By Paul Edmondson and Owen Ross, Partners at global law firm CMS
Insurance company capital raisings are likely to be good business for banks, however it is important to consider the regulatory requirements and types of capital that insurers can hold.
There has been a lot of speculation recently about the need for insurers to raise capital. Increased claims as a result of the coronavirus pandemic, combined with volatile, and typically reduced, asset values mean balance sheets and solvency ratios are taking a hit. Regulators are warning that insurers may need to respond by raising capital, and several insurers have already done so.
Insurers are required to hold:
- Assets to meet their liabilities to policyholders – known as technical provisions, these correspond to the amount the insurer would have to pay to transfer its insurance obligations to another insurance company, which is calculated using a best estimate of liabilities plus a risk margin; and
- Eligible own funds (capital) in excess of technical provisions to cover the firm’s solvency capital requirement (or SCR) – the aim of the SCR is to ensure that the insurer can still meet its liabilities to policyholders if the amount of its liabilities goes up, or the value of its technical provisions goes down.
The SCR is calculated by reference to detailed rules set out under Solvency II (the EU prudential regime governing insurance companies) and delegated legislation, and looks at all quantifiable risks to which the insurer is exposed. It covers existing business and new business expected to be written over the next 12 months and aims to assess the real risks faced by the insurance company. Underwriting risk, credit risk, market risk and operational risk are all thrown into the mix. In practice, most UK insurers hold considerably more own funds than are required to cover the SCR. This is expected by regulators and rating agencies. Solvency ratios of 150% and above have been common in the UK and ratios have often been higher in other EU countries. However, in the current environment increased claims and volatility in asset prices and spreads are likely to bring solvency ratios down, hence the discussions about capital raising.
In addition, a regulator may apply a “capital add-on” which increases the insurer’s capital requirement because of specific factors not captured in the existing SCR. This may come in to play if the regulator believes that the unique risks an insurer is exposed to because of coronavirus, counterparty failure or economic shocks are not properly reflected in its existing SCR calculation.
A range of own funds are available to insurers to meet capital requirements. These are split into 3 tiers. Tier 1 capital provides the best protection against the insolvency of the insurer but can therefore be more expensive for insurers to raise and service. There are limits to the amounts of tier 2 and 3 capital that can be used to cover the SCR. Under Solvency II, and as far as compliance with the SCR is concerned, more than one third of a firm’s eligible own funds must be tier 1 and less than one third must be tier 3.
The detailed features governing a capital instrument will determine its classification as tier 1, 2 or 3. Ordinary shares, for example, may be tier 1 or tier 2. Preference shares and subordinated debt may be tier 1, 2 or 3. However, to qualify as tier 1 capital, a preference share must be paid in, contain significant restrictions on redemption within 10 years of issue and be subject to write down or equity conversion in prescribed circumstances. If it does not satisfy those (and other) criteria, it may qualify as tier 2 or 3. Similar provisions apply in respect of subordinated debt. While Solvency II was implemented in 2016, some insurance companies still have debt which should not receive optimal capital treatment under Solvency II. In the medium term, this type of inefficient debt may be swapped out with new debt or modified via a trustee/noteholder consultation process.
Given current uncertainties, we may see a rise in the use of ancillary own funds. These were a new form of eligible capital introduced by Solvency II. So far, their use has been limited, but they provide an element of additional flexibility for tier 2 or tier 3 capital. In particular, there is no need for cash to be provided up front: they are legally binding commitments to provide funds on demand if and when the insurance company so requires. They may be structured, for example, as unpaid ordinary or preference shares, as commitments to subscribe and pay for subordinated liabilities, or as letters of credit or guarantees. This may give banks an opportunity as intermediaries, or providers of those letters of credit or guarantees.
Getting the right capital mix – and therefore the right cost of capital – is a crucial issue for insurers and an obvious area where banks’ expertise can be invaluable, either as an adviser or a provider of finance. Once the right mix has been agreed, specialist legal input will be required to ensure the documentation governing the relevant instrument meets all the prescribed criteria to deliver the desired capital treatment.
Insurers can also mitigate potential shortfalls through reinsurance arrangements, where risk is transferred to the balance sheets of reinsurers, thereby reducing the amount needed to meet the insurer’s technical provisions. There is limited role for banks in the context of reinsurance. However, when advising insurers it is worth bearing in mind that reinsurance may form part of a mitigation strategy, or reinsurance may be a simple competitor for a bank’s products.
In uncertain times, a big challenge for insurers is to manage portfolios to reduce volatility, which in turn will reduce the likelihood of additional capital being required to meet regulatory requirements or, perhaps more pertinently, regulators’ and rating agencies’ expectations. Of course, some insurers are raising capital to bolster balance sheets for growth rather than solely to meet regulatory requirements. Those companies are likely to have more flexibility in relation to the types and tiers of capital raised and therefore benefit from reduced capital costs, which in turn allows them to be more competitive with their pricing. However, the challenge for all insurance companies is to get the balance right: in such a volatile environment, how much capital is required (whether for business, regulatory or rating purposes), what’s the best and most efficient capital structure and who are the capital providers who can be relied upon to provide support in the medium to long term?