• ALTERnative finance

    Author; Seb Kafetz Relationship director, Lloyds Bank

    Publication date; 19.01.2012 in Post Magazine


    Last year was a difficult one for the insurance industry in many ways. Public stocks in the sector were trading around 20% down at the end of the year compared with the start, with the industry not only mirroring the trend of the FTSE but also impacted by the tens of billions of pounds in catastrophe losses. In addition, class specific issues, such as the rise in bodily injury claims, have fuelled investor apathy in the sector. Alongside the decline in valuations, as well as real book value in many cases, the bond market in the UK has largely remained closed and many overseas banks have retreated. Now, in 2012, the outlook for financing within the sector remains fragile. Capital is increasingly high on the agenda of the boards of underwriting businesses. Companies want to ensure they have enough eligible capital to satisfy regulators and rating agencies that they are Solvency II compliant, and they have enough flexibility to withstand another catastrophic year to take advantage of a potential hardening market.


    Historically, the insurance sector has been strongly supported by the equity markets. In 2005, the year of hurricanes Katrina, Rita and Wilma, there was a bout of equity raising to repair balance sheets and create new platforms to capitalise on the new market. It is believed that the equity markets, if called upon, would not be as receptive this time.


    Attracting equity

    Firms trading significantly below book value are not compelling for follow on equity issuance at the best of times. However, the volatility seen in 2011 from writing cat insurance, combined with the low investment environment, means it is more likely that only larger, more diversified and better-rated firms will be able to attract equity on attractive terms. This means that companies will be increasingly reliant on other forms of funding, such as bonds, bank facilities, reinsurance quota-shares or placings from private  equity firms.


    The UK general insurance sector has, in the past, utilised longer-term bond finance as a core part of its capital structure. Regulators and rating agencies have allowed a signifi cant element of longerterm finance to count as regulatory capital. Public bond issuance needs to be close to £100m before it becomes a viable capital option, although in the mid 2000s many smaller firms accessed this market through participating in pooled collateralised debt obligation vehicles, which allowed firms to raise as little as £10m.


    The period between 2005 and 2007 marked the recent peak in bond issuance in the sector, and there has since been a sharp fall off. While a large part of this decline has been driven by market conditions, making coupons unattractive, coupled with a high carry cost given low asset yields, there has been uncertainty about the capital treatment of certain instruments under Solvency II. Whereas, in the past, 10year securities with fiveyear call periods have been eligible as regulatory capital and, in many cases, have achieved up to 25% rating agency credit, debt securities will now need to be at least 10 years — with no call periods and full discretion on coupons — to qualify as tier one capital and, even in this scenario, will likely be limited to up to 20% of tier one.


    This limits the pool of investors and raises the interest cost for borrowers, restricting supply and demand. It is expected that a number of companies with existing bonds in place will look to review the potential to undertake liability management exercises. These could make the existing bonds eligible under the revised criteria — for example, by pushing out call dates or amending their position in the capital structure.


    Alongside capital markets, bank markets continue to be a key source of finance for underwriters. One widespread use of bank finance is in the Lloyd’s market, where letters of credit are considered eligible as regulatory capital. For a standalone Lloyd’s entity, it is often possible to utilise letters of credit for up to 35% of the total capital requirement. For entities with significant overseas support it is not uncommon to see letters of credit making up 100% of the capital structure. This is an attractive form of finance as, unlike conventional loans, no London interbank offered rate is paid on top of the letter of credit commitment fees.


    The market to provide this capital has shrunk, given the need for these instruments to be at least four years old, combined with European banks’ reluctance to provide finance outside their home markets. However, there is still the liquidity to support the sector. Bank finance remains the most userfriendly form of capital to support mergers and acquisitions.It can generally be arranged quickly and can often be  raised at holding companies and then dropped down into regulated entities.


    This type of finance is useful for PE houses looking to acquire insurance businesses as it can help provide certainty of funding and minimise upfront equity cheques. Banks remain open to this type of finance for midsized companies but the ability to finance large cap transactions remains limited due to the continued pressure to deleverage bank balance sheets. Other forms of quasi capital include reinsurer quota shares, side cars and insurance linked securities. The insurance linked securities market is relatively benign with only the larger, more diversified players having signifi cant access. Side cars are being utilised  for specific lines of business — in particular, cat reinsurance — and are seen in the Lloyd’s market through special purpose syndicates. It is quota shares, however, that continue to be the most attractive form  of capital.


    These are generally structured as whole account quota share which have a number of benefits. These include allowing companies to increase their underwriting capacity, providing flexibility to scale up and down in line with the market and providing strategic partners who can provide companies with longterm support. Several Asian and US insurers entered this market for the fi rst time in 2011 and it continues to be a growing source of capital support.


    Supporting the market

    There are, therefore, plenty of alternative sources of fi nance to continue to support the London market into 2012, but the availability, cost and certainty of execution all remain in a fragile state. Companies looking to raise finance need to allow longer lead times, strengthen their relationships with capital providers and should look to consider tapping different capital sources in any fundraising initiative.

6/19/2018 8:49:29 PM