Contingent capital has been back on our radar recently thanks to the market rumours suggesting that reinsurer Swiss Re has been arranging a marketing roadshow for a contingent convertible bond issuance recently. The first time we wrote about contingent capital on Artemis it was not with reference to reinsurers however, it was discussing whether contingent capital and contingent convertible bonds could become a form of catastrophe insurance for banks.
We wrote that article back in November 2009, when a representative of the Bank of England called for a market in contingent capital which could serve as a source of insurance against the kind of financial shocks that the markets have suffered in recent years. At the time regulators had been actively discussing making a contingent capital facility a requirement for all banks, thus providing an insurance protection against large declines in Tier 1 capital at the world’s largest financial institutions.
The discussions never seemed to go anywhere unfortunately. The idea made a lot of sense though, as banks could issue contingent capital bonds which could be convertible to equity or payout the principal, rather like a catastrophe bond. In fact there is a lot of similarity between certain contingent capital structures and catastrophe bonds, and cat bonds themselves provide a source of contingent capital for insurers and reinsurers (a source of capital which is contingent on certain pre-determined factors; or a trigger).
Contingent capital and contingent convertible bonds continue to be used by financial institutions around the world and they are indeed becoming ‘catastrophe insurance for banks’ as we predicted in our November 2009 article.
The latest example of this comes in an article from Bloomberg which suggests that the UK’s second largest bank, Barclays Plc, is planning a contingent convertible note issuance to protect its balance sheet. Barclays is said to be planning to issue as much as £7 billion ($11 billion) in contingent convertible notes, or CoCo’s, according to the story.
It’s not the first time Barclay’s has done this. It issued $3 billion of convertible notes back in November. That deal involved 10 year notes paying 7.625%, the value of which would be written down to zero if Barclays Tier 1 capital equity ratio dropped below 7%.
It’s not just Barclays rumoured to be planning such a transaction. Another UK bank, RBS or Royal Bank of Scotland, which is 82% government-owned since the financial crisis, is said to be considering its own contingent capital transaction.
For Barclays, the November deal came at a price as the 7.625% return was thought to be high, although the appetite of investors for these notes was demonstrated by the deal being massively oversubscribed, with some reports saying that there was as much as $17 billion worth of demand for the $3 billion of issued notes.
The interesting thing about this market is how similar it all sounds to insurance-linked securities and catastrophe bonds. Providing a source of just-in-time capital contingent on certain factors being met, such as losses or financial solvency ratios to do with capital adequacy. Our regular readers will be aware of French reinsurer SCOR’s natural catastrophe linked contingent capital facility, a contingent notes issuance that triggers based on SCOR’s loss experience.
If you think about the recent Vitality Re IV Ltd. health insurance linked cat bond, the fourth such deal from Aetna, it is easy to think about this deals motivations as providing a source of contingent capital. When we talk about cat bonds we do so in terms related to the peril or risk they cover, so in Vitality Re’s case it’s protecting against ‘increases in medical benefit claims ratio’ or ‘extreme morbidity’ or ‘claims resulting from pandemics’. It’s also perfectly accurate to describe the Vitality Re deals as a source of capital contingent on Aetna’s claims experience hitting a certain level. The two, cat bonds or ILS and contingent capital, are not that different in motivation at all.
Similarly, longevity risk transfer deals are a form of contingent capital to some degree, as they can be structured to pay out based on longevity trend increasing within a pension funds book of business. Would longevity securitization be more prevalent if it was looked on as a contingent capital solution rather than a reinsurance solution?
In our discussions with participants in the reinsurance, ILS and cat bond markets we regularly hear of a desire to broaden the usage of cat bond type structuring out to financial market participants such as banks, to provide them with contingent insurance protection. When you think of the major banks around the world who underwrite loans on a massive scale, it could even be providing them a form of reinsurance.
It seems inevitable that there will be some blurring of the lines between instruments like cat bonds and contingent capital in future. The skills to structure them are very similar, the motivations for doing a deal are similar, the design of solutions are similar and even the investor markets who buy into them are similar.
As insurers and reinsurers look to contingent capital and contingent notes or bonds with more appetite and banks continue to get more sophisticated with their use of contingent capital, we could see contingent capital and ILS instruments like catastrophe bonds become part of the same menu (albeit perhaps on different pages of said menu) of risk transfer solutions available to sponsors.
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