Capital Markets

A Boost for Insurance Capital

Insurers could get a big regulatory-capital benefit by securitizing private-equity investments. But it's easier said than done.
Marie LeoneFebruary 4, 2010

What if securitization could free up regulatory capital for insurance companies that have invested in private-equity funds? The idea is still just an idea, as no one has done it yet, but it could be attractive to insurers with liquidity concerns.

Offered up during a recent press briefing by David Larsen and Warren Hirschhorn, managing directors at financial-advisory firm Duff & Phelps, the idea is straightforward, even if the resulting financial structure is complex. In the simplest terms, insurance companies could boost their calculated regulatory-capital levels by pooling and securitizing their investments in private-equity funds.

To ensure that insurers have adequate capital, regulators impose risk-based capital charges on insurers’ investments; the riskier the investment, the higher the charge. In general, investments in private-equity funds add more risk to an insurer’s overall portfolio. Securitizing private-equity-fund investments into higher-rated bonds is one way to mitigate that risk and cut the capital charges.

Capital charges and the associated formulas vary by type of insurance company and asset class, and they are updated annually, says Jean Connolly, a managing director with PricewaterhouseCoopers’s national professional services group. For instance, this year the baseline charge for an investment in common equities by a property-and-casualty insurer is 15% of the asset value; for every dollar invested in common equities, a P&C insurer would be charged $0.15. (A charge for an equity investment by a life-insurance company starts at 30% and can rise as high as 45% or drop as low as 22.5%, depending on the risk profile of the insurance company’s common-stock portfolio.)

By comparison, a low-risk bond, one that is rated AAA, for example, carries a charge of less than a penny — 0.3% — for a P&C insurer. The disparity in charges between higher- and lower-risk investments could be an opportunity worth exploring, says Larsen.

In Larsen’s simplified example, a P&C insurance company invests $200 million in private-equity funds during 2010, and accordingly pays a risk-based capital charge of $30 million (15%) on the investment. Alternatively, the same company securitizes the $200 million worth of equities into an AAA-rated bond. Based on the formula, the company pays a capital charge of only $600,000 on the highly rated bond.

To be sure, Larsen admits private-equity-fund securitizations are easier said than done. Indeed, there hasn’t been a regular flow of such transactions for at least seven years, he says. Securitizations depend on steady inflows of cash — from, say, traditional mortgages, credit cards, or car loans — that are used to pay bondholders on an equally steady basis. But “private equity is incredibly hard to turn into bonds because it has no scheduled cash flows,” says Matti Peltonen, chief of the Capital Markets Bureau of the New York State Insurance Dept.

To help smooth the flows for bondholders, some type of funding vehicle has to be incorporated into the securitization, creating a level of complexity not seen in plain-vanilla securitizations. “Mechanically, these structures have a lot of different moving pieces,” says Larsen. Yet the time and expense of setting up a securitization could be offset by a big cash savings.

The price tag on the securitization comprises investment banking, valuation, and legal fees to set up the vehicle, as well as the cost of having the bonds rated. That makes the structure relatively expensive to put in place. The idea “only makes sense if an insurer has big chunks of assets that have substantially higher regulatory-capital requirements,” says Larsen.

No matter how sensible these kinds of securitizations are, they are sure to invite regulatory scrutiny. The concept of lowering capital charges by securitizing equity is valid in theory, but regulators will try to determine the motives behind such financial engineering. If an insurer is just trying to lower its capital, then regulators will want to know more about how the company plans to mitigate the added risk related to the securitized instruments.

Meanwhile, Larsen notes that if bank holding companies are forced to divest their private-equity arms — as was proposed by President Obama in January — they may also want to consider securitizing cash flows from limited partners to retain “some upside.”


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