A multi-billion dollar market that allowed life insurers to gain incremental income has all but vanished and market participants don’t expect it back anytime soon.
Industry watchers say the market for funding-agreement-backed notes (FABN) has been crippled by the credit crisis and investor squeamishness. Those changes, coupled with new regulations, could spell the end of a business that offered life insurers hefty spread off their capital base.
“As a general matter, the market is closed,” says Matthew Kaplan, a partner with the law firm of Debevoise & Plimpton LLP in New York. “Right now structured products are out of favor.”
Funding-agreement-backed notes are structured securities that allow life insurers to capture the spread between notes issued using their own high credit ratings by purchasing lower quality paper.
At its peak during the last several years, the market for FABNs was a multi-billion dollar business for life insurers, according to Gary Martucci, an analyst with Standard & Poor’s in New York.
“Prior to 2008, this was a very popular way to deploy excess capital by the life insurance industry,” Martucci says. “You borrow money from investors at a AA level and lend through asset purchases at an A or a BBB plus.”
Insurers could earn a spread anywhere from 75 to 100 basis points using FABNs.
The market for FABNs exploded earlier in the decade when they expanded from traditional institutional investors to the retail market.
Kaplan, who helped structure the first SEC-registered FABN in early 2003, says investors saw funding-agreement-backed notes as a safer investment.
He explains that under applicable state laws FABNs have the same priority in the insolvency of a life insurer as an insurance policy, so the notes themselves reflected the financial strength rating of the issuing insurance company.
“Depending on the company, the size of their balance sheet and the size of the program, these could provide a meaningful return,” Kaplan adds.
But the collapse of the credit markets and the resulting turmoil in insurers’ capital bases have shut down new institutional and retail FABN issuance.
Since spreads have narrowed significantly from the early part of this decade investors’ interest in all structured products has waned, says Martucci.
Even though spreads have widened, there is concern about investing in any type of debt issued by the financial services sector in general and the life insurance industry in particular.
Another big question that has kept issuers and investors away from the market are new credit rating agency and asset backed securities proposals by the Securities and Exchange Commission that could have the knock-on effect of limiting the market, Kaplan says.
Kaplan explains the rule changes would make it difficult for issuers to sell FABNs into the retail market.
“The SEC revisions to the asset backed rules could limit if not make [FABN] unworkable,” he says. “As long as the proposals are out there new entrants will think twice about issuing paper and existing players will think twice before they commit additional resources.”
Eventually, the market could rebound and insurers could begin issuing FABNs once again.
For life insurers, returning to the market would be an easy about-face, Martucci says. “It’s not like you have a huge amount of infrastructure,” he explains. “They can flip a switch and get in and out fairly quickly.”
But whether the life industry’s capital base will recover — and investor interest will return — remain the two of the biggest questions for the FABN market.
“I think there are several life insurance companies trying to ween off this business,” Martucci says. “For them, it’s more of an add-on business and a one-trick pony.”
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