Rating agency Moody’s Investors Service expects that use of contingent capital securities, including contingent convertibles (CoCo’s) by insurance and reinsurance companies will increase as they are set to be considered as regulatory-efficient capital.
Contingent capital securities and contingent convertibles have been used by banks and financial companies as a way to establish sources of capital which become available ‘contingent’ on specific events occurring.
In the case of contingent capital, the specified event is typically tied to a solvency or regulatory capital driven trigger, making them a good source of capital contingent on events in financial markets taking a turn for the worst.
Moody’s said recently that it expects the volume of contingent capital securities issued by insurers and reinsurers will likely increase, as “insurance companies will soon be able to issue and classify these securities as regulatory-efficient capital.”
The impending regulatory environment, in Europe and Asia in particular, encourages companies to issue increasing proportions of junior debt securities, Moody’s notes. This could result in greater use of CoCo’s and other forms of contingent capital security, however Moody’s expects the form and scale of insurance contingent capital use will differ depending on local regulations.
“Many insurers globally are examining CoCo issuance, given low interest rates, successful issuance from banks and evolving regulatory capital requirements. CoCos have been largely the preserve of global banks thus far, but that could soon change,” commented Simon Harris, a Moody’s Managing Director.
In particular Solvency II in Europe, the Swiss Solvency Test, C-ROSS in China and Australian regulation, all support greater use of junior-ranking debt or preferred securities for capital requirements, as they encourage greater loss absorption to be put in place to protect policyholders.
Contingent capital comes with costs associated, in terms of structuring and selling the securities, however Moody’s notes that they are beneficial to loss-absorbing regulatory capital which it would see as a credit positive.
In insurance and reinsurance a number of contingent capital, or CoCo, securities have been issued in the past, as insurers and reinsurers have looked to them as another capital tool which provides risk transfer for specific exposures, while also tapping into new sources of capital liquidity.
As a result contingent capital has often been likened to a financial catastrophe bond, providing liquidity when a catastrophic financial or economic event occurs. However they can also be structured to include a trigger linked to the occurrence of natural disasters or to losses suffered, as has been seen in the reinsurance industry previously.
There is an expectation that the Solvency II regulatory environment in Europe could stimulate further use of insurance-linked securities (ILS) such as catastrophe bonds, as these securities could also help to improve regulatory capital outlooks. Contingent capital could gain in favour in a similar manner.
In the first-half of 2015 global banks have issued over $47 billion worth of contingent capital securities, following on from $175 billion of CoCo issuance in 2015. As a result these securities are a tested marketable product so re/insurers seeking to use them should find an accepting investor base for them.
The ability to classify contingent capital securities as regulatory capital under new regimes could stimulate new interest in these securities as another form of capital protection. If insurers and reinsurers chose to add natural disaster or loss triggers into them they could find favour among the ILS investor community as well.
A contingent capital security would not have the same low-correlation with broader financial markets as a catastrophe bond, even if it had a natural disaster trigger built in. However there will be some cross over in the investor base, particularly among pension funds.
Also, Moody’s noted that these dual-trigger CoCo’s or catastrophe contingent capital deals have added complexity which could make them more difficult to issue.
“CoCos can operate very similarly to Cat Bonds, ILS and even conventional reinsurance, in that they provide additional capital or loss-absorbing capacity in the event of a certain scenario occurring (“trigger”). In the case of CoCos, we expect most securities to include some form of regulatory capital-related trigger, which should capture a variety of often severe capital-reducing scenarios such as financial market turbulence, high levels of claims or catastrophe events.
“Adding an additional catastrophe-related trigger would provide additional specific loss-absorbing capacity in that scenario, but would add to instrument complexity,” explained Harris.
The use of contingent capital though could see insurance and reinsurance capital modelling change significantly, with more capital available on demand when certain triggers are met, with perhaps less needing to be held instead.
By adding capital sources which become liquid after specific events trigger them, insurers and reinsurers could make their capital base more efficient and perhaps over the longer-term be able to hold less on the balance-sheet as it is in contingent instruments instead.
Combined with catastrophe bonds, which provide capital liquidity on-demand after specific natural disaster losses occurred, the contingent security can help to protect against solvency risks caused by economic factors. Together a powerful loss-absorbing capital combination.
Additionally, Moody’s notes that the ongoing efforts to define rules for insurance and reinsurance companies that are deemed “too big to fail” could result in further use of contingent securities.
“Rules for global systemically important insurers and internationally active insurance groups are still pending, but may also include scope for CoCo issuance,” the rating agency explains.
As regulatory capital requirements and solvency rules are updated and roll-out around the globe there is an increasing belief that it will stimulate re/insurers to use securities as a form of capital and loss-absorbency. That should stimulate greater use of these contingent capital securities, as well as ILS and catastrophe bonds, an attractive prospect for institutional investors.
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