Insurance companies’ slow embrace

Some of Italy’s largest life insurers are using credit derivatives in their structured retail products, but most insurers remain on the sidelines. Carola Schenk examines why

Massimo Sala, chief financial officer at Monte Paschi Vita Group, the life insurance arm of Gruppo Monte dei Paschi di Siena, in Rome, is reluctant to use credit derivatives or structured credit products for his firm’s retail products. “We did not feel comfortable passing leveraged exposure to the credit market on to the retail market in this financial environment,” Sala says. So far, his firm has only used such a tool in its retail products once – a credit-linked note (CLN) on a basket of some six to eight triple-A rated names.

But not everyone shares Monte Paschi’s concerns. Credit derivatives have become increasingly common in Italian retail life insurance policies. Italy’s life insurers have been using credit default swaps, CLNs and tranches of collateralised debt obligations (CDOs) to enhance returns and diversify the risk of their index-linked life policies. These life products offer capital protection via a minimum annuity rate and upside participation in the underlying market index. Demand is booming: as in other European markets, retail investors in Italy have suffered substantial losses in the tumbling equity markets, and they now want savings products with capital guarantees.

But structuring index-linked life policies that are attractive for the insured and profitable for the insurer has become increasingly difficult. These products are essentially zero-coupon bonds with options added in to provide exposure to the indexes. The bulk of Italy’s life insurers have been using zero-coupon corporate bonds to structure them. But with interest rates falling, the price of zero-coupon bonds has been rising – cutting into the insurers’ financial leeway for purchasing the option on the underlying market index, and into their commission margins.

Insurers have also become increasingly concerned about the concentrated credit risk exposure they take on via zero-coupon bonds in the deteriorating credit environment. Insurers use bonds with a minimum rating of single-A minus – the legal floor on insurance assets in such retail products, typically issued by financial institutions or the insurance industry. But the number of such issuers is limited, say market participants.

To boost returns on their index-linked policies and to diversify their credit exposure, several insurers have started to tap the credit derivatives markets.

But dealers say many insurers do not yet understand the market. Also, there is no clear regulatory framework for using credit derivatives in index-linked policies. Monte Paschi’s Sala says this is another reason his firm has not used credit derivatives or structured credits for its index-linked policies, except on the one occasion.

Like Sala, other insurance officials are concerned about the leveraged credit risk exposure such tools can introduce into retail products. To some extent, their concerns have been exacerbated by the severe downgrades of several CLN and CDO structures used by Italy’s life sector over the past year or so, market participants say.

Despite this, investment bankers insist that a growing number of Italy’s life insurers are contemplating or expanding their use of credit derivatives for their index-linked business. Falling interest rates, wide spreads in the credit markets in the second half of last year and some successful index-linked life product launches based on credit derivatives have stimulated this interest. In some instances, this interest has already resulted in transactions, they add. “[Since the autumn], more insurers have started looking at and doing this – but in smaller volumes of e30 million to e40 million – and mainly using CDO tranches, not first-to-default baskets,” says one banker. Short of a regulatory ban on these tools, this trend will probably continue, dealers say. “Interest rates are collapsing. So there is a need,” one says.

New regulations may boost demand

Investment bankers hope upcoming regulations on the use of credit derivatives and asset-backed securities by life insurance companies will help stimulate demand. Regulators are responding to the growing number of retail transactions involving credit derivatives – and the casualties they have caused. Rome-based insurance regulator Istituto per la Vigilanza sulle Assicurazioni Private e di Interesse Collettivo (ISVAP), confirms that it is working on the regulations but will not comment on their content. Investment bankers and insurers say they expect strict regulations on minimum ratings, diversification and the type of special-purpose vehicles (SPVs) used. Transactions rated by a single rating agency will probably have to have a triple-A rating; those rated by two agencies a double-A rating. ISVAP is also expected to prohibit first-to-default structures because of the recent under-performance of some issuers, and to require SPVs to be Italy-based to have better control over these tools. Some bankers also expect a regulatory cap on synthetic CDO holdings. The life insurance industry appears to welcome the regulatory move. “I hope they will oblige insurance companies to have a higher rating,” says Paolo Polloni, chief financial officer at Poste Vita, the life insurance arm of the Italian post office. But many companies seem as yet undecided on their strategy for the future. “I would like to better understand the regulator’s approach,” says Massimo Sala, chief financial officer at Monte Paschi Vita Group in Rome, the life insurance arm of Gruppo Monte dei Paschi di Siena. l