South Carolina Restructuring Initiatives Enhance Predictability
And Strengthen Special Purpose Financial Captive Structures
Michael Molony
Jim Buxton
T. Douglas Concannon
October 26, 2007
Entering its seventh year, South Carolina’s captive insurance program has grown to the second largest onshore captive domicile and the leader in complex risk transfer transactions. South Carolina’s special purpose financial captive (“SPFC”) insurance securitization program continues to experience strong transaction flow in Regulation XXX and AXXX securitizations. The program is on pace for over $7 billion in risk transfer transaction value for the calendar year, including a total of approximately $2.63 billion which closed or is scheduled to close in the fourth quarter. This success has been driven by key restructuring initiatives at the South Carolina Department of Insurance (the “Department”), which, among other competitive advantages, has reduced the average time frame for the application process to less than 90 days. Additionally, the growth of the domicile has increased even in the midst of tighter liquidity in the greater capital markets due to the recent sub-prime mortgage meltdown.
Earlier this year, the Department embarked on a restructuring initiative in order to handle securitizations more efficiently and ensure predictability of both application and change in business plan review and in the ongoing monitoring of SPFC’s. The new programs put in place include:
· appointing a Deputy position to lead the SPFC program;
· outsourcing actuarial services;
· outsourcing legal services;
· Revised SPFC application forms (form agreements, e.g Custody agreement);
· Recruiting an in house actuary; and
· Hiring an assistant actuary;
· Substantially increasing office space.
This does not mean the heart of the review is outsourced, rather it allows the Department to focus on strengthening each transaction by relying on an independent actuarial and legal review of the transaction protection measures. This is critically important in a turbulent market environment. Furthermore, South Carolina remains the only state insurance department in the country with a program dedicated to complex financial captives. The South Carolina program now has embedded in its SPFC application process enumerated risk transfer testing and standard stress case scenarios so that prospective SPFC’s will know the various deal model outputs they will be required to produce as part of their application. These recent initiatives have increased predictability in the South Carolina application process to the point where the Department’s most recent SPFC application was processed in 59 days.
The continued success and revitalized efficiency of the South Carolina program begs for a bright line to be drawn separating captive insurance securitizations from the recently maligned sub-prime mortgage-backed securitizations. Shortly following the recent financial meltdown of the sub-prime mortgage market, the term “securitization” was not favored in the greater capital markets. In actuality, the structure of the securitization itself remains sound. It is the quality of the underlying securitized asset that should be examined when grading the quality of a particular securitized transaction. The sub-prime mortgage securitization market collapsed because the companies that securitized the loans originated these loans with borrowing consumers on terms the consumers could not repay. The underlying securitized mortgage was inherently of poor quality and high risk. This is a far cry from the financially conservative underlying risk in the most common captive insurance securitizations: mortality. More importantly, the licensees in South Carolina receive a thorough testing and analysis during the review process. These SPFC’s are not simply financial “deals”. They are true insurance companies, some spanning 30 years or more that are ongoing regulated entities.
Compared to the relatively recent boom in sub-prime mortgage-backed securities, insurance companies have been managing risk in their assets for a much longer time frame and inherently have a more mature risk management structure than most of the nascent sub-prime mortgage companies. Risk management is a basic operating component of insurance companies, and risk managers constantly seek out ways to hedge this risk while creating value for company shareholders, or more directly, those who ultimately bear that very risk. South Carolina’s captive insurance securitization program presents an alternative, efficient means to manage risk at a lower cost while creating value for the parent insurance company through capital transfer mechanisms such as an experience refund or an embedded value transaction.
Risk is still present in insurance securitizations. Certain SPFCs’ market stress case scenarios were tested during the sub-prime financial market meltdown in August 2007. SPFC securitizations with a money-market securities component in place, market 28-day paper every month in the Dutch auction market. A Dutch auction is a method of auction consisting in the offer of securities at an offered price at a certain value and then at gradually increased prices until a buyer is found. The spreads in the auction on the money-market securities generate a monetary yield to the securities holder. If the money-market securities cannot be successfully resold to a buyer at the Dutch auction on the 28-day cycle, then this triggers a maximum rate re-pricing of the money-market securities. The Dutch auction market experienced such a maximum rate re-pricing in August for the first time as a side effect of liquidity tightening in the greater capital markets due to the sub-prime meltdown. Rather than having a deleterious effect, in several captive insurance securitizations this triggered certain built-in protection measures. In these examples, the experience refunds were trapped in the captive. This trapping of the experience refunds provided assurance that there will be additional funds held at the captive level to ensure that the captive will comply with its formula to meet its statutorily-required excess reserve requirements. Additionally, securitizations with this money-market securities component built in a cap so that the maximum rate re-pricing in the worst market scenario was capped at LIBOR plus 125 basis points. Prior to licensure, each captive is required to produce a deal model output to reflect the maximum rate re-pricing scenario such as the re-pricing event experienced this past August. At the outset of a captive’s licensure there is a deal model scenario reflecting maximum interest expense in the event of a maximum rate re-pricing. This worst case scenario is built into the deal structure of the insurance securitization in order to ensure stability in the captive. As a result, each South Carolina captive utilizing a money-market component came through this liquidity event financially strong, thanks to rigorous testing and regulatory review.
The year 2007 marks a significant maturation in the domicile. South Carolina’s captive insurance securitizations have successfully weathered the recent market turbulence with strong financial positions as a direct result of the experience of the South Carolina regulatory team. The restructuring initiatives put in place by the SCDOI have enhanced the SPFC application and licensure process. Moreover, the flexibility and valuable experience of the South Carolina regulators ensures long-term strength for the many successfully closed transactions and further anchors South Carolina as the veteran and premier domicile for complex captive insurance risk transfer transactions.
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