With the insurance industry having returned to rude health after its weakness at the beginning of the decade, a key driver of hybrid issuance in the past year has been merger and acquisition activity. "M&A has certainly provided the impetus for insurance companies to look at hybrid transactions and produced some major deals," says one hybrids specialist in London.
And consolidation is expected to continue. "The insurance industry in Europe is, to a greater or lesser extent, quite fragmented," says Guy Miller, head of the financial institutions advisory and solutions group at Royal Bank of Scotland in London. "It depends on which market you are in, but certainly in the UK, and even more so in Germany, we would expect to see a lot of consolidation."
M&A activity was a key driver behind the largest hybrid debt issue for a European insurer this year, a Eu2bn equivalent issue at the end of January for Assicurazioni Generali, which had hitherto been characterised as one of the industrys more conservative players.
Led by HSBC, JP Morgan, Mediobanca and UBS, the Eu1.25bn and £495m perpetual non-call 10 issues followed up the Italian insurers Eu2.87bn three tranche hybrid transaction in June 2006.
Before last years deal, Generali had announced in March a three year corporate plan, a key pillar of which was its capital optimisation strategy.
That included a buy-out of minority shareholdings and a share buy-back totalling Eu4.1bn, so after last years hybrid it should have had around Eu1.3bn of hybrid capital left to raise.
However, almost immediately after executing last years hybrid Generali jumped at the opportunity to acquire Italian motor insurer Toro for Eu3.85bn.
Although Generali cancelled its share buy-back, it still required extra capital, which explains the Eu2bn size of this years hybrid.
The Italian insurers quick change of plan was perceived as aggressive, so it worked hard on the roadshow to explain its strategy. "Management also reiterated their strong commitment to Generalis double-A ratings and the traditionally conservative nature of the company," said Massimiliano Ruggieri, head of Italian debt capital markets at JP Morgan in London.
That appeared to do the job as the deal was ultimately successful. "The Toro acquisition was a big surprise at the time," said one hybrid investor in London. "However, people have moved on and you cant say that we are still ruffled by what happened."
Insurance bankers suggest that M&A activity was also a contributory factor in the decision by Allianz to launch a rare senior debt issue in November 2006, its first in four years. The Eu1.5bn 4% 10 year issue was led by Dresdner Kleinwort and Lehman Brothers.
The German insurer had senior debt issues coming up for redemption in July and November of this year and prefinancing these at attractive levels 20bp over mid-swaps was cited as the rationale for the deal. "We opted for senior debt rather than a hybrid because we wanted to make use of the outstanding market environment in terms of investor demand, underlying low government yields and tight senior credit spreads," said a spokesperson for Allianz in Munich.
One banker in London says that the timing could have benefited Allianz in other ways. "They did the Eu1bn 10 year deal in December and announced the minority buy-outs of AGF in January for Eu6bn, so maybe they needed some short term cash," he says. "They had the redemptions coming up this year and maybe they took the view that they could live with the leverage until this year, when it would fall again."
Legal & General was also happy to increase its leverage when it launched a £600m perpetual non-call 10 hybrid through HSBC, Merrill Lynch and Royal Bank of Scotland in April.
The deal was driven by the redemption of an outstanding convertible in December 2006 and L&Gs acquisition of Nationwides life and unit trust subsidiaries, but the UK insurer took advantage of the opportunity to address another issue.
"A number of commentators had been talking about how relatively undergeared we were, so it seemed sensible to look for an opportunity to put something like this on the balance sheet," says John Whorwood, group treasurer at L&G in London.
Crisis no brake on M&A
Just how adventurous insurance companies prove to be in the wake of this summers financial markets crisis remains to be seen, but the early signs are positive: Norwegian insurer Storebrand announced the acquisition of SPP from Swedens Handelsbanken for Skr18bn (Eu1.9bn) in early September to create the largest life insurance and pension provider in the Nordic region.
"This is a truly transforming transaction for Storebrand with substantial benefits for shareholders, customers and employees alike," said Idar Kreutzer, Storebrands CEO in Oslo. "The transaction brings leadership in Nordic life and pensions, increased scale with continued clear strategic focus, reduced risk profile and enhanced growth prospects."
As well as a Eu1.24bn equivalent rights issue, the acquisition is being financed by a Eu570m equivalent bridge loan underwritten by JP Morgan and UBS, which Storebrand plans to refinance through hybrid tier one and lower tier two capital "as soon as practically possible following the closing of the transaction".
"Its quite instructive that the Storebrand acquisition of SPP was announced in the middle of some fairly torrid markets," says one insurance DCM banker in London. "The rating agencies effectively affirmed the ratings and JP Morgan and UBS are clearly happy to foot the bridge financing until sub debt can be issued.
"It bears credence to the larger picture that insurance is not fundamentally affected by the crisis and that it is very much a banking problem and not an insurance problem."
M&A looks set to continue in the UK life business as well, with Resolution Life and Friends Provident pushing ahead with their £7.9bn merger. Miller at RBS also sees UK activity as a sign of a more assured industry.
"There was a fair amount of consolidation in the late 1990s, particularly with the UK demutualisations, but in the early years of the decade the industry was on its back from a solvency point of view," he says. "When insurers were worried about cutting their dividend they were hardly going to think about buying someone else, but the industry has climbed out of the hole again in the past couple of years and is showing more self-confidence.
"The other thing that should create a level of consolidation is the growing appreciation of the imperatives for active capital management, which means that people are more aware of the need to accelerate the release of capital from closed books and to use that capital to write new business," he adds. "I think there is more consolidation to come in the UK closed funds sector, and the same dynamics will start playing out in other European markets."
Basle II boosts Solvency 2
Active capital management has increasingly become an imperative for insurance companies if they are to outperform their peers, and it will become even more of an imperative as Solvency 2 introduces a risk-based approach to capital that more closely aligns economic and regulatory capital.
That Solvency 2 is on its way has been known for many years and, like banks with regard to Basle II, insurance companies have had to play something of a guessing game about when it might be implemented and how soon they should start preparing for it. The first draft proposal released in July by the European Commission was therefore a big step on the road to Solvency 2.
"The positive side is that we now have something that can be used as a basis for ongoing discussions," says Stephan Theissing, head of corporate finance at Allianz in Munich.
However, it could be interpreted by insurance companies as a reason either to push on with or to hold back from preparing for the new regulatory framwework.
"The European Commission released the first draft in July, which was the first real written indication of what Solvency 2 is going to look like," says Simon Woods, executive director, risk advisory and capital solutions at UBS in London. "But on the other hand, implementation has been pushed back to 2012, rather than to 2010, so as with Basle II it has been delayed for two years, and it is still not guaranteed that 2012 will be the final implementation date as it needs to go through the European Parliament and the European Commission in the next 18 months."
But Miller at RBS suggests that the fact that Basle II has finally been implemented in the European Union at least, and in spite of all the delays and scepticism it faced along the way has been a wake-up call for the insurance industry.
"Quite a lot of banks didnt want Basle II and they were often the ones who said that it probably wouldnt happen anyway or would be delayed so far into the future that it wasnt worth worrying about," he says. "The fact that Basle II is actually now coming makes it quite difficult by analogy for insurers to completely ignore Solvency 2.
"The argument that it simply wont happen is difficult to maintain when Basle II did."
DCM bankers covering the insurance industry point out that resistance to the notion that Solvency 2 is a looming imperative tends to be concentrated among insurers who simply wish the whole project would go away.
"Ive certainly sat in on many meetings with senior people on the risk side of insurers who are very, very focused on what Solvency 2 will mean for them," says one such banker in London. "But their attitude varies depending on whether or not they think Solvency 2 will be a good thing for them.
"I suspect that someone like Axa, which will probably have the sophistication in terms of systems and people, probably wishes Solvency 2 was here now as they are going to be the winners. Some of the sleepier German mutuals are far less enthusiastic about embracing it."
Negotiations end in tiers
Indeed, what the first draft did confirm without a doubt is that the new framework would move the goalposts for insurance companies by some distance. "It is very pro-active," says Woods at UBS. "The modernisers have come out on top over the more traditional conservative approach."
The approach is well aligned with the UKs risk-based solvency regime, the cornerstone of which is Policy Statement 04/16. But this was no surprise, partly because of the man at the centre of developments: the UK Financial Services Authoritys Paul Sharma is chairman of the internal models expert group of the Committee of European Insurance and Occupational Pensions Supervisors (Ceiops), which is in charge of Solvency 2.
However, observers warn that it would be too simplistic to expect the EU-wide regulation to be completely copied and pasted from the UKs framework given differing national interests, and already under the first proposals differences with the UK have emerged.
"In terms of what will be eligible as capital and for each tier of capital, that is very much open for debate," says Shazia Azim, head of capital advisory and structuring at Royal Bank of Scotland in London. "It does look increasingly like the UK model, but in certain cases it is actually quite different from what there is in the UK. The current proposal for Solvency 2 talks about tier three capital, for example, and this is a concept that insurance companies in the UK simply dont have available to them.
"It would be incorrect to say that the Solvency 2 framework is being driven by the UK because the continental European insurers are very big players and for something to gain support it will have to be a compromise that is agreed upon by all sides."
In this respect, Azim expects Solvency 2 to resemble the Basle 1998 accord that determined what was eligible as hybrid capital.
"That laid down the basics of what is included as innovative tier one and what isnt," she says, "but it was left to each individual member state to do the fine-tuning because they each have a unique legal and tax environment, and what you can legislate for in one country isnt necessarily going to work in another."
In the absence of any more detailed guidelines, the UKs definition of tier one, upper tier two and lower tier two capital has nevertheless been a useful model for continental European insurers looking to ensure that their hybrid securities will qualify for the most equity-like forms of capital when the new framework is introduced. The only other guidance has been the rules for banks.
"Issuers on the continent have been pre-empting Solvency 2 by effectively issuing instruments that would be eligible as tier one but without actually getting the benefit for it yet," says one hybrid capital specialist in London.
Anthony Fane, joint head of European financial institutions origination at BNP Paribas in London, agrees. "The type of issuance we are seeing from insurance companies is predictive," he says. "The likes of Swiss Re or Munich Re are issuing ahead of Solvency 2 and getting tier one type capital on their balance sheets."
Juerg Hess, treasurer of Swiss Re in Zurich, confirms this. "With respect to hybrid capital we have tried to anticipate the changes under Solvency 2, which in Switzerland is preceded by the so-called Swiss Solvency Test, for quite a while already," he says.
Lobbying by some insurers to get new tier one guidelines introduced ahead of Solvency 2 has thus far come to nothing. Such a proposal was jointly rejected by the Committee of European Banking Supervisors and Ceiops after an assessment by the Interim Working Committee on Financial Conglomerates.
"The French were pushing for the adoption of tier one hybrids within the Solvency 1 framework before Solvency 2 comes in, and there was a great degree of sympathy for that," says one insurance banker in London. "However, nobody could quite agree on what tier one should look like.
"Certain regulators wanted to open the window for tier one with what might be an imperfect definition of hybrids, but others wanted to make sure that it is consistent with banking tier one and preferred to wait until the definition was absolutely right."
Insurers will therefore have to continue to try to guess what the different tiers of capital under Solvency 2 will eventually look like.
"It is not altogether like Basle II or what the FSA has in the UK," says Theissing at Allianz. "But when you see where we are coming from, it is a big step in the direction of the banking system.
"However, we are far away from the final version and it would be premature to go into final details. It proposes three tiers like banks, but in the banking world there are more subsets and for insurance these still need to be worked out."
Continental European insurance companies will therefore have to continue to wait to gain regulatory recognition of their hybrid securities, but they have been happy to continue issuing them because instruments resembling tier one bank hybrids are assigned high equity credit ratings from Moodys."In Europe, transactions are at the moment very focused on Moodys, because their requirements are toughest," says Jake Atcheson, director in debt capital markets at RBS in London. "If you achieve the Moodys requirements, you have essentially already met the Standard & Poors requirements, and in most cases the expected regulatory requirements as well." (See chapter on hybrid structures starting on page 18 for more on Moodys requirements.)
S&P 2, too
While S&P might take a backseat to Moodys in the determination of hybrid structures, its overall capital model has always been more prominent in the insurance landscape.
"S&P has focused much more on its criteria for overall capital adequacy, as opposed to fine-tuning the structural features of a hybrid, whereas Moodys has been extremely explicit about what it expects of a hybrid, but it places more weight on qualitative capital adequacy measures," says Azim at RBS. "S&P has broad categories of what can be put in its hybrid bucket, but the size of that bucket is very explicit."
In 2006 this was changed from 15% of total adjusted capital to 25%, a move insurance bankers view as reactive. "All the insurers were above 25% anyway, or at least certainly way above 15%," says one.
More fundamentally, S&P is updating its overall, risk-based capital model.
It is currently running the old and new versions in parallel, but is expected to switch off the old version at the end of 2007.
"We would characterise it more as an update than a new model," says Rob Jones, managing director and European insurance criteria officer at S&P in London. "All of the principal charges in the pre-existing model have been updated on the basis of what we have observed since the original model was put in place.
"The biggest difference between the old and the new is that we have introduced diversification credits into the model for the first time. But we dont expect it to increase the industrys capital requirements overall, although there will be a redistribution of where that capital is needed within the industry."
The winners and losers from the updated S&P model are likely to be the same as those from Solvency 2. "The inclusion of the diversification benefit for the first time will benefit the bigger, more diversified insurers compared to smaller, concentrated businesses," says Jones.
The quantitative diversification credit was only introduced by S&P after feedback from insurers during the consultation period for its updated model. Previously it was only planning on giving qualitative credit for diversification, even though this old approach had long been criticised by major insurers.
"We have always had a strong element of diversification in our overall analysis," says Jones, "but up to this point it had only been qualitative.
We were really looking for quantitative evidence of the benefit of diversification, and we are now starting to get that with the introduction of companies economic capital models."
This change of heart has been warmly received by insurance companies.
"It is a giant leap forward," says Theissing at Allianz. "The old model was static and the new one moves very far in the direction of a dynamic model. We also appreciated highly the quantitative credit that will be given for diversification.
"We have been using this in our internal model for six or seven years. We expect to get a net release of ratings capital as a result of the diversification credit."
Regulators trump raters
Under the lenient requirements of Solvency 1, S&Ps risk-based capital model was a key determinant of insurance companies capital management. But the risk-based Solvency 2 will usurp the rating agencys pre-eminent position and bankers say this is, to an extent, forcing S&Ps hand.
"The rating agencies are in a funny position in relation to regulatory change, and this has been evident in relation to Basle II," says one FIG banker in London.
"The rating agencies may say that it doesnt affect them if the regulator changes its mind, but the fact is that a rating agency cant ignore it if the regulator says that an insurance company has too much or too little capital.
"The rating agencies are therefore moving closer to the more economic balance sheetbased view that the regulators are adopting."
Hess at Swiss Re agrees. "S&P has made significant steps forward with its new model, but of course there are many details that we are still in discussions with them about," he says. "There will be greater reliance on internal models under Solvency 2 and the rating agencies seem to recognise that."
While acknowledging the greater alignment between regulatory and rating agency requirements, Jones at S&P says that this is not the rationale for the rating agencys changes.
"Solvency 2 will not be implemented until 2012, whereas our updated model is in place now," he says. "However, a lot of the work we are doing in the form of enterprise risk management and particularly the analysis of insurers economic capital models is pretty consistent with the incentives built into Solvency 2."So, for example, under Solvency 2 internal models will be incentivised. Our approach incentivises them as early as next year."