The increasing pressure on life insurance companies to optimize their capital use and to improve earnings is fueling interest in securitization, according to an new report from Standard & Poor’s.

The report, “Interest in Life Insurance Securitization Heats Up,” said that these transactions also enable investors to diversify portfolio risk. “In the past, insurers have both created insurance products and kept them on their balance sheets, rather like being a manufacturer and a warehouser of the same product,” said Jay Dhru, a director with S&P’s Financial Services Ratings group.

The report added that insurance market conditions have made the time ripe for securitizing life insurance policies. Investors benefit from diversification of risk, and insurers can achieve higher returns on equity and greater financial flexibility without hurting the ratings.

“The development of this market is clearly in its infancy,” said Mark Puccia, a managing director of S&P’s Financial Services Ratings. “However there is a significant interest from insurers and the capital markets. Insurers are confronted daily with the challenges of utilizing their earnings power more effectively. If used properly, securitization can provide an insurer with the currency to grow organically or through acquisitions.”

Beyond the risk that anticipated cash flows do not materialize, the investor’s primary concern is any regulatory action that gives priority to policyholder claims and prevents the insurer from passing on surpluses to investor.

Also, life securitizations have come close to segregating risk for investors, but the transactions rated by S&P so far have not managed to completely sever it from the sponsoring company. The capital markets have not generally been enthusiastic about investing in transactions that are not wholly separated from the financial strength rating on the underlying insurer.

As a result, greater separation between the sponsoring insurer and the securitized block of business will be necessary for this market to develop. Furthermore, in the early days of life insurance securitization, when the volume of transactions is small, the pioneer insurance companies will have to accept less attractive terms than those that will ultimately be the norm, to gain capital-market acceptance.

Insurers also are faced with the prospect that investors will only pick the best risks and leave insurers sitting with a book unduly weighted in the least attractive ones.