The National Association of Insurance Commissioners' (NAIC) Model Regulation XXX requires insurers to establish heightened statutory reserves for term life insurance policies with long-term premium guarantees. Likewise, Actuarial Guideline XXXVIII (more commonly known as Regulation AXXX or AG38) requires insurers to establish heightened statutory reserves for certain universal life insurance policies with secondary guarantees (SGUL).

Funding XXX/AXXX reserves has been a challenge to the industry since Jan. 1, 2000. Initially, bank-issued letters of credit (LOCs) were the most popular solution. Beginning in 2003, securitizations offered a permanent nonrecourse alternative funding solution to U.S. insurance companies for the financing needs that arose from the application of Regulation XXX. In that year, Standard & Poor's Ratings Services rated $600 million of XXX notes. This total increased to $4 billion in 2007. In addition, by 2007, we rated $890 million of notes that would cover the redundant reserves that arose from AXXX requirements. However, since 2007, we have not rated any public securitizations used to fund XXX or AXXX reserves.

While securitizations are currently not a source of financing for U.S. insurance companies, these companies still need to fund their XXX/AXXX reserves. We have seen some companies (primarily mutual insurance companies) use their own capital, whereas most other companies have returned to obtaining LOCs. We continue to be concerned with the potential mismatch between insurance companies' reserve financing needs and the terms of the LOCs (e.g., term to maturity and changes in pricing from potential step ups). LOCs might not be available or might be uneconomical--that is, the cost of the LOC might be prohibitive--thus forcing the insurer to put up capital to support the reserves, which could severely strain its capital base (see New Method Of Analyzing Use Of Short-Term Credit Solutions For U.S. Firms, published March 13, 2006, on RatingsDirect).

Regulatory Discussions

Current regulatory discussions may significantly affect XXX/AXXX financing needs and solutions. Most notably, the discussion surrounding the interpretation of AG38 for multitiered SGUL and term UL products may affect the level of XXX/AXXX financing needs. Based on the Jan. 13, 2012, draft framework put forward by a joint working group of the NAIC's Life Actuarial Task Force, it appears likely the statutory reserve requirements for these products will increase at a minimum for new business and potentially for in-force blocks as well.

Under this framework, new business as of a to-be-determined cutoff date would face reserving levels more consistent with the statutory reserves experienced by single-tiered SGUL products that produce the AXXX financing requirements. Whether offered in the current form in a more simplified form (i.e., single tiered or traditional term), we expect companies to try to maintain sales volumes that would generate a noteworthy uptick in AXXX or XXX reserve financing needs.

For in-force business, however, the guidance from the draft framework is more ambiguous. Depending on how various items still under review are resolved--most notably the definition of "moderately adverse scenarios"--in-force blocks could face an increase in statutory reserve requirements. If this increase were significant, we would expect companies gradually to finance all or some of the increase via means similar to the aforementioned solutions.

Also potentially affecting the nature of future XXX/AXXX financing solutions is the outcome of the study being conducted by NAIC's Captive & SPV Use Subgroup. The study broadly encompasses the uses and regulatory requirements of captives and special-purpose vehicles--primarily those utilized in XXX/AXXX financing solutions. This study might lead to supplementary discussions and in turn, changes to the regulatory treatment of certain funding solutions.

Solutions Have Followed Similar Formats

Beginning in 2008, the structured redundant reserve solutions we have been asked to review have followed a similar format. An insurance company would cede a block of term, SGUL, or a combination thereof to a captive, which in turn would enter into a LOC that named the ceding insurance company as the beneficiary. The cedant would capitalize the captive, which in turn invested the capital in assets that typically minimized credit risk and were closely duration matched to the liabilities. The economic reserves were typically ceded on a funds-withheld basis, with the ceding company guaranteeing the asset's book value and investment return. The cedant would receive reserve credit for economic reserves based on the value of the assets in the funds-withheld account and for the redundant reserves based on the face amount of the LOC. One constant we have observed is that the likelihood of a draw is remote. Typically, for the XXX deals, there would have to be extended mortality in excess of 150% per annum for there to be a draw. The AXXX issues would need combinations of extended low-interest rate environment periods such as exist now, and lapse and mortality experience that differed significantly from expectations.

Since 2008, the term to maturity of the LOCs has increased while pricing has decreased.

We have seen transactions in which companies have downstreamed proceeds to a captive from a senior-note issuance and placed them into a Regulation 114 trust. In such instances, we assess the likelihood of the proceeds being drawn on to meet insurance obligations to determine whether to assign operational or financial leverage to the debt issuance. When the proceeds will be drawn in only the most remote scenarios, we usually view the debt as operational leverage, based on our expectation that the debt will be "funded" throughout its life.

One additional form of financing we have seen is bank-funded solutions. In these transactions, a captive issues a surplus note to a bank. In some instances, additional credit support is provided on the notes, either by the holding company (e.g., a guarantee), or through a financial-guaranty policy.

LOCs For Now, And Then?

We do not know what means the insurance industry will choose to finance its future XXX/AXXX reserve needs. Currently, we do not expect a return to a capital-markets solution. For the near term at least, we expect LOCs to be the most viable and cost-effective way to finance the reserves. If there are changes from a regulatory or economic perspective that affect the industry, or changes to our criteria, we will update the market accordingly.