The Securitization of Surplus Notes by Property and Casualty Insurers: Empirical Evidence

Transcription

1 The Securtzaton of Surplus Notes by Property and Casualty Insurers: Emprcal Evdence Tao Zhang Cohen Bros. & Company 1818 Market St., 28 th Floor Phladelpha, PA Larry A. Cox School of Busness Unversty of Msssspp Unversty, MS Ths verson: July 7, 2006

2 The Securtzaton of Surplus Notes by Property and Casualty Insurers: Emprcal Evdence Abstract Surplus notes have been utlzed by nsurers for decades, although large nsurers domnated n ths market long ago. Lately popular securtzaton deals revve surplus notes as an effcent fnancng devce for small and md-szed nsurers to tap captal markets at a reasonable cost. Ths paper ntends to fll n the gap never touched by the pror studes by nvestgatng what factors determne the nsurers decsons to securtze ther surplus notes and what are the underlyng ratonales of surplus notes securtzaton. After mplementng several models on censorng data, our results show that nsurers sze, organzaton form, and rsk-based captal poston sgnfcantly affect the partcpaton decson made by nsurers to securtze surplus notes, whle the sze and organzaton form mpact the volume decson n a dfferent way from they do the partcpaton decson. In addton, the ratng agency s ratngs sgnfcantly affect both partcpaton and volume decsons. Overall, our results suggest that deductons of fnancal dstress costs and agency costs are mportant ncentves for nsurers to securtze ther assets/labltes. Keywords: surplus notes, hybrd captal, nsurance company, securtzaton JEL Classfcaton: G22, G32

3 1. Introducton One mportant trend occurred recently n nsurance ndustry s the convergence of nsurance markets and fnancal markets by securtzaton. Several studes (Doherty, 1997; Doherty and Schlesnger, 2002; Cummns, Lalonde, and Phlps, 2004; Cowley and Cummns, 2005; Iacobucc and Wnter, 2005) have ntended to analyze the economcs of nnovatons regardng catastrophc rsk (CAT) securtzaton, assets-backed securtzaton (ABS), and XXX reserve securtzaton by lfe nsurers. Snce the year of 2002, securtzaton of surplus notes has sparked resurgence n the ssuance of these hybrd notes by nsurers. As unsecured ndenture deeply subordnated to polcyholder clams and other ndebtedness, surplus notes have been wdely used by nsurers for several decades. However, based on a study by A.M. Best n 2003 (A.M. Best, 2003), ssuers of surplus notes wth large face amount and long maturty n 1990 s were usually bggest nsurers that had more access to captal markets, whle small or md-sze nsurers could only ssue surplus notes n relatvely small denomnaton and short maturty. At the same tme, surplus notes are not regarded as an effectve fnancng devce to rase captal for small or md-szed nsurers, who tradtonally lack channels to captal markets. Wth the ncepton of the frst nsurance collateralzed debt oblgaton (CDO), the securtzed nterest n the pool of collaterals such as bonds and loans n 2002, the securtzaton of surplus notes receves warm welcome n small and md-szed nsurers as they obtan a sesame door to captal markets at reasonable costs. Accordng to Ftch Ratngs survey (Ftch Ratngs, 2005), thrteen nsurance CDO offerngs wth $3.76 bllon assets had been completed from December

4 2002 to December 2004, of whch surplus notes and trust preferred securtes account for 30% and 70%, respectvely. Dumm and Hoyt (1999) provde the frst emprcal study about surplus notes ssuance by lfe nsurers durng 1992 to 1995, but ths unque hybrd securty receves lttle attenton n the academa under the background of securtzaton. Therefore, the reasons for nsurers renewed nterest n ssung surplus notes are unclear based upon both scholarly research and ndustry reports. Under the assumptons of perfectly effcent captal markets, securtzaton of surplus notes would not add nsurers value and therefore nsurers should have no ncentves to securtze. Nevertheless, f any assumpton underlyng perfect markets s volated n the realty, nsurers are wllng to securtze drven by frcton reducton and utlty maxmzaton. Several hypotheses have been proposed by researchers (Doherty, 1997; Doherty and Schlesnger, 2002; Cummns, Lalonde, and Phlps, 2004; Cowley and Cummns, 2005; Iacobucc and Wnter, 2005) about ncentves of securtzaton by nsurers and other fnancal nsttutes. They argue that n the presence of bankruptcy costs, nformaton asymmetry, agency costs, and regulaton costs, securtzaton may help nsurers mtgate these costs and add some value to frms. Emprcal studes on hybrd securtes n the bankng ndustry delver supports to these hypotheses to some extents, and they fnd that banks use securtzaton generally to mtgate tax burdens (Engel, Erckson, and Maydew, 1999), fnancal dstress costs (Benston, Irvne, Rosenfeld and Snkey, 2003; Harvey, Collns, and Wansley, 2003; Sron, 2003), and regulatory scrutny (LaCour-Lttle, and Sander, 2004). The ncreasng popularty of surplus notes securtzaton over last four years prompt us to explore the logc behnd the phenomenon and examne the above

5 hypotheses for the nsurer unverse. Hence, the sgnfcant relaton between surplus notes securtzaton and frm characterstcs related to fnancal dstress costs, nformaton asymmetry, agency costs, and regulatory costs, wll llustrate how the surplus notes securtzaton s motvated. However, lttle work has been done on how surplus notes securtzaton s drven by frm characterstcs, especally for property-casualty (P-C) nsurers, although P-C nsurers ssued 75% total assets of nsurance CDOs from December 2002 to June 2004 (Ftch Ratngs, 2005). Therefore, P-C nsurers provde a good arena to study factors drvng securtzaton of surplus notes. In ths paper, we examne the characterstcs of nsurers that lead to actvty n the ssuance of securtzed surplus notes ssues. The purpose of ths study s to nvestgate what factors determne nsurers decson to partcpate n securtzaton of surplus notes, and furthermore, how these factors affect ssuers decson - how much surplus notes they should ssue n the pool. Followng Cummns, Phlps, and Smth s (2001) study on dervatve usage by nsurers, we dstngush the partcpaton and volume decson n the securtzaton of surplus notes ssuance. Moreover, our study wll shed some lghts on the economc ratonale of surplus notes securtzaton by nsurers. Usng a sample of 1686 P- C nsurers consstng of 45 surplus notes ssuers and 1641 non-ssuers n nsurance CDO deals durng year 2003, we emprcally test the effects of frm characterstcs, ncludng sze, fnancal strength ratng, organzaton form, leverage, and rsk-based captalzaton, on the nsurers decsons to engage n surplus notes securtzaton. Our results ndcate that nsurers wth larger sze, weaker rsk-based captal poston, and mutual nsurers are more lkely to ssue surplus notes. On the other hand, we fnd that smaller nsurers, stock nsurers, group afflated nsurers, and nsures wth

6 margnal A.M. Best s ratngs ssue more surplus notes after decdng to ssue. Overall, our results provde strong support to the fnancal dstress hypothess, and margnal support to the agency costs and asymmetrc nformaton hypotheses. Our analyss has mportant mplcaton for how regulators should regulate the ssuance of surplus notes and how ratng agences control credt rsk of ssuers by nsurer s characterstcs such as sze and organzaton form. The rest of paper s organzed as follows. In part 2, we ntroduce the background about securtzaton of surplus notes and revew the prevous research on the surplus notes ssuance. We dsclose the potental determnants of securtzed surplus notes ssuance n part 3. We then descrbe our data and methodology n part 4. Emprcal results are presented n the part 5, and we conclude n part Background and Lterature Revew 2.1. Standalone Surplus Notes Issues Surplus notes are unsecured debt oblgaton ssued drectly by nsurance operatng companes and thereby provde double advantages to ssuers: the nterest payments are tax deductble as surplus notes are reported as debt on a GAAP bass, and at the same tme, they are treated as statutory surplus by state regulator and ncluded n the calculaton of total adjusted captal (TAC) of RBC rato by NAIC. Regulators usually treat surplus notes as statutory captal on the bass of not only ts deep subordnaton and unsecured, but also regulator s control on payments to surplus notes. Under the most restrctve condton, some state regulators (e.g. New York and Calforna) requre approval for any nterest payment and prncpal repayment of surplus notes before

7 nsurers want to do so 1. As a less rgd form, some state regulators (e.g. New Jersey) permt pre-approval for nterest and prncpal payments on case that nsurers have met some explct requrements 2. Because of the equty-lke nature of surplus notes, the dsapproval of nterest or prncpal payments on both two types of surplus notes by regulators s not regarded as default, and nterest s cumulatve and payable once obtanng approval. Despte some dvdng opnons regardng pre-approval surplus notes between regulators 3, major ratng agences vew both types as equty as long as they meet certan crteron on maturty, subordnaton, and payment restrcton. For nstance, A.M. Best requres equty-lke surplus notes: (1) have a stated maturty of 10 to 30 years; (2) subordnate to polcyholders, clamants, benefcary clams and other classes of credtors; (3) any nterest and prncpal payment s subject to approval of state regulators. Smlarly, S&P s consders long maturty (at least 10 years) and structure (subordnaton and no ongong payments leadng to bankruptcy) to be two basc requstes of equty treatment for surplus notes. On the other hand, to address the hybrd nature of surplus notes, ratng agences only takng account certan percentage of surplus notes n calculatng fnancal ratos. Based on the A.M. Best s contnuum, surplus notes usually receve 25% to 50% equty credt of ther face amounts. The major three ratng agences (S&P s, Moody s, and Ftch) do not explctly ndcate the amount of equty credt 1 Despte no specfc gudelne or nterpretaton regardng how state regulators determne the payment approval, t s wdely held that the nsurers own fnancal condtons are the underlyng bottom lne for decson. 2 Most common requrements nclude: (1) nsurers has not defaulted any clam or ndebtedness; (2) no federal or state agency has fled any acton (e.g. rehabltaton, lqudaton, conservaton, or dssoluton) on nsurers; (3) nsurers RBC rato must exceed the mnmum level after prncpal repayments. 3 In December 2003, a NAIC subcommttee tentatvely voted that the second form of surplus notes should be accounted for as lablty as a result of ts pre-approval feature and nomnal requrements. However, ths decson s never fnalzed snce then.

8 surplus notes wll receve, but they publcly provde ther own debt-equty contnuum or equty credt lst as a reference. Hstorcally, surplus notes were manly ssued by troubled nsurers to polcyholders for addtonal surplus snce they usually had no other access to captal. Crppled by ther lmted access to captal markets, mutual nsurers also used surplus notes to releve the sole dependence on retaned earnngs to grow ther statutory equty. In addton, nsurers drected ther proceeds from surplus notes towards mtgatng operatng leverage pressures, retanng addtonal proftable busness n leu of quota share partcpatons from ther rensurers, fundng acqustons, and refnancng more expensve debt that may not receve equty-lke treatment from the ratng agences. In 1990 s, large nsurers such as Prudental, MetLfe, and New York Lfe domnated the surplus notes ssuance market (Dumm and Hoyt, 1999), as scale of economy made them more effcent to fnance externally. Unfortunately, the trckle down effect orgnatng from ths large company syndrome became tenuous for small and md-szed nsurers because the hurdles of tradtonal fnancng stll plagued wth the rse of surplus notes. From the ssuer s vew, fees pad to nvestment bankers and ratng agences 4 made the costs of standalone debt ssuance n small sze unaffordable. Vcsstudes of debt markets also made prcng of ndvdual ssuance very dffcult. From the nvestor s perspectve, surplus notes tend to be rather llqud nstruments due to the absence of an exchange lstng and prvate placement to nsttutonal nvestors. Therefore, nvestments on surplus notes ssued by small and md-szed nsurers wthout proven track records were confned to the most sophstcated nvestors. 4 A large proporton of small and md-szed nsurers do not obtan publc ratngs from major ratng agences, so nvestors usually requre ratng before the ssuance. Furthermore, unfavorable ratng change may deterorate the nsurers fnancng burden.

9 2.2. Securtzaton of Surplus Notes The emergence of nsurance CDO pools opened up a cost-effcent soluton to reach broad nvestor crcles for small and md-szed nsurers. Exhbt 1 brefly llustrates the typcal cash flow structure of nsurance CDO pools. Around 30 to 40 nsurance companes ssued surplus notes or trust preferred securtes (TPS) 56 to specal purpose vehcles (SPVs) wth maxmum sngle ssuer concentraton of 2.5% to 5.0%. Collateral manager pools these collateral securtes together, and ssues CDO n dfferent tranches rated by ratng agences. CDO tranches are usually sold drectly to nsttutonal nvestors under Rule 144A of the 1933 Securtes Act, and proceeds are channeled back to nsurance companes. Because CDO tranches are rated and some are even lsted on exchanges, t essentally creates demands on the buy sde. More mportant, the poolng of ndvdual small or md szed ssuers ncreases the debt capacty and drves down the costs of fundng compared to standalone ssuance. The average pool sze orgnally was around $350 mllon to $400 mllon, and further ncreased to $600 mllon to $700 mllon after the nventon of hybrd CDO pools mxng collaterals from banks and nsurers. The spread of surplus notes over LIBOR ranged from 350 to 450 bass ponts, dependng on the sze and credt qualty of collaterals, and was dragged down modestly (around 50 bps) by lower spreads on bank papers n the hybrd pools. In addton, the 5 A Trust preferred securtes are preferred shares ssued by a busness trust formed by a company seekng to rase captal, generally bank and nsurance holdng companes. The company establshes the trust and sells deeply subordnated deferrable nterest debentures to the trust. The trust pays for these debentures wth the proceeds of preferred shares sold to nvestors. The debentures are the only assets of the trust. large proporton of small and md-szed nsurers do not obtan publc ratngs from major ratng agences, so nvestors usually requre ratng before the ssuance. Furthermore, unfavorable ratng change may deterorate the nsurers fnancng burden.

10 ndvdual ssuance amount ncreased n lne wth the whole pool sze, and the fees 7 related to the ssuance also decreased slghtly (around bps). Bascally, surplus notes and trust preferred securtes are very smlar wth respect to payment deferral, length of maturty, non-call opton, non-amortzaton, and the credt spread. For nstance, surplus notes usually have long maturtes at least 10 years wth a typcal of 30 years, and nsurers can defer nterest payments to surplus notes for up to fve years. Lke trust preferred securtes, surplus notes can be redeemed before the stated maturty under certan condtons. However, surplus notes have two mportant dstnctons from trust preferred securtes: Frst, surplus notes are ssued by operatng nsurance companes, whle trust preferred securtes are ssued by nsurance holdng companes that depend on up-streamed dvdends to servce the debt. Hence, small and md-szed mutual nsurers wthout the holdng companes are only able to gan access to captal wth surplus notes nstead of trust preferred securtes. Second, surplus notes are subject to greater regulatory scrutny and restrctons on such ssues as pre-ssuance approval and nterest rate cap than holdng company debts lke trust preferred securtes. Accordngly, surplus notes ssuers usually are able to mantan lower ratngs than trust preferred ssuers. Rather than merely comparng demand and supply of surplus notes securtzaton by ndustry practtoners, the academcans tend to explore the underlyng ncentves of securtzaton. After explorng the deal structures, Cowley and Cummns (2005) argue that securtzaton may help nsurers mtgate bankruptcy costs, agency costs, and regulaton costs. Frst, securtzaton can reduce nsurers transacton costs ncludng 7 Typcally, senor fees, subordnated fees, trustee fees account for 3% of ssuance amount. Admnstratve expenses amount to $1000 to $3000 per year. Sometmes, the underwrters wll compensate ssuers the ratng costs.

11 bankruptcy costs. Second, relatvely homogenous assets ncludng mortgage, bonds, and nsurance polces are put n the pools through securtzaton, so less nformatonal asymmetry are contaned n the asset pools. Thrd, ssuers have to dsclose fnancal nformaton to ratng agences and nvestors to market the offerngs and receve ratngs, whch further reduce the nformaton asymmetry. Last, securtzaton preclude assets held n SPV from the nfluences by managers other actvtes, and therefore securtzaton would reduce possble agency costs. Iacobucc and Wnter (2005) suggest that securtzaton not only decreases nformaton asymmetry between nvestors and nsurers, but also reduces nformaton asymmetry among dfferent classes of nvestors possessng dfferent level of prvate nformaton. In addton, securtzaton may help reduce agency costs for the followng reasons: Frst, securtzaton may enhance montorng effcency by reducng ambguousness n dstngushng frm performance and management performance; second, securtzaton puts managers reputaton as a dscplne on management, so nvestors regard securtzaton as a sgnal of hgher qualty of management; thrd, securtzaton may optmze the management ncentve contract and mprove the effcency of management ncentve Research on Securtes Offerngs by Insurers Notwthstandng extensve research on securtzaton of catastrophc bonds (Cummns, Lalonde, and Phllps, 2004; Doherty, 1997; Doherty and Schlesnger, 2002), exstng studes on securtzaton of surplus notes are very spare n both the ndustry and academa. Ftch Ratngs (2005) surveys all CDO pools backed by collaterals of trust preferred or surplus notes ssued from 2002 to 2005, and fnd that nsurers n CDO pools are generally small P-C underwrters wth concentrated busness lnes and lmted access

12 to captal markets. On the other hand, banks partcpatng n CDO pools are relatvely larger than the average bank. Dumm and Hoyt (1999) nvestgate the standalone surplus notes ssuance by lfe nsurers durng the perod from 1992 to They fnd that mutual nsurers, nsurers afflated to a group, nsurers wth lower A.M. Best fnancal strength ratng, or nsurers wth weaker NAIC RBC rato are more lkely to ssue surplus notes. They conclude that lfe nsurers captalze on surplus notes to avod fnancal dstress, regulatory scrutny, and lmted access to captal. Nonetheless, several lteratures cover other hybrd securtes such as trust preferred securtes, subordnated debts, and mandatory convertbles ssued by nsurers, banks and other frms. Engel, Erckson, and Maydew (1999) fnd that the ssuers of trust preferred securtes are larger than the average n ther ndustres. They examne a sample of 28 companes ssung trust preferred securtes to retre preferred stocks, and fnd sgnfcant tax savngs at about 28% of ssued securty amount. Besdes, they fnd substantal ncentve of frms to mprove ther captal structure by ssung trust preferred securtes to redeem ther debts. Benston, Irvne, Rosenfeld and Snkey (2003) dscover sgnfcant postve abnormal stock returns of bank holdng companes ssung trust preferred securtes after Federal Reserve announced the qualfcaton of trust preferred as Ter One captal on October 21, They subsequently mplement unvarate and multvarate probt test to dfferentate the trust preferred ssuers and non-ssuers. The results are generally consstent: compared to non-ssuers, trust preferred ssuers are larger, have hgher tax rate and rsker fundng structure, as well as mantan hgher nsolvency rsk and less equty and Ter One captal. Therefore, they conclude that trust preferred ssuances are manly drven by tax savngs and regulatory captal requrements,

13 whle offset by transacton costs related to ssuance. Although they do not fnd convncng evdence to show the banks wth more growth opportuntes are more lkely to ssue trust preferred, ther fndngs strongly reject the moral hazard hypothess that undercaptalzed banks are less lkely to ssue trust preferred securtes and more wllng to take advantage of under-prced federal depost nsurance. Sron (2003) examnes the mpact of bank rsks on the ssuance spread (or prmary spread) of subordnated debts ssued by European banks durng the perod of 1991 to He fnds that the market dscplne bank behavors by takng the ratng agences fnancal strength ratng and loan loss reserve to total loans rato nto account when accessng the rsk. Ther fndngs suggest that the hgher fnancal soundness of banks, the lower spreads borne by subordnated debts. Ambrose, LaCour-Lttle, and Sander s (2004) compared the default rate of securtzed mortgage loans and unsecurtzed mortgage loans, and fnd that securtzed loans have lower default rsks than un-securtzed loans. They attrbute ths dfference to reduced nformaton asymmetry about mortgage loans by repeated transactons between prmary loan underwrters and secondary securtzaton market partcpants (Fanne Mac and Fredde Mae). In addton, ther results advce that the mortgage loan underwrters may use securtzaton to arbtrage on regulatory captal requrements on securtzed and un-securtzed loans. Yan, Nandy and Chemmanur (2004) suggest that the underlyng ratonales of ssung mandatory convertbles nclude decreasng prvate nformaton about the frm, fnancal dstress costs, and tax burden. 3. Potental Determnants of Securtzed Surplus Notes Issues

14 Followng the prevous studes on hybrd securtes and rsk securtzaton (Dumm and Hoyt, 1999; Cowley and Cummns, 2005; Benston, Irvne, Rosenfeld and Snkey, 2003; Cummns, Lalonde and Phllps, 2004), we nvestgate the underlyng factors that drve the P-C nsurers demands for sellng surplus notes n CDO pools as follows: Informaton Asymmetry Bank lteratures have already ponted out that nformaton asymmetry wth regard to loan rsks plays an mportant role n banks decson to securtze ther loans. DeMartzo and Duffe s (1999) model argues that f banks ntend to tap ther prvate nformaton about loan rsk, they may securtze hgh rsk loans and retan low rsk loans n ther book. As a result, the nvestors have to set up strcter credt standards to protect themselves from adverse selecton problem. After repeated negotaton and transactons, banks wll retan hgh rsk loans n ther book whle securtzng low rsk loans to sell out securtzed securtes. On the other hand, DeMarzo (2005) bulds a model to llustrate that the nvestors may process superor evaluaton ablty and varous hedgng nstruments (e.g. tranchng and dervatve), and thereby reduce ther adverse selecton rsk. One natural extenson of DeMarzo s (2005) model s that banks stll have opportuntes to captalze on ther prvate nformaton about loan rsk profles. Smlarly, Zhang, Cox, and Van Ness (2005) provde emprcal evdence to show that the nformaton asymmetry about underwrtng book n the nsurance markets can cause severe adverse selecton costs n the secondary stock markets, especally for P-C nsurers. As the opaqueness of underwrtng portfolos may deterorate the nformaton asymmetry between nsurers and nvestors, Cowley and Cummns (2005) suggest that nsurers may mtgate ther nformaton asymmetry durng the process of securtzaton.

15 They argue that the ratng agency s ratng analyss, actuaral report, and cash flow analyss of SPV wll contrbute to ncreasng nformaton transparency of nsurers busness. One mportant measure of opaqueness of nsurance underwrtng busness s the adverse reserve development. Rothschld and Stgltz (1976) establsh a model to ndcate that opaqueness regardng underwrtng labltes s wdely present between the nsurer and the nsured, and therefore the nsurer s not able to accurately estmate the future loss n ther busness mx. Concentratng on ntra-day stock tradng data of P-C nsurers, Ruhland and Sommers (2004) fnd a sgnfcant relaton between adverse loss reserve development and nformatonal asymmetry n stock tradng transacton. As small or md-szed nsurers possess adamant opaqueness emboded n ther underwrtng book, the securtzaton process ncludng tranchng and credt enhancement wll help them allevate the nformaton asymmetry problem of ther busness. Reserve deteroraton may also lead to nsurers nsolvency snce severe loss reserve deteroraton wll cause the dran of surplus (Carson and Hoyt, 1995). In an A.M. Best survey (A.M. Best 2004) on nsolvent P-C nsurance companes from 1969 to 2002, major reasons of nsolvency are defcent loss reserve (54%), fraud (16%), and catastrophe losses (7%). As a result, nsurers may engage n surplus notes securtzaton to cushon the loss of captal and avod the regulatory acton (Cowley and Cummns, 2005). From the regulators respectve, reserve nsuffcency s also regarded as one mportant measure of underwrtng rsk, one of four components of RBC calculaton when they montor the fnancal soundness of nsurers. Hence, reserve development wll be an mportant determnant of nsurers wllngness to ssue surplus notes n securtzaton transactons.

16 Ratng Agency s Ratng As an ndependent ratng agency specalzng n nsurance ndustry for over one century, A.M. Best assgns fnancal strength ratngs to almost all nsurers n North Amerca whch reflect nsures fnancal strength and ablty to meet ongong oblgatons to polcyholders (A.M. Best, 2006). A.M. Best groups ther ratngs nto two man segments: secure and vulnerable, and further breaks down nto several categores, whch are shown on Exhbt 2. To avod the fnancal dstress costs, frms wth hgher default rsk are less lkely to depend on nternal captal accumulaton and are more eager to obtan captal from outsde sources. Pror studes (Adel, 1996; Anthony and Petron, 1997; Cummns and Danzon, 1997; Potter, 1998) have used A.M. Best s fnancal strength ratng to measure nsurers fnancal soundness and represent nsolvency rsk. Usng A.M. Best s fnancal strength ratng as proxy for default rsk of lfe nsurers, Dumm and Hoyt (1999) fnd sgnfcant evdence that nsurers wth lower ratngs are more wllng to ssue surplus notes. Cowley and Cummns (2005) argue that nsurers are confrontng hgher fnancal dstress costs as they facng more rgd regulatory scrutny and operatonal restrctons. As a result, securtzaton wll be an effectve way for nsurers to relef ther fnancal dstress costs. For surplus notes securtzaton, the smlar logc prevals: as nsurers wth low ratngs have lmted access to tradtonal fnancng methods, partcpaton n nsurance CDO provdes a feasble alternatve to addtonal captal. Organzaton Form Cummns, Lalonde and Phlps (2004) argue that mutual nsurers are more averse to rsk because polcyholders are overexposed to rsk to purchase nsurance polcy and

17 managers are also rsk averse to concern ther job securty. Therefore, mutual nsurers are more effcent n catastrophc securtzaton than stock nsurers. In contrast, stock nsurers can tolerate hgher level of nsolvency rsk based on agency costs theory (Cummns and Sommer, 1996; Smth and Stutzer, 1990), and ths proposton receves support from emprcal studes (Lamm-Tennant and Starks, 1993). Moreover, n the structure of nsurance CDO, surplus notes are more often ssued by mutual nsurers than by stock nsurers, snce surplus notes provde opportuntes tappng captal markets to the mutual that s owned by polcyholders and as such cannot ncrease ts captal bases by rasng equty. Usng a panel dataset from 1992 to 1995, Dumm and Hoyt (1999) fnd emprcal evdence that lfe nsurers n the mutual form are more lkely to ssue surplus notes. Sze There exst conflctng theores about the effect of frm s sze on surplus notes ssuance. Cummns, Lalonde and Phlps (2004) suggest that larger frms have hgher ablty to mplement ndex-lnked securtzaton, snce the fxed and varable costs of acqurng expertse ncurred durng the deals are more affordable to larger frms. On the contrary, Dumm and Hoyd (1999) fnd evdence to support ther hypothess that smaller nsurers are more eager to ssue surplus notes snce they lack the smlar access to captal markets as ther larger counterpartes and need more captal for growth. Underwrtng Leverage As one of twelve IRIS ratos, net premums wrtten (NPW) to surplus rato measures the ablty of nsurers surplus to absorb adverse loss from underwrtng busness. Ths rato s also regarded as a proxy of underwrtng leverage by practtoners

18 and ratng agences. Hgher rato ndcates lower adequacy of surplus to wthhold any future loss deteroraton and undermnes nsurers fnancal strength. Hence, fnancal dstress hypothess assumes that larger polcyholder clams derved from unfavorable loss create the predomnant bankruptcy rsks (Chamberlan and Tennyson, 1998). Carson and Hoyt (1995) examne varous nsolvency predcton models and dentfy underwrtng leverage as a sgnfcant ndcator of lfe nsurer fnancal strength. Fnancal Leverage Fnancal dstress costs hypothess suggests that hgher proporton of debts n total assets leads to hgher probablty of bankruptcy and offsets the tax sheld benefts (Stgltz, 1972). Other studes on captal structure also reveal that hgher fnancal leverage would ncrease bankruptcy costs and decrease frm value (Stgltz, 1972). As surplus notes receve equty lke treatments from regulators and ratng agences, ssuance of surplus notes n nsurance CDO wll mtgate captal constrants mposed on nsurers balance sheet caused by adverse loss reserve development or nvestment loss. Agency costs theory (Jensen and Mecklng, 1976) ndcates that debt generates agency costs due to three reasons. Frst, asset substtuton n the nterests of the agent transfers wealth from debt holders to owner-manager. Second, the preventon of wealth transfer ncurs montorng and bondng costs. Last, there exst drect or ndrect bankruptcy costs related to the fxed clam of debt holders. Meanwhle, agency costs theory predcts that hgh fnancal leverage reduces the free cash problem, and thereby releves the agency costs problem (Jensen, 1986). Therefore, nsurers may ntend to ssue surplus notes to reduce agency costs. Captal Adequacy

19 Numerous studes (Carson and Hoyt, 1995; Stakng and Babbel, 1995) have already ndcate that nsurers captalzaton provdes the sgnfcant ndcator of nsolvency and captal provdes the most mportant cushon for polcyholders. As a hghly regulated ndustry, nsurance companes receve promnent attenton on nsolvency ssue. After collapse of several large nsurers n early 1990 s, NAIC adopted a seres measures to montor nsurers fnancal strength, ncludng the rsk-based captal rato and FAST system. NAIC mplemented Rsk-Based Captal Rato (RBC) n 1993 to establsh mnmum captal adequacy requrement relatve to rsks assumed by nsurers encompassng 4 categores: asset rsk, lablty rsk, busness rsk, and mscellaneous rsk. NAIC has stated that RBC s not a measure of nsolvency alone, and RBC has to be used wth other ratos to reflect overall fnancal condton for an nsurer. Consstent wth ths statement, Grace, Harrngton and Klen (1998) fnd that although RBC ratos have less predctng power than Fnancal Analyss Trackng System (FAST) ratos, RBC ratos stll convey new nformaton about nsolvency rsk when combnng wth FAST ratos. Dumm and Hoyt (1999) also fnd that lfe nsurers wth lower RBC rato are more nclned to ssue surplus notes. Group Afflaton Cummns, Lalonde and Phlps (2004) suggest that an afflated nsurer s less dversfed than sngle nsurer snce the group dversfes across subsdares, and therefore a group member has lmted ablty to nvolve n catastrophc ndex-based securtzaton due to larger bass rsk. On the other hand, Dumm and Hoyt (1999) fnd that lfe nsurers afflated to a group are more lkely to ssue surplus notes than nonafflated nsurers, snce

20 groups can allocate captal n nternal captal markets to support subsdares experencng fnancal dstress. 4. Research Desgn 4.1. Data The major data source s the A.M. Best Property & Casualty Statement Database 2004 verson that contans the most comprehensve nformaton of Amercan nsurers fled to Natonal Assocaton of Insurance Commssoner (NAIC). Many nsurers are afflated to group, so A.M. Best provdes statutory fnancal data for both operatng companes and holdng companes. However, we focus our sample on ndvdual companes snce surplus notes are ssued exclusvely by operatng companes. On NAIC regulatory statements, nsurers report the detal of surplus notes ssuance n Notes to Fnancal Statement. From the subttle of number 13, Captal and Surplus, Dvdend Restrctons and Quas- Reorganzatons, we fnd that out of 62 surplus notes ssuance by P-C nsurers n 2003, 45 are drectly ssued n a CDO pool. The remanng 17 surplus notes are ssued to polcyholders or holdng companes. Followng Cummns, Phlps, and Smth (2001), we elmnate nsurers wth zero or negatve assets, premums, and surplus and nsurers wthout enough group afflaton dentfcaton. We also elmnate nsurers that were under any regulatory acton taken by state nsurance regulators durng The fnal sample after screenng conssts of 1686 observatons from P-C nsurers for the tme perod of year 2003, ncludng 45 ssuers of surplus notes n CDO pools Methodology 8 The normal operaton ncludng outsde fnancng wll be under strct restrcton by state regulators f the nsurer s under regulatory acton.

21 To estmate the effects of frm characterstcs on surplus notes ssuance, we essentally estmate the followng model for the nsurers n our fnal sample: Surplus Notes = f (Re serve Devp, BestRatng5, BestRatng NR, Organzaton Sze, BestRatng 2, BestRatng3, BestRatng 4 Underwrtng Leverage, Fnancal Leverage,, RBC, Group ) (1) Where: Surplus Notes = Surplus notes notonal value ssued by the nsurer scaled by total assets; Re serve Devp = the two-year reserve development dvded by the nsurer s surplus; Sze = the natural logarthm of total assets for the nsurer ; BestRatng 1 = a dummy varable that s equal to 1 f the A.M. Best assgned a fnancal strength ratng of A++ or A to the nsurer, or 0 f otherwse (Not n the regresson); BestRatng 2 = a dummy varable that s equal to 1 f the A.M. Best assgned a fnancal strength ratng of A or A- to the nsurer, or 0 f otherwse; BestRatng 3 = a dummy varable that s equal to 1 f the A.M. Best assgned a fnancal strength ratng of B++ or B+ to the nsurer, or 0 f otherwse; BestRatng 4 = a dummy varable that s equal to 1 f the A.M. Best assgned a fnancal strength ratng of B or B- to the nsurer, or 0 f otherwse; BestRatng 5 = a dummy varable that s equal to 1 f the A.M. Best assgned a fnancal strength ratng of C++ or below to the nsurer, or 0 f otherwse; BestRatng NR = a dummy varable that s equal to 1 f the A.M. Best assgned a fnancal strength ratng of NR to the nsurer, or 0 f otherwse;

22 Organzat on = a dummy varable that s equal to 1 f the nsurer s a stock frm, or 0 f otherwse; Underwrt ng Leverage = the net premums wrtten dvded by the nsurer s surplus; Fnancal Leverage = the nsurer s equty/surplus dvded by total assets; RBC = the NAIC RBC rato that s equal to adjusted captal dvded by authorzed control level rsk-based captal as estmated by the NAIC; and Group = a dummy varable that s equal to 1 f the nsurer s a group member or 0 f otherwse. To address the severty of nformaton asymmetry and subsequent possblty of reserve strengthenng, we nclude two-year reserve development dvded by surplus (ResrveDevp), one of twelve Insurance Regulatory Informaton System (IRIS) ratos used by NAIC to montor nsurers fnancal condton. We expected ths varable to be postvely related to surplus notes ssuance. Followng Dumm and Hoyt (1999), we categorze nsurers nto the followng classes: BestRatng 1 f the nsurer s ratng s A++ or A+ (Superor), BestRatng 2 f the nsurer s ratng s A or A- (Excellent), BestRatng 3 f the nsurer s ratng s B++ or B+ (Very Good), BestRatng 4 f the nsurer s ratng s B or B- (Far), and BestRatng 5 f the nsurer s ratng s C++ or below. Fnally, we take all Not Rated Categores (NR-1 to NR-5) nto account as one class, BestRatng NR. We do not nclude BestRatng 1 n the regresson, so the coeffcents of BestRatng 2, BestRatng 3, BestRatng 4, BestRatng 5 and BestRatng NR llustrate the mpacts on the surplus notes utlzaton pattern f the nsurer s ratng deterorate from Superor to less secure. The projected sgn of ths varable s postve.

23 We assgn 1 to varable representng ownershp structure (Organzaton) f the nsurer s a stock frm or 0 otherwse. Followng McShane and Cox (2005), we regard stock nsurers held by a mutual stll as stock, snce the study by Lee, Mayers and Smth (1997) fnds that managers of mutual-owned stock nsurers behave more lke those of stock nsurers. Based upon the prevously cted theores and emprcal studes, we expect the sgn to be negatve. Followng the pror studes, we measure the nsurer s sze by natural logarthm of total assets (Sze). As the result of conflctng hypotheses, we cannot determne the drecton of ths varable. To account for the desre to strengthen captal base due to underwrtng leverage dfference across nsurers, the NPW-to-surplus rato s used (UnderwrtngLeverage), and the expected sgn s postve. Fnancal leverage s measured as surplus to total assets rato (FnancalLeverage), we expect fnancal leverage to have a postve relaton to surplus notes actvtes. Followng Dumm and Hoyt (1999), we use an RBC rato (RBC) that s equal to total adjusted captal deducted by surplus notes ssued then dvded by authorzed control level rsk-based captal 9, and expect the mpact of ths varable on the total rsk s negatve. Followng Dumm and Hoyt (1999), we add a dummy ndcatng membershp (Group) n an nsurance group and expect t to be postvely related to surplus notes ssuance. Frst, we mplement Tobt model to estmate equaton (1). Because our dependent varable s both censored and concentrated, the OLS estmate s not consstent and usually based toward zero (Greene, 2002). On the contrary, the Tobt model uses the maxmum 9 NAIC establshes four levels of regulatory acton, but the authorzed control level s consdered to be the prmary trggerng pont snce t s equal to the result of RBC formula developed by NAIC workng groups.

24 lkelhood functon to ncorporate two dfferent sets of observatons: one set wth observable ndependent varables and unobservable dependent varable, and the other wth both observable dependent and ndependent varables. Therefore, Tobt model s a conceptually better approach than OLS to estmate censored data. However, Tobt model fals to deal wth the sample selecton problem n that Tobt model cannot explan why the data s censored, and therefore cannot account for those censorng thresholds that determne nsurers decson to ssue surplus notes. Heckman model (1979) provdes a soluton to the problem by a two-step regresson: The frst step s to regress equaton (2) for the full sample by a Probt model and calculate the nverse mller rato λˆ, a measure of omtted varable. The second step s to nsert λˆ nto the equaton (3) as a regressor, and regress equaton (3) by OLS wth consstent standard error. Pr obablty ( Surplus Notes ) = k (Re serve Devp (2) BestRatng 4, BestRatng5, Sze, BestRatng 2, BestRatng NR Underwrtng Leverage, Fnancal Leverage Surplus Notes Pr o > 0 = j (Re serve Devp BestRatng 4, BestRatng5, Sze, BestRatng 2, BestRatng NR Underwrtng Leverage, Fnancal Leverage, Organzaton, RBC, BestRatng3, RBC, Group ), BestRatng3, Organzaton,,, Group, ˆ) λ (3) Cragg (1971) suggests a two-hurdle approach to model censored data: observatons are observed only after two hurdles are passed. In the frst decson (partcpaton decson), the nsurer decdes whether he wants to ssue surplus notes. After makng the decson to ssue, the nsurer then decdes how much he wants to ssue. Fn and Schmdt (1984) pont out that each ndependent varable may affect two decsons ndependently,,,

25 but the Tobt model assumes that each varable affect two decsons n the same drecton. For nstance, a buldng age would be postvely related to probablty of fre accdent, whle the damage caused by the fre may be negatvely related to the buldng age. Recent studes (Cummns, Phllps, and Smth, 2001; Carter and Smpson, 2004; Ln and Schmdt, 2004) on censored data demonstrate that Cragg model, as a generalzed Tobt verson, s more flexble than Tobt model and Heckman model, especally when the partcpaton decson s ndependent of volume decson. To address ths problem, we use the Cragg model as our last estmaton method. Specfcally, n the frst step (partcpaton decson), we use the Probt model to estmate the lkelhood that an nsurer ssues surplus notes or not n the equaton (4) by usng all nsurers no matter they ssue surplus notes or not. In the second step, we mplement truncated regresson model to estmate the equaton (5) usng the nsurers that ssue surplus notes n nsurance CDO. We also use lkelhood rato test to compare these two models to test the null hypothess that the coeffcents affect two decsons n dfferent ways. Pr o bablty( Surplus Notes ) = g (Re serve Devp (4) BestRatng 4 Surplus Notes Pr o > 0 = h (Re serve Devp (5), BestRatng5, Sze, BestRatng 2, BestRatng NR Underwrtng Leverage, Fnancal Leverage BestRatng 4, BestRatng5, Sze, BestRatng 2, BestRatng NR Underwrtng Leverage, Fnancal Leverage, BestRatng3, Organzaton,, RBC, BestRatng3, RBC, Group ), Organzaton,, Group ),, 5. Emprcal Results

26 5.1. Summary statstcs 10 Panel A of Table 2 shows the summary statstcs of all varables used n the paper. The loss reserve deterorates 10% relatve to surplus n average, whle the medan value s relatvely modest, at 1% rate. Over 80% nsurers mantan an A.M. Best s fnancal strength ratng over B+, or secure ratng, whle less than 20% nsurers hold a vulnerable ratng. Specfcally, the class of BestRatng 5 whch combne C++, C+, C, C-, D, E, F and S ratng only accounts for less than 5% of total nsurers, whle the class of BestRatng NR ncludng NR-1 to NR-5 accounts for 11% of total nsurers. The mean of organzaton dummy s 0.77 and ts medan s 1, whch suggests that stock nsurers account for over 70% of our sample. Smlarly, the mean of group dummy s 0.71 whch shows that the majorty of nsurers are group afflated. The regulatory rsk-based captal rato s 831%, well above the 200% threshold that trggers regulatory actons. Panel B compares the statstcs of 45 surplus notes ssuers and 1641 non-ssuers, whch demonstrates several dfferences between two sub-samples. Issuers experence more favorable loss reserve development than non-ssuers, and ssuers are sgnfcantly larger than non-ssuers. The Best s ratngs of ssuers more concentrate on Excellent (A or A-) and Very Good (B++ or B+). Issuers wrte more busness relatve to surplus than non-ssuers, and ssuers captal opton s weaker than non-ssuers, as evdenced by both smaller surplus-to-assets rato and regulatory rsk-based captal rato. Only 33% of ssuers are stock nsurers, whle 78% of non-ssuers are stock nsurers. There have no sgnfcant dfferences of group afflaton between two sub-samples. 10 We also mplement Pearson correlaton test for all ndependent varables. Most correlaton coeffcents are mnmal and all are less than 0.50 so ntercorrelaton of the ndependent varables s not a problem. We are pleased to provde results upon request.

27 5.2. Regresson results In Table 4, we report the estmate results of Tobt model and Cragg model, respectvely 11. The frst column shows the results of Tobt model, whch suggest that Best s ratngs, sze, and organzaton form sgnfcantly affect nsurers surplus notes ssuance. In partcularly, nsurers wth lower A.M. Best s fnancal strength ratng ssue more surplus notes, whch suggests that ssuers use surplus notes to allevate the fnancal dstress costs and regulatory pressures. Sgnfcant and postve coeffcent estmate of sze s more consstent wth Cummns, Lalonde and Phlps (2004) than Dumm and Hoyt (1999), suggestng that larger nsurers ssue relatvely larger amounts of surplus notes n CDO offerng than small and md-szed nsurers. Result for organzaton dummy s consstent wth our hypothess that mutual nsurers ssue more surplus note to strengthen ther captal bases. The other estmates such as group dummy, RBC rato, fnancal and underwrtng leverage are generally n lne wth our hypotheses although none of them s sgnfcant. One excepton s that estmate of reserve development s negatve whle t s nsgnfcant. To account for dfferent effects of frm characterstcs on partcpaton and volume decsons, the results of Cragg model are shown n the last two columns. The frst step of Cragg model, usng Probt model to estmate the partcpaton decson, s the same as the frst step of Heckman model. However, there have sgnfcant dfferences about how each factor affects the partcpaton and volume decsons. Two most predomnant dfferences les n sze and organzaton form. In contrast to the partcpaton decson, smaller nsurers and stock nsurers ssue relatvely more surplus 11 We omt the results from Heckman estmaton snce t s generally consstent wth Tobt model and shows no sample selecton bas. We wll provde the results upon request.

28 notes. Ths result suggests that although bgger nsurers and mutual nsurers are more lkely to partcpate n surplus notes securtzaton deals, smaller nsurers and stock nsurers actually ssue n relatvely larger denomnaton once they decde to ssue. Our speculaton about opposte sgn of sze varable s that there exsts a sze hurdle to some extent for pool canddate. After partcpatng n the pool, the smaller nsurers are more eager to the new captal. For the opposte sgn of organzaton form, our explanaton s that although surplus notes are natural choce for mutual nsurers compared to trust preferred securtes, stock nsurers may ple up larger captal to support ther busness underwrtng. In addton, nsures wth weaker RBC rato are more nclned to ssue surplus notes, whle the captal adequacy level seems to have no sgnfcant mpact on the amount of ssuance. Smlarly, although the group afflaton wll not affect nsurers wllngness to ssue, nsurers afflated to the group do ssue larger amounts of notes. Furthermore, the coeffcents of Best s Ratngs suggest the nsurers wth lower ratngs are more lkely to ssue surplus notes, and the nsurers wth margnal ratngs ntend to ssue larger amount of surplus notes. At last, we test the hypothess that each factor affects both two decsons n the same way followng the lkelhood rato test suggested by Greene (2003). The sgnfcant Ch-squared statstc rejects the null hypothess. In sum, ths result favors Cragg model over Tobt model. 6. Concluson Havng been utlzed by nsurers for over half century, surplus notes have become an ncreasngly popular fnancng tool for small and md-szed nsurers n recent years wth supports from vbrant securtzaton markets. It s crtcal to explan what factors

29 determne nsurers decson to partcpate n surplus notes securtzaton offerngs, and ther subsequent decson on how much to ssue. Ther ssues are also closed related to the economc ratonale underlyng nsurers securtzaton. Pror studes focus on trust preferred securtes used n the bankng ndustry (Harvey, Collns, and Wansley, 2003) and nsurance ndustry (Potter, 2004), whle researchers seldom nvestgate surplus notes n recent securtzaton deals. Ths study ntends to fll up ths gap by dentfyng the factors affectng P-C nsurers behavors n surplus notes securtzaton. Our results from prelmnary Tobt model show that large nsurers, mutual nsurers, and nsurers wth weaker A.M. Best s ratng ssue more surplus notes n nsurance CDO deals. Next, we mplement models to address sample selecton problem n censorng data, and separate dfferent effects on partcpaton and volume decsons. Our results show that organzaton, sze, rsk-based captal rato and A.M. Best s ratngs mpact sgnfcantly on nsurers decson to partcpate n surplus notes securtzaton, although Heckman estmaton suggests sample selecton problem s not serous n our sample. However, sgnfcant dsparty exsts n the factors underlyng n the partcpaton and volume decsons. For nstance, bgger nsurers and mutual nsurers, and nsurers wth lower rsk-based captal poston are more nclned to partcpate n surplus notes ssuance, whle smaller nsurers, stock nsurers and nsurers afflated to a group ssue larger amounts once they decde to ssue. The nsurers wth weaker A.M. Best s ratngs are more lkely to ssue notes, and those wth margnal ssuers ssue larger amounts of notes. Overall, our results provde supports to fnancal dstress costs and agency costs hypotheses.

30 One mportant mplcaton for future research emerges from ths study. As more and more small and mutual nsurers are pourng nto nsurance CDO pools, regulators and ratng agences should watch the trend closely, montor nsurers rsk profle by frm characterstcs, and gauge the whole pool s rsk by consderng underlyng ratonale of ssuance. Further research on effects of ratng agences ratng on nsurers partcpaton decson and volume decson on surplus notes ssuance needs to be furnshed.

31 Reference A.M. Best, 2003, The Treatment of Surplus Notes and Trust-Preferred Securtes n the Fnancal Strength Ratngs of Insurance Companes, A.M. Best Specal Report A.M. Best, 2004, Best s Insolvency Study: Property/Casualty Insurers , A.M. Best Specal Report A.M. Best, 2004, Best s Insolvency Study: Lfe/Health Insurers , A.M. Best Specal Report A.M. Best, 2005, Ratng Surplus Notes and Insurance Trust-Preferred CDOs, A.M. Best Methodology A.M. Best, 2006, Gude to Best s Fnancal Strength Ratngs, A.M. Best Methodology Adel, R., 1996, Rensurance and the Management of Regulatory Ratos and Taxes n the Property-Casualty Insurance Industry, Journal of Accountng and Economcs, 22, Anthony, J. H. and K. R. Petron, 1997, Accountng Estmaton Dsclosures and Frm Valuaton n the Property-Casualty Insurance Industry, Journal of Accountng Audtng and Fnance, 12, Ambrose, B.W., M. LaCour-Lttle, and A.B. Sander, 2004, Does Regulatory Captal Arbtrage, Reputaton, or Asymmetrc Informaton Drve Securtzaton? Unversty of Kentucky, Workng Paper Benston, G. J., P. Irvne, J. Rosenfeld, and J. F. Snkey, 2003, Bank Captal Structure, Regulatory Captal, and Securtes Innovatons, Journal of Money, Credt and Bankng, 35, Carson, J.M. and R. E. Hoyt, 1995, Lfe Insurer Fnancal Dstress: Classfcaton Models and Emprcal Evdence, Journal of Rsk and Insurance, 62, Carter, D., and W. G. Smpson, 2004, Manageral Incentves and the Use of Foregn- Exchange Dervatves by Banks, Oklahoma State Unversty Workng Paper Chamberlan, S. and S. Tennyson, 1998, Captal Shocks and Merger Actvty n the Property-Lablty Insurance Industry, Journal of Rsk and Insurance, 65, Cowley, A. and J. D. Cummns, 2005, Securtzaton of Lfe Insurance Assets and Labltes, Journal of Rsk and Insurance, 72, Cummns, J. D. and P. M. Danzon, 1997, Prce, Fnancal Qualty, and Captal Flows n Insurance Markets, Journal of Fnancal Intermedaton, 6, 3-38.