Regulations alone won’t ignite insurance CoCo market

The volume of contingent capital securities (also known as CoCos) issued by insurers globally is set to increase as insurance companies will soon be able to classify these securities as regulatory-efficient capital, according to rating agency Moody’s. 

But new regulations alone will not be the sole driver of the growth or otherwise of the nascent market for insurer CoCos. 

Thus far, CoCos have been mainly the preserve of global banks, as they have sought to adjust to developing regulatory capital regimes. In the first half of 2015, banks issued over $47 billion, and $175 billion in 2014. 

Like banking capital regulation, evolving insurance regulation has encouraged – and may even require – insurers to issue higher proportions of more junior-ranking debt or preferred securities to support their regulatory capital requirements. CoCos have gained the regulatory seal of approval because they can convert into equity to absorb losses in times of financial distress, limiting the need for public sector support.

The news comes at a propitious time for insurance companies. “At the moment insurance companies have the lowest level of debt on their balance sheets for many years so there is space to issue more of these kind of securities under the new regulation,” said Antonello Aquino, associate managing director with Moody’s and co-author of the report. 

But, although international reinsurer Swiss Re has already made its first foray into the CoCo market, expectations of further issuance from the insurance sector have so far not materialised into concrete deals. 

“There is no real specific need for insurance companies to issue CoCos at the moment because the securities they have currently outstanding will be grandfathered for ten years under Solvency II, which comes into force on January 1 2016,” said Aquino.

Banks versus insurers

The investor base for CoCos issued by banks and insurers is broadly the same, with Aquino reporting interest from the investor community in buying the insurance papers. 

But, he continued, the potential difference between CoCos issued by a bank and those issued by an insurance company lies in the perceived volatility of the solvency ratios. “There is a perception that the volatility of the solvency ratio in the insurance sector could be higher than in the banking sector,” he said. “That could be a reason why investors will look at banks and not insurers.”

“Investors in the bank space are likely to have been looking at the pricing for new issuance on the assumption that conversion or write down remains highly unlikely,” added Neil Dixon, a London-based capital markets managing associate at Linklaters.

He continued: “Work may have to be done with prospective investors to explain any issuer or sector-specific risk of conversion or write down and to get them comfortable that, even with a degree of volatility in the SCR [solvency coverage ratio] measure underlying the trigger event, the securities remain unlikely to convert or write down.”

New precedents

While banks have set their own precedents for issuance, these templates cannot be imported wholesale into the insurance market. Dixon noted that, although there will be some borrowing of the technology used in the bank space, it will have to be tailored for Solvency II’s requirements; in particular, around the triggers for write down or conversion.

And it will be up to local insurance regulators to determine what they want to see in the drafting. “They may not always agree with the way that bank regulators have analysed what the terms should do,” said Dixon.

As in the bank space, tax legislation may also need to be amended to allow insurers to issue the so-called restricted tier 1 capital that is tax efficient.

But Dixon pointed out that insurers may be looking at other capital structures as well as CoCos to bolster their balance sheets. “They may be looking at ancillary own fund structures - for example structures under which an issuer can demand that investors subscribe for ordinary shares and then take ancillary own funds tier 2 benefit for that,” he said.

Credit implications

According to Moody’s, the credit implications of CoCo issuance will vary by issuer and depend on factors such as issuance size, the issuer’s existing debt profile and its regulatory capital position.

The agency’s proposed rating approach incorporates three components:

• The difference between the insurer’s current local solvency ratio and the trigger;
• The probability of the insurer’s solvency ratio reaching a level that Moody’s associates with the insurer failing; and
• The loss severity if either or both of these events occur.

“The model will provide an output by inserting these three key factors,” said Aquino, but there is an element of discretion. “The rating committee will use a model-based approach as a starting point for discussion and then assign a final rating that reflects the expected loss of the security.”