Insurers embrace innovative hybrid capital structures

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Hybrid capital is occupying an ever-larger segment within insurers’ and reinsurers’ capital structures. Swiss Re reported a hybrid and contingent capital ratio of 9.4% in 2012, up from 6.6% in 2011, while Aviva’s stock of subordinated debt made up 20% of its capital structure on a market consistent embedded value basis in 2012, compared with 17.5% in 2010 (22% in 2011). Similarly, Zurich’s subordinated debt has increased over the past two years from 16.5% to 17%.

This year has witnessed a marked surge in the issue of hybrid capital instruments by insurers, and not just of vanilla instruments. Several large European insurance undertakings have launched innovative hybrids designed to adapt to future Solvency II capital requirements, with features that kick-in when the directive goes live.

Meanwhile, Swiss Re is making waves in the contingent capital bond (CoCo) space with hybrid instruments that ape the structures used by banks in a bid to increase the “quality, flexibility and fungibility” of its capital structure.

All this action reflects a market that is developing a mature understanding of insurance hybrid debt and is hungry for more.

But insurers need to beware of the impact of regulatory changes. A slew of new international rules and guidelines are being introduced that seek to bring insurers’ capital requirements in line with banks, especially for those deemed systemically important, and will have significant implications for the market As a result, companies will have to think carefully about their hybrid issuances and ensure CoCos are suitably structured to ensure they receive the seal of approval from regulators.

Boom time
The market for insurance hybrid debt is booming. This year, Axa, Achmea, Zurich, Aviva and Uniqa issued hybrid instruments to the tune of nearly €3 billion in total to shore up their capital structures in preparation for Solvency II.

With delays to the legislative process kicking the implementation of the directive down the road to at least 2016, and a 10-year transition period promised by the current Level 2 draft text, firms are less cagey about the type of hybrids they are issuing compared with last year.

Under Solvency II, hybrid instruments will be permitted to cover up to 20% of Tier 1 and up to 50% of Tier 2 capital requirements. Tier 1 hybrids will need to be loss absorbing if a firm’s Solvency Capital Requirement (SCR) is breached, meaning they have to be able to convert into equity or be written down, which offers a good incentive for firms to start experimenting with CoCos in preparation.

For Tier 2 capital – the part of the capital structure where hybrids typically slot in – the rules stipulate that all instruments that currently qualify under Solvency I, such as the popular 30-year non-call 10 instruments issued by Aviva, Axa and Zurich this year, can be grandfathered into the new regime. Once the transitional period is over, the full Solvency II rules allow insurers to issue hybrids under Tier 2, as long as they are able to defer interest payments or redemption if their capital dips below the SCR minimum.

As a result, Solvency II offers firms the opportunity to design capital structures that are more flexible than in previous years, says Kai Harden, BNP Paribas’ co-head of debt capital markets for financial institutions in Germany, Austria and Switzerland.

“Under Solvency II, you have more capacity to use hybrids. The question for insurance companies is [will] they use the higher capacity to bolster their risk-bearing capital or rather opt for increased leverage?” he says.

Some firms are moving ahead of the curve by issuing instruments with conditions that guarantee their admissibility under Solvency II once it is implemented.

Christoph Hittmair, London-based head of the financial institutions group for Europe, the Middle East and Africa debt capital markets at HSBC, says: “A lot of insurers are issuing instruments with language on coupon deferral that allows them to meet current and future solvency requirements.”

This is true, for instance, of Aviva’s recent €650 million hybrid issue, which permits the deferral of interest payments if the firm breaches its Solvency II SCR at some point in the future.

On the investor side, interest in insurance debt is also running high while they wait impatiently for rules around bank hybrid capital to be finalised. Piers Ronan, debt syndicate banker at Credit Suisse in London, explains: “If we look at traditional hybrid instruments such as perpetuals, there is strong demand. Insurers have had this window of opportunity to access the capital market and they’ve taken advantage of that.”

While most investors have yet to create dedicated insurance funds, they are increasingly focused on the asset class for existing funds, even if it means tweaking mandates to accommodate that. “We anticipate more dedicated funds in the future,” Ronan adds.

Banking rules
The rigmarole around the regulatory treatment of bank hybrid debt has undoubtedly helped insurers penetrate debt capital markets. Basel III rules for bank hybrids are more restrictive than under Solvency II, allowing insurers to observe a variety of structures and trigger scenarios to see what works and what is popular. The restrictions on banks have also slowed down issuance from the sector, clearing the way for insurers to steal the limelight.

Harden comments: “Bank CoCo issuance opened the market up on the investor side to look at a variety of different transactions. However, new bank regulation has introduced the concept of the point of non-viability, allowing regulators to step in before a bank goes under, which adds more risk to bank credits.

“While the G-Sii [global systemically important insurer] discussions might add some form of non-viability bail-in for systemic insurers in the future, they typically don’t face the same liquidity risks as banks. This has enabled issuers like Swiss Re to tap that market,” Harden adds.

In certain jurisdictions, banks are required by the regulator to issue CoCos that trigger at the point of non-viability, limiting the scope issuers have to structure the debt in an attractive form for investors. Basel III rules require banks looking to issue Tier 1 hybrids to structure the instruments so they can convert into equity or be written down if their common equity Tier 1 ratio falls below 5.125%, while Tier 2 instruments are barred from including ‘step-ups’, a feature that automatically increases coupon payments if an investor holds on to an instrument past a predefined date.

The restrictions on insurers are far less prescriptive, according to Matthias Jaeggi, head of funding at Swiss Re in Geneva, meaning they have an advantage when it comes to CoCos. “Insurers are not being forced into issuing an instrument with a specific type of trigger [like the banks], they’re still basically issuing under the old framework,” he says.

This is not to say, though, that innovations in bank hybrid capital have not had an impact on insurers’ strategies. Swiss Re, for instance, is following in the footsteps of banks with its new CoCo issues. “When we observed in the markets that the banks were bringing out these contingent instruments, we felt the time might soon come for stronger credits outside of the banking industry to issue these kinds of instruments as well,” says Jaeggi.

“We had earmarked a write-off instrument for issue when we saw banks like Barclays and KBC had successfully issued them, and this year we felt the market was ready for a similar instrument from Swiss Re,” he adds.

If structured correctly, a CoCo can provide regulatory and rating agency benefit as well as a capital injection following a tail-risk event, all at a knock-down price. For example, earlier this year, Swiss Re issued a $750 million write-down CoCo that pays a 6.375% coupon to investors. After adjusting for the tax deductibility of CoCo coupons, assuming a 20% tax rate, the cost to Swiss Re is around 5.1%. This is less than half of the reinsurer’s cost of equity, judged by Bloomberg at 11%.

International pressure
This is just as well, for regulators and international standard-setters have taken a long hard look at insurers’ capital structures and seem to have decided it is in the best interests of global financial stability for systemically important firms to adhere to the same capital rules as banks.

This is clear from two separate policy documents both released in July, the first being the International Association of Insurance Supervisors policy measures for G-Siis and the second being the European Commission’s recent communication on the application of state aid rules.

The former document recommended that companies designated as G-Siis be subject to a higher loss absorbency (HLA) charge comprised of “the highest quality capital; namely, permanent capital that is fully available to cover losses of the insurer at all times on a going-concern basis”. This is longhand for equity capital, which G-Siis could potentially claim can be provided for in the form of a CoCo.

Bob Haken, insurance partner at law firm Norton Rose Fulbright, certainly sees the appeal: “If the result of being made a G-Sii means a firm has to increase its Tier 1 capital, then [a CoCo bond] may be the way to do it because issuing that is going to be cheaper than issuing equity.”

But it is far from certain that insurers will be able to use CoCos to meet this additional obligation. The Financial Stability Board, which is responsible for designating G-Siis, has already announced that systemically important banks cannot meet their additional capital requirements using CoCos.

This does not bode well for insurers, although there may be some room for manoeuvre if large insurers act now, suggests Thibaut Adam, head of capital markets structuring at BNP Paribas in London “Undoubtedly, the discussions [on the HLA] will still be going for a number of years, and based on the actual quantum of the capital surplus, may provide an angle for designated G-Siis to get Cocos included.”

Meanwhile, the European Commission’s communication on state aid may act as an even greater incentive for large European firms to issue hybrids with CoCo features, according to some legal experts. The commission’s document lays down the conditions under which a member state can bail-out systemically important banks and insurers. One of these requires firms to ensure all junior (subordinated) debt is converted into loss-absorbing capital. This may compel the largest insurance firms to issue more CoCo instruments to ensure this condition can be met.

Steven McEwan, partner in the corporate and regulatory insurance team at Hogan Lovells in London, says: “It’s unusual in the insurance world to issue CoCos, but what this document is saying is that the state should only be allowed to bail out an insurer after it has already converted its subordinated debt into equity or written it down. To do that, it must be the case that the law or the terms and conditions of the relevant instrument provide that the subordinated debt can be converted into equity or written down, because otherwise it’s not possible.”

If investors consider an insurer to be ‘too big to fail’, and subject to the EU’s rules on state aid, it is very likely these firms will be put under pressure to ensure their subordinated debt instruments are written with conversion clauses to bring them in line with the commission’s requirements, says McEwan.

Some national regulators are also attempting to place insurers’ capital requirements on an equal footing with banks. The Australian Prudential Regulation Authority (Apra), for example, set out in January the criteria for admissible Tier 1 and 2 instruments for insurers, which included the ability to convert into shares or be written off following a “non-viability trigger event”. This trigger closely resembles the situation described in the commission’s communication, where a firm would collapse without an immediate injection of public money.

Sting in the tail
But it is not just regulatory concerns that will spur insurers to issue CoCos. Bankers suggest companies have wised-up in recent years to the need to build a capital structure that can withstand the most destructive tail risks and still bounce back to reap new business opportunities out of the wreckage.  This has led some reinsurers to deploy CoCos more strategically.

BNP Paribas’ Adam says: “There’s a number of ways to look at it. There’s the aggressive strategy where, if you have a lot of capital, you can replace some equity with a CoCo, because it is cheaper and therefore improves your return on equity for shareholders. Then there’s the defensive strategy, where an insurer is concerned about the rainy day scenario, and instead of making a secondary public offering at a time of financial weakness, issues CoCos to cover that scenario today.”

For large reinsurers such as Swiss Re, CoCos can perform another function, enabling the company to exploit rising premium rates following a major loss event.

Following a significant natural catastrophe event in, for example, the US market, rates would tend to go up for the next renewal cycle. In such an event, a CoCo instrument can be used to increase the company’s risk-bearing capital and benefit from the attractive market conditions. “At the flip of a switch, [we can] move from fixed-income hybrid to core capital at predefined terms, allowing us to go into that renewal season with a fortified capital structure that enables us to take advantage of the opportunities the reinsurance cycle is presenting us with,” says Jaeggi. In this way Cocos can be a springboard to future profits even in the depths of an annus horribilis.

But what will the hybrids of tomorrow look like? In a not-too-distant future, where the largest (re)insurers are subject to both national regulation and supranational requirements in the form of G-Sii policy measures, will hybrids and Cocos have to change?  

Swiss Re’s Jaeggi thinks the boundaries between vanilla hybrid instruments and exotic CoCos are already starting to blur, and that future debt issues will be designed to slot more neatly into regulatory frameworks. “In our view, a contingent capital instrument just has a higher degree of loss absorption than a standard hybrid. They are already two sides of the same coin. If you look at Solvency II as it stands currently, there has to be a write-down or stock settlement feature to qualify for Tier 1 credit, so in the future, what was once called CoCo will just be normal Tier 1,” he says.

For investors, the trend is pointing to a future where several small, dedicated funds buy into insurance hybrids and CoCos, rather than one or two massive institutions dominating the market.

Credit Suisse’s Ronan says: “A specialist investor space is emerging where funds market their expertise to the people who ultimately have the assets, like pension funds, and [acquire mandates] on the basis that they really know what they’re doing. I think as the market grows you’ll see more and more investment coming from specialist funds like these.”

The time seems right for CoCos to take centre stage. 

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