ERM WHAT ARE YOUR OPTIONS WHEN YOU NEED CAPITAL

Transcription

1 ERM WHAT ARE YOUR OPTIONS WHEN YOU NEED CAPITAL Graham Bancroft, FSA, FCIA 1 February 2010

2 Agenda 1. Financial Crisis 2. Capital Considerations 3. Options to improve capital position 4. Capital market instruments 5. Reinsurance

3 FINANCIAL CRISIS

4 Financial Crisis the Perfect Storm 1. Stock market crashed Asset value dropped Liability increased (VA) EV decreased 2. Corporate bond spread increased Asset value dropped 3. Volatility increased VA can no longer be hedged at reasonable cost Reserve for VA increased 4. Liquidity disappeared on most assets Cash became king 5. Yield on risk free assets drops Statutory reserve increases 4

5 Capital Markets - Year 2008 in a historical context Historical stock market development (annual development of the US stock market since 1801) Stock market indices in economic crises (normalized on 100, development in weeks since peak) was the third worst year since 1801 No timely rebound in three out of four cases Source: Bloomberg, MEAG Research, Datastream, University of Fribourg 5

6 Insurance Sector Capitalization Declined Comparison of Accounting view and Economic view Decline of equity typical for recent disclosures > 20% Main reasons for higher drop in economic view Increased hedging costs in an economic view (enormous rise of market volatility) esp. for life insurance business Different consideration of goodwill and other intangibles Market-consistent valuation of liabilities in an economic balance sheet in a low interest environment Accounting View Economic View Main reasons for worsened capital situation of insurers: Realized and unrealized investment losses 6

7 Results of Crisis in Asia - General Regulatory actions - positive HK relax valuation interest rate to 3 year average from 1 year Taiwan only 20% unrealized losses need to be taken into RBC calc Regulatory actions - negative Much more focused on group exposures Restrict movement of capital from local operations Look closely at related party reinsurance transactions Local subs, branches Parents were focused on keeping capital fungible Some local operations were on their own Statutory capital position 7

8 Results of Crisis in Asia - Statutory Capital Position Some markets improved Singapore changed dividend scale (Assets & Liabilities actually dropped 13%) Korea capital injections Some (most) worsened Japan without capital injections capital declined 15%, u/r losses 5T Taiwan high asset leverage increases volatility China top 3 company s statutory surplus dropped 22% Total Market YE 2007 YE 2008 Statutory Statutory Capital/ Equity Capital/ Equity Change 2008 / 2007 Japan (yen B) 5,876 5, % Korea (Won B) 6,567 7, % Singapore ( S$ B) $ 3.00 $ % Taiwan (NT B) NT$ NT$ % 8

9 CAPITAL CONSIDERATIONS

10 Capital considerations Future needs KPMG 2009 survey: 392 insurers in 47 countries : Insurance industry largely weathered financial crisis At board level focus on capital management has increased substantially 85% feel that they are well capitalized verses their risks, but over half said that they will need to increase capital over next 12 months Regulation viewed as the biggest driver of capital requirements Current standards Upcoming Solvency II Other external factors share price, market expectations, debt holder requirements less important Capital foremost issue considering growth constraints Cost/ availability of capital, also of concern 10

11 Capital considerations - ERM Enterprise Risk Management is where a company Identifies Assesses, Controls, Monitors and Communicates Risk from all sources for the purpose of increasing the company s value to shareholders ERM helps you to quantify the risk/return of your business allowing you to make better decisions 11

12 Capital considerations - Measurement Risk philosophy: Understand your company s Comfort with different types of risks Level of risk willing to assume Risk measurement : Economic capital (EC) company assessment of assets required to cover obligations with a high degree of confidence (i.e %) over a stated horizon Other Capital measurements Regulatory Local Parent/Consolidated Shareholder reporting i.e. US GAAP Rating agency 12

13 Capital considerations How much What level of capital to hold? EC drives your decision making based on principle based accounting Regulatory requirements and local business practices normally drive the capital you need to hold locally (note - sometimes economic capital greater) Other considerations: Future acquisition activity Future new business growth 13

14 Capital considerations - Type You know your level of capital What type of capital will provide the best risk/reward combination for your current state As the crisis showed, capital requirements move, sometimes drastically Do you position yourself with excess capital Do you structure flexibility in your position Types of Capital- quality: Tier 1 : Retained earnings, Equity, Reinsurance, Securitization, some types of Hybrid Capital Tier 2 : Subordinated Debt, some types of Hybrid Capital 14

15 OPTIONS TO IMPROVE CAPITAL POSTION

16 Options to improve capital position Reduction of capital requirements / Increase available capital: Assets: Reduce Required Capital: De-risk Re-allocations within investment portfolios Sale of participations Reduction of equity ratio Liabilities: Reduce Required Capital: De-risk Reduce Liabilities Increase Capital Reduce business volume Reduction of, or exit capital intensive lines of business Restructure products & their management Reduce product &/or mismatch risk, hedge Risk transfer mechanisms Reinsurance Capital structure Increase equity, hybrids, subordinated debt Increase income Reinsurance Sale of blocks/companies Reduce sales of high strain business 16

17 Options to improve capital position Example 1: Capital market tools Companies have been using all the tools at their disposal to improve their finances Example of actions taken by a large North American company to improve position: Date Common Shares Preferred Shares Tier 1 note Debt Nov $2.5 B Aug Cut div by 50% July $1 7.4% June $350M June $1 4.9 due 2014 April due 2019 March $450M Dec $2.275B Also some corporate structure changes to optimize capital Overall Corporate philosophy of this company on Capital... 17

18 Options to improve capital position Example 1: Capital market tools Fortress Capital: Provide financial flexibility to weather many (but not all) potential adverse scenarios without being forced to raise common equity under stressed conditions Provide more flexibility to respond to both risks and opportunities from a continued position of strength Companies with strong financial strength ratings and capital ratios will benefit from flight to quality * *Exert from large North American company web site 18

19 Options to improve capital position Example 2: Sale of block AEGON has completed the sale of its Taiwanese life insurance business. The decision to sell the Taiwanese life business is a result of AEGON s strategic priorities to optimize capital allocation and returns. The sale resulted in a total negative earnings impact of EUR 385 million in the second quarter of AEGON expects the sale of its life insurance activities in Taiwan to positively impact future earnings. The sale has no impact on AEGON s excess capital. At the same time, the scheduled capital contributions to AEGON Taiwan will no longer be required. As a result, the transaction will have an immediate positive effect on the Group s cash flows. In addition, the sale results in a significant decrease of the longterm interest rate exposure for AEGON, which, in turn, substantially lowers required economic capital. Aegon s web site 19

20 Options to improve capital position Example 3: Reinsurance An Asian Insurance company had some financial difficulties..the insurer last year wrote off HK$25.87 billion on its investment in an ailing European Financial Group. It led to net profit plunging by nearly 99 percent despite its core business showing growth. The insurer last year partly offset its investment loss through a reinsurance deal and reported a HK$2.3 billion one-off gain The Standard HK names removed & text slightly changed 20

21 CAPITAL MARKET INSTRUMENTS

22 Equity Financials Balance Sheet Assets Equity (+) Cash (+) Liabilities Total (+) Total (+) P&L Statement Earnings before interest and taxes (EBIT) Benefits: increases liquidity (cash position increases by the proceed for the sale of new shares), increases the equity (paid-in capital, increases total size of the balance sheet If dividend remain the same, reduces retained earnings./. Net Income (NI) Dividend (+) Increase in retained earnings ( ) Equity markets may not react well to dilution effects 22

23 Subordinated Debt Subordinated debt ranks below senior debt but above equity Moody s classification of equity equivalence: Basket A Basket B Basket C Basket D Basket E All dated subordinated debt (with maturity less than 49 years) Perpetual Typically non-call 10 years Subordinated debt Optionally deferrable (cumulative) coupon Soft Capital Replacement Language Perpetual Typically non-call 10 years Deeply subordinated Optionally deferrable (noncumulative) coupon or ACSM Soft Capital Replacement Language Perpetual Typically non-call 10 years Deeply subordinated Optionally deferrable coupon (can be cumulative) Mandatory Deferral or Hard Capital Replacement Language Blue print C Basket instrument plus Mandatory Deferral plus Hard Capital Replacement Language A 100% Debt B 25% Equity credit C 50% Equity credit D 75% Equity credit E 100% Equity credit Source: Moody s

24 Hybrid Capital A vehicle that combines features of both debt and equity. Some examples are: A convertible bond usually gives the holder the right but not the obligation to convert the bond into shares of common stock at an agreed-upon price at maturity or at certain defined points in time A mandatory convertible has to be converted into equity at maturity at the latest. Since is mandatory to convert the debt to equity a mandatory convertible can be regarded as a forward equity issue and therefore carry cost of capital similar to the equity cost of capital Preferred shares have preference to dividends (usually at a preset rate) over common shares. They normally are convertible into common stock, callable at the option of the corporation and are nonvoting

25 Hybrid Capital Examples of Hybrid Capital with Tier 1,2 triggers 2000 Royal Bank of Canada Contingent capital - If the policy is triggered (it is linked to an undisclosed drop in Royal Bank s general reserves), XXX Re will provide C$200 million cash in exchange for C$200 M in Royal Bank preferred shares. The preferred shares are priced at their market rate on October 27, The premium is charged against annual earnings, providing a nondilutive equity cushion in the event of losses. Pricing not disclosed 2009 Lloyds Banking Group Issued 9 B in enhanced capital notes to existing Tier 1 and Upper Tier 2 holders Allows Lloyds to avoid the need for further support from the U.K. govt Ten year term and pays fixed, non-deferrable interest. They are convertible into a fixed number of Lloyds ordinary shares if Lloyds core Tier 1 ratio falls below 5% EU rules prohibit banks that have received state aid from calling or paying coupons on core Tier 1 securities Source : Financial times Nov 2009

26 Hybrid Capital Examples of Hybrid Capital with Tier 1,2 triggers S&P Treatment of Lloyds transaction: Lower Tier 2 hybrid capital instrument (that is, a dated nondeferrable bond) S&P comments on contingent capital: Attractions it adds a different strand to bank capital management strategy. Clarity: The situations in which contingent capital securities convert into equity would also be transparent for investors from the start Concern whether contingent capital securities will convert into capital early enough to help the bank Contingent capital securities are sufficiently attractive to investors at a price that is also attractive to the issuing banks While we expect to see material interest in (and debate around) this concept, we note that contingent capital securities are not designed to repair current weak capital positions and are not meant to act as a main plank of capital strategy Source :S&P 2009

27 Securitization Description Insurance risks transferred to the capital markets by transforming insurance cash flows into tradable financial securities Types: Contingent (cat bonds), and Embedded value (life bonds) provides regulatory capital Cost efficient for large transactions Issues: No Embedded value securitizations done in Asia (primarily US & Europe) Due to CMO issues, public market for product has largely dried up Structure issues - Mono line credit wraps in difficulty Not very flexible. Designed for large, long term transactions However still activity for private deals AEGON recently did a securitization with JP Morgan for 650M US$

28 Securitization Issuances in life insurance since 2001 Only one public life cat bond in 2008: Nathan Ltd: Extreme mortality cover for Munich Re issued by Munich Re All other transactions private deals

29 REINSURANCE

30 Reinsurance Generate capital Increases Tier 1 Capital Decreases Required Capital (which other vehicles tend to increase) Availability Reinsurance solutions do not depend that heavily on current capital market circumstances. As shown by the Crisis - capital markets might be closed for certain transactions or the transaction is prohibitively expensive Flexibility / Tailor made solutions Reinsurance solutions can be customized to the client s needs whereas capital market instruments oftentimes require a certain minimum of standardization 30

31 Reinsurance Speed Simpler & faster than Securitization As risks can be limited, less due diligence required than with securitization Better Alignment to your business Payback of relief variable - based on profits, so matches income stream Removes risk from balance sheet Duration can be variable compared to a block sale which is permanent Lower transaction costs Issuing capital market instrument usually require large internal resources as well as fees for external advice: Financial and legal advisory & placement and Rating Agencies fees 31

32 Reinsurance No public disclosure Compared to the issuance of capital market products reinsurance solutions do not require a public disclosure Favourable financial terms Reinsurance might be cheaper compared to capital market solutions Other benefits Can be contingent (capital on call) Improve returns by up fronting profits Improve stability, timing of earnings Reduces strain of acquisition costs Allows you to redeploy capital into higher yielding lines 32

33 SUMMARY

34 Summary Comparison of options complementary tools Equity Hybrid Subordinated Debt Securitization Reinsurance Size Med - Very Large Medium Medium Large Small - Large Capital treatment Tier 1 Tier 1-2 Tier 2 Tier 1 Tier 1 Required capital Increase Increase Increase Reduce Reduce Cash provided Yes Yes Yes Yes (or contingent) Optional Duration Perm Med - Long Med - Long Long Short - Long Cost High Med - High Medium Low (for big deals) Low - Med Collateral Last call on value of company preferred call on value of company preferred call on value of company Block of business Block of business Time to place Med Med Med Med - Long Short Commit to future capital Yes - debt that at fixed terms No converts to equity No Cat Bonds Trigger Yes (but for limited time horizons) Fixed durations, Tier 1 level trigger experimental Insured event Can be at insurers option Counterparty risk No No No No Depends on structure 34

35 Summary Appropriate ERM identifies your risks and helps set your capital levels, and processes to maintain appropriate levels of capital, even in adverse market conditions As can be seen from the examples, there are many tools to use it depends on circumstances and needs Reinsurance is a powerful tool that unlocks value by increasing Tier 1 and reducing required capital 35

36 2009 Münchener Rückversicherungs-Gesellschaft 2009 Munich Reinsurance Company THANK YOU VERY MUCH FOR YOUR ATTENTION.