New Firm Targets Rising Subordinated Debt Demands Among Europe’s Insurers

With the advent of Solvency II, European insurers will need to increase their regulatory capital to meet stricter solvency standards, a development than prompted the launch of a company — Insurance Regulatory Capital Ltd. — that specializes in providing those insurers with subordinated debt as a capital-raising tool.

Chief Executive Oliver Tattan said IRC, launched last year, is targeting a market opening created in part by the development of tighter solvency standards for insurers in Europe.

"It's a way for midsize insurers who can't access the capital markets to put a little bit of leverage into their operations," said Tattan of the attractiveness of subordinated debt.

Tattan added midsize insurers are about the only segment of the European economy that doesn't normally use debt, or "an appropriate amount of leverage in their business activities."

Given the natural conservative views of insurers and the difference in their business model from banking, which is cash-based and driven by leveraging the balance sheet ("insurance is almost like banking stood on its head," Tattan said), he added it isn't surprising many insurers do not use debt to leverage their business.

Solvency II is set to change that. Tattan said until now, only the larger insurers with high credit ratings could bring enough resources to bear to access capital markets and issue debt. But with Solvency II's approach (it is currently slated to take effect in 2014), the European Commission through its regulations "designed a debt product that insurers would be eligible for."

IRC describes its business model as offering capital solutions by acting as a conduit between insurers and investors. Its special-purpose Insurance Debt Fund is designed to assist mid-cap European insurers enhance solvency cover through issuing subordinated debt instruments.

According to IRC, such "sub-debt" is constructed as a hybrid instrument between debt and equity. An issuer receives all the benefits of debt (tax-deductible, fixed-rate, long-term but finite) without the drawbacks of equity (dilution of control, expensive, high administration, nonflexible).

Under the coming Solvency II guidelines sub-debt instruments "are designed to alleviate financial pressure in times of stress," said IRC in a report. "This new note structure offers a more attractive proposition for issuers."

The use of subordinated debt offers midsize insurers a third way to meet EU-mandated solvency capital requirements, according to IRC. The other two are issuing equity and engaging in reinsurance contracts.

Tattan said IRC is targeting midsize insurers across the European Union as potential clients for its services, including mutuals and specialist companies such as health insurers along with the traditional publicly listed companies.

"We would work with insurers across the EU, regardless of business lines — life, nonlife, health — and regardless of ownership structure — listed, mutual, state-owned, privately owned, private equity-owned," he said.

There are two reasons for insurers to want to use subordinated debt to strengthen their balance sheets, said Tattan: growth or refinancing/equity release.

Companies by want to finance growth because they are start-ups with high growth rates, or are entering new markets or launching new products, said Tattan. Companies that are acquiring other companies, books of business or managing general agencies may also look to capital enhancement.

"They all need extra regulatory capital to write that new business," he said.

Raising equity can be a complex method of financing growth, while reinsurance involves ceding some of the business to the reinsurer. Tattan said issuing subordinated debt can be a much simpler process for insurers.

Insurers looking to refinance might want to release their equity for a variety of reasons. Tattan cited mutual insurers and France and various European health insurers, who might own hospitals and clinics and would look to release some equity to finance those operations. "They can release that equity to the hospital and substitute it with debt," he said.

Mutuals in particular can benefit from using subordinated debt as they can't, by definition, raise equity and thus have only reinsurance as an option. "That is one of the reasons the European Commission likes it so much," said Tattan of subordinated debt. "It will work for mutuals and smaller companies in general."

Insurers owned by private equity firms might release capital to improve the performance of their owners and finance that with subordinated debt, as would publicly listed companies looking to return a dividend to shareholders.

Subsidiaries of multinational companies might also have local capital requirements or might want to return a dividend to the parent company, which can also be financed by debt, said Tattan.

The potential market for subordinated debt in the insurance market is big. Tattan estimated that of the roughly 5,000 insurance companies in Europe, about 3,000 are candidates for subordinated debt at some point in their development.

Tattan said IRC has "about 40" insurance clients "in the pipeline" for subordinated debt products.

(By David Pilla, international editor, BestWeek: [email protected])

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