In a perfect world, a big insurance group with several operating subsidiaries would have capital in each to cope with expected losses, plus immediate access to additional capital in the event of a catastrophe. This capital would have to be agile, so the group could send it wherever needed, while not weighing on the balance sheet of the group itself, affecting returns and ratings.
For the past two years, idealists at Swiss Re and Credit Suisse have been trying to engineer this perfect world and, in 2016, they got closer to it, issuing the third in a series of hybrid notes that have created a $1.9 billion contingent capital cushion for the group's risk-taking units.
"We get peace of mind and flexibility on our capital structure. This was exactly our goal," says Knut Pohlen, group treasurer at Swiss Re.
"One thing we see in this big debate around financials is trapped capital and fungibility of capital around the group," says Samir Dhanani, head of capital structuring in Europe, the Middle East and Africa (Emea) at Credit Suisse. "If one of those operating companies suffered a significant event, getting excess capital that is sat in other operating companies out of those and down into the affected company can be a very difficult process. You not only have to satisfy the regulator that they are happy with capital coming out of those operating companies at a time of stress but also the individual boards."
To address these issues, a number of puzzles had to be solved. Because the notes take the form of hybrid debt, placing them on the Swiss Re balance sheet would have added to the group's leverage in the eyes of rating agencies – instead, the notes are issued by Demeter Investments, a special-purpose vehicle belonging to Credit Suisse.
Swiss Re pays a facility fee for the use of the vehicle. In the latest pre-funded subordinated note issued in May last year – 36NC11 – Swiss Re pays a 3.673% fee that is passed into the coupon paid to investors.
We structured the instrument so there was effectively no difference between what investors were buying here and what they would ordinarily buy if Swiss Re issued a subordinated debt instrument to them directly on day one
Knut Pohlen, Swiss Re
In addition, Demeter Investments invests the proceeds from the sale of the notes into US Treasury strips. The 1.952% interest on those is combined with the facility fee to produce the total 5.625% coupon.
"If Swiss Re was to raise all the capital it thinks could be useful in the future, the group would be left with a very inflated capital ratio that does no real good and causes an increase in leverage," says Dhanani.
Issuing from Demeter solves that problem, but introduces another - how to convince investors that the notes are the same as holding Swiss Re paper.
"We structured the instrument so there was effectively no difference between what investors were buying here and what they would ordinarily buy if Swiss Re issued a subordinated debt instrument to them directly on day one. As a result, we were able to say to investors that there shouldn't be a structural premium. In the end, we think the premium was only a handful of basis points, if that," says Swiss Re's Pohlen.
Investors' exposure is to Demeter, but the vehicle can enforce Swiss Re's obligations on the subordinated notes issued to Demeter. The transaction has a number of automatic triggers, which forces Swiss Re to draw down the subordinated notes. These triggers are activated upon all default scenarios.
The approach had the desired effect. For the previous two pre-funded subordinated notes, the premium paid on the instrument being held off-balance sheet was in the high single digits compared with normal subordinated debt issuance, says Julius Kirchner, head of financial institutions group, debt capital markets, Germany, Austria and Switzerland. For the 36NC11 it was further reduced.
If Swiss Re needs to deploy the capital, it receives the US Treasury strips, which can be liquidated. This should allow swift replenishment of the injured unit's capital base.
"Because it's clear they will be able to replace capital very quickly, if required, at virtually no additional cost, the market should be very supportive – it creates more stability. If, however, a company starts with excessive capital and then has to show a reduction, even to an adequate amount, the market will definitely not be as strong," says Chris Tuffey, head of Emea debt syndicate at Credit Suisse.
Another hurdle was the need to qualify for rating agency equity credit, which meant Swiss Re needed the option to delay calling the notes. The 36NC11 has its first call election 11 years after issuance, which can be extended for up to five years. The delay can be activated in the five years prior to the first call election.
In total, the three hybrid contingent capital notes issued by Swiss Re represents 5% of the group's core capital, and would be significantly more if counted as part of each operating unit's total. The first of the notes was issued in November 2015.
Credit Suisse had previously developed similar products for insurance firms, Voya Financial and Prudential, in the US but those provided liquidity rather than capital.
"The genesis of this structure was a couple of deals we did in the US for some insurers who had a similar issue but were focused on liquidity. They need large amounts of liquidity but are also leverage-constrained. For Swiss Re it was a similar fact pattern but in the capital world that led them to do this. This really is a unique solution," says Dhanani.