Over the last few years, the insurance industry has changed profoundly, partly as a result of catastrophes and losses and the response of regulators and rating agencies to them, and partly because of the changing dynamics of the capital markets.
The Indian Ocean tsunami of December 26, 2004 ended a year already strewn with natural disasters.
Losses directly attributable to natural disasters and man-made catastrophes totalled $123bn, of which $49bn was covered by property insurance, with hurricanes in the US and Caribbean and typhoons in Japan and its neighbours the most costly events. According to a study by Swiss Re, published in early March, claims against property insurers hit a record high in 2004.
Since 1987 the annual average total for claims, adjusted for inflation, has been a mere $23bn.
So when German insurer Allianz approached the capital markets in late January 2005, seeking to achieve its main financing goals for the year in one shot, it might at first glance have appeared overly ambitious.
But the results of the financing exercise showed otherwise.
A perpetual bond that formed one piece of the Eu4bn three tranche funding package was snapped up by investors. Bookrunner Dresdner Kleinwort Wasserstein was able to increase the size of the non-call 12 year step-up coupon transaction from Eu1bn to Eu1.4bn.
"We built a book of more than Eu4.7bn in four hours," says Ronan Donahue, head of hybrid capital at DrKW in London, "and after going out with spread guidance in the mid to high 70s over swaps, this momentum enabled us to price the deal at 73bp over.
"The deal has also performed very well in the secondary market and showed that there is great demand for the sector from a broad investor base across Europe."
The Eu1.4bn subordinated bond, rated A2/A, was part of a package that also included a Eu1.2bn note, led by JP Morgan, linked to the Dax stockmarket index and mandatorily exchangeable into shares of BMW, Munich Re or Siemens. The third tranche was a Eu1.6bn bond issued by JP Morgan and mandatorily exchangeable into Allianz shares that the US bank had bought from Allianz's subsidiary Dresdner Bank.
Looking back on the deal, Stephan Theissing, director of corporate finance at Allianz in Munich, says he was pleased, but not surprised with the speedy and successful outcome.
"Insurance companies' credit spreads have tightened a lot over the last 18-24 months," he says, "and what we are seeing is a fundamental change in how the market is looking at insurance credit."
Indeed, Allianz's transaction can be seen as something of an encouraging end of term report for the broader industry.
"The European insurance sector has been severely tested over the last three to four years — from both a business/underwriting and asset/liability management perspective," says Amir Hoveyda, managing director and head of Financial Institutions group capital markets and financing at Merrill Lynch in London. "The industry participants have, by and large, withstood the test successfully, coming out stronger, more sophisticated in the way that they manage their capital and balance sheets, as well as more responsible both in the products they offer and the disclosure surrounding these products.
"And the growing confidence of investors is reflected both in their share prices and credit spreads, showing that the industry has fully recovered from the dark days of 2002-2003."
Back in 2003, insurance company funding officials could only have dreamt of the kind of spreads that Allianz can command today.
Munich Re, for one, had to pay 245bp over mid-swaps when it raised Eu3bn of subordinated debt in April 2003. The 20 year non-call 10 deal was led by bookrunners Deutsche Bank and UBS and joint lead HVB.
The company was raising capital to deal with two problems that were hitting the whole insurance industry. "This was in the aftermath of the World Trade Centre events and the very severe capital markets turndown," says Andreas Sauerbrey, Munich Re's head of group investments, corporate finance, who worked on the transaction. "These had affected the capital position of the Munich Re group and according to our internal risk model and as a result of discussions with the rating agencies, we felt that we should optimise our capital position."
The subordinated issue was the first time in its history that Munich Re had ever issued hybrid capital. "We wanted to optimise our capital at a reasonable cost and, comparing the alternatives at the time, the subordinated debt capital raising was the most attractive option," Sauerbrey says.
The deal turned out to be the largest subordinated issue ever in euros and the second largest ever in any currency. This was made possible by a book of some Eu6.5bn.
"We were definitely surprised that the book ended up north of Eu6bn for two reasons," Sauerbrey says. "It was the first time that we had raised subordinated debt and the capital markets were at that time in a very depressed situation."
|Most costly insurance losses|
|Insured loss (US$bn)||Dead or missing||Date (start)||Event||Country|
|11||124||Sep 02 2004||Hurricane Ivan||US, Caribbean et al|
|8||24||Aug 11 2004||Hurricane Charley||US, Cuba et al|
|5||38||Aug 26 2004||Hurricane Frances||US, Bahamas|
|5||280,000||Dec 26 2004||Indian Ocean tsunami||Indonesia et al|
|4||3,034||Sep 13 2004||Hurricane Jeanne||US, Caribbean|
|4||45||Sep 06 2004||Typhoon Songda/No 18||Japan, South Korea|
|22||43||Aug 23 1992||Hurricane Andrew||US, Bahamas|
|20||3, 025||Sep 11 2001||Terrorist attack||US|
|18||61||Jan 17 1994||Northridge earthquake||US|
|11||124||Sep 02 2004||Hurricane Ivan||US, Caribbean et al|
|8||24||Aug 112004||Hurricane Charley||US, Cuba et al|
|8||51||Sep 27 1991||Typhoon Mireille/No 19||Japan|
|Source: Swiss Re|
The success of the Eu3bn transaction — and a subsequent £300m piece — was all the more surprising since Standard & Poor's (S&P) had cut Munich Re's rating by two notches just before marketing for the deal began, after the insurance company had announced its latest results. The downgrade from AA+ to AA- with a negative outlook left the subordinated issue carrying a single-A rating from S&P, alongside A2 and AA- from Moody's and Fitch.
That August, S&P put further pressure on Munich Re, lowering its senior rating another notch to A+ and warning that further falls could follow if the company did not raise capital. A Eu3.97bn rights issue followed in October, although Munich Re argued that the exercise was to fund growth rather than stave off further downgrades.
Today, investors who bought Munich Re's bonds have been richly rewarded. The company has shared in the return of confidence in the insurance industry. In late February, the subordinated transaction was trading at 74bp over mid-swaps — just outside where Allianz priced its new issue.
Despite the sharp recovery in insurance spreads, many investors appear ready to stick with the sector. "The insurance industry has definitely improved a lot over the last 18 months," says one fund manager in London. "The sector had a torrid time during the equity bubble, has faced regulatory and distribution changes, and over the last year or so all the companies have worked hard to improve their balance sheets. And at the same time you have got a more benign regulatory environment and better capital markets.
"So all in all, everything points towards a better fundamental picture for the insurance sector and the improvement continuing."
Laurent Frings, a credit analyst at Morley Fund Management in London, agrees. "The insurance sector has performed very strongly, but if you look at it versus other industries it still offers reasonable value," he says. "And if you look at the recent results we have seen in terms of sales, capital management and earnings, they all point towards a better trend in terms of financial fundamentals and ratings."
Frings says that he is positive on both the life and property and casualty sectors. "The life insurance sector, especially on the UK side, has derisked its balance sheet massively over the last couple of years," he says. "Nowadays they don't write so much with-profits business and they have cut their bonus payments dramatically. And if you look at it going forward, they will be very much paying out, at most, what the policyholders should receive on the basis of the investment returns."
On the non-life side, Frings says that there have also been fundamental changes. "There is a definite change versus 10 or 20 years ago, when everyone was writing for market share," he says. "Then, they were not making money on underwriting, but on the investment side. But if you look at the combined ratio for the non-life sector for the last few years, they have all been very conservative and defensive in the way that they write business."
The combined ratio (the ratio of claims and expenses to premiums written) of Axa, for example, came down from 112.5% in 2001 to 99.4% in the first half of 2004, while that of Munich Re's reinsurance business fell from 135.1% to 95.6% in the same period, according to research by Royal Bank of Scotland (RBS).
Corinne Cunningham, senior financial institutions analyst at RBS, believes the insurance companies have learned lessons from the problems they faced.
"One of the reasons we are bullish on the insurance sector is a fundamental call about the management of the companies," she says. "I believe insurance company management teams still have the situation of two years ago firmly in the front of their memories, so I don't think that they are going to be up for undertaking high risk strategies, whether that be risk acquisitions or aggressive competition.
"They are all coming up with a similar voice about pricing for profits and not following markets down when they become competitive. And while all of the big players might look at small add-ons or a reasonable sized acquisition where the business case is strong, we don't expect any big M&A."
As evidence of this level-headedness, Cunningham contrasts the industry today with the trends after Hurricane Andrew hit the US and Bermuda in 1992, causing the most costly insurance losses ever.
"This time there is no wall of fresh money coming into this market that would spoil the overall returns," she says. "When you have a hard market, it typically attracts a new wave of capital that pushes prices back down. Well that is not really happening this time.
"After Hurricane Andrew you saw the growth of Bermudian catastrophe writers, but the absence of new money now means that companies can keep prices reasonably tight. They have all talked about premium rates coming down in some lines, but it is not dramatic, maybe 5% or so. The companies are desperately trying to hang on to margins and profits for as long as they can, and that is quite positive."
Paths of righteousness
Underpinning the renewed confidence that many market participants have in the insurance sector are new and forthcoming regulations. Realistic accounting for assets and liabilities has already been introduced by the Financial Services Authority in the UK, and other European regulations are moving in a similar direction.
The introduction of more realistic capital requirements should mean that if any wayward insurance company decides to deviate from the straight and narrow, regulators will show it the right path.
"The new regulations being introduced are an important factor in the way that companies are managed," says Damien Régent, executive director, European credit research at UBS in London. "Previously the regulatory framework was too simple and did not incorporate a number of risks, and the level of risk assessment conducted by the insurance industry was probably on the weak side. However, that did not matter because there was excess capital in the industry."
But that excess capital has now disappeared and companies have to take risk management more seriously, says Régent. "They therefore have to manage the capital base actively, and that is positive for bondholders."
One of the most often cited concerns regarding European insurers is any exposure they might have to the US. Several companies have had to reserve against potential liabilities relating to asbestos lawsuits and other exposures with long tail risks. Meanwhile, the investigation by New York attorney general Eliot Spitzer into insurance industry practices in the US remains a potential cause of headline risk.
However, analysts and investors who are less enthusiastic on the sector are most likely to be so because its new-found popularity has driven spreads in to what might appear unsustainable levels.
"Subordinated insurance paper was very cheap two years ago, but it is not so cheap anymore," says Tjomme Dijkma, a fund manager at F&C Asset Management in Amsterdam. "We are therefore not so positive on the insurance sector."
Such paper is also seen as vulnerable to a correction in the credit markets. "Because subordinated debt is potentially riskier by its nature, it tends to underperform in weak markets," says Régent at UBS, "and as our credit strategists are a bit more cautious on credit markets going into the second half of 2005 we have kept a market-weight recommendation on subordinated debt."
A new asset class
Swimming against the tide in the credit markets today is not easy. The supply/demand imbalance is restricting the ability of many investors to resist participating in new issues.
One fund manager at a big institutional investor who declined to participate in the Allianz transaction, for example, felt that his action was almost futile. "We were in the book, but they priced it 2bp tighter than guidance so we did not buy any," he says. "We felt that if we pulled our order then we might be able to make a statement, but when deals are so oversubscribed it is difficult to put any pressure on the issuer."
Debt capital markets bankers argue that insurance companies should take advantage of these dynamics to further strengthen their capital positions. "The market is very attractive by any historic measure," says Gareth Braithwaite, director, financial institutions group at Barclays Capital in London, "and the opportunity to raise long dated capital at the current levels certainly exists for a great many prospective insurance issuers."
To increase their flexibility to issue subordinated debt and take advantage of opportunities when they appear, a growing number of insurance companies are establishing EuroMTN programmes, says Tom Keatinge, head of insurance debt capital markets at JP Morgan in London. Issuers such as Allianz, Legal & General and Prudential all have such a capability under their programmes.
But underlying the conjunction of events that make attractive funding possible today — investors' hunger for yield and the recovery in the insurance sector — are foundations that have been built over several years to place subordinated insurance paper in the mainstream.
"When I first moved over to London in 1997, basically the only insurance capital outstanding was that issued by a few mutuals in the UK, and that was the end of it," says Ben Katz, head of the structured capital solutions group at Lehman Brothers in London. "Then in 1998-2000 more issuance emerged and everybody started taking an interest. And today, insurance paper is a full-blown asset class with 10 times the outstandings it had only five years ago."
The price is right
Investors are perhaps becoming overconfident about subordinated insurance paper.
"I used to have endless conversations about make-whole language in the event of early redemptions and we would have quite lengthy negotiation sessions with issuers as a result of investors' concerns," says one financial institutions banker in London. "But there have been recent transactions that have had no make-wholes on early redemptions and a whole host of other conditions that not a single investor queried.
"What that says to me is that investors are not going through the documentation with a fine-toothcomb in the way that they used to. The red herring is arriving at 10am on a Monday morning and by 11am they have a Eu100m order in."
Investors acknowledge that they are placing less pressure on issuers to include stringent covenant packages, but say that this is a conscious decision rather than the result of any carelessness on their part.
"It is not that we are not looking at the documents," says one fund manager. "We still look at it, but in our search for yield we are prepared to take on a little bit more risk."
He cites as an example the Eu1bn perpetual non-call 10 year tier one issue launched by Barclays Bank in late November. This was the first institutionally targeted hybrid capital deal to be a true perpetual, in which the issuer has no economic incentive to call the bond. By using this structure, Barclays was able to count the proceeds as non-innovative tier one capital.
Bankers say that the issue was a sign of the low yield times, and that such a transaction would not have been possible 18 months earlier.
To compensate investors for the structure, Barclays paid a spread some 45bp-50bp over traditional tier one step-up structures. "Bankers may say that they can get away with all these new structures, but the Barclays deal was in my opinion priced too cheap," says the fund manager. "It tightened 10bp-15bp in 10 minutes. We were big buyers of that and also the similar AIB issue that followed.
"If the price is right, then we are willing to be big buyers of new structures."
But Patrick O'Connell, managing director, fixed income syndicate at Merrill Lynch in London, warns that insurance companies and banks should not get carried away with the possibilities now open to them. "Issuers and underwriters still need to be professional about the way they operate in the marketplace," he says, "because there are times when people are pushing structures too far. People need to be mindful of the risks that such a strategy has for their reputation and ongoing market access and take a longer term view."
New structures for retail
This is particularly important for issuers seeking to sell capital securities to retail investors. "There is a tremendous amount of liquidity in the retail markets out there that has to be put to work," says one financial institutions syndicate official, "and retail investors are always much more open to considering structures, even if they have less ability to value such deals."
One of the most popular ways of accessing the retail markets has been issuing transactions with a coupon linked to the constant maturity swap (CMS) rate.
Having been introduced by French insurer Axa in 2003, the CMS-linked structure was adopted and used by other companies such as Aegon, though so far issuance has been dominated by banks.
However, investors' enthusiasm for that product has ebbed and flowed as coupon structures and pricing have become more aggressive.
The most popular structure has been one that pays a high coupon up front for one year, then a margin over the 10 year CMS rate. More aggressive structures have been sold, notably a 'steepener' that pays a fixed coupon and then a multiple of the margin between the 10 year CMS rate and the two year rate.
The other steepener trades, so called because investors benefit when the yield curve steepens, have included caps and floors for the floating coupon, but became unpopular at the the beginning of this year when investors realised that they might well end up receiving only the floor.
More recently, and to counter retail investors' loss of interest after structuring became too aggressive, the market for CMS-linked product has been revived. After sluggish trades for the likes of Bank Austria and Banque Fédérative du Crédit Mutuel failed to excite investors, a Eu600m tier one issue for Bank of Ireland — led by BNP Paribas, Davy, Merrill Lynch and UBS — reignited interest in late February by offering a high upfront coupon for two years instead of one.
While retail investors are the target of transactions, there is also interest from some institutional accounts. "I really like the structure," says one. "In Europe we will continue to have a curve that is steep and I don't see the ECB hiking rates, so Euribor should be in a range of 2%-2.25%. So if you can buy a product that is linked to the 10 year CMS rate and it is one that you can book as a floater, then you will have a nice carry over normal floaters and other short dated credit bonds."
However, the most interesting play for institutions is typically to trade out of CMS-linked trades when they have tightened on the back of retail demand. "The key to those CMS-linked trades that have performed well and those that have not is the name," says the fund manager. "It is about which names retail like and which they don't."
This investor bought transactions from Deutsche Bank and Deutsche Postbank, which pay the difference between the 10 and two year CMS rates with a floor, even though he disliked the structure. "I thought that they were great retail names so bought them and they have done extremely well, and we have now sold them," says the fund manager.
Issuers and underwriters also need to be aware of the liquidity that investors may demand on such structured products. "Liquidity is really a concern for us," says one investor. "That is why most of the time we try to be out of the holding within two or three months of launch. However, we have a few positions left in our portfolio that we will have difficulty getting out of now."
Sitting on the sidelines
The new regulatory regime in the UK has prompted insurance companies such as Aviva and Prudential to raise hybrid capital, while in continental Europe the likes of Axa and Fortis have, like Allianz, launched successful transactions.
Financial institutions bankers have nevertheless been surprised that more insurers are not taking advantage of the propitious market conditions.
But some insurance company finance officials are relaxed about their capital needs — despite receiving daily calls from coverage bankers encouraging them to issue.
"We are fully aware that market conditions these days are very attractive," says one, "but we are happy with our capital position and do not have any liquidity or refinancing needs. The cashflow our business is generating is strong, so we have no need to strengthen our capital position or liquidity position. Therefore we won't be coming with a subordinated issue just for opportunistic reasons — I feel that we would have to have a story before coming to the market."
Debt capital markets bankers argue that such issuers are suffering from two apparently conflicting problems: complacency and insecurity.
"The market is really strong at the moment and yet these guys are sitting on the sidelines saying that while they might need capital at some stage, they don't need it now, so why bother," says one banker. "But by the time the fire alarm has gone off it will be too late, because then the cost will have gone up or the market will be shut to them."
Other insurers are said to be concerned about the market questioning their motives if they seek more capital. Companies such as Munich Re and Prudential have both had to defend capital raising exercises as proactive rather than defensive measures, and some of their peers are keen not to face a similar presentational challenge.
Bankers are nevertheless optimistic that at eventually insurers will find the markets too attractive to ignore. "If you look across not only the fixed income markets, but also at the equity markets — for IPOs and disposing of equity stakes and non-core assets — then you have very fertile ground," says Oliver Jalouneix, co-head of European FIG capital markets origination at DrKW. "It is rare that these markets are open at the same time and these opportunities should mean that it is a great time to be an insurance treasurer right now."
However, balanced against these opportunities are the challenges that insurers across Europe are facing in dealing with changing regulatory and accounting regimes, as well as the evolving requirements of the rating agencies.