The Intelligent Quarterly from the publishers of The Insurance Insider

Spring 2012

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Click to enlarge 2011 has so far been a year of significant events for the insurance industry. The brutal toll of catastrophe events in the first half, even before the start of the hurricane season, has made it the costliest year on record for cat-related economic losses.

This has been exacerbated by the turmoil in the global financial markets, driven by concerns about the health of the global economy. Limited growth in most advanced economies has increased fears about weak demand in the long term and there are also concerns over sovereign credit risks.

And all this while the insurance sector is enduring the ongoing costs and potential capital demands of Solvency II.

However, even following the events of 2011, the insurance industry remains in good health and rate hardening seems to be gaining momentum. Lloyd's and the London market has proven to be highly resilient to these stresses given strong underwriting skills, robust financial risk management, strong capital positions and an effective regulatory regime.

To demonstrate this, at the time of writing, these events are still considered by many of the key players to be earnings rather than capital events for 2011.

RBS has been actively covering the insurance sector for more than 20 years, focusing strongly on Lloyd's and the London market. It is this longevity in the sector that leads us to believe that, should further losses lead to capital erosion, this capital can be restored to take advantage of current and future rate hardening.

In addition we would envisage debt playing a role in any expansion of underwriting plans moving into 2012. We have been keen to support our key clients that operate across all insurance sub-sectors, as they have demonstrated very strong risk metrics, and we look forward to this continuing.

While the bank debt market has remained strong, the bond markets have become very volatile. When will the capital markets be more conducive to new insurance issues? According to the RBS Debt Capital Markets team, insurers were active users of the public bond markets during the first half of 2011 with so-called Solvency II-proofed Tier II transactions in Euro and sterling, and it also saw the emergence of the Swiss franc, Swiss Solvency Test compliant hybrid market.

This supply was driven largely by refinancings ahead of the first call dates associated with outstanding hybrid capital issues. It was also due to a supportive investor backdrop, given the lack of competing hybrid capital supply from banks.

During the second half, however, the combined effect of fears centred on stalling global economic growth, the ongoing peripheral sovereign debt crisis and the US debt ceiling debacle has eroded confidence considerably, and new issuance conditions are less attractive for insurers.

In the secondary market bid offer spreads have pushed wider, while credit spreads have increased significantly from where deals were priced and market trading in insurance paper has been thin and illiquid.

Investors have perhaps behaved indiscriminately towards insurance assets, given the very low absolute exposure of many insurers to the sovereign debt. The hybrid Tier II structure of choice has been the 30NC10, issued by names such as Aviva, which were seeking to gain Standard & Poor's (S&P) intermediate equity credit. However, names such as Old Mutual, which are not rated by S&P, issued bullet structures instead in order to meet the less onerous regulatory capital credit criteria.

These issuers also benefited from reduced pricing driven by the omission of optional coupon deferral language and the hard maturity date. The bullet structure is more investor friendly, which can be seen by the more pronounced widening in credit spreads/yields of the 30NC10s over the bullets in today's poor market conditions.

In terms of outlook, the new regulatory regime should open up numerous avenues in the capital management space, such as group organisational restructurings, new hybrid issuance and opportunistic liability management, as well as increased focus on contingent or ancillary capital.

There will also be renewed focus on securitisation, given the increased regulatory benefit such structures may bring, as well as on transactions designed to improve the recognition of trapped capital at subsidiary level to improve capital fungibility and bolster available group capital.

Contingent capital can address capital management and economic risk transfer requirements in the context of enterprise risk management, rating agency and regulatory capital constraints and the broader need for financial flexibility.

In the future, insurers as well as banks might well evaluate structures that provide hybrid credit under Solvency II own funds criteria (and rating agency eligible hybrid credit) for the "host instrument" while converting to Tier 1 Basic Own funds in a stressed scenario. These are not dissimilar to the contingent convertibles (or CoCos) that have been seen in the bank space.

So, after the challenging first half of the year, what are the prospects for the industry in future? According to the RBS Equity Research team, 2011 has already proved to be extremely challenging for the insurance sector, given the exceptional loss activity to date, combined with a notable reduction in the achievable investment yields, as well as other pressures.

However, we remain of the view that those companies with a strong underwriting ethos, a disciplined approach and a focus on the bottom line will deliver superior returns to their peers and that this will be recognised in valuations.

The sector remains well capitalised. However, should events trigger a desire in the industry to access additional capital to take advantage of the upturn, we are confident that it will be available for those underwriters that have shown themselves to be top quartile performers. We are also confident that capital providers will be willing to offer a variety of products/options to companies with the appropriate track record.

In summary, to be part of the insurance sector means accepting that, occasionally, catastrophic events occur and our clients may have material exposures to such events. The key is to understand the dynamics of the market and for banks to support clients through all-encompassing product capabilities.