It is not hard to understand why some regulators have started paying closer and closer attention to insurance companies in the past decade.
The insurance sector was largely able to look on as the financial crisis ripped through the global banking system. But the colossal failure and subsequent bailout of American Insurance Group in 2008 raised very important questions about how insurance firms should be supervised.
In Europe, financial market participants have been taking those questions very seriously. Last year, the European Insurance and Occupational Pensions Authority (EIOPA) published an opinion paper in which it called for the introduction of a recovery and resolution framework for insurers.
Though there are already regional rules in place governing resolution and insolvency procedures for European insurance companies, EIOPA wants to bring them all together with a single framework that would hand authorities significant powers to deal with failing firms.
“The EIOPA opinion was very clear,” says Andrew Bulley, a partner in risk advisory at Deloitte in London. “It brings to a head a debate that has been simmering for a number of years.”
For debt market participants, perhaps the most important of EIOPA’s recommendations was its call to introduce explicit powers that would allow authorities to “restructure, limit or write down liabilities and allocate losses to shareholders and creditors”.
This will all seem very familiar given Europe’s experiences with the Bank Recovery and Resolution Directive (BRRD), which aims to shift the burden of dealing with bank failures from taxpayers to credit and equity investors. But the idea of doing the same with insurance companies is controversial to say the least, because it is tied up with the question of whether or not you can consider some large insurers as systemically important to the financial system.
“Some of the concern around whether or not there should be a resolution framework for insurers stems from the fact that they are very different from banks,” says Tom Grant, a partner at Allen & Overy in London. “They are differently capitalised, they are better able to hunker down and not pay out on some of their capital instruments in times of perceived stress and they are also not subject to liquidity runs in the same way that banks might be.”
Responses to a consultation on EIOPA’s proposal revealed that many stakeholders feel that Solvency II, the set of capital regulations that came into effect for European insurers in 2016, already provides plenty of safeguards to protect insurance policyholders against heavy losses.
The Solvency II regulations mean that insurance firms have to run, at the very least, with enough capital to be protected against the sort of severe shock that might occur only once in every 200 years. In other words, they have to have enough capital to be 99.5% confident that they could meet their obligations if they ran into any trouble. Solvency II also provides further protection through the risk margin, which is an addition to liabilities and therefore a further offset to capital.
But Bulley explains that proponents of having a harmonised framework for insurance resolution “observe that there have been a few instances where insurers have experienced difficulties on a short timescale, for which a resolution regime would have provided the authorities with additional policyholder protection tools”.
And the idea certainly seems to be gaining traction in Europe. Last August the European Systemic Risk Board published a report echoing the conclusion of EIOPA’s own opinion paper from earlier in the year, while the Bank of England has since said that it is watching these developments very closely.
Before the ball can start rolling, though, the European Commission will first have to decide how it will respond to EIOPA’s opinion paper.
Bulley predicts that the Commission may consult on implementing a recovery and resolution scheme for insurers during the lifetime of this parliament, though it may not seek to introduce any actual legislation until the next parliament is in session in 2019.
New capital considerations
Should the Commission act in favour of an insurance resolution regime, it would probably have a profound effect on the balance sheets of large European insurers.
But as firms wait to see whether or not European authorities will force them to start drawing up pre-emptive recovery and resolution plans and begin removing any impediments to resolvability from their business structures, many of them have already been looking to optimise the cost and quality of their capital stacks in line with the supervisory tools present under Solvency II.
This preoccupation will probably be an important factor in determining primary issuance this year.
For the first time in 2017, insurers began warming towards issuing restricted tier ones (RT1s) — the most junior form of debt capital that firms can issue under Solvency II.
RT1s are similar to the Basel III-compliant additional tier one (AT1) instruments issued by banks, with regulators intending both sets of liabilities to absorb losses if the issuer runs into financial difficulty.
Their structures are also unlike any other subordinated bonds issued by insurance companies, because the issuer has the discretion to cancel interest payments at any time and must cancel payments if it does not have enough distributable items or lacks the funds to meet its Solvency Capital Requirement (SCR) or Minimum Capital Requirement (MCR).
People had been predicting that insurers would start to embrace RT1s for about two years, but the first deal in a core currency came only in October when ASR Nederland, the Dutch insurer, sold a €300m perpetual non-call 10 year bond with a coupon of 4.625%.
ASR’s pioneering deal was followed swiftly by a deal from Direct Line Insurance, which sold RT1 capital in the sterling market at the same time as it was getting rid of some of its tier two bonds with a tender offer.
“Given the incremental cost, where you are seeing interest in the RT1 space is generally where companies are full or approaching capacity on their tier two and tier three buckets,” says Peter Mason, co-head of financial institutions group banking EMEA and head of FIG DCM EMEA at Barclays in London. “Some insurers also appreciate that the current tight yields for this product make opportunistic issuance highly compelling.”
Taxing decisions
But there will be clear limits on RT1 supply this year. European insurers are under no obligation to issue this class of debt and, though RT1s could be used to reduce shareholder equity and increase dividend payout ratios, firms already have lots of tier one capital and may therefore not have a great deal of capacity to issue the junior debt instruments.
“We are not going to have a flurry of RT1s like we did with AT1s, because there is no regulatory requirement driving that issuance for insurers,” says Claire McNicol, a senior financials credit analyst at Rabobank in London.
And one of the big problems deterring issuance is that insurance companies have been unsure whether or not tax authorities would treat RT1 securities like bonds or shares, as the instruments have bond-like payment structures, but equity-like downside risk.
If they are treated like bonds, tax officials would probably allow issuers to deduct their interest payments from pre-tax rather than post-tax profits. This is certainly possible in the Netherlands, where ASR confirmed that it would be paying RT1 coupons out of pre-tax profits, effectively lowering the cost of payments by about 25%. And the UK passed a law in 2015 to provide certainty on the tax treatment of RT1s for insurance firms.
“It is still a fragmented approach, and insurers need to be sure whether or not RT1 distributions would be tax deductible before they access the market,” explains Grant. “In jurisdictions where there isn’t an applicable tax law, they might be more confident about issuing if the local tax regime has worked to allow tax-deductibility on AT1s from banks — because the two types of instruments have similar features. But without legislation insurers cannot be certain, without having gone through any local tax clearance process themselves.”
But it takes only one deal for others to follow. And with more and more insurers looking to give themselves additional headroom for tier two and tier three issuance, while reducing refinancing risk for debt capital instruments with call dates coming up in the next few years, the prospects for RT1 supply are looking up.
Mason certainly believes that there will be more issuance in the format in 2018.
“Very strong market conditions, combined with better visibility now on the role and future form of RT1 in insurers’ capital stacks from a regulatory and tax perspective, has given a number of issuers confidence to access the market across different currencies this year,” he says.
A year in flux
For the moment, European insurance companies are able to think about managing their capital structures in terms of living with the best mix of cost and quality, while remaining well clear of their Solvency II minimums.
But one of the biggest questions hanging over their heads remains whether or not supervisory authorities will also require them to start planning for their own funerals.
EIOPA’s forceful opinion paper ruffled a few feathers in the European insurance market in 2017, at a time when some of the largest US firms are arguing successfully through the courts that they are not systemic and therefore do not require closer supervision.
“We are waiting with great interest to see what the response will be in Europe,” says Bulley.