Securitisation transactions as an investment for insurers – green shoots or wilting flowers?

Introduction

(Re)insurance companies are becoming increasingly active in helping financial institutions to transfer risk off their balance sheets using credit risk mitigation transactions, often structured as securitizations.

Under these transactions, (re)insurers sell unfunded credit protection from the liability side of their balance-sheet, and cover losses in specific tranches of securitizations, which allows the financial institutions buying such protection to achieve significant risk transfer (SRT), thereby benefitting the real economy as such banks then have capacity to lend again to support growth. By the end of 2024, the total outstanding insurance protections on SRT tranches amounted to about €6 billion, according to IACPM.¹

Before the Global Financial Crisis, (re)insurers were also significant investors in securitization transactions, and can still do so as funded investors on the asset side of their balance-sheets, either holding positions in securitizations or investing in assets directly themselves and securitizing those assets internally so as to qualify for matching adjustment (MA) treatment under Solvency II² (now Solvency UK³ in the UK). Their appetite to do so since the GFC has been driven by a number of factors, including the impact of regulation.

In this article we focus on (re)insurers as funded investors in securitization transactions and some of the reasons why, in stark contrast to (re)insurers activity on the liability side, there has been muted activity in asset-side transactions.

Impact of regulation

On the asset side of an insurer’s balance sheet, Solvency II introduced a more risk based approach to the calculation of capital applies which allows for an assessment of the overall solvency of (re)insurance undertakings. As part of the determination of an insurer’s solvency capital requirement (SCR), Solvency II applies capital charges to the insurer’s assets, on the basis of a number of risk modules (and in particular the spread risk module in the case of securitizations). When the new capital requirements and matching adjustment rules promulgated thereunder became effective in 2016, this had an impact on (re) insurer’s investments in securitizations.

The capital charges depend primarily on asset type, rating and duration, and on the status of the counterparty, and are derived either from the Solvency II standard formula or in cases where the insurer has received the necessary regulatory approval, from the insurer’s own internal model.⁴

Under the standard formula, securitization positions were originally divided into three categories for the purpose of calculating capital charges, namely (in descending order of relative capital charge):

• type 1, which were listed senior positions with a credit quality step of 3 or above (i.e. BBB+) meeting certain asset and granularity requirements (and which expressly excluded synthetic securitizations);
• type 2, which were securitizations that were not Type 1 and that were not re-securitizations;
• re-securitizations, which were securitizations of a securitization or position in a securitization.

This approach resulted in a number of comparable asset classes and investment positions (such as corporate bonds) being subject to disproportionately lower capital treatment in circumstances where their credit quality step and duration was the same, and as such notes in these types of securitizations were not attractive to an insurer using the standard formula, since its SCR would be higher compared to what it would be if the insurer invested in a different asset class.⁵

This resulted in calls for reform of the capital treatment of investments in securitizations, and the type 1 and type 2 categories in Solvency II were replaced with senior STS, non-senior STS and non-STS to more closely align with the Securitization Regulation⁶ (EUSR) and the simple, transparent and standardized (STS) securitization regime thereunder. However, although the capital charges for senior STS securitizations were seen as more comparable to exposures by (re)insurance undertakings to other investment products such as corporate bonds, the changes for non-senior STS and non-STS securitizations remained high.⁷

Unfortunately, the STS categorization changes did not have the desired effect of revitalizing insurers’ involvement as investors in either the SRT market or the asset-backed securities market, more generally. In large part this is because the capital requirements are not the only obstacle holding back investments by (re)insurers in securitization. A key issue is that securitization products often do not align well with (re)insurers’ long-term liabilities and holding them complicates asset-liability management compared to other simpler asset classes. Another reason is that many insurers use the standard formula to calculate their SCR, which does not give them the flexibility of an internal model to lower the capital charge applicable to securitization positions where appropriate data would support that.

The European Commission recently announced proposals to amend the EU regulatory framework for securitization, including by lowering capital charges for credit institutions holding securitized assets, reducing due diligence obligations for institutional investors and simplifying reporting templates for issuers, as part of a wider effort to integrate the EU’s capital markets and stimulate economic growth. It remains to be seen whether the proposals will achieve their intended goals in practice, but they are a step in the right direction despite the fact that some concerns remain. Proposals by the European Commission for adjustments to insurers’ capital charges are expected in late July 2025 and it is hoped that, notwithstanding our earlier comments, this will be seen by the market as being a positive step to help increase insurer demand for securitized assets.

Matching adjustment

Solvency II requires (re)insurance undertakings to hold certain liabilities to cover their insurance obligations to policyholders, the “technical provisions” which are calculated as a best estimate of liabilities and a risk margin (an additional reserve required to be maintained above an insurer’s best estimate of liabilities).

Under Solvency II, (re)insurers may, with the prior approval of their supervisory authority, apply a matching adjustment to the risk-free discount rate used in their “best estimate” calculation if they are able to demonstrate that it separately manages a portfolio of assets which replicate the cash flow characteristics of the relevant portfolio of insurance obligations and that it maintains such separate management over the lifetime of such liabilities. If the (re) insurer meets these tests and receives regulatory approval, it may then use a higher discount rate than the usual risk-free rate used for “best estimate” calculations as part of its technical provisions (thereby reducing the assets which are required to be held against such liabilities). The higher discount means the liabilities will be valued at a lower level, which improves the capital position of the (re)insurer. In essence, as the (re)insurer intends to hold the investment assets to maturity, it is allowed to recognize a proportion of the spread on the assets upfront as it is really only exposed to default risk, not price volatility.

The MA can only be applied where certain eligibility criteria are met. Cashflows must be fixed and cannot be changed by the issuers of assets or any third parties, and the fixity of the cashflows must be reliable under stressed conditions, and if those cashflows can be changed optionally outside a default, compensation needs to be payable to negate the reinvestment risk.

Asset cash flows dependent on longevity, morbidity, the realizable value of property, and exposure to pre-payment risk are unlikely to qualify for the MA, absent a “transformer” structure, which is essentially a restructuring of cashflows through a securitization to create a senior “fixed” cashflow (which would be eligible as a MA asset) and a junior “non-fixed” cashflow which the insurer would normally hold in its non-MA portfolio, subject to the usual capital regulatory treatment.

In a typical “transformer” structure, the insurer acquires a legal or beneficial interest in the eligible assets (whether under forward flow arrangements or otherwise) within its non-MA funds and on-sells the beneficial interest in such assets to a wholly-owned special purpose subsidiary of the insurer⁸ (the Issuer), which funds its acquisition of the assets through the issuance of:

• one or more senior notes (Senior Notes) structured to deliver a base set of fixed amortizing cash flows that can be viewed as compliant with the MA eligibility criteria; and
• one or more subordinated notes which are either subscribed for by the (re)insurer’s non- MA funds or, alternatively, placed to third party investors in the market (as was the case on Aviva’s recent Lifetime Mortgage Funding 1 deal).⁹

The ratings assigned to the Senior Notes would typically reflect a level of redemption payments set to pass either a 1 in 200 years stress scenario or a BBB rating, and the Senior Notes would typically benefit from liquidity provided to the Issuer through a liquidity reserve or by a facility provided by the (re) insurer’s non-MA fund. The credit enhancement provided through the subordinated notes, the liquidity support and the establishment of certain reserves (to mitigate prepayment risk, for example) will be aimed at securing the “fixity” of the cashflows so the Senior Notes maintain MA eligibility.

In other respects, such structures broadly follow the structuring of other traditional cash securitizations, with the Issuer appointing, for example, a servicer to manage its interests in the eligible asset portfolio and a cash manager to manage its cashflows.

Reform

Key changes proposed by the PRA in its recent policy statements and consultation papers,¹⁰ which aimed at simplifying, improving flexibility and encouraging entry of (re)insurance undertakings into the UK market, include:

• widening the MA eligibility test to permit a limited proportion of asset cash flows that are capable of being changed by issuers or any third parties provided these assets have “highly predictable cash flows”, but which can only form a maximum of 10% of MA benefit for any portfolio;
• widening the scope of MA liabilities which MA assets can match;
• streamlining and speeding up the PRA approval process;¹¹ and
• removing the MA cap in respect of assets which are sub-investment grade credit quality (which might benefit investment in priority assets, such as digital).

The UK has already lowered the risk margin for both life and non-life insurers,¹² which resulted in a substantial release of Technical Provisions and a reduction in their capital requirements, freeing up capital which could be used for other investments.

From a (re)insurer’s perspective, a more risk-based approach to determining the capital requirements for securitization position spread risk does not seem likely as it has not been proposed as part of the PRA package of reforms discussed above or in the EU considerations on Solvency II reform. Instead, the debate appears to be shifting to the relevant Securitisation Regulation requirements and whether reporting and due diligence requirements need to be more proportionate.

Recent market developments

The changes to MA and the decrease in the risk margin (freeing up capital which could be used for other investments) may lead to an increase in (re)insurers’ investments in more “illiquid” assets, and further balance sheet optimization transactions like Aviva’s recent Lifetime Mortgage Funding 1 securitization transaction, which was in effect a publicly placed “transformer” structure backed by a number of legacy equity release portfolios. That transaction reflected a recent trend for (re)insurers to place the junior notes with a third party investor with appetite to take that risk, primarily because such junior notes have become increasingly capital intensive for a (re)insurer to hold itself in its non-MA funds.

The signs are promising for further growth in these types of transactions, as investors in the junior notes in these transactions become more comfortable with their risks and balancing those against the higher yields they might access if they participate. That, in turn, is likely to cause more innovation in the types of assets that support MA eligible transactions, especially given the relatively low levels of origination in equity release mortgages (which have been the principal asset class backing recent MA transactions) in the current market. The green shoots are there, but will regulators and market conditions allow them to flourish?