Global Capital, November 2015
Issuance from the insurance sector has been muted through 2014, caught between two milestones: the end of a grandfathering clause for cheap perpetual issuance at the start of this year, and the beginning of the new Solvency 2 regulatory regime at the start of next year.
2014 was a big year for issuance, one that has not been repeated in 2015. European insurance issuance in the international debt markets was Eu13 billion in 2012, Eu15 billion in 2013, and year-to-date (as of mid-October) Eu11 billion – but shot up to Eu25 billion last year.
The reason was that, ahead of Solvency 2 standards, a deadline of January 2015 was set for the grandfathering as tier 1 capital of old-style perpetual instruments. Plenty took the chance to get issues away while they still could. “Old style perpetuals under Solvency 1 were a much cheaper way of putting grandfathered Restricted Tier 1 capital on a Solvency 2 balance sheet than the new style loss-absorbing Restricted Tier 1 capital,” says Theo Lentzos, head of insurance debt capital markets and corporate banking in EMEA at Bank of America Merrill Lynch. So many insurers pre-funded while they had the chance.
Last year saw Eu16 billion in perpetual capital alone from ex-UK European insurers, and that’s now largely gone from the market. “Two thirds of issuance that year was made up of perpetual instruments,” says Arnaud Mezrahi, in the insurance capital structuring team at SG. “But this year has been more similar to 2013 and earlier years: more limited issuance, two thirds of it in dated instruments.”
The weak market for issuance has not just been about the grandfathering deadline. “At the same time” as the deadline issue, “the market has been volatile since May, driven by Greek sovereign debt woes and the Chinese growth slowdown,” says Tom van Lent, vice president, financial institutions DCM at ING. “It has not been a perfect backdrop for capital market issuance.”
Issuance is unlikely to climb now until the Solvency 2 regime comes into effect in January, and in any case is being held up by the fact that many insurers are still finalizing with regulators whether their own solvency model fits that new regime. It would be hard to communicate a clear rationale for launching a deal with that in progress.
“Most issuers are finalising their discussions with regulators on their Solvency 2 models,” says van Lent. “The focus is on getting this done and approved by the end of the year,” at least for jurisdictions where Solvency 2 starts on January 1, “rather than ‘can we get more funding out of the market’.”
So will issuance come back next year? “It depends where solvency ratios come out,” says Lentzos. “The insurance sector as a whole is not like banks, where you have material annual refinancing requirements with an upward trend in target capital ratios.” Insurers are relatively infrequent issuers and in many cases don’t want any more leverage or hybrid capital anyway. “I don’t expect volumes to suddenly increase materially, but I do expect them to be higher than this year.”
The big question in the insurance DCM sector is when we will start to see new-style tier 1 issues under the new Solvency 2 regime. So far, there have been none, for a variety of reasons.
“Insurance companies have not started to issue Tier one yet,” says Mezrahi at SG. “There remain some uncertainties on how some features would work. We know the rules to make an instrument compliant, we can write the terms and conditions that would meet all criteria, but as long as you have not tried an instrument with a regulator you are not sure that it can fly.
“From a pure regulatory standpoint, we can structure and roadshow this kind of instrument, but the stamp from a regulator is still missing.”
Lack of regularity clarity, though, is not the whole issue. “It’s less about structural clarification: issues on the tax or regulatory side will eventually be resolved,” says Lentzos. “It’s more around the fact that insurance Restricted Tier 1 capital is going to be materially more expensive than Tier 2.”
Moreover, there isn’t an obvious advantage for insurers to issue Tier 1 capital, or at least not in the same way as in banking. “For an insurer, issuing Tier one or Tier two has pretty much the same value and impact on their solvency margin,” says Mezrahi. “But given that you do not have a specific minimum bucket of Tier 1 [unlike banks, where it’s 1.5%], there is not the same incentive for insurers to do Tier one compared to banks, for instance.”
So the decision facing an insurance company CFO is not the same one facing a bank CFO. A banker issues Additional Tier 1 partly because they effectively convert hybrid capital into equity, which boosts their Core Tier 1 ratio. “But in the insurance sector,” says Lentzos, “if you convert from a hybrid into equity, the solvency ratio doesn’t really change under most scenarios.” The key metric for an insurer is its solvency ratio – available capital divided by required capital. Generally, issuing restricted Tier 1 or Tier 2 brings about the same percentage increase in the solvency ratio.
Also, so much grandfathered tier 1 issuance was launched last year that insurers are top-heavy on it anyway. “Most insurers are entering Solvency 2 with a high volume of Hybrid Tier 1 capital, perhaps more than would be the efficient level,” says Christian De Monte, head of European Issuance DCM at Morgan Stanley. “I expect that when the first call dates come up on that grandfathered Tier 1 capital, it will mostly be refinanced as Tier 2.”
On top of that, the trigger for Restricted Tier 1 capital in the insurance sector – broadly at or below 75% of solvency coverage ratio (SCR), or below 100% for three months – is considered so remote that many insurance companies do not believe they will ever get to that point. There would therefore be no gain in issuing Restricted Tier 1, and it would be more expensive. So why bother?
Well, there are several possible prompts. One is an issuer who has run out of room to issue Tier 2, and therefore has to go to Restricted Tier 1. “Companies that have utilized most of their Tier 2 headroom might be a driver for future Restricted Tier 1 supply, but when you look across the sector – and not everyone has disclosed their Solvency 2 positions yet – you don’t expect too many companies to be driven by limitations in their Tier 2 limits,” says Lentzos. Most have plenty of capacity.
Another prompt might be the sense that they will need Restricted Tier 1 sooner or later, and it might as well be now. “At some point, insurers may have to think about where global capital regulations are heading,” says Lentzos. “G-SIIs [Global Systemically Important Insurers] in particular may take a forward looking view that loss-absorption capital may be a required component of their available capital structure” and so issue ahead of rules being finalized, since interest rates and spreads are low.
That could mean the big European GSIIs like Allianz, Axa, Aviva, Gerali and Prudential become the first Restricted Tier 1 issuers.
A third prompt might be a belief that, even if Solvency 2 only holds insurers to a 75% SCR trigger, it would be prudent to hold loss-absorbing instruments as if the trigger fell at a higher level, perhaps 125%. “That provides additional protection to their capital structure,” says Lentzos. “Perhaps that could be a driver, but a much higher cost.”
If Restricted Tier 1 issues do reach the market, they would be likely to find a willing audience. “We did a survey earlier this year on investor attitudes to tier one,” says van Lent at ING, “and we do anticipate good demand from investors for the product as soon as issuers can provide the necessary transparency.” Insurance is considered to have a different risk profile to banking, offering diversification, though there is a question about how it would be priced and how easy insurance Tier 1 issues will be to understand (see box).
And De Monte believes that complexity will not keep investors out. “I draw a lot of comfort from the banking space,” he says. “Contingent capital, or AT1, had a slow start: the first issuers had to pay up a bit. But now it’s an asset class with a lot of demand. I do expect that to be the case for insurers as well, once there is clarity around Solvency 2 and people get familiar with capital management under the new regime.
While there are uncertainties ahead, getting insurer’s models approved by their regulators is not considered to be one of them. “It’s not a formality, but neither do we see major problems ahead,” says van Lent. “It is costing a lot of manpower and a lot of calculations. Making calculations on your solvency 2 capital ratio, on historical volatility, on sensitivity analyses, requires an awful lot of capacity. I wouldn’t call it a walk in the park, but also I don’t expect major problems as most insurance companies are run by experienced professionals.”
And in some jurisdictions, issuance has got underway even after the ending of the grandfathering of old structures, and before the formal beginning of Solvency 2, particularly the UK. “We saw Phoenix come to the market after the grandfathering deadline expired, confident that they would get a Solvency 2-compliant stamp,” says van Lent. “We have seen Aviva and Legal & General from the UK too. In those kinds of jurisdictions, where either the regulator is very accommodative to issuers or provides more insight on the requirements they will have for Solvency 2, you have seen more issuance.”
Meanwhile, in the mainstream, maturities are settling into defined patterns, and edging longer. “Investors are looking for yield and are keen to buy longer maturities, says Sebastien Domanico, global head of DCM financial origination at SG. “Over the last few months investors have been less comfortable buying shorter-dated transactions. We used to see a lot of non-call 5 structures; now investors prefer bullet structures and longer-dated. 10 year bullet has become the classic structure for banks.”
30-year non-call 10 is also the standard because it qualifies as Tier 2 under Solvency 2, and meets the requirements to get Standard & Poor’s equity credit (Fitch allows this with a 10-year bullet).
A recent example, a Eu1.25 billion subordinated bond from Generali on October 20, was an example: at 32 non-call 12, it showed that the euro market has a bit more versatility than it is given credit for. “The sweet spot in the euro market is more around the 10-year area in terms of the call date, as opposed to sterling where it is 15 plus,” says De Monte at Morgan Stanley, one of the bookrunners on the deal, who says the tenor was chosen by Generali to smooth out their maturity profile, since they had several call dates in 2025 and 2026. “But 10 to 12 is doable in the euro market, and you saw non-call 11s last year to make the most out of the grandfathering date. Non-call 15 starts to become more challenging in the euro market.”
Even if tier 1 is a while longer coming, there is still also classic redemption issuance to come. “We can expect to see a lot of refinancing of existing issues,” says Mezrahi at SG. “Next year we have Eu8 billion of instruments reaching their first call date or their maturity date, and in 2017 it will be Eu9 billion. There is already a lot to refinance, even if a big chunk of the refinancing was done last year.”
Bankers say the second quarter is usually the busiest for insurance issuance, and add that there may be other drivers besides changing regulation. “M&A could impact the picture,” says Domanico.
Box: The investor perspective.
Thomas Maxwell is investment director for fixed income and credit at Standard Life Investments. He, like all institutional investors who look at insurers, is trying to assess value in the sector against the backdrop of complex regulatory change.
“The fundamentals of insurers are relatively strong in terms of capital position and asset quality,” he says. “Solvency 2 ultimately reinvigorates the risk management side of these business, where they are having to account more holistically for risk both on the asset and liability side.”
Assessing the macro position is relatively easy. “The challenge has been on the technical side. There are quite a lot of different structures employed from different companies, which makes it difficult as an investor.”
Maxwell’s experience shows that investors are in some sense as inconvenienced by new regulation as the insurers themselves are.
“One issue I have with regulation is that the structures are not as investor-friendly in Solvency 2 as they were in Solvency 1,” he says. For example, with tier two issues under Solvency 2, there is mandatory interest deferral on the coupon, “which as a bondholder is not ideal. And in a bank tier 2, you don’t have optional coupon deferral language, whereas with an insurer you do. As an investor, how do you price that extra risk?
“The other difficulty as an investor is the sheer complexity of it all,” he says. “We don’t really know how volatile the insurers’ capital bases are going to be under Solvency 2, because we haven’t seen the final models,” which are still under discussion between insurers and their local regulators. “As an investor, it’s a bit of a black box.”
Perhaps surprisingly, it is even more of a black box where the big, established issuers are concerned. “Most large insurers issuing debt are applying for internal models, which makes it difficult to compare one with another,” Maxwell says. “You might have a German insurer with a solvency ratio the same as a UK insurer, but we as investors don’t know whether they rank pari passu or if one is better than the other. Ultimately, we are reliant on trusting in the risk management of the company.”
The consequence of this is a preference for familiarity. “We tend to focus on the names we have more confidence in, the ones we believe will have strong capital positions.” By extension, that makes it harder for newer or smaller issuers. “It will be difficult to invest in small names with a limited track record in the market.”
How about new-style Tier 1 issues, when they come? Will those issues be of interest? “Clearly it will be on a case by case basis, and dependent very much on valuations,” Maxwell says. “In theory, the structure will be quite similar to bank AT1, which we have been investing in. So long as the reward is appropriate, we think we could be involved.”
But, as the bankers in the main feature suggest, investor appetite is not really the challenge. “The issue is, we’re not sure how much demand there will be from the issuer side,” Maxwell says. “Solvency 2 allows a lot of credit for Tier 2 in the capital structure: up to 50% of the solvency capital requirement can be filled with Tier 2 debt. So from a cost analysis perspective, I think insurers will look more down the Tier 2 route.”
Standard Life is not particularly bothered about tenor. “We’re relatively agnostic on the curve. Most issues of insurers have been focused on the 30 non-call 10 area, a long duration, especially for the euro market. There’s not much we can do: it’s driven by rating agency requirements.”
It is a common refrain: that structure, tenor and format are dictated not so much by investor demand or issuer preference but external forces. It sounds like regulation that is attempted to help investors is in fact making life more difficult for them. “I’d agree with that.”