CDOs: A New Source Of Insurer Capital

The recent development of a new investment security backed by insurance company senior debt, surplus notes and trust preferred securities has created a unique opportunity for smaller insurers and mutual insurers to raise new capital.

Since November 2002, three separate offerings of these securities, known as insurance collateralized debt obligations (CDOs), have been completed, raising some $1.2 billion.

CDOs are structured securities that pool collateral (i.e. debt) from a number of issuers. The pool of funds is then organized into a series of classes whose rating and risk are a function of their priority of payment. The CDO market has grown substantially over the last few years as investors are attracted to the diversification that the pools provide and the relatively high yields on investment.

Various asset classes have been utilized across many industries to create CDOs including mortgage and asset backed securities, investment-grade and high-yield bonds, bank loans, and trust preferred securities.

The market for trust preferred CDOs in the bank market has been robust since 2000, with over a dozen bank trust preferred CDO offerings completed in that period. The success of these products led to the development of CDOs for insurance companies.

Recent examples of insurance CDOs include a $359 million offering in December 2002 and a $506 million deal in April 2003, led by Nashville, Tenn.-based FTN Financial Securities and Keefe Bruyette & Woods in New York. Another example is a $386 million offering completed this past May by Sandler O'Neill and Fox-Pitt Kelton, both based in New York.

An example of companies that participated in CDO offerings include specialty medical malpractice writer American Physicians Capital Inc. in East Lansing, Mich., which issued a total of $30 million of trust preferred securities in two transactions, and regional property-casualty insurer Donegal Group Inc. in Marietta, Pa., which issued $15 million of trust preferred securities last May.

Issuers in these offerings represented a broad cross section of the insurance industry, with a mix of roughly 70 percent p-c and 30 percent life-health insurers. The business mix of pool participants is also well-diversified geographically and by product line. To promote diversification and spread of risk, the maximum participation of any one issuer in these pools is limited to four percent of the total collateral issued.

The mix of securities in these transactions has been roughly 70 percent trust preferred securities and 30 percent surplus notes. Trust preferred securities are hybrid capital instruments issued by trusts that are owned by a holding company. Obligations of the trust are guaranteed by the parent, so the ratings of the trust preferred securities are tied to the parent rating.

Trust preferreds are popular with banks as these securities receive favorable capital treatment for regulatory purposes. Rating agencies also give considerable equity credit to trust preferred due to their hybrid nature (e.g. a typical maturity of 30 years or more and an ability by the issuer to defer interest payments), which has made trust preferred securities an attractive financing option for insurers as well.

Surplus notes are debt securities that regulators allow insurers, typically mutual companies, to issue at the insurance company level. These obligations are treated as surplus for regulatory and the National Association of Insurance Commissioners risk-based-capital purposes, and as debt under Generally Accepted Accounting Principles accounting.

Fitch has rated all three of these insurance CDO transactions, borrowing from our expertise in rating other CDO instruments and insurance companies generally. Insurance company default rates have historically been lower than the broader corporate universe, another factor that has spurred interest in insurance CDOs.

Credit analysis of prospective issuers in the pools was initially done on a pass/fail basis following a review of candidates financial statements and other key financial information. For passing credits, the minimum requirement roughly corresponds to a rating of “double-B-Minus” or higher on Fitch's debt rating scale.

Going forward, Fitch will evaluate prospective issuers in insurance CDOs through a quantitative scoring model that considers factors similar to those used in our normal rating process, such as capital and reserve adequacy, profitability, investment allocation and risks, operating and financial leverage, and credit exposures to reinsurers.

Insurance CDOs have created an opportunity for smaller insurers and mutual companies to raise capital. Mutual companies, which have not typically had holding company affiliates, are unable to tap the public debt market, except through surplus notes, which require regulatory approval to make interest payments. Smaller insurers traditionally relied on bank debt for financing, which generally has short maturities and restrictive covenants; private equity, which tends to be costly, and difficult to place; or even more expensive financial reinsurance transactions.

In contrast, insurers issuing securities under the recent CDO offering have issued 30-year-term securities, at a fixed or floating rate that is considerably lower than what the companies could receive in individual borrowings.

With a more favorable p-c insurance pricing environment and low interest rates, companies have a desire to raise capital to support premium growth, while others have a need to replace capital lost from previous poor underwriting experience, adverse reserve development and investment losses.

Recent insurance CDO transactions have created considerable interest among investment banks and insurers to create more of these structures in the near term to address insurers' capital needs. Given this activity, Fitch believes that several more insurance CDO offerings will be completed within the next twelve months.

However, it remains unclear whether insurance CDOs will develop into a more robust market or if recently completed issues represent a passing fad.

Questions remain regarding the depth of the universe of potential issuers. While there are thousands of insurance organizations in the United States, it is uncertain how many would be interested in participating in these pools. Several companies that have issued securities in the recently completed offerings have reached a maximum level of financial leverage that their balance sheets can absorb for the next few years.

Also, many companies that are interested in participating in these transactions are unable to participate because of credit concerns.

For an enduring market to evolve for insurance CDOs, Fitch believes that larger insurers will need to be attracted to these transactions. This development will only take place when the costs of issuing under a CDO structure are on par with larger firms' costs of issuing public debt, and larger insurers are more assured of the ability to issue sizable amounts of securities in multiple CDO issuances. If larger insurers can be attracted to regularly issue securities under insurance CDO structures, the overall market will benefit from an improvement in pool credit quality and diversity.

From an investor standpoint, it is difficult to gauge the long-term level of interest in insurance-backed CDOs. For investors that are comfortable with structured investments and want a diversified portfolio of CDO investments, it is helpful to have exposure to another industry, like insurance, which is not necessarily correlated to other parts of the economy. Still, this demand will be dictated largely by the future investment performance of CDOs, particularly with the performance of the riskier lower ranked equity tranches in these pools.

Insurance CDOs represent a significant innovation in insurance company financing techniques. The development of this product will have a significant impact on the course of the insurance market and future prospects for smaller companies.

James Auden is a senior director for Fitch Ratings in Chicago.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, July 21, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.