadsufficient capital to meet PRE in all but exceptional cases.

New valuation regulations took effect from 29 May 2000 and these will further increasethe capital requirements for some life companies.

1.5 Current Issues Impacting Capital

Over the recent past there have been a number of major issues that have resulted insignificant capital impact on the life industry.

During the last few years we have seen significant merger and acquisition activity inthe UK life assurance industry, at least partly driven by capital requirements. This islikely to continue and will provide further scope for innovative mechanisms of raising orreleasing capital. At the time of writing this paper there are at least two mutual lifeassurance organisations in the UK that are considered to be actively on the market.

Guaranteed annuity options, which were added as a benefit to many pensions policiesin the 1970s and 1980s, offered policyholders a fixed annuity rate based on a low rateof interest. As interest rates have fallen, the options have provided annuity rates thatprovide better value than those available in the market. This, together with the needto reserve for future exercising of options, has had a significant negative impact onsome office’s free capital. In particular the recent legal judgement against EquitableLife has led to their announcement that they are looking to sell the business.

Pensions misselling has resulted in offices having to hold significant reserves to meetfuture compensation payments. Again this has impacted to a major extent on someoffices’ capital positions.

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Recent adverse reports about some endowment mortgage products and theirlikelihood or otherwise of providing sufficient returns to repay mortgages has started tohave capital implications as further guarantees have been added to products.

Pricing pressures are having an impact on the level and shape of charges that a lifecompany can impose. In particular, the advent of stakeholder pensions and CATmarked ISA products are leading to additional capital requirements for those officesthat decide to operate in these markets. Also impacted here are market pressures toavoid the use of market value adjusters on with-profits business.

Finally the new UK valuation regulations will have significant capital implications forsome offices, particularly for unitised with-profits business. These new regulations willrequire life companies to reserve more realistically (i.e. effectively allowing for PREexplicitly) and result in additional capital requirements, the scale of which will dependon the companies’ current approach to valuation.

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Section 2. - Products and Techniques for Managing Capital

In section 1, we looked at some reasons why a life office might need to manage it’s capital.In this section, we look at some of the ‘products’ that have been used in the UK lifeassurance industry to help to manage that capital position.

The products and techniques considered are as follows:-

2.1 Financial Reinsurance2.2 Securitisation2.3 Subordinated Debt2.4 Banking Products2.5 Derivatives2.6 Equity2.7 Internal Reorganisation

An office may employ one or more of these concepts at once, and sometimes more thanone tool may be employed in a single transaction.

To cover some of these areas fully would need a paper (or a book) in itself. What we intendhere is to provide an outline description of each topic together with typical features andexamples.

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2.1 Financial Reinsurance

Financial Reinsurance, or FinRe as it has become known, is difficult to defineprecisely. It was defined in the paper “FinRe”1 as:-

“FinRe is reinsurance that is motivated by financial as well as risk transfer goals.FinRe employs the future profits contained in a block of new or in-force business toachieve a financial objective for a direct writer.”

Generally, the main aim of FinRe is to exploit some form of regulatory arbitrage inorder to more efficiently manage the capital, solvency or tax position of a life office.By definition, this is done in the form of a reinsurance contract between the Reinsured(say, a UK life company) and the Reinsurer (an offshore reinsurance company).

Traditionally, the most common form of FinRe is known as surplus relief, and we lookat this in more detail below. However, there have been many different kinds ofreinsurance contracts designed in recent years, all of which could be classified broadlyas FinRe.

We will now look in more detail at the following examples of types of FinRe:-

2.1.1 Surplus Relief2.1.2 Asset Admissibility2.1.3 Virtual Capital

1 “FinRe” by Brett & Cowley, SIAS 1993

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2.1.1 Surplus Relief

Definition of Surplus Relief

Surplus relief involves taking (part of) the embedded value, locked into a lifefund as a result of prudent reserving requirements, and turning some of it into anupfront regulatory asset.

The aim of this type of product is to raise regulatory capital. An asset is created,either in the form of cash or in the form of a deposit with the reinsurer. However,there is no equivalent liability on the balance sheet, as repayments of the ‘loan’are contingent on future surplus emerging.

A typical structure for such a transaction would be as follows:-

Reserves

Deposit back

Initial Advance

A block of business is selected with an embedded value of (say) 2000. This2000 ‘asset’ is inadmissible for regulatory accounts, but may or may not beincluded in the company accounts.

The block is reinsured with a Reinsurance company, and a reinsurance premiumequal to the reserves held is payable to the Reinsurer. For reasons includinginvestment control and credit risk, this premium is deposited back with (i.e.loaned to) the life company. The life company now has no liability to thepolicyholders in respect of the chosen block of business, but instead has anequal liability to repay the deposit from the Reinsurer.

Now, in return for having first call on specified margins emerging from thechosen block, the Reinsurer will make an initial advance to the life company.The advance, plus interest, is repaid out of the margins emerging and oncerepaid, the treaty can be canceled. However, if insufficient margins emerge overthe lifetime of the business reinsured, whatever is left unpaid is a loss to thereinsurer.

The advance made is a cash asset in the hands of the insurer, but sincerepayment is contingent on the emergence of margins not included in theregulatory returns, no reserve needs to be put up to allow for repayment. As amodification, the advance may be loaned back to the reinsurer. Then, the assetto the insurer is a loan due to be repaid.

Effect on Company Accounts

There may be little effect on accounts, but this depends heavily on how futureprofits are accounted for. If an embedded value is included as an asset in the

Life Company Reinsurer

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company accounts (either directly or in part as a DAC asset), then the onlychange will be that part of the embedded value will have been replaced with anet asset (of the same order of size).

As a result, there is likely to be little or no effect on the share price of a publiclyquoted company. Analysts are unlikely to notice, let alone understand, such areinsurance transaction unless it is of a very significant size. Even then, themost likely effect will come from any change in rating from the major ratingagencies.

Timescale

The length of time required to put together such a reinsurance contract variesgreatly, depending on the size and complexity. Often, the most important factoris how fast the life company can or wants to move. A treaty can take anythingfrom a few weeks (for the simplest of transactions) to a year.

Capacity

Capacity within the reinsurance market depends on the type of transaction. Fora simple cashless surplus relief, it should be possible to construct a treaty thatprovides up to £1bn of financing for any one life company with any one of themajor reinsurers. For a more complicated structure, or one with, say, downsideinvestment risk, there may also be a market cap - any one reinsurer will onlywant to be exposed to a limited amount of one type of risk across all itsbusiness, and there are only a limited number of high quality reinsurers, strongenough and capable enough to write such deals.

Pricing

If a cash advance is made, say under a surplus relief contract, the price willprobably be expressed as a margin (usually between 1% and 3%) over LIBOR.If there is no cash involved, the margin will be between 0.75% and 3% of theregulatory benefit achieved. The actual amount charged for any one deal willdepend on its size & complexity, the size, strength and rating of the lifecompany, the type of business reinsured and so the security and volatility of thetreaty to the reinsurer, whether cash is advanced or not, and the country andcurrency of origin.

New Business Financing

New Business Financing is very similar to Surplus Relief. The aim is the same -to generate regulatory capital - though often there is a specific need for the cashto be advanced, i.e. the payment of the initial expenses incurred when writingnew business.

The main difference is that new business financing involves reinsuring blocks ofnew business as they are written. Often, this involves splitting new business upinto tranches. Each tranche consists of business written during, say, a calendarquarter. At the end of each quarter, the business written is reinsured, and anadvance is made.

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2.1.2 Asset Admissibility

Background

Occasionally, a life office will hold an asset that is not admissible for thepurposes of the statutory valuation. For example, an asset value may breachcounterparty limits, or an in-the-money derivative held may be of the typedeemed inadmissible by the authorities.

In this case, the life office must either exclude the value of the asset, leading toa weaker solvency position, or must sell the asset and reinvest, which may beexpensive or undesirable. Alternatively, there may be a way, throughreinsurance, to solve the issue.

The Reinsurance Arrangement

A reinsurance contract may be constructed that mirrors the realistic value of theasset. The asset may be transferred to the reinsurer as a reinsurance premium,and the equivalent liability is reinsured through the treaty. Since liabilitiesreinsured are netted off from total liabilities, this structure falls outside of theadmissibility rules, and so solves the problem.

Example

Let’s suppose that the office holds an asset, perhaps a package of derivatives,which for some reason is not an admissible asset for regulatory purposes.However, the office has a good reason for holding the asset, and does not wantto sell.

A reinsurance treaty may be put in place between the life company and anoffshore reinsurer. To qualify as a reinsurance arrangement, there must be atransfer of risk in the structure, and in addition:-

• a block of liabilities (preferably those that give rise to the need to hold theasset) is reinsured,

• the derivatives are (notionally) transferred over to the reinsurer as thereinsurance premium,

• to avoid the need to actually transfer assets, they may be loaned back to thelife company to manage, and

• the mechanism within the treaty will then ensure that any differencebetween the proceeds from the derivatives and the cost of meeting thereinsured liabilities is recouped or repaid.

The life company has now reinsured a block of business, the liability for which itcan net off against its total mathematical reserves. In return, it has paid apremium in the form of assets that had no regulatory value. Its regulatoryposition is therefore improved.

Effect on company accounts

There should be little effect on company accounts. Any effects will be secondorder. These small effects will include:-

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• the company will no longer have to put up extra capital to bolster itsregulatory position, or take some other form of action to mitigate theregulatory effect of the inadmissible asset, but

• the company will have to pay a charge to the reinsurer for the use of itsbalance sheet and to cover expenses and profit.

Timescales

A structure such as this should not take long to put together. There may besome development time to ensure that the treaty achieves its aim, while notcreating any undesirable side effects for either party. If time is an issue, it maytake as little as a few weeks to complete such a transaction.

Pricing

The cost of such a transaction will vary depending on what risks are actuallybeing transferred to the reinsurer, and if there are any other risks (e.g. credit) tothe reinsurer.

However, for a fairly simple, low risk transaction, the price might be of the orderof 2% per annum of the liabilities outstanding (and so the regulatory benefitprovided).

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2.1.3 Virtual Capital

Background

Until a few years ago, Surplus Relief was the standard reinsurance solution for alife company seeking to boost its published free asset ratio. Surplus Relief isalmost always structured using non-profit business as the conventional wisdomwas that the regulators would not allow the use of with-profits business for FinRedeals.

Recently however, the pressures on the solvency positions of several UK lifecompanies has been great, and these offices have looked to raise much moreregulatory capital than could be provided by ‘traditional’ means. A new solutionwas required.

Structure

The Virtual Capital innovation is, in essence, a whole account stop lossreinsurance. Broadly, the initial structure is as follows:-

• A block of long term with-profits liabilities is chosen and reinsured.• Since, on the valuation basis, the life office expects to pay these liabilities as

claims, it notifies a claim to the reinsurer immediately.• The claim is not paid, but is held as a receivable to the life office, to be paid

when the primary liabilities are settled (expected to be in 30 or more years).• The life office can take immediate credit for the reinsurance receivable in its

regulatory statements, reducing its liabilities by this amount.

Of course, on a realistic basis, the life office expects that there will be plenty offuture surplus emerging over the life of the business. This will be distributed asreversionary and terminal bonus (and shareholder dividend if appropriate). Butthis surplus is not expected to emerge on the valuation basis assumptions, andso it is available to write down the outstanding reinsurance claim without losingthe regulatory effect.

So, on an ongoing basis, the following is expected to occur:-

• The amount of the reinsurance cover escalates with interest, calculated atthe average valuation rate of interest used each year for the reinsured blockof business. This avoids the need to discount the amount of the cover fromexpected payment date to the valuation date.

• The cover is also increased by the charges (detailed below), to avoid theneed to reserve for their payment.

• The cover is then reduced by a predetermined amount, designed to ensurethat the effect of the cover is reduced to zero over a certain number of years.

• This predetermined amount is, however, subject to a maximum in any oneyear equal to the surplus emerging in that year, calculated on a basis thatensures that the maximum amount of surplus is included without causing anyunwelcome reserving issues.

This structure provides the life company with a number of benefits:-

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• The desired regulatory effect is achieved.• There is little or no impact on administration and systems.• The treaty is very flexible - it could be cancelled or re-negotiated at any time

if necessary.

There is also some benefit to policyholders – the treaty effectively guaranteesthat the amount of the cover will emerge as surplus for distribution, therebyenhancing PRE. Also, the reinsurer will be at least AA rated, and probably AAArated, providing an enhanced level of security to policyholders with all but thestrongest life offices.

Effect on Company Accounts

There should be little effect on company accounts. Any effect is likely to besecond order in nature.

Timescales

It can take anything from 3 months to a year or more to get one of these deals inplace, depending on the size of the deal and the complexity of the underwritingprocess (the bigger the deal in relation to the level of security, the longer it willtake for the reinsurance company to get comfortable with the risks). Also, if thestructure needs adjusted, it may be that some discussions with the regulatorswill be required. The biggest driver though is likely to be the urgency with whichthe life office needs the deal in place.

Capacity

Several large Virtual Capital transactions have already been written, and marketcapacity is running low. There are a limited number of reinsurance companiescapable of accepting such a deal, and each one will have a limited capacity towrite more. Since the risk to the reinsurer is the same in each treaty (long termvery low investment returns), writing several smaller treaties doesn’t help areinsurer to diversify its risk.

It is possible to put together a cover offering a £1bn regulatory effect, perhapsby spreading the risk over more than one reinsurer. From the life office’s pointof view, it is probably not worthwhile using this structure for a small deal due tothe complex nature of the treaty and the underwriting involved.

Pricing

The cost of a Virtual Capital transaction will depend on many factors such as theperceived level of risk and the level of cover, the exposure of the life office todownward movements in investment returns, the credit worthiness of the officeand the availability of alternative sources of capital.

Therefore, there is a wide range of possible costs – such a deal could costanywhere between 1½% and 3% of the outstanding cover per annum.

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2.2 Securitisation

Securitisation, in its most general form, is the moneterising of an illiquid assetinto tradable instruments. Typically, to achieve regulatory or accounting off-balance sheet treatment that are often primary motivations, such transactionswill be structured with an element of transfer of risk associated with the value ofthe asset thus resulting in the capping of any potential loss in value of the asset.

Here, we will look at two forms of securitisation relating to efficient capitalmanagement:-

• Embedded Value, and• Policy Loans & Other Assets

Examples of public transactions that have taken place in the market that areillustrative of the above are:-

• Mutual Securitisation – £260m Embedded Value Securitisation in April 1998for NPI

• San Giorgio – €275m Policy loan securitisation for Alleanza in Dec 1999.

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2.2.1 Securitisation of Embedded Value

Overview and objective

The securitisation of Embedded Value is the monetisation of the embeddedvalue, the present value of future expected surplus, of a block of in-forcebusiness for a life insurance company by the creation of tradable securities thatare sold to capital market investors. It is conceptually similar to FinRe althoughthere are a number of significant and clear differentiations.

The primary aim of Embedded Value Securitisation is to improve the regulatorysurplus capital ratios of the insurer or improve return on capital. The details ofhow this is achieved are discussed below. Secondary objectives of suchtransactions may include raising the profile of the institution in the markets andimproving the rating agency view of the institution.

Outline of Structure

A brief outline of the structure of a typical Embedded Value Securitisation is asfollows:-

• A Special Purpose Vehicle (SPV) is established, in an appropriate domicile,for the sole purpose of facilitating this transaction.

• The SPV will issue bonds in the international market; there may be a numberof series of bonds with different maturities and amortisation schedules.

• The proceeds of the bond issue are used to provide a limited recourse loanto the insurance company over which the bond holders have security.

• Repayment of loan principal and payment of interest on the loan to the SPVis made contingent on the emergence of future surplus from the definedportfolio of life insurance policies.

• A Reserve Fund is established using part of the issue proceeds to provideliquidity and an additional layer of protection to bond holders and is toppedup on occurrence of certain trigger events.

• Because the loan repayment is contingent on the emergence of futuresurplus, the loan from the SPV it may not considered a liability for regulatorypurposes.

• The loan proceeds however, may count as an asset for solvency purposes.

• Hence the insurance company’s solvency ratio may be improved.

• Financial guarantees may be used to enhance the ratings of the notes in thegiven structure.

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Issuer SPV InvestorsInsurance Company

InsurancePortfolio

Bond Principaland Interest

Limited Recourse Loan

Bond IssueProceeds

On-Going Cashflows

Initial CashflowsReserveAccount

Loan Principal andInterest subject to

emergence ofsufficient surplus

SurplusEmerging from

SecuritisedPortfolio

Initial Transfer

with Further Transfers

on Trigger Events

Transfers

on Occurrence

of Shortfall

Shortfall Cashflows

Rating Agency Analysis of Transaction

For a public deal, transactions are typically rated by two of the three leadinginternational rating agencies (S&P, Moody’s, Fitch), who will carry out a detailedand thorough analysis of the transaction. Each may have differing approachesto their analysis of the same transaction but the key aspects the rating agencieswill focus on are the same, i.e.:-

• Legal structure of the transaction.• Exposure of the transaction to the financial strength and operating risk of the

insurer and the impact of the securitisation on the insurer itself.• Credit enhancement provided by creation of a reserve fund or third party

liquidity provider.• Coverage ratios:-

- Asset Coverage Ratios (EV versus debt outstanding).- Debt payment coverage (emerging surplus versus debt service).

• Other structural features such as guarantees, derivatives and swaps thatmay mitigate the risks of the transaction.

Unless the structure incorporates an external guarantee from a suitably highlyrated counterparty or other suitable credit enhancement features in thetransaction structure, the rating of the Bonds issues is likely to be capped at theclaims paying ability of the insurer.

A fundamental part of the rating agency analysis will be to look at theperformance of the assets and cashflows under suitably stressed scenarios.The main parameters (depending on the transaction structure), the impact ofwhich they will investigate in their required stress tests might be:-

• Investment returns• Termination rates• Mortality

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• Expenses• Interest rates

Regulatory Impact

To achieve the desired impact on regulatory solvency for such an EmbeddedValue Securitisation transaction it is vital to have clearance from the appropriateregulatory authorities. The key to the regulatory analysis will be the extent towhich the loan provided to the Insurance Company is truly on a limited recoursebasis and the extent to which the repayments that are contingent on theemergence of sufficient surplus on the defined portfolio of policies amounts to aclear transfer of risk.

If regulatory approval is achieved then the insurance company will be able toconsider the loan as a liability of the long term business fund which, because ofthe limited recourse nature of the loan, will have beneficial reservingimplications. Consequently there will be an improvement in the company’sregulatory solvency by an amount equal to the proceeds of the issuance less theReserve Fund and expenses of the transaction. It is possible that theimprovement may be greater depending on the reserving policy adopted for theReserve Fund.

Impact on Accounts

The impact on the balance sheet resulting from such a transaction is likely to bethe increase of both assets and liabilities equal to the net proceeds of the issueas the “off-balance” sheet nature of the loan is from a regulatory perspectiveonly. If however the EV is already shown as an asset in the accounts, the valueshown should be reduced accordingly to reflect the EV that has beensecuritised.

Share Price / Analysts View / Rating Agency View

The impact on the business of the company, the analysts view and implicationsfor the share price should be positive in general. In part this will depend on costof the capital released compared to other available sources. In particular, theuse to which this capital will be put may, potentially, play a more significant partin this analysis; for example, if this capital raising exercise is part of anacquisition or expansion strategy.

From a rating agency perspective the analysis is different. When assessing thefinancial strength of an insurance company they already allow credit for theembedded value to a degree. To the extent that a securitisation releases capitalby “selling” embedded value, credit will be given. The proportion of capital thatcan come from this source is limited. The use to which the capital is placed willalso impact their analysis.

Timescale

Embedded Value Securitisations are typically complex and can require 6months to structure for the first deal. They can be executed more quickly butthis will depend on, amongst other things, internal commitment to the

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transaction, resource available and systems implications. Subsequent dealswould typically be executed much more quickly.

Costs and Pricing

The expenses of a typical transaction, consisting chiefly of fees for legalcounsel, rating agencies and other third-party advisors can be significant makingsmaller deals less viable. In addition, underwriting fees for the Bonds will needto be paid to the Lead Manager possibly together with a structuring/arrangementfee also.

The Mutual Securitisation Bonds were sold at rates of 7.39169% and 7.58730%which corresponded to 1.4% and 1.7% over the relevant gilts at the time ofpricing. Pricing for such deals will be a function of duration of the notes andrating but will be dependent on market conditions with respect to gilt pricing andcredit spreads at the time of pricing.

Capacity and Investor Types

The capital markets have capacity for very large deals – multi billion $, Euro and£ deals are not unusual in the mortgage backed securities (MBS) and corporateloan securitisation (CLO) markets, so size is not necessarily a constraint. Forsmaller deals (less than £50m) a public offering may not be viable and a privateplacement may be more appropriate. The large available capacity can be onekey advantage of the capital markets over the reinsurance market.

The type of investors that can expect to buy into such a transaction will beprimarily insurance companies, pensions funds and asset managers, especiallyfor longer dated issues. Banks and structured investment vehicles will havemore interest for bonds with shorter dated maturities.

The depth and breadth of the European securitisation market investor base haveincreased dramatically over the last two to three years. This is beneficial for theplacement of such transactions.

Repayment Period

One of the key advantages of securitisation is that it is able to tap the capacitythat exists for long term funding in the capital markets, at competitive rates. Inthis respect it can compete favorably with the reinsurance and banking markets.To extract full value, the transactions need to reflect the period over which theembedded value is expected to emerge – possibly 30 to 40 years.

The graphs below show the expected amortisation profile of the MutualSecuitisation Bonds:

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Tax Implications

The tax implications of such a transaction can be complex and will need to beanalysed in the context of the particular proposed transaction structure and taxposition of the insurer.

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2.2.2 Securitisation of Policy Loans and Other Assets

Overview and Objectives

This type of securitisation relates to the monetisation of the various categories ofassets that may be held by an insurance company by the creation of tradablesecurities that may be sold to capital market investors.

Such transactions can typically be used to improve the regulatory capital ratiosof the insurance company by managing the level of admissible assets.

However other objectives may be more significant; these may include using thecash raised to invest in higher yielding assets to improve overall returns topolicyholders or return on capital.

Types of Assets

The sort of assets that may be securitised include:-

• Policy Loans• Real estate• Mortgages• Illiquid bonds

Policy loans are clearly a form of securitisation more specific to life insurancecompanies. The other types of assets mentioned are often also securitised byother financial institutions and are therefore also similar to these othertransactions with respect to structures and investor base.

Outline Structure

A brief outline of the structure of a typical securitisation, using policy loans as anexample, is as follows:

• A Special Purpose Vehicle (SPV) is established, in an appropriate domicile,for the sole purpose of facilitating this transaction.

• The policy loans are sold to the SPV by the insurance company; a legal truesale opinion is typically required in relation to this.

• The SPV will issue bonds, secured on the assets of the SPV, in theinternational market to fund the purchase of the assets.

• There may be a number of series of bonds with different levels of time andcredit subordination to provide the optimum financing arrangement.

• The interest and principal cashflows of the assets will be used to provide theinterest and principal payments in relation to the bonds.

• The transaction structure may incorporate interest basis and currency swapsdepending on the interest basis and currency of the assets and that of thenotes issued.

• For a transaction backed by policy loans, without external guarantees orcredit enhancement, the highest possible rating achievable on the Notes

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may be restricted to that of the claim paying ability of the insurer asultimately it is the surrender value of the policies (payable by the insurer) thatcollateralises the loans that are being securitised. This sort of linkage maynot be the case for other assets such as mortgages.

• The insurer may be required to hold an equity position in the transactionwhich will expose it to the first layer of loss experienced for the loan portfolioand provides credit protection for the Noteholders.

• The insurance company would continue to administer the assets on behalf ofthe Noteholders.

Issuer SPV Investors Insurance Company

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Rating Agency Analysis of Transaction

The key aspects of the transaction that the rating agencies would be expected tofocus on are:

• Legal structure of the transaction.• True sale of assets.• Historic payment, loss and delinquency statistics for the portfolio• Exposure of the transaction to the financial strength and operating risk of the

insurer.• Credit enhancement aspects of the transaction such as reserve funds,

excess margins and subordination of different tranches of Notes.• Other structural features such as guarantees, derivatives and swaps that

may mitigate the risks of the transaction and the financial strength of thecounterparties.

• Again the analysis will be based on a robustness of the transactioncashflows to various stresses of the key risk parameters both in isolationand together.

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Regulatory and Accounting Impact

For a particular category of asset, such as policy loans, the insurer may behitting regulatory limits for admissibility of assets for the purposes of solvencycalculations. By securitising the assets they are effectively sold and the cashraised can be used to buy assets that fall within admissibility limits. In this waythe insurer may see an improvement in its solvency ratio. This thereforeimproves the capital position of the company from a regulatory perspective.

The impact on the balance sheet resulting from such a transaction is likely to beneutral as one type of assets are transferred into another. The exception mightbe if assets were shown at book value and are sold at a higher price, closer totheir true economic value, to the SPV. This of course ignores the impact oftransaction expenses and taxation.

Share Price / Analysts View / Rating Agency View

As with EV securitisation the benefits depend largely on the availability and costof other sources of capital and more significantly the impact of the additionalcapital on the future of the business, based on the use to which this capital is tobe put.

Timescale and Costs

These types of securitisation transactions can typically take 3 to 6 months tostructure for the first deal with greater efficiencies for repeat transactions.

Transaction costs would be expected to be significantly less than that for anembedded value securitisation as these structures are more standard in nature.

Pricing will depend on market conditions but will be based upon factors includingrating, term, average life, BIS weighting and asset type.

Capacity and Investor Types

Securitisation of policy loans and mortgages in particular are likely to get bestexecution structured as Floating Rate Notes with 3 to 5 year expected averagelife targeted at Banks and Structured Investment Vehicles and Asset Managersas this is where the market for these notes would be deepest. Real estatebased securitisations are likely to include longer dated fixed rate tranches whichwould typically be sold to insurance companies and pension funds.

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2.3 Subordinated Debt

2.3.1 Description

A life company can raise capital through issuing subordinated debt in the capitalmarkets. The main aim of subordinated debt is to generate additional capitalthat improves the free capital position of the office. In the UK, life offices issuingsubordinated debt include:-

• Scottish Amicable, which raised £100m in 1993

• NPI, which raised £100m in June 1996 and a further £30m in October 1996.

2.3.2 Structure

The company issues debt, normally through a stand-alone subsidiary, which isguaranteed on a subordinated basis by the Life Company, i.e. the repayment ofthe debt is guaranteed only after the policyholders’ reasonable expectationshave been met. The debt can be dated or undated, though this will impact theamount available as an admissible asset and may impact the tax implications.

2.3.3 Regulatory Effect

The impact of a subordinated debt issue will be to increase the assets, ascalculated for regulatory purposes, of the Life Company. However, as the debtranks behind policyholders in a wind-up, there is no requirement to reserve forthe repayment of the debt, and so there is no increase in the long-term liabilities.Hence the free asset position of the company is improved.

In considering the amount of debt to issue, some consideration needs to begiven to asset admissibility limits. Where the subordinated debt is undated, theamount allowed under admissibility limits to count towards the regulatory assetsis restricted to 50% of the required margin of solvency. Where the debt is dated,this restriction becomes 25% of the required minimum margin.

2.3.4 Impact on Rating agency and Analysts View

The overall impact of the arrangement is likely to be seen positively by analystsin terms of the finances of the organisation. However, it could also be seen asan indication of a lack of capital, which could have a negative impact onoutsiders’ perspective of the company.

Rating agencies will treat subordinated debt as equity subject to someconstraints on issues such as there being a sense that the debt is permanentand that only equity ranks behind it in a liquidation scenario. Overall limits willhowever, be set on the ratio of hyrbrid capital (including subordinated debt andsecuitisation) to equity capital.

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2.3.5 Practicalities and Costs

To organise a subordinated debt issue is likely to take approximately 3 to 6months. Depending on the intricacies of the eventual structure, it could takelonger. Costs are likely to be of the order of 1½% - 2% above the yield on giltsthough this all depends largely on the credit rating of the company.Implementation costs will depend on the complexity of the arrangement butcould be significant, not least because of the requirement for investmentbankers and legal advisers to support the issue.

As mentioned above, the debt can be dated or undated. For undated stock,arrangements can be made in the structure to give an indicative repayment date.For example, a margin step up could be set after say 25 years which allows thebenefits in terms of admissibility (and potentially tax) of undated debt, but impliesan effective repayment term for investors.

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2.4 Banking Products

2.4.1 Overview

In this section we will discuss capital management solutions provided by thebanking sector directly (and not as intermediaries as with securitisation).

There are a number of products that the banking sector has to offer theinsurance industry:-

• Monetising embedded value (as with securitisation)• Liquidity Facilities• Contingent capital• Senior unsecured financing• Derivatives

2.4.2 Monetising Embedded Value

Monetising of embedded value is the provision of limited recourse lendingsecured on the embedded value of a block of business. In this sense it is verysimilar to securitisation although it may be structurally more straight forward andrely on the bank itself for financing as opposed to the capital markets. Thecapital relief achieved should be the same as with securitisation. The appetitefor long term financing (other than for real estate) is limited with a tenor of 5 to10 years being typical. This makes it difficult to release embedded value asefficiently as with securitisation. Cost effective fixed rate financing is also morechallenging to obtain in the banking sector.

2.4.3 Senior Unsecured Financing

Senior unsecured financing directly for an insurance company would not havecapital benefits. However such financing at the group level can be used within agroup structure to provide capital to insurance subsidiaries. It can be more costeffective than other forms of capital but clearly has financial strength implicationsat the group level.

2.4.4 Liquidity Facilities

Liquidity Facilities can be used to provide short term financing for companiesfacing rapid business growth. This will not help capital ratios.

2.4.5 Contingent Capital

Contingent Capital can be a cost effective method of protecting the capital baseof an insurance company. Under such an arrangement capital would beprovided as it was required following a deterioration of experience (i.e. it isprovided when it is needed). Although such arrangements clearly improve thefinancial strength of an insurer and can be given credit for by a rating agency,they lack visibility.

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2.4.6 Derivatives

Derivatives, provided by Banks, some of which may be highly structured mayalso be used for capital management (see section 2.5).

2.4.7 Timescale and costs

From a timescale and cost perspective, solutions in the banking market can berelatively cheap and quick to execute. The costs are likely to be more thanreinsurance market solutions but less than capital market solutions.

2.4.8 Capacity

Balance Sheet capacity is an issue for all lines of business in the banking sector.Generally capital is increasingly being rationed with the use of balance sheetbeing subject to strict ROE criteria. This makes the cost effective provision ofcapital solutions from the banking sector potentially challenging. There is agreater degree of flexibility to execute smaller transactions than with the capitalmarket based solutions.

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2.5 Derivatives

2.5.1 Introduction

Regulatory requirements and prudent management require that any life insurerentering into derivative contracts must exercise caution. The insurer needs toensure that its derivative strategy assists in the efficient management of itsbusiness and serves to reduce the insurer's risk. Apart from the efficientmanagement of its asset portfolio, derivatives have been used by offices to helpprotect their statutory solvency position.

2.5.2 Examples of the use of derivatives

If an insurer is concerned about the impact of a fall in its equity values it couldenter into a contract to protect its equity portfolio falling below a certain level.Potentially, the cost of this "downside protection" could be partially met by thesale of some "upside" potential via a second derivative contract.

Another example of the use of derivatives to protect an insurer's capital basehas been seen recently for some offices that find themselves with a "guaranteedannuity option" problem (i.e. the insurers have written deferred annuities with theoption to convert the cash at vesting into an annuity on guaranteed terms). Inorder to protect against the very large increase in liabilities that could occur inthe event of a fall in interest rates, some insurers have entered into "swaptions"(i.e. an option to take out a swap on a pre-determined basis at the deferredannuity vesting date). In the event of an interest rate fall, the change in value ofthe swaptions is intended to match the change in the insurer's liabilities.

A full description of the use of derivatives would merit an entirely separatepaper. Pricing these contracts can be complex. The statutory regulationsconcerning the use of derivatives, especially those purchased from theinvestment banks specialising in these contracts (and their treatment asadmissible assets) are certainly complex. Additionally, when establishing suchcontracts, the legal/contractual arrangements (particularly as regards securityand limiting counter party risks) and confidentiality issues need carefulconsideration.

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2.6 Equity

2.6.1 Introduction

The main thrust of this paper is around hybrid capital products. However, in thissection we also provide, for completeness, a very brief overview of the mainsource of new capital for life companies in the UK, namely equity.

2.6.2 Structure

The opportunity to raise equity capital will depend on the fundamental structureof the company. A mutual life office will have to change its structure to ashareholder owned organisation before it can access equity markets. This couldeither be achieved through a sale / merger or through floatation.

For a life company, there are two potential sources of equity capital. If thecompany is part of a group, then the company’s source of equity is most likely tobe their parent company. It is probable that the company will have to go througha rigorous justification process to source the capital and the parent will demandan acceptable return. Once a parent has put equity capital into a subsidiarycompany, it is extremely difficult to get it back, other than through extraction ofdividends over time or selling their shareholding to another party. However,subject to these considerations and the parent’s capital position, the sourcing ofthe capital should be reasonably straightforward.

For a stand-alone company, equity can be found in the capital markets. To raiseequity capital in this way, the company will need to demonstrate a successfultracking history and a coherent business plan for the future.

For a new (non-mutual) life company authorisation, the regulators in the UK willnormally look for shareholders to have committed a significant proportion of thecapital either in equity or in some form of debt capital that can be converted toequity at a future date. Thus it is likely that any new insurer will require asignificant shareholder commitment in addition to potentially using some of theother products (e.g. financial reassurance for new business financing) coveredearlier in this paper.

2.6.3 Timetable and cost

Raising capital in the market may take several months as market rules andregulations will have to be followed. The extent of these will depend on themarket in which the capital is being raised. In any event, equity capital onceinjected into in a company will rank after all other capital. As a result, the rate ofreturn required on equity will be higher than the other forms of capital covered inthis paper.

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2.7 Internal Reorganisation

2.7.1 Introduction

There are a number of "internal" strategies that can be adopted to improve theuse of capital and ensure that capital within an insurance group is allocated tothose areas of a group's business where it is needed. Broadly, these internalapproaches can be categorised as:-

• optimising the structure of the insurance group• reviewing the asset allocation of the group• reviewing the product mix and statutory reporting approach currently

adopted.

2.7.2 Structure

It can sometimes be the case that, for entirely valid historical reasons, an insurerfinds that its group structure is not entirely appropriate for its current needs. Forexample, a group may contain a number of life insurance companies operatingas separate subsidiaries. For statutory purposes each of these subsidiaries willbe required to be capitalised on a prudent basis and it may be that if thecompanies were combined in a single life insurer some duplication could beeliminated and capital thereby released.

Another situation can arise in the case of insurers with established and wellcapitalised with-profits funds. It may be appropriate to utilise the estate(effectively that part of the with-profits fund that will ultimately provide terminalbonuses) as capital to invest in appropriate activities. Naturally, suchinvestments need to be carefully considered and in particular there will be aneed to ensure that the investment is appropriate for policyholder funds and willproduce an appropriate investment return for policyholders.

A review the operations of the company may suggest that certain activitiesshould not be retained within the life assurance fund. For example, somecompanies have set up a separate non-insurance company designed to providemanagement services to the insurer.

Further, the marketing and sales function could be undertaken by a companywithin the group but outside of the life insurer. This can facilitate the financing ofsalesforce recruitment and initial commission (this approach can be of mostinterest to companies with direct salesforces and to bancassurers).

2.7.3 Asset allocation

The asset allocation strategy of an insurance company can have a markedeffect on its statutory capital. In broad terms the maximum valuation yieldrequirement and the current resilience test causes an insurer with an equityoriented strategy to have higher statutory reserves than an insurer whose policyis more focused on bonds. A life insurer with limited capital may find itself in thesituation where to demonstrate statutory solvency it has to invest a higherproportion of its assets than it would wish in gilt-edged stocks and corporatebonds.

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In respect of its bond portfolio the life insurer needs to make decisions that havean effect on its regulatory capital. The more closely an office matches the lengthof its bond portfolio to its liabilities, the lower its statutory resilience reserve willbe. Conversely, the more capital resources an office has, the more it is able totake a position as regards mismatching its bond portfolio.

Also, a decision needs to be made on the balance between government stocksand corporate bonds. A higher yield is likely to be obtained from investing incorporate bonds than government stocks but, of course, this is at the price ofadditional risk. The extent to which the office can take risks will depend upon itscapital resources.

2.7.4 Statutory Issues

The insurer can consider the strength of its valuation basis relative to thevaluation regulations and in the context of its business plans. Clearly a change invaluation basis can increase or decrease the insurer’s apparent regulatorycapital, but the office needs to be careful not to infringe rules on arbitrary basischanges.

A number of life insurers make use of an "implicit item" (an intangible assetbased on past profits) to support their statutory solvency margin requirements.The use of an implicit item is subject to the approval of the regulator.

Insurers with long established with-profits funds with "orphan estates" can seekto clarify the rights and expectations of policyholders and shareholders (whichmay have become unclear over time). Clarifying these rights is likely to requireextensive discussion with the regulator but the clarification of the ownership ofthe estate can ensure that this capital is used appropriately.

Insurers can review their product mix and product terms. One point to bear inmind is that "guarantees" in products (much liked by marketing departments)can be expected to carry onerous reserving requirements and as such be heavyconsumers of an insurer's capital.

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Section 3 - Perspective

To put capital management in the life insurance industry into perspective, it is interesting tolook at how these issues are dealt with in other industries. For this purpose, in this sectionwe take a brief look at the management of capital in the non-life insurance industry and thebanking sector from which a number of interesting parallels can be drawn.

3.1 Non-Life

The issues that non-life companies face, and the way they deal with them, aregenerally very different from the life industry. Hence, the motivation behind non-lifefinite risk transactions, and the structure of the solutions tend to differ from those ofthe life industry.

Typical reasons behind non-life finite deals are:-

• smoothing of profit and loss accounts.• improving the solvency and matching position of the balance sheet.• provision of capacity to write more direct business.• guarantee of provision of reinsurance capacity for a number of years.

For example, when the first ‘alternative’ reinsurance deals were struck, regulationspecific to Lloyd’s syndicates could be restrictive. Liabilities had to be valued withoutdiscounting to allow for the fact that claims may not be made and settled for manyyears, while assets had to consist of short term, highly liquid instruments. This forcedcompanies writing longer term non-life business to mismatch, and reduced profits.

To solve this issue, the Time & Distance structure was created. This involved theinsurer paying a premium to a reinsurer out of current assets in return for the reinsurersettling some future claims. The claims to be settled were defined in such a way that,effectively, no risk was being transferred – the amount of the claims was fixed to bethe premium plus interest. This solved both the discounting and mismatchingproblem.

T&D deals are now ineffective from an accounting standpoint, but have been replacedby the Loss Portfolio Transfer. An LPT is broadly similar to a T&D, but with a limitedelement of risk involved. Usually, a block of liabilities will be reinsured, and a premiumpaid. However, the premium will be expected to be sufficient to meet the claims, withthe excess being returned as a profit commission. The reinsurer will typically charge afee to cover any risk involved, plus a facility fee for the use of their balance sheet.

A second typical non-life structure is the spread loss treaty. Here, the motivation forthe reinsurer is to spread the effect of a possible big loss over several years. Forexample, an insurer covering an earthquake risk may expect that nine years out often, there will be no claims, but in that other year, there will be a very large claim. Inthat year, whenever it turns out to be, there may be a severe, adverse effect on theprofits of the company.

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To deal with this, the insurer may pay a series of premiums to a reinsurer, and inreturn, the reinsurer will pay a claim when it is needed. The definition of the claim willbe such that it cannot be much greater than the sum of the premiums, while if low orno claims occur, the premium can be refunded. In this way, the reinsurer is onlytaking limited, timing risk, and so can keep his charges down. While the insurer gainslittle economic benefit, he has a facility that helps him to reduce the volatility of hisreported results, which may be important at the very least for presentation purposes.At a more strategic level, reduction in result volatility should reduce the requirementfor capital allocation and, therefore, improve return on capital employed.

Often, reinsurance is the best medium for such structures, for two main reasons.Firstly, the accounting treatment of a reinsurance treaty may be different from that of atreaty written with another entity, e.g. a bank. Secondly, there may be tax efficienciesto a reinsurance treaty that may not exist with other types of structure.

In summary, non-life finite reinsurance has evolved separately from life financialreinsurance, and for different reasons, but there are similarities:-

• both usually involve some, but a very limited amount of, risk being transferred.• both can be used to help the company manage its profit flow and balance sheet

efficiently.• both can be used in a tax efficient way.

However, when you look at the detail, there is little comparison. The actual legislationis different, especially with regard to the valuation of assets and liabilities, and so thefinancial reporting of the business. Hence for example, a non-life finite riskreinsurance treaty looks very different to a life financial reinsurance transaction, bothin structure and in the language used.

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3.2 Banking Industry

3.2.1 Overview

Capital management is currently also a significant issue in the Banking Industry.In this sector, as with the insurance sector, it is necessary to distinguish betweenregulatory capital and economic capital when discussing capital management.Historically the focus has been on regulatory capital; this is changing withincreasing focus on economic capital. Capital and return on capital are keyelements of the banking business that increasingly impact on lending capacityand pricing in the market today.

3.2.2 Role of Capital

The Role of Capital in the Banking industry is:-

• to demonstrate regulatory solvency.• to demonstrate financial strength to market and rating agencies.• to enable the business to withstand deterioration of credit experience and

unexpected losses.• to provide funds in the event of other adverse events.• to finance growth and investment in the business.• to finance acquisitions.

3.2.3 Economic and Regulatory Capital

Regulatory Capital

Banks are regulated by their individual local regulators. Banks regulated andlicensed in a EU country can operate in any other EU country. Although there isharmonisation of banking regulations throughout Europe, there can besignificant differences from state to state as regulators interpretations of detailsvaries with respect to actual implementation.

The Basic bank minimum regulatory capital requirements are set out by theBasle Accord. Assets are given a risk weighting (BIS weighting) depending onthe type of asset. Capital equal to 8% of the BIS risk weighted assets must beheld as capital.

The current BIS weightings are as follows:-

• Loans to corporates and individuals 100%• Loans backed by residential mortgages 50%• Loans to OECD Banks 20%• Loans to Governments 0%

This means effectively that a minimum 8% capital must be held againstcorporate loans and commercial mortgages, 4% capital against residentialmortgages, 1.6% against loans to OECD banks and 0% capital against loans togovernments.

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This 8% minimum capital requirement can be made up of different “types” ofcapital. At least 4% must consist of Tier 1 Capital, which is equity. Tier 2Capital, which is effectively callable perpetual debt, can make up the remaining4%. Hybrid Tier 1 capital, which has characteristics of both Tier 1 and Tier 2capital, can also be used. The exact definitions of the Tier 1, 2 etc capital typescan vary from regulator to regulator.

Moves are under way to refine the current system to make the weightsdependent upon ratings/credit quality of the assets as opposed to just the typeof assets. For example under the new proposals, AAA rated credits will have aBIS weighting of 20% and a BB rated credit will have a 150% weighting.

Economic Capital

The definition of economic capital in the broad sense is the amount of capitalthat the institution determines it is appropriate to hold given its assets and itsbusiness objectives. Typically it will be determined based upon the risk profile ofthe individual assets in its portfolio, the correlation of the risk and the desiredlevel of overall credit deterioration that the bank wishes to be able to withstand.The analysis of the credit quality of a portfolio and the correlation of theexposures is not a simple task to undertake. There are a number of proprietarysystems in the market that are typically used in conjunction with internal creditanalysis systems and information from public rating agencies.

3.2.4 Factors influencing Capital

There are a number of factors leading to a current focus of attention on capital inthe banking sector:-

• Focus on return on equity by shareholders and therefore the need forefficient use of capital in the industry requiring proper rationing, allocation,monitoring and pricing within institutions.

• Consolidation in the sector leading to strains on capital ratios and theavailability of capital with a reduction in overall capital in the industry.

• Overall increase in risk profile of lending activities with new higher marginhigher risk business requiring suitable analysis of risk and allocation andpricing of capital.

3.2.5 Sources of Capital

The sources of Capital are as follows:-

• Equity/Tier 1• Hybrid Tier 1• Tier 2• Tier 3

Rather than issuing new capital, other Balance Sheet management activities canbe used to reduce the requirement for capital (see below).

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3.2.6 Capital Management

There are a number of ways in which a bank can manage its balance sheet toreduce regulatory and economic capital requirements. The most appropriatestrategy will depend on a variety of factors including:-

• cost of capital• cost of implementation• timescale of implementation• nature of assets• market conditions• overall strategic objectives.

Securitisation

Securitisation is one of the major tools that banks have available to manage theirbalance sheets. This enables assets to be removed from the balance sheet thatprovides substantial capital relief whilst also transferring catastrophic risk to thecapital markets and retaining the economic benefits of the assets. Securitisationhas been used by banks in relation to mortgage portfolios for many years.Increasingly over the last few years securitisation is being used in relation tocommercial loan portfolios where the regulatory capital relief achievable can bemore significant.

The benefits of a securitisation of a banks corporate loan portfolio (a corporateloan obligation or CLO) will depend largely on the credit quality of the assetssecuritised and therefore the level to which the capital participation of the bankin the CLO can be reduced. With a typical funded CLO the on balance sheetcapital requirement for a portfolio of corporate credits may be reduced from 8%to 2-3%. There are “Synthetic” CLO structures that utilise credit derivatives andthese may be easier to execute but are not as efficient from a capital releaseperspective because of collateralisation requirements and counterpartyexposures.

Credit Derivatives

Appropriate use of credit derivatives can also provide suitable risk transfer. Ifthe correct criteria are met regulators will accept reduced capital requirements inrelation to assets covered by such contracts (typically reducing from 8% to 1.6%reflecting the removal of exposure to a corporate credit replaced by a newexposure to an OECD bank which is the swap counterparty).

Issuing of Capital

Banks can issue further capital to help boost ratios, typically hybrid tier 1 and tier2, which are cheaper than equity. Equity can also be issued but that is unlikelyto gain favour in the market unless it is to finance a specific business objectivesuch as an acquisition.

Reducing Final Takes and Syndication

For a bank with strengths in originating and arranging loans and thereforegenerating substantial fee income a possible strategy may be to syndicate a

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higher proportion of such loans. This will reduce the amount of a loans finallyretained on a banks balance sheet and therefore reduce the level of capitalrequired.

Sale of Assets

Capital requirements can be reduced by selling assets. This is not workable asan ongoing strategy but can be an appropriate solution when exiting a particularbusiness sector.

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Section 4 - Future trends

In the future we see increasing pressure on the capital base of life assurance companiesarising from factors such as:-

• Consolidation and expansion in the industry.

• Increasing RoE focus and demands of shareholders.

• Flat loaded products (fuelled by the effect of stakeholder pensions.

• aggressive competition from fund management groups and new distribution methodssuch as the internet).

• tightened regulatory requirements as the regulators become increasingly concernedover factors such as policyholders' bonus expectations in with-profits funds andimproving annuitant longevity.

• lower investment returns in the future than have been experienced in recent years.

To be successful against this background life assurance companies will need to monitortheir use and pricing of capital increasingly carefully. This will apply to the larger offices aswell as the smaller players. In particular:-

• Insurers will need to make increased use of financial modelling tools.

• Insurers will increasingly consider the value of financial economics.

• Insurers will increasingly make use of products related to the banking and capitalmarkets including sophisticated derivatives and other products.

• Insurers will make increasing use of the very sophisticated reinsurance solutions nowavailable in the market and will take advantage of cross border reassurance (particularlyif there are any arbitrage opportunities).

• The large well capitalised reinsurers will seek to make additional returns on their capitalby employing it to support weaker insurers.

• Insurers will be increasingly reluctant to offer "guarantees" in products.

In short, the demands and challenges relating to capital management for insurers willcontinue. We expect this to be matched by more and more innovative and interestingsolutions from the increasingly diverse group of market practitioners.

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References

BRETT & COWLEY (1993) FinRe

SANDERS, A.J. (2000) Securitisation And Other Financing Options Available ToLife Companies

MUTUAL SECURITISATION offering circular for issue of limited recourse bonds