CDOs: A New Source Of Insurer Capital

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

Since November 2002, three separate offerings of thesesecurities, 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 intoa series of classes whose rating and risk are a function of theirpriority of payment. The CDO market has grown substantially overthe last few years as investors are attracted to thediversification that the pools provide and the relatively highyields on investment.

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

The market for trust preferred CDOs in the bank market has beenrobust since 2000, with over a dozen bank trust preferred CDOofferings completed in that period. The success of these productsled to the development of CDOs for insurance companies.

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

An example of companies that participated in CDO offeringsinclude specialty medical malpractice writer American PhysiciansCapital Inc. in East Lansing, Mich., which issued a total of $30million of trust preferred securities in two transactions, andregional property-casualty insurer Donegal Group Inc. in Marietta,Pa., which issued $15 million of trust preferred securities lastMay.

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

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

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

Surplus notes are debt securities that regulators allowinsurers, typically mutual companies, to issue at the insurancecompany level. These obligations are treated as surplus forregulatory and the National Association of Insurance Commissionersrisk-based-capital purposes, and as debt under Generally AcceptedAccounting Principles accounting.

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

Credit analysis of prospective issuers in the pools wasinitially done on a pass/fail basis following a review ofcandidates financial statements and other key financialinformation. For passing credits, the minimum requirement roughlycorresponds to a rating of “double-B-Minus” or higher on Fitch'sdebt rating scale.

Going forward, Fitch will evaluate prospective issuers ininsurance CDOs through a quantitative scoring model that considersfactors similar to those used in our normal rating process, such ascapital and reserve adequacy, profitability, investment allocationand risks, operating and financial leverage, and credit exposuresto reinsurers.

Insurance CDOs have created an opportunity for smaller insurersand mutual companies to raise capital. Mutual companies, which havenot typically had holding company affiliates, are unable to tap thepublic debt market, except through surplus notes, which requireregulatory approval to make interest payments. Smaller insurerstraditionally relied on bank debt for financing, which generallyhas short maturities and restrictive covenants; private equity,which tends to be costly, and difficult to place; or even moreexpensive financial reinsurance transactions.

In contrast, insurers issuing securities under the recent CDOoffering have issued 30-year-term securities, at a fixed orfloating rate that is considerably lower than what the companiescould receive in individual borrowings.

With a more favorable p-c insurance pricing environment and lowinterest rates, companies have a desire to raise capital to supportpremium growth, while others have a need to replace capital lostfrom previous poor underwriting experience, adverse reservedevelopment and investment losses.

Recent insurance CDO transactions have created considerableinterest among investment banks and insurers to create more ofthese structures in the near term to address insurers' capitalneeds. Given this activity, Fitch believes that several moreinsurance CDO offerings will be completed within the next twelvemonths.

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

Questions remain regarding the depth of the universe ofpotential issuers. While there are thousands of insuranceorganizations in the United States, it is uncertain how many wouldbe interested in participating in these pools. Several companiesthat have issued securities in the recently completed offeringshave reached a maximum level of financial leverage that theirbalance sheets can absorb for the next few years.

Also, many companies that are interested in participating inthese transactions are unable to participate because of creditconcerns.

For an enduring market to evolve for insurance CDOs, Fitchbelieves that larger insurers will need to be attracted to thesetransactions. This development will only take place when the costsof issuing under a CDO structure are on par with larger firms'costs of issuing public debt, and larger insurers are more assuredof the ability to issue sizable amounts of securities in multipleCDO issuances. If larger insurers can be attracted to regularlyissue securities under insurance CDO structures, the overall marketwill benefit from an improvement in pool credit quality anddiversity.

From an investor standpoint, it is difficult to gauge thelong-term level of interest in insurance-backed CDOs. For investorsthat are comfortable with structured investments and want adiversified portfolio of CDO investments, it is helpful to haveexposure to another industry, like insurance, which is notnecessarily correlated to other parts of the economy. Still, thisdemand will be dictated largely by the future investmentperformance of CDOs, particularly with the performance of theriskier lower ranked equity tranches in these pools.

Insurance CDOs represent a significant innovation in insurancecompany financing techniques. The development of this product willhave a significant impact on the course of the insurance market andfuture prospects for smaller companies.

James Auden is a senior director for Fitch Ratings inChicago.

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