BEST S SPECIAL REPORT

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1 BEST S SPECIAL REPORT Our Insight, Your Advantage. Issue Review June 15, 2015 A.M. Best expects European insurance companies to continue to take advantage of the heightened demand for insurer debt A.M. Best Examines Debt Trends in the Capital Structure of European Insurers Low interest rates together with highly liquid and stable financial markets have prompted European insurers to tap the capital markets in their efforts to lower the cost of capital and optimise levels of risk-adjusted capitalisation. Since the European sovereign debt crisis, which peaked in late 2011 and early 2012, actions by the European Central Bank (ECB) have provided capital market stability, and have allowed insurers to continue debt financing activity at reasonable rates. However, in A.M. Best s opinion, quantitative easing measures in Europe, the United States and Japan have pushed yields to extremely low levels where investors are no longer able to achieve adequate returns for the risks they are assuming. A.M. Best has conducted in-depth analysis of over 90 billion of debt issued by European insurers between 2005 and The conclusions drawn in this study, which focuses primarily on rated debt issued by A.M. Best clients, is considered representative of the overall European insurance debt market. The data identifies several key trends, including: Most European insurers active in the capital markets are highly rated with stable, diversified businesses that produce strong debt service ratios, with the majority of interest coverage ratios between five and ten times. This is reflected in the ratings of their debt (see Exhibit 1). In terms of the volume of debt issued, A.M. Best s analysis shows soft pricing and limited growth opportunities have led to many European Union (EU) insurance groups using excess capital to pay down debt and reduce overall financial leverage in the past two years. Over the near term, financial leverage is expected to remain fairly stable. Analytical Contacts: Stefan Holzberger +44 (0) Stefan.Holzberger@ ambest.com Catherine Thomas +44 (0) Catherine.Thomas@ ambest.com Writer and Researcher: Yvette Essen, London +44 (0) Yvette.Essen@ambest.com Editorial Manager: Richard Hayes +44 (0) Richard.Hayes@ambest.com SR Group level capital management is a key trend that has emerged in the wake of increased regulatory scrutiny. In 2014, several companies with high financial leverage have reduced external borrowings gradually. Insurers are also issuing new debt, buying back shares, paying special dividends and holding excess capital at the ultimate parent while maintaining regulatory minimum requirements at the operating subsidiary level. Debt issuers have been active in 2014 and 2015 as Exhibit 1 Distribution of A.M. Best-rated Debt (as of Mar. 09, 2015) 9.6% 6.7% 21.2% 16.3% 18.3% 16.3% 3.8% 7.7% aa- a+ a a- bbb+ bbb bbb- bb+ Copyright 2015 by A.M. Best Company, Inc. ALL RIGHTS RESERVED. No part of this report or document may be distributed in any electronic form or by any means, or stored in a database or retrieval system, without the prior written permission of the A.M. Best Company. For additional details, refer to our Terms of Use available at the A.M. Best Company website:

2 4.7bn insurers take advantage of the low interest rate environment to issue cheap paper and make early redemptions of outstanding debt. A.M. Best expects European insurance companies to continue to take advantage of the heightened demand for insurer debt. Some European insurers have been rebalancing their capital positions ahead of the introduction of Solvency II. New hybrid debt instruments have been structured in line with the requirements for capital credit under the new regulations. However, as the Jan. 1, 2016 deadline for implementation of the insurance directive approaches, Solvency II is likely to become less of a driver for insurer debt issuance. Insurance Debt Characteristics The global financial crisis resulted in a sharp slowdown in debt issuance which was most severe in Europe in 2008 and 2009 (see Exhibit 2). By early 2011, debt issuance of European insurers analysed by A.M. Best recovered Exhibit 2 Total Debt by Year of Issue (2005 to year-end 2014) 10.7bn 10.6bn 2.9bn 6.5bn 4.4bn 8.5bn 17.4bn 10.8bn 16.3bn Exhibit 3 A.M. Best-rated Debt by Country (2005 to year-end 2014) () Sweden 0.6bn France 1.9bn Luxembourg 2.4bn Switzerland 6.1bn Italy 7.9bn United Kingdom 9.5bn Netherlands 16.4bn Germany 10.4bn 2 marginally, but by the fourth quarter of 2011 issuances again decreased sharply, owing to the turmoil associated with the European sovereign debt crisis. While the amount raised in 2011 was an increase on 2010, the financial crisis which emerged in the fourth quarter of 2011 impacted overall debt issuance, with only 8.5 billion of debt issued for the full year. Liquidity was scarce and yields were rising rapidly resulting in most insurers waiting on the sidelines. However, the ECB s decisive actions in 2012 restored calm to the markets by midyear; interest rates declined and European insurers returned to the capital markets with the sense that a crisis had been averted. Insurers in A.M. Best s sample issued 17.4 billion of debt in 2012, although issues were predominately based on the stronger, more stable economies such as Germany and Switzerland. As interest rates reduced to historical lows in 2014, insurers took the opportunity to refinance to lower their cost of capital, and debt raised reached 16.3 billion. Not surprisingly, companies domiciled in the largest economies in Europe are the most active issuers of debt into the capital markets (see Exhibit 3). For the purposes of this study, A.M. Best has included a small amount of debt issued by non-eu subsidiaries of European groups. For example, debt issued by Swiss Re s U.S. intermediate holding company in the United States is classified for this study as debt issued by a Swiss insurance group.

3 In some countries, the national champions have been the predominant participants. This has been the case with Generali in Italy and Mapfre in Spain, while Aegon, based in the Netherlands, has also been particularly active in the debt markets. In other countries, several issuers both in the primary and reinsurance segments have been active issuers in their respective countries, for example, Hannover Re, Allianz, Munich Re and HDI/Talanx in Germany. Exhibit 4 Total Debt by Type of Company (Life, Non-Life, Composite) (2005 to year-end 2014) Non-Life 7.9bn Life 6.2bn Composite 78.8bn In Europe, the profile of insurers active in the capital markets is overwhelmingly that of the composite insurer (see Exhibit 4). As evidenced in this study, most insurers issuing debt actively write a significant amount of both life and non-life business with 78.8 billion (85%) of debt issued by composite insurers from 2005 to year-end In addition, most of the EU insurance groups in this study maintain extensive geographic diversification. Further enhancing the uncorrelated nature of their diverse product offerings, many actively write both primary and reinsurance lines of business. Given the size and scale of many leading European insurance groups balance sheets, the majority of debt issuances are greater than 500 million (see Exhibit 5). In fact, a significant portion of debt issued by EU insurers is greater than 1 billion per issuance. Fewer, larger issuances reduce costs and contain the amount of time senior management needs to spend conducting roadshows and lining up investors. Insurance Sector Debt Proves Attractive Debt issuances are commonly several times oversubscribed, indicating a strong demand from investors for insurer debt this despite the general understanding that insurance market conditions are soft, growth levels will be modest at best, and returns are under pressure. The offsetting factor is the clear lack of better investment opportunities in other industries and in other asset classes. Exhibit 5 Total Debt by Size of Issue (2005 to year-end 2014) 38.9bn 35.0bn The good demand for insurance sector debt is evidenced by strong order books for issuances by a number of Continental European insurers. Generali demonstrated this in April 2014 when it directed its 1 billion subordinated bond, with an interest rate of 4.125%, to institutional investors and attracted orders for 7.4 billion. This followed Europe s third-largest insurer drawing strong interest from international 0.1bn Up to 100 million 3.9bn million 14.9bn million billion Greater Than 1 billion 3

4 Solvency II Drives Debt Issuance Transitional provisions under Solvency II have resulted in heighted activity in the debt markets. To ensure a smooth conversion from Solvency I, the grandfathering of existing hybrid ownfund items that are eligible under the current regulations will be permitted, aiming to make it easier for insurers to meet the new capital requirements. The industry will be given 10 years to adapt the composition of its capital to Solvency II standards. Subsequently, as Tier 1 subordinated debt has been classified as qualifying debt until the end of the Solvency II transitional arrangements in 2025, Continental European insurers were active with regards to capital market issuance in The new directive is very specific on the definitions for Tier I and Tier II capital and insurers are confident they will receive appropriate credit. Going forward, the new style Tier 1 will be perpetual, with loss-absorbing features. With the grandfathering of Tier 1 capital a focal point, call dates on recently issued European subordinated debt have tended to be for 2025, or just prior to the transition date. In May 2014, AXA stated that its 1 billion issue was structured to comply with the eligibility criteria for the 50% perpetual subordinated debt limit under Solvency I and would be eligible as capital under Solvency II. Similarly, when Generali launched its 1.5 billion perpetual bond in November 2014, it stated the new issue was expected to be treated as grandfathered Tier 1 debt under Solvency II. Meanwhile, Crédit Agricole Assurances issuance of debt in September 2014 aimed to increase the company s Tier 1 hybrid instruments. Crédit Agricole said the debt was expected to be grandfathered during the transitional period and fully compliant with Solvency II requirements after the first call date. However, while Continental European insurers have taken the opportunity to raise qualifying capital, there has been less perpetual issuance from U.K. companies. This reflects the Prudential Regulation Authority (PRA) discouraging the issuance of non-conforming subordinated debt for the purpose of being counted toward Tier 1 capital under transitional arrangements. U.K. insurers have been instead encouraged to fully adhere to the principles and spirit of Solvency II prior to its implementation date. investors in January 2014 for a fixed rate senior unsecured bond with a coupon of 2.875%, oversubscribed by 7.5 times the target amount. The current interest rate environment is causing investors to search for yield, with limited opportunities to obtain even reasonable returns. Insurance debt is attractive as it offers relative security and insurers have tended to avoid many of the issues that have plagued the banks. In general, insurers have strong free cash flow ratios, enabling good service of interest and steady payment of dividends. The long-tail nature of life and casualty insurance is considered appealing, with investors such as pension funds requiring long-term financial instruments to match long-dated liabilities. EU-based insurers are not limited to the European capital markets to meet their financing needs. For example, retail and high net worth investors in Asia are eager to benefit from the relatively appealing yields and high credit quality offered by European insurer debt. Zurich placed undated capital notes with a coupon of 8.25%, primarily targeted to investors in the Asian markets in January While the search for yield is heating up, insurers generally are less likely to hold the debt of other insurance companies. Solvency II and internal economic capital models set higher 4

5 required capital levels where correlations exist between asset and underwriting portfolios. A.M. Best expects the insurance sector to remain an attractive proposition as interest rates are forecasted to remain low. Investors are consequently continuing to demand relatively secure investments, although they have little choice but to accept reduced returns. It is worth noting that, when viewed in the context of the broader debt capital markets, the insurance sector remains quite small. Factors that are likely to lead to a more suppressed appetite for insurance sector debt include rising interest rates in other industries and asset classes that result in more attractive investments being found elsewhere. A reversion to recessionary trends in peripheral Europe, or a severe downturn in insurance sector performance, would also alter investor demand. A.M. Best s Approach to Debt Ratings If an insurance organisation issues public debt, A.M. Best may assign a rating specific to its view of the credit quality of the debt issue. A.M. Best s debt ratings are established by reference to the issuer credit rating (ICR) of the issuing entity, whether it is an operating holding company or an Insurance Holding Company (IHC). Ratings of debt issued by an IHC are notched from the IHC s ICR. A.M. Best views subordination of the security in the capital structure of the IHC as the primary factor for notching. The rationale is that in the event the IHC becomes bankrupt, senior obligations must be repaid before subordinated creditors receive any payment. Typical financial leverage and coverage ratio guidelines at the different rating levels can be seen in Exhibit 6. Assigning Equity Credit for Hybrid Securities In ranking securities along an equity-debt continuum, A.M. Best places senior debt with a short time to maturity and a cash put option at one end and common stock at the other end. All other securities fall in between, based on loss-absorption characteristics and their cash-flow flexibility. Given that equity credit is linked to loss absorption (structural subordination) and relative permanency in the capital structure (term to maturity or call date), equity credit can be assigned to a security relative to its time to maturity and notching (see Exhibit 7). For more information, please refer to Insurance Holding Company and Debt Ratings (published May 6, 2014) and A.M. Best s Debt Ratings: Methodology Summary & FAQ (published May 9, 2014). Exhibit 6 Typical Holding Company Financial Leverage & Interest Coverage Guidelines Interest Coverage** ICR Category Debt/Capital* aaa <15% >10x aa <25 >7x a <35 >5x bbb <45 >3x bb <65 >2x b >65% <2x * Long-term + Short-term Debt (adjusted for hybrid securities)/ [(Total Shareholder s Equity +Minority Interest and Other + Preferred Stock (Non Equity) + Long- term Debt + Short-Term Debt) net of AOCI] ** Pretax Operating Income + Interest Expense/Interest Expense + Preferred Dividends A.M. Best s economic view of capital in any given organization can differ significantly from reported capitalization. A.M. Best Methodology Insurance Holding Company and Debt Ratings Exhibit 7 Equity Credit Guidelines: Notching Versus Maturity Notches Remaining Years to Maturity % 0% 10%-20% Perpetual A.M. Best Methodology Equity Credit for Hybrid Securities 5

6 Assigning Debt Ratings The vast majority (92%) of A.M. Best s debt ratings for European insurers are investment grade ICRs of bbb- or above (see Exhibit 1). As a general rule, A.M. Best limits notching to two levels from the IHC or three levels from the issuer if it is an insurance operating company, although the final decision rests with the rating committee. Generally, an IHC is notched two to three levels below its lead operating subsidiary. This reflects the legal entity separation, distance from operating earnings and structural subordination between policyholders and creditors. Therefore, senior debt issued by a pure holding company at the a- level would indicate an operating subsidiary ICR of aa-. Most European operating insurers followed by A.M. Best are rated in the aa- to a+ ICR range. However, these levels of notching should be viewed as a guideline that would apply to most situations. It is possible for the rating committee to decide that narrower or wider notching is warranted. For example, in Europe, many insurance groups are composite insurers writing life and non-life, primary and reinsurance risks with strong and diverse earnings streams. In these cases, A.M. Best may tighten the notching between operating company and holding company ICRs. Furthermore, in Europe, many insurance groups operate with an operating holding company structure and here the debt is issued directly by the entity generating earnings. This proximity to the group s cash flows is added security to investors and thus a tighter notching is applied. As such, senior debt issued by an operating holding company is generally notched only one level from the operating ICR. The securities issued at the lower end of the credit scale are deeply subordinated to policy holder obligations and senior creditors, such as junior subordinated notes and preferred stock. These securities are normally notched two levels from the senior debt rating. Exhibits 8 and 9 illustrate the rating distribution of the various classes of debt securities issued by EU insurers. As shown in these charts, the most popular class of security in Europe is subordinated debt. Both investors and issuers are most comfortable with this level of subordination, as well as the cost of capital and return characteristics. More recent issues have been designed to qualify for capital credit under Solvency II. In terms of absolute amounts, there has been very little debt issued below investment grade even debt issued at the bottom of the investment grade range (i.e. bbb- ) has been scarce. Exhibit 8 Class of Debt A.M. Best-rated Debt (as at year-end 2014) Senior Unsecured Subordinated Junior Subordinated Preferred Stock aa- a+ a a- bbb+ bbb bbb- bb+ A.M. Best Debt Rating 6

7 Exhibit 9 Class of Debt and Amount () A.M. Best-rated Debt (as at year-end 2014) 8.5 bn 5.6 bn 8.6 bn 4.4 bn 3.5 bn 6.9 bn 1.3 bn 6.2 bn Senior Unsecured Subordinated Junior Subordinated Preferred Stock 3.2 bn Subordinated 0.5 bn 1.3 bn 0.3 bn 1.1 bn aa- a+ a a- bbb+ bbb bbb- bb+ A.M. Best Debt Rating Conclusion The insurance debt market is likely to remain active as capital management efforts lead to continued opportunistic redemption and refinancing activity. In recent years, EU insurers have improved their ability to manage down both operating and financing costs a necessity in today s highly competitive, low growth environment. These efforts tie in well with group level enterprise risk management (ERM) and strategic business initiatives. Centralised reinsurance purchasing and cautious expansion into emerging markets are further evidence of prudent activities designed to cut costs and utilise excess capital. Right-sizing capital levels goes handin-hand with these activities. Factors likely to influence issuance activity in the remainder of 2015 and into 2016 include changes in interest rate policies by the U.S. Federal Reserve, the Bank of England and the ECB. In March 2015, the ECB began a quantitative easing programme which is expected to last until September 2016 with total purchases reaching 1.1 trillion. The ECB is attempting to increase aggregate demand, stimulate the economy and spur moderate inflation towards 2%. Quantitative easing-related purchases by the ECB, together with reduced corporate and sovereign debt issuances, have engineered an acute shortage of highly-rated assets in Europe. These conditions will fuel continued demand for insurer debt and keep issuance costs low, but also remove much hope of a badly-needed rise in investment income. 7

8 Published by A.M. Best Company Special Report Chairman & President Arthur Snyder III Executive Vice President Larry G. Mayewski Executive Vice President Paul C. Tinnirello Senior Vice Presidents Douglas A. Collett, Karen B. Heine, Matthew C. Mosher, Rita L. Tedesco A.M. Best Company World Headquarters Ambest Road, Oldwick, NJ Phone: +1 (908) WASHINGTON OFFICE 830 National Press Building th Street N.W., Washington, DC Phone: +1 (202) A.M. Best América latina, S.A. de C.V. Paseo de la Reforma 412 Piso 23 Mexico City, Mexico Phone: A.M. Best Europe Rating Services Ltd. A.M. Best Europe Information Services Ltd. 12 Arthur Street, 6th Floor, London, UK EC4R 9AB Phone: +44 (0) A.M. Best asia-pacific LTD. Unit 4004 Central Plaza, 18 Harbour Road, Wanchai, Hong Kong Phone: A.M. Best Asia-Pacific (Singapore) Pte. Ltd. 6 Battery Road, #40-02B, Singapore Phone: Dubai Office* (MENA, SOUTH & CENTRAL ASIA) Office 102, Tower 2 Currency House, DIFC PO Box , Dubai, UAE Phone: *Regulated by the DFSA as a Representative Office A Best s Financial Strength Rating is an independent opinion of an insurer s financial strength and ability to meet its ongoing insurance policy and contract obligations. It is based on a comprehensive quantitative and qualitative evaluation of a company s balance sheet strength, operating performance and business profile. The Financial Strength Rating opinion addresses the relative ability of an insurer to meet its ongoing insurance policy and contract obligations. These ratings are not a warranty of an insurer s current or future ability to meet contractual obligations. The rating is not assigned to specific insurance policies or contracts and does not address any other risk, including, but not limited to, an insurer s claims-payment policies or procedures; the ability of the insurer to dispute or deny claims payment on grounds of misrepresentation or fraud; or any specific liability contractually borne by the policy or contract holder. A Financial Strength Rating is not a recommendation to purchase, hold or terminate any insurance policy, contract or any other financial obligation issued by an insurer, nor does it address the suitability of any particular policy or contract for a specific purpose or purchaser. A Best s Debt/Issuer Credit Rating is an opinion regarding the relative future credit risk of an entity, a credit commitment or a debt or debt-like security. It is based on a comprehensive quantitative and qualitative evaluation of a company s balance sheet strength, operating performance and business profile and, where appropriate, the specific nature and details of a rated debt security. Credit risk is the risk that an entity may not meet its contractual, financial obligations as they come due. These credit ratings do not address any other risk, including but not limited to liquidity risk, market value risk or price volatility of rated securities. The rating is not a recommendation to buy, sell or hold any securities, insurance policies, contracts or any other financial obligations, nor does it address the suitability of any particular financial obligation for a specific purpose or purchaser. Any and all ratings, opinions and information contained herein are provided as is, without any expressed or implied warranty. A rating may be changed, suspended or withdrawn at any time for any reason at the sole discretion of A.M. Best. In arriving at a rating decision, A.M. Best relies on third-party audited financial data and/or other information provided to it. While this information is believed to be reliable, A.M. Best does not independently verify the accuracy or reliability of the information. A.M. Best does not offer consulting or advisory services. A.M. Best is not an Investment Adviser and does not offer investment advice of any kind, nor does the company or its Rating Analysts offer any form of structuring or financial advice. A.M. Best does not sell securities. A.M. Best is compensated for its interactive rating services. These rating fees can vary from US$ 5,000 to US$ 500,000. In addition, A.M. Best may receive compensation from rated entities for non-rating related services or products offered. Data sourced from the BestLink system is retrieved around the time of the report creation and is subject to revision. A.M. Best s Special Reports and any associated spreadsheet data are available, free of charge, to all Best s Insurance News & Analysis subscribers. Nonsubscribers can purchase the full report and spreadsheet data. Special Reports are available through our Web site at or by calling Customer Service at (908) , ext Briefings and some Special Reports are offered to the general public at no cost. For press inquiries or to contact the authors, please contact James Peavy at (908) , ext