The case for subordinated debt


The Case for Subordinate Debt

With the advent of Solvency II it is imperative that executive management considers more carefully their company’s access to sources of capital. Insurance Regulatory Capital offers capital solutions through acting as a conduit between insurers and investors. We aim to help mid cap European insurers enhance solvency cover through issuing subordinated debt (sub debt) instruments.

Sub debt is specifically constructed to be a hybrid instrument between debt and equity. As such, 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, non flexible). In addition, under new Solvency II guidelines sub debt instruments are designed to alleviate financial pressure in times of stress. This new note structure offers a more attractive proposition for issuers.

As discussed below, maintaining an appropriate buffer in excess of the minimum solvency requirement will be more important under Solvency II. This paper also covers the benefits of issuing sub debt as part of a fully diversified capital structure and as an attractive alternative to existing forms of capital.

Capital is rarely efficiently available when it is needed most. For example, the collapse in both equity and fixed income investor confidence throughout the credit crunch had a dramatic impact on the cost and availability of capital. Many insurers and re-insurers were forced to raise capital at penal rates and enter into punitive reinsurance transactions.

All forms of financial leverage are most efficiently and affordably structured in advance of an active requirement. Pro-actively securing a long term capital buffer provides solvency insurance.

“As CEO of two high growth midsized insurers, sourcing reliable cost effective long term capital was a principle component in achieving strategic objectives”
Oliver Tattan, CEO, Insurance Regulatory Capital

Maintaining a Capital Buffer

Under Solvency II, a regulator will assess the level of capital in operating insurance companies against a required level of capital. This level of required capital (eligible own funds) will be calculated through a standard formula or (if approved by a regulator) an internal model developed by the company itself. There are two capital requirement levels as defined below by EIOPA.

1) The Solvency Capital Requirement (SCR): is defined as the potential amount of own funds that would be consumed by unexpected large events whose probability of occurrence within a one year time frame is 0.5%.

2) The Minimum Capital Requirement (MCR): is defined as the potential amount of own funds that would be consumed by unexpected events whose probability of occurrence within a one year time frame is 15%. The MCR is expected to be calculated within a range of 25-45% of the SCR. Whether an insurance company uses the standard formula, or receives regulatory permission to apply internal models, it will have to maintain eligible capital to at least 100% of its SCR to prevent regulatory interference and ensure operating flexibility. A breach of the MCR triggers the ultimate supervisory intervention of the withdrawal of authorisation.

The solvency ratio under the new regulation is expected to be much lower than under Solvency I. The calculation of both eligible capital and solvency required for Solvency II fundamentally differs from the basic calculation for Solvency I. As both liabilities and assets are to be fair valued (market value where possible) the capital eligible for solvency purposes will be more comparable to accounting capital under International Financial Reporting Standards (IFRS). The EIOPA Quantitative Impact Study (QIS5) covering 2,520 insurance companies reported that the new methodology will lead to an average 28% increase in eligible capital. However, it also leads to an average 140% increase in the solvency requirement which results in an overall 43% reduction in capital surplus. As such, the average solvency ratio under Solvency II of 165% falls well below the average existing Solvency I ratio of 310%.

The introduction of mark to market valuations under this new methodology is expected to lead to significantly more volatility in annually reported eligible capital than under the previous regulations. The recent credit crunch demonstrates how volatile capital, and ultimately solvency levels, could prove to be under Solvency II. The chart in the margin depicts that shareholder equity for publicly listed Western European insurers fell 21% on average between 2007 and 2008 (ranging between – 56% and +58%). This fall in shareholder equity occurred despite the average profile of insurance investment assets being heavily weighted to higher quality fixed income debt and a low exposure to subprime instruments. As stated previously, insurers will be permitted to calculate solvency requirements through a standardised formula or from regulatory approved internal models. Many of the larger insurance companies already use such models as best practice to price capital more efficiently. The performance of such models further demonstrates the expected volatility and fall in solvency cover under Solvency II and the necessity for a larger capital buffer. As well as having a margin to protect against a breach of regulatory guidelines, a firm capital buffer offers many other advantages to insurance companies, such as:

1) The ability to readily avail of opportunistic acquisitions.
2) Greater flexibility in managing and negotiating reinsurance terms.
3) The ability to access debt markets at more attractive terms.
4) An additional risk buffer for policyholders.

The QIS5 study also reported that most European insurance companies maintain a strong solvency buffer and will enter Solvency II with a good level of SCR coverage. Approximately 50% of European insurers’ current capital exceeds 200% of SCR, 35% would be between 100-200%. However, 15% or 378 of the sample companies have capital below the SCR.

Subordinated Debt Instruments

Along with issuing equity and engaging in reinsurance contracts, sub debt represents a third alternative to meaningfully raising the ratio of eligible capital to SCR. The relative ease of issuance and unique performance enhancing benefits highlight sub debt as an attractive consideration for all insurance companies, irrespective of the level of solvency cover.
Solvency II directives for eligible sub debt instruments are fundamentally different from the existing market issued sub debt notes. A key guiding principle from EIOPA is that no eligible form of capital can have features which “cause or accelerate insolvency”. In effect, the terms and conditions of eligible notes have been restructured to ensure that the issuer comes under limited financial pressure to either pay a coupon or redeem principal, if doing so would lead to a breach of its SCR. The adoption by the European Parliament of the Omnibus II Directive in March 2014 and the issuance of Level 2 measures by EIOPA have provided further guidance on the eligibility of sub debt instruments under Solvency II.
Although the sub debt instruments are still segregated into tiers as under Solvency I, the characteristics have been adjusted to address the perceived weaknesses in the existing instruments.

• Tier 1 capital is considered core capital and includes ordinary equity. Insurers will be directed to cover at least 50% of its SCR in this form of capital. Tier 1 sub debt notes will be the most similar to ordinary equity and issuers will be eligible to contribute up to 20% of their SCR in this instrument.
• Tier 2 will have more debt like features and issuers will be eligible to cover up to 35% (or up to 50% if Tier 3 is unutilised) of its SCR in this instrument.
• Tier 3 will be the most like standard debt and issuers will be eligible to cover up to 15% of their SCR in this instrument.

“Solvency II will lead to a much improved regulatory and operating environment. A common regulatory platform will lead to greater ease in writing premium across European borders presenting significant organic and inorganic opportunities for growth”
Maria Teresa Kelly Oroz, CCO, Insurance Regulatory Capital


The only form of capital that can exist entirely in its own right is ordinary equity. Although raising equity is always an option it has certain drawbacks, some of which are listed below.

• A very heavy administrative process involving both the company and existing shareholders. Privately owned insurers entering into a bespoke and one off equity issue can find the process onerous.
• A valuation of the business must be negotiated and agreed with new equity investors.
• A very time consuming consultative process with existing and prospective shareholders.
• Existing shareholders face dilution without a pro-rata take up.
• Sourcing new equity investors for unlisted insurers can be difficult, particularly without a route to exit.

The Optimal Capital Mix

Both sub debt and reinsurance provide alternative forms of raising the SCR coverage by increasing the eligible own funds or reducing the capital requirement. The optimal capital structure should take advantage of an ideal mix of equity, sub debt and reinsurance and will vary depending on the requirements of individual companies. At Insurance Regulatory Capital we specialise in providing the optimal mix of reinsurance and sub debt.

Even for a company satisfied with its current level of capital, the performance enhancing attributes of sub debt are often overlooked by issuers who are predominantly focused on managing their solvency ratio. The tax deductible status of coupons is a key benefit of the instruments. In one example depicted overleaf, an issuer has replaced 25% of equity with a subordinated issue. The eligible capital and SCR have remained the same, but the issuer has been able to retire both existing equity and enhance the return on the remaining equity by 4.7%. This potential to enhance performance, even as equity is returned and greater capital diversity is achieved, should make sub debt an essential part of the capital management toolkit.

Benefits of Issuing Subordinated Debt under Solvency II

Above we have briefly discussed some of the more fundamental aspects of sub debt instruments. Insurance Regulatory Capital has established a special purpose vehicle aimed at assisting mid cap insurers wishing to issue Tier 2 sub debt as part of their regulatory capital requirements. We would invite issuers to get in contact to discuss any of the benefits listed below in greater detail.

Increases own funds eligible for SCR and thus SCR coverage.

No default trigger. The coupon and principal are deferred if eligible capital is below 100% of SCR. Uniquely, the instrument alleviates financial stress when a company is at its most vulnerable.

  • No dilution of control. The instruments confer no rights to a note holder with the exception of coupon and principal repayment upon regulatory consent.
  • Interest payments are tax deductible in most jurisdictions.
  • Can positively enhance performance ratios.
  • Incentives to redeem are only permitted after 10 years for Tier 2 instruments.
  • Capital is maintained as cash on the balance sheet and can be reinvested.
  • Products are transparent and loan notes have a simple structure.
  • Limited restrictions or covenants in loan notes.
  • Enables access to new investor classes previously inaccessible to mid-sized insurers.
  • Very flexible in stress situations.
  • Ensures greater options for future capital structures.
  • Can provide protection against M&A by enabling a strong balance sheet.
  • Facilitates business growth in adjacent markets or with similar insurance products.
  • No rating agency input required, normally readily available financial and qualitative information will be adequate.
  • No counterparty risk, capital is not contingent.

“As an active investor and asset manager the benefits of investing with experienced and aligned industry professionals cannot be over emphasised”
Aogan Foley, Independent Director, Insurance Regulatory Capital

Investor Considerations

Solvency II has been established to overcome the risk measurement shortfalls in the current regulatory model and apply a uniform standard across all European insurers. The ability to combine the fair value of liabilities and assets into one ratio allows for a much greater level of reporting transparency and comparative benchmarking than
exists for most other corporate sectors. Insurance Regulatory Capital consider that the demand for mid yielding, low risk, fixed income assets from investors will grow. Insurance Regulatory Capital acts as a conduit between the issuers and investors in order to provide sub debt capital solutions.

At Insurance Regulatory Capital we have designed a comprehensive medium term program to facilitate insurers investigating and considering the benefits of issuing sub debt. All categories of insurer are eligible, including non-life, life (motor, home, liability) and health insurance and any ownership structure: i.e. listed, state owned, privately owned and mutuals. Once an insurer enters the program we work with them to:

  • Assess their potential appetite for sub debt on a 0 to 4 year horizon, considering their long term ideal balance sheet structure and business motivators such as growth ambitions, performance and market consolidation activity.
  • Determine the ideal regulatory capital mix.
  • Identify any potential barriers to a successful issue.
  • Work through the timing of issues and the process to issuing sub debt. Additionally potential issuers benefit from our sector and sub debt research
    and participate in regular communications.

Appendix: Outstanding Subordinated Debt Market

Sub debt is by no means a new concept or a new market instrument. In fact, European insurance companies (particularly the large public listed insurers) have been supplementing capital with sub debt instruments since the 1980s. What is new however, is the directive for capital eligibility under Solvency II as discussed in the main body of this paper. Practically speaking, the majority of the estimated €80bn outstanding market issuance today does not conform to the directives for Solvency II. The expectation is that issuers will still receive capital eligibility (“grandfathering”) for transitionary purposes, but will be encouraged to retire and replace capital at the earliest feasible opportunity.

That is not to say that eligible Solvency II sub debt notes cannot be issued in advance of the Solvency II live date (Jan. 2016). The most recent market issues have used flexible term language to allow for eligibility under both a Solvency I and Solvency II environment. A key provision in the notes ensures that the issuer will not be disadvantaged by changes in the regulatory environment. Approximately 50 European issuers have outstanding sub debt traded instruments in the market. In terms of size, the smallest company with an outstanding issue generated revenues of €240m in its latest fiscal year. Insurance Regulatory Capital consider the application of the more sophisticated Solvency II evaluation as conferring a heretofore absent risk equivalent status to European insurance
companies. This risk equivalence has been calibrated by EIOPA to approximately equate an SCR level of 100% to an investment grade rating of BBB. As such, the absence of a public rating should no longer be viewed as a serious impediment to efficiently issuing sub debt instruments. Insurance Regulatory Capital would engage with issuers of all sizes regarding the potential of issuing sub debt.


The actual pricing of Tier 2 debt acquired must take account of the fact that the issues will be illiquid in comparison to the large listed issues of major insurers. Naturally, the actual pricing will very much depend upon the individual circumstances of the issuer and will be heavily influenced by the following aspects:
• Prevailing interest rates and long term expectations (yield curve)
• Credit quality of issuer, peer group, sector and country
• The amount and blend of subordinated instruments (Tiers 1-3)
• The rationale for issuance
• Size of issuance relative to total own funds
• Term of issuance

For more information on pricing and sub debt markets please contact Insurance
Regulatory Capital.

Read about: “Sub debt approved as regulatory capital for mutual insurers”

Read about: “How sub debt can fulfil regulatory requirements under Solvency II”

tags: Subordinated Debt, Solvency II, eligible capital, Insurance Regulatory Capital