In the first of a two part document, Youssef Al Kareh explores the processes involved in the transfer of credit risk from the capital markets to the insurance markets
A derivative is a financial instrument that derives its value from the performance of another instrument called the underlying. A credit derivative is one where the underlying is mostly a portfolio of bank loans. Since our interest in this paper is to investigate the transfer of risk across different industries, this type of product is a classic case since it involves the transfer of bank credit risk to investors in general and to (re)insurance1 companies in particular, the latter being our focal point.
1.1 How can insurance companies assume bank credit risk?
This can be done in two ways, either via normal contracts of insurance (underwriting activity) or as part of their investment activity. These two methods actually corrrespond to the two ways in which banks lay off their credit risk.
The first one is the direct transfer through insurance contracts. This is the classical case of credit insurance where insurance companies write financial guarantees to creditors, i.e. they guarantee the performance of a financial obligation by the debtor. In other words, should the debtor default on its obligation, the insurance company has the obligation to discharge the debtor's liability towards the bank.
The second method is of more importance to us because it involves the issuing of securities (cash transaction) or the use of credit derivatives (synthetic transaction). This is usually done by the use of a transformer vehicle, be it a captive company, a special purpose vehicle (SPV) or a segregated cell in a Protected Cell Company (PCC). These transformers are usually set up in tax havens such as Bermuda and Guernsey for regulatory and fiscal reasons.
1.2 Why use a transformer?
The reason for using a transformer is to create bankruptcy remoteness from the originator or the sponsor so that investors are shielded from any financial difficulties that the originator might face.
In the case of an SPV, the assets are sold to the transformer and the latter issues securities. The proceeds are then invested in highly rated securities (usually T-Bonds) and are overseen by a trustee who would only allowtheir liquidation in case there is a default (i.e. to pay a legitimate claim), or upon maturity.
In the case of a PCC, the cell executing the transaction is part of a mother company, however, its assets are ring-fenced and whatever happens to the mother company or to the other cells, its assets remain intact. The PCC approach is said to be much quicker and much less expensive than a typical structure involving an SPV.
1.3 Cash Collateralised Debt Obligation (CDO)
The bank packages a portfolio of debt obligations of similar characteristics (loans, mortgages, credit card receivables...) and sells it to the transformer. The transformer issues bonds to investors in the capital markets to which insurance companies have access in their capacity as major investors. These bonds are serviced (coupon and principal) from the cash flows generated by the underlying portfolio.
The issue is normally made up of several tranches in order to appeal to different risk appetites. The highest tranch usually carries most of the structure (70 per cent to 90 per cent) and is often rated AAA and called senior or super senior debt because it ranks higher than all other tranches (higher order of repayment) and it is called upon only if there is a severe downturn in the economy. The lowest tranch is not rated; it is called the first loss and is equity-based.
This is similar to a classical excess of loss (XOL) reinsurance where the insurance company retains the first amount of a loss. In between these two tranches we have the mezzanine layers whose rating and riskiness vary according to the quality of the underlying pool of assets and the general economic environment.
These mezzanine tranches are sometimes credit wrapped2 by AAA rated insurance companies to facilitate their absorption by investors who might have stringent acceptance criteria. Figure 1 below is a graphical illustration of a typical cash CDO transaction (securitisation).
It is important to note that a marking feature of a cash CDO is the actual transfer of the legal title to the underlying assets to the SPV. This same feature will distinguish it from a synthetic one.
1.4 Synthetic Collateralised Debt Obligation
The main feature that distinguishes a synthetic transaction from a cash CDO is that there is no actual physical transfer of the assets (legal title to the assets) to the transformer, rather it is only the economic risk which is transferred through a credit derivative (credit default swap). This is a cheaper method since the originators do not have to ensure the actual transfer of the underlying assets.
Below we will consider two structures that will serve to highlight the role played by an insurance company.
The type of the structure is limited only by the imagination and the innovation of the parties involved. Each of these transactions are tailor-made and sometimes take months to negotiate and execute.
Structure A (Figure 2)
The bank swaps its credit default risk on a portfolio of loans with an investment firm. The latter enters into a back to back swap with a transformer vehicle which in turn approaches the insurance markets for a back to back credit insurance policy. The question now is, why can the bank or the investment firm not directly purchase the credit insurance policy without the establishment of a dedicated transformer?
Or why can the bank not by-pass the intermediating role of the investment firm? These extra links in the chain don't seem necessary. There is a valid explanation, however.
Banks are comfortable with contracts they are familiar with, they are not comfortable with insurance contracts, and the same applies for insurance companies who are not comfortable writing capital market contracts and would rather deal with insurance contracts that they are familiar with. The transformer provides both entities with the opportunity of dealing with the type of contract over which they have better control and understanding. The bank and the financial institution are involved only with credit default swaps (CDS) using ISDA3 documentation, while the transformer converts the credit risk into an insurance risk, thus allowing the insurance company to participate in the transaction via an insurance contract.
The presence of an investment firm, however, is often necessary in its capacity as a marketmaker and lead arranger of the deal.
In this case, the back to back insurance policy integrates the ISMA documentation and, as such, eliminates the basis risk (the risk that the coverage provided does not respond to the purchaser's exposure) for the transformer. This is market practice, though from a legal point of view it is said that this integration could later create problems for the insurance company whose regulators might not be comfortable with its involvement in the derivatives markets in such away.
Structure B (Figure 3)
This in fact is one practical example of a synthetic CDO. The transaction was arranged by the Royal Bank of Scotland (RBS) through its captive PCC (Drummonds) in Guernsey. RBS wanted to lay off its balance sheet some US$500 million of loans and bonds. For that, the capital markets were approached but these required the comfort of a financial guarantee of an insurer. Insurers on the other hand did not want to have the bank directly as their client (for reasons cited above).
The solution for RBS was to retain a first loss of US$ 5 million, swap US$ 45 million (second loss) with a cell in its PCC captive which in turn purchased a credit insurance to protect this tranch. The rest (US$450 million) was easily transferred to investors as a super senior tranch.
In the above structure, the individual cell is authorised to issue its own shares (cellular shares) to third parties to whom it pays dividends of cash. The cell also pays management fees to the mother PCC.
Despite its apparent complexity the above structure is nothing more than an Excess of Loss layered insurance protection as follows (not to scale):
1.5 Why do banks need to transfer credit risk?
Banks as originators of these deals have many reasons to engage in such an activity:
Regulatory arbitrage: banks under the Basle Committee Agreements have to keep regulatory capital commensurate with their many counter-party exposures.
By transferring their credit risk, banks free up this regulatory capital which can later be put to a more productive use.
This is believed to be one of the major underpinnings of this market.
Balance sheet management: banks might decide that they have taken an excessive exposure in respect of a particular type of business long-term mortgages for example. They can reduce this exposure by packaging a part of their portfolio and laying it off to the capital markets/insurance industry. At the same time banks might not be comfortable with the maturities of the loans and bonds they have on their books. The same process allows them to re-adjust their exposure to self-imposed limits.
Diversification of funding sources: securitization allows the banks to tap the capital markets and broaden the sources of funding available to them.
Price: AAA rated securities might constitute a cheap source of funding especially when there is a strong demand at the level of the different investors.Moreover, lower-rated tranches immediately receive an enhanced rating when they are credit-wrapped; these tranches literally borrow or buy the rating of the financial guarantors that are mostly AAA rated companies. This process enhances the marketability of the issue where otherwise it would have been very difficult to entice investors to participate.
1.6 Why do insurance companies assume bank credit risk?
Monolines: first of all, a separate line of business within the insurance industry exists and deals only with financial guarantees. Some insurers write this type of business on their books as part of an overall multi-line portfolio.However, there are companies, called monolines that specialise in writing only one line of business.
Among these monolines there are those who specialise in writing financial guarantees. As such, their core business is credit risk and this cross both sector activity is an integral part of their existence. From a monoline perspective, the involvement of multilines in the financial guarantee industry is dubbed as 'naive' capacity that has dwindled over the years. This last point shows the importance of having a comprehensive knowledge of the risks involved, and a dedicated set of qualified individuals able to safely engage in such a business.
New source of revenue: from an underwriting perspective, credit risk is a source of new premium and a strategic way of diversifying insurance portfolios.
This practice of growing premium income by writing new lines of business becomes particularly relevant in soft market conditions4.Moreover, since credit risk does not have any correlation with Property & Casualty risks, it becomes an ideal way of diversifying insurance portfolios.
Institutional investing: insurance companies worldwide sit on huge amounts of investable assets and they constitute an impressive part of the institutional investment industry. As such, asset-backed securities (Collateralised Debt Obligations) with bank credit portfolios as the underlying were always considered to be as natural candidates for their investment portfolios for the purposes of diversification.Moreover, tranching makes it possible to offer securities to appeal to different risk appetites with lower rated tranches commanding high yields for the willing investor.
1.7 Legal issues
There are many question marks still surrounding this business from a legal perspective. The robustness of the structures employed and the legal construction of the contractual agreements are two such cases.
Pundits agree that the legal structure of transformers (be it an SPV or a Protected Cell) is not really tested in courts. We have seen that the major function of a transformer is to create bankruptcy remoteness from the originator. As such, a legal due diligence is essential before contracting with a transformer. Insurance companies engaging in deals with transformers first seek the advice of their legal counsel.
Still, so far there is no true precedent providing guidance on the subject. In a cash transaction, the major issue is whether the assets have been truly acquired by the transformer, and as such whether or not they are readily available if they are called upon in case of default.
A court case in the US5 set the alarm bells ringing when an originator in a securitisation transaction disputed the claim of investors (Chase Manhattan & Abbey National) to the securitised physical assets arguing that no actual transfer has taken place. Rather, the transformation process was a mere manoeuvre to enable the "transaction" to take place even though there was never any real intention on the part of the sponsor to give up actual ownership of the assets. Judges are seen to be sympathizing with this argument, which could prove detrimental to the development of the securitisation markets.
Another legal issue involves the construction6 of insurance contracts in credit insurance. The incorporation of ISDA documentation to provide back to back coverage to a credit default swap and minimise basis risk, could be seen unfavorably by some courts that might consider the insurance as a disguise allowing the insurance company to carry on prohibited activities such as trading in derivatives.
There is also the issue of the blurred boundaries and the difficulty of characterisation of the contracts as insurance or as derivative business.
Viewed within the context of IAS 39, it is clear that the accounting implications of those structures are extremely complex and uncertain to say the least.
The Hollywood film cases were a typical example of the construction problem. Monolines agree to waive many of the foundation insurance principles, such as the duty of disclosure7 and remedies for misrepresentation8,rights of subrogation9... This is so because they followthe capital market's philosophy in settling default claims: 'pay now sue later'. However, the multilines (Property & Casualty insurance companies) adopt a pure P&C approach, i.e. aggressive claims handling which adopts a policy of "sue now pay later". This was the situation in the above mentioned case where the insurers (led by HIH and Lexington) disputed payment citing misrepresentation, non-disclosure and breach of warranty as defenses.
These cases have created reluctance on the part of the lead arranging investment firms to deal with insurance companies. They also caused Standard & Poors in May 2000 to introduce a new rating called FER (Financial Enhancement Rating) reflecting the insurer's willingness to pay claims on financial guarantee contracts on a timely basis. During a recent review of its rating criteria, S&P also decided that financial guarantee insurers with an FER who fail to meet their commitments might be at the same time jeopardising all their other ratings: counterparty credit, insurer financial strength and debt ratings.
1.8 Regulatory concerns
Several elements (size of the market, complexity of the deals, inadequate involvement of ratings agencies, inadequate risk management practices...) of the credit risk transfer market have attracted the attention of regulators.
The sheer size of the market sends chills down the backs of regulators who are wary of any potential threat to systemic stability. The Bank of England estimates the market at US$ 300 billion US$400 billion (notional amounts). As such, these figures speak for themselves and regulators are becoming increasingly awareof the need to take action beforeit's too late.
The deals themselves are getting more and more complex especially synthetic securitization.
"Even experienced bankers who have spent their lives pricing risk sometimes struggle to assess these deals.
"(Reactions,May 2002 issue) Yet insurance companies take on exposures worth billions of dollars. Sometimes the most they knowabout the underlying pool is a geographical breakdown or a breakdown by industry. This remoteness from the original risks challenges regulators who are concerned that insurance companies might be taking exposures they do not really understand.
On the other hand, regulators usually draw comfort from the fact that all these deals are rated. However, even the rating agencies "have not always got it right" and "have a far from perfect record in this area".
This shortcoming has been highlighted in the Hollywood film cases cited above when AIG (parent of Lexington) had a dispute with S&P who rated the transaction.
Margaret Lyons Kessler, vice president and senior analyst at Moody's, admits this fact and details many reasons why credit default swaps do not fit usual risk categories for financial guarantors, a characteristic that makes the rating of CDS's very difficult and at best uncertain.
All of the above have led regulators to take heightened interest in the subject. The FSA's Cross-sector risk transfers discussion paper (May 2002) is a case in point. For the moment, there is still a lot to be done on this front and until something concrete emerges, the industry will have to struggle with uncertainty as to the robustness of the structures and the deals involved.
1.9 Regional applications
If we look at the reasons that got Western Banks to engage in this sort of securitisation, it appears that there are really no obvious reasons why banks in this part of the world should not do the same. Given the latest oil-driven boom in the region, banks balance sheets are constantly growing with more loans generated driven by a positive outlook for the regional oil based economies and a robust world economy that is defying all inherited macro-economic wisdom that points to potential slow down.
The growth in loan portfolios is coupled with an even closer deadline for implementation of the new Basle II requirements which in principle should make the prospect of off loading credit risk a tempting one.
Regulatory arbitrage should by no means be the sole impetus for such an activity. Ifwe consider the good quality of the underlying portfolio of loans in the current economic environment, it becomes clear that banks may be able to lock in relatively cheaper rates on a potential CDO which is an exciting opportunity especially in the current rising interest rate environment. Clever CDO structuring should also appeal to various investors in a region awash with capital looking for alternative investment opportunities. At the same time regional banks would be able to access the capital markets for funding rather than typically relying on expensive equity finance.
Other factors that may increase the likelihood of seeing some insurance-enabled CDO activity is the mushrooming of aggressive regional financial centers that adopt international standards while chasing added capital markets activity. Investors in the region are growing in sophistication and, as such, new types of securities such as CDOs should be a welcome addition to the universe of investments currently available to them.
From an insurance perspective, the picture is not as clear. A securitisation drive will provide regional (re)insurers with an opportunity to develop a new source of revenue, financial guarantee premiums. This, however, needs to be weighed carefully against the need for sophisticated underwriting which is probably difficult to find at this level in the region.
One possible solution is for local players to team up with long established monolines that would provide the necessary underwriting expertise in return for access to a pool of loans that would give them a great opportunity to diversify their portfolios heavily concentrated in North America and parts of Europe.
Insurance companies as investors can also benefit from CDO activity as it provides them with an opportunity to diversify their asset holdings while maintaining a regional commitment.
One possible disadvantage though for (re)insurers is the move by insurance regulators to apply heavier risk-based capital requirements on insurance companies. This eventually will increase the cost of financial guarantee insurance which can have a negative impact on banks' willingness to issue CDOs.
Whether or not this type of activity will ever see the light in this part of the world remains to be seen. One thing is for sure though, the region has a history of insurance-wrapped CDO activity to learn from, this should help it to experience the smoothest of launches if a maiden transaction ever takes place.
© POLICY 2006
