May The (Value In) Force Be With You

This is the second instalment in a series discussing the different ways longevity, mortality, morbidity, lapse and other insurance-related risks may be transferred or otherwise dealt with in the insurance sector.  The first discussed longevity risk transfers using derivatives.  This piece discusses VIF.

With revenues of $71 billion, the life insurance industry is among the largest components of the insurance and reinsurance sectors in Australia.¹  The nature of the life insurance industry has traditionally presented unique inherent risks and capital and liquidity demands on life insurers. To address these challenges, life insurers in certain jurisdictions such as the UK have looked to the capital markets and utilised securitisation to monetise the value in force (VIF) of their insurance policy portfolios. It is worthwhile for Australian insurers and institutional investors to consider the breadth of public and private opportunities that may be available to monetise and invest in the VIF of life insurance policy portfolios.  It represents an effective mechanism for managing a life insurer's capital, to transfer risk and, if desired, to raise finance.     

VIF?

In a portfolio of in-force life insurance policies, the VIF refers to the monetary value that is expected to emerge from that portfolio as profits across the full term of the policies. Transactions that monetise the VIF realise these future profits into a present value that will become immediately available to the life insurer. Through securitisation, the value embedded in a portfolio of life insurance policies can be transformed into tradable securities that are sold on the capital markets with the resulting proceeds becoming available to the insurer. Portfolios that are able to be securitised in this process may be open or closed book, meaning that the policies in a portfolio are either existing and definite (closed book) or expected and not yet written (open book). Accordingly, closed book securitisations are likely to be more attractive to a wider range of investors as these transactions generally provide more clearly defined and ascertainable cash flows and will present fewer commercial challenges than securitising open book portfolios. 

Why monetise VIF?

VIF monetisation through securitisation may provide opportunities to achieve a number of commercial objectives. Among these are potentially more effective liquidity management and capital management by insurers. Generally, life insurers bear the expense of writing new life insurance policies in the first policy year with associated profits from premium flows only being amortised over the term of the policy, so liquidity considerations may be raised when new policies are written.²  VIF monetisation provides life insurers with access to a source of liquidity that can be used to assist in the financing of writing new business or in the financing of other business activities such as acquisitions or investment in other lines of business. Two early public VIF monetisation transactions in the UK, separately involving the life insurance businesses of Barclays Life and Friends Provident Life & Pensions, resulted in the raising of £400 million and £380 million respectively.³  Access and utilisation of additional liquidity is pertinent in the context of recent industry-wide developments characterised by weak growth and falling profitability.⁴  

APRA regulatory capital requirements mean that life insurers must keep capital reserves to absorb risks to which they are exposed and satisfy policyholder claims as and when they fall due. In the management of capital, Tier 1 capital that must be maintained by insurers can be supplemented by the capital released from VIF monetisation, and can be a less costly alternative to further leverage or injections of equity. From a prudential perspective, APRA's recent notice to life insurers in connection with 'stress testing' last year suggests, among other things, that effective capital management will continue to be an important challenge in the Australian life insurance industry.⁵

The structuring of a VIF monetisation transaction may also achieve a significant transfer of risk as a hedging strategy, with the mortality risk and associated insurance and market risks of the securitised portfolio being borne by the investors to the securities in addition to some reinsurance component, if applicable.

From the perspective of a counterparty to a VIF monetisation transaction, the opportunity exists for investment spread and diversification beyond participating in securitisations which are backed by conventional asset classes (eg mortgages, consumer credit and so on). Exposure to Australia's demographics of an increasingly long-lived population and the possibility of competitive investment yields merit further investigation.  

Simplified example transaction

What now?

Monetising VIF through the capital markets is a solution that warrants further investigation by insurers and financial investors. Insurers should carefully consider their business and the specific commercial goals that monetising VIF would be intended achieve for their business. In any analysis, the risk and reward profile for the relevant portfolios and associated cashflows considered for securitisation will need to be carefully examined. Major prudential considerations will include the interests of policyholders and the adequate protection that must be maintained for them at all times, additional regulatory compliance costs if another regulated insurer is added to the corporate group, capital relief implications where reinsurance is with a related entity, as well as how effective any transfer of risk will be. Public transactions monetising VIF through securitisation have to date all occurred outside of Australia and as such, there is significant potential in developing and pioneering best practices for this method of monetising VIF in the Australian capital markets. There may be more immediate opportunities for private transactions whereby investors looking to diversify risks and returns may enter into bilateral transactions with insurers using securitisation techniques.

Authors: Jamie Ng, Partner; Wilson Lu, Graduate.

¹ Life Insurance in Australia: Market Research Report (IBISWorld, 2017).  

²  Georges Dionne (ed.), Handbook of Insurance (Springer, second edition, 2013) p 589.

³  Vinod Kothari, Securitization: The Financial Instrument of the Future (Wiley Finance, 2006) p 520; Pauline Barrieu and Luca Albertini, The Handbook of Insurance-Linked Securities (Wiley Finance, 2009) p 225.

⁴  Michael Roddan, 'Life insurers bleed cash as industry growth slows', The Australian, 26 October 2016.

⁵  Michael Roddan, 'Life insurers put on notice by APRA', The Australian, 19 August 2016.