Securitization is a process by which claims to cash flows from illiquid assets, such as car loans, mortgages, receivables, and leases, are transformed into traceable securities. The technology was introduced by Bank of America in 1977 and has been popularized through the issuance of mortgage-backed securities, which had a total volume of over $1 trillion outstanding in 1992. Securities backed by other assets also grew dramatically in the 1980s: from $1.2 billion in 1985 to $26 billion in 1988 (Bryan, 1989).
The growing significance of securitization to banks and other financial services firms has been attributed to several factors that fall into two major categories. First, sale of mortgages through securitization is a form of regulatory arbitrage (Pavel, 1986; Greenbaum and Thakor, 1987; Pavel and Phillis, 1987; Kopff and Lent, 1988).(1) Securitization allows banking institutions to sell mortgages in capital markets and thereby frees up banks' capital for more lending. As a result, banks are able to originate loans (to earn fees) without permanently funding them. Second, securitization enables banks to sell mortgages at competitive prices and to redeploy the sale proceeds in assets, which allows more effective management of interest rate risk and better diversification of asset portfolios (Kopff and Lent, 1988, and Harvey, 1991).
Although the amount of securitization is tremendous in banking and some other parts of the financial sector, it is rare in the insurance industry. Indeed, we have been able to identify only a few transactions: Prudential's sale of policyholder loans (PHLs), Cananwill's sale of premium loans, and the "sales" of premiums (with no securities issued) by General American Life and Monarch Capital. These transactions are used to analyze the benefits, costs, and issues of securitization unique to the insurance industry and to explain why securitization has not grown in the industry. The analysis suggests that these transactions are primarily motivated by tax and regulatory considerations and by the pursuit of capital at competitive costs. However, the prospect of securitization in the industry is not promising because (1) it is costly to transform unstable cash flows from insurance products into fixed-income securities, (2) regulations do not allow insurers to take the securitized assets or liabilities off the insurer's balance sheet, and (3) insurers have little demand for using securitization to diversify asset portfolios.
The Securitization Process
In a securitization transaction, at least four parties are involved: borrowers, originators (or sellers of assets), buyers of the assets, and investors in securities backed by the assets. The buyer can be a special purpose corporation (SPC) or a grantor trust, established solely to purchase assets and to issue securities against the assets to investors. In this way, the underlying assets are isolated from the originators' other assets and liabilities. The originators usually act (and are compensated) as servicers of the sold assets for collecting and distributing interest and principal payments.
An asset-backed security (ABS) can be structured as a pass-through or a pay-through. A pass-through structure features equity financing with a trust passing interest and principal payments from the original borrowers to ABS investors. A pay-through transaction, however, raises capital by issuing both bonds and stocks, allowing active management of cash flows from the underlying assets to provide bondholders with stable cash flows. Guaranteed investment contracts (GICs), issued by banks or insurers, are commonly used for stabilizing cash flows by guaranteeing the rate of return on unscheduled principal repayments.
To improve their marketability, most ABS issues have credit enhancement to protect investors against normal losses on the underlying assets.(2) Greenbaum and Thakor (1987) purport that the originator possesses sufficient information about the borrower's quality to design an appropriate schedule of guarantee. …