The market for single asset insured repacks is set to grow, and potential changes to loan structures and insurance products, together with growing interest from institutional investors looking for value in fixed income assets, will increase the flow of these transactions going forward, writes John Wake, Head of WTW Financial Solutions Structuring.
The banking ‘originate-to-distribute’ model has been evolving since the 1980s. Rather than retaining loans that they originated, banks gradually began to distribute loans into the secondary market, either directly or by repackaging them into various financial instruments which fall under the general category of asset-backed securities (ABS) or single asset repackagings. This activity has the advantages of diversifying banks’ funding sources, reducing concentrations of credit risk, minimising overall funding costs and, under certain conditions, reducing or optimising regulatory capital.
This article is intended to provide a high-level and simplified overview of a complex product that is attracting increasing interest from banks, insurers and investors and, within the constraints of available page space, does not drill down into the fine detail of how these structures work for all the parties involved.
Repack product development
Single asset swap repacks have been used for over 20 years to transform the cash flow characteristics of one asset into another, for example by changing the currency of the initial asset to one preferred by the investor, or from fixed rate to floating rate.
Many European banks have established vehicles, many of which are Luxembourg domiciled, to facilitate these transactions. In addition to the distribution of assets and meeting the needs of their investors, banks can make good revenue from the embedded swap, although this creates a residual credit risk to the bank.
A more recent development has been the application of Comprehensive Non-Payment Insurance (CNPI) to repack structures in order to credit enhance higher yielding/lower credit quality assets to meet the needs of asset managers looking for yield, but whose mandates may prohibit them from holding non-investment grade assets. With its genesis in the insured trade receivables market, in which insured pools of receivables are routinely repackaged and sold as shorter dated investments to institutions, there is now significant interest from both originating banks and asset manager investors in single loan insured repacks, with insurance appetite to support these structures coming from the CNPI, rather than the trade credit insurance market.
The concept is relatively straightforward. The originating bank sells or sub-participates a loan to the repack SPV, which buys CNPI to cover 100% of both interest and principal payments due on the loan. Notes are then issued to the investor and the note proceeds are passed through to the originator.
The reality is somewhat more complex, owing to all the parties involved in the structure and their often misaligned requirements. This highlights the need for the insurance broker to add value to the originating/structuring bank by demonstrating a capability beyond that of simply arranging a contract of insurance, including a deep understanding of all the documentation involved, together with the provision of certain operational support for the transaction.
It is important to note at this stage that the insurance does not ‘wrap’ nor guarantee the performance of the notes issued by the repack Special Purpose Vehicle (SPV) to the investor but insures the cash flows due from the borrower according to the terms of the loan asset held by the SPV.
A key motivation for the arranging banks considering insured loan repacks is to develop alternative distribution and funding channels for the assets that they originate or structure and most banks have a deep understanding of the issues involved and structuring and legal capabilities to arrange repack transactions. Consideration is also required around the originating bank’s potential need to deconsolidate the loan from its balance sheet, whilst retaining the unhedged/uninsured retention of a percentage of the loan, in order to satisfy the normal requirement of CNPI insurers. An insured repack may also involve an asset swap, depending on the characteristics of the underlying asset and the requirements of the investor.
In terms of economics, there are several mouths to feed in an insured repack, so the original loan acquired by the repack SPV needs to generate enough yield in order to pay for the arranger’s fee, the repack SPV frictional costs (establishment, legal, trustees, etc), the insurance premium and finally the investor’s returns. The available universe of both high yielding and insurable loans for repacks is currently limited, with a number of banks currently looking at existing loans held as potentially suitable assets to repack in addition to new loans. Some have been checking out a variety of structured products to be considered as alternatives, including Collateralised Loan Obligations (CLO) tranches, asset-based loans, Significant Risk Transfer (SRT) tranches and potentially other, more exotic credit assets.
Unlike the predominant ‘principal-only’ CNPI cover for bank-held loan assets, most investors will require the full cash flow to be insured, and the calculation of insurance premium to cover the future interest and principal payments due from the borrower can easily eat into the available economics. This is a factor that has become more significant in the current rising interest rate environment especially in the context of the ‘known unknown’ benchmark factor for floating rate assets. As reported in the Financial Times on 23 May1, Christine Lagarde signalled for the first time that the European Central Bank’s eight-year experiment with negative rates will end within months, saying borrowing costs are on track to hit zero by the end of September. The ECB president wrote in a blog that, “based on the current outlook”, the institution was “likely to be in a position to exit negative interest rates by the end of the third quarter”. The deposit rate is now minus 0.5% and has been in negative territory since 2014, when the region was facing a sovereign debt crisis.
From the insurer’s perspective, they will normally expect to receive a similar level of premium rate on their exposure (which, in the case of repacked loans includes capitalised future interest) were the asset to be brought to them by a loan syndicate bank. Despite these challenges, there is increasing interest from credit insurance providers to work with banks and brokers to develop structures to deliver single loan repacked assets to non-bank financial institutions.
The target group of investors includes a number of large US, UK and European insurance asset managers. Generally, repacked assets can be allocated to one or more of their internal funds, depending on currency, duration and structural characteristics, and the fund’s mandate and purpose. These investors will place great emphasis on the robustness of the credit insurance structure and documentation as the basis of the investment. Investors will also consider a number of additional factors when looking at an insured loan repack proposition, including the market price and yield of any external debt that the insurer may issue, to ascertain the relative value of the proposed investment, which, unlike an insurer’s own issued debt, is highly illiquid and in most cases likely to be held to maturity. Part of the investment approval process will include an analysis of the likely capital treatment that is required internally. For example, for investors who are focused on investing in longer dated assets to feed future life and pension liabilities and are governed under Solvency II regulations or their equivalents, the borrower’s ability to prepay can be highly detrimental to their Matching Adjustment capital treatment, as can loan acceleration following a default. In this case they are looking for certainty of future cash flow, whether it be from interest and principal payments due from the underlying asset or an insurance claim payment following the default of the underlying. The investor might also need a rating on the note that it buys, reflecting the credit enhancement of the asset in the repack SPV, although they will normally bear the cost of this and, in terms of timing, a rating is not normally a pre-condition to execution.
As outlined above, there can be significant challenges in taking a transaction from enquiry to execution, but with the right bank, broker, insurer and investor partners it can be done, yet again demonstrating the CNPI market’s capacity to innovate and adapt to meet the needs of its clients and the loan market in general.
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