Has the time finally arrived for small insurers to raise capital in a cost-effective manner? Since Benjamin Franklin began insuring Philadelphia homes against the threat of fire, small to mid-size insurers have not had the luxuries of the larger insurers when it comes time to raise capital.
Large companies have unencumbered access to the capital markets as needed, and frequently utilize their size and quality advantage when it comes time to raise capital. Frequently large insurers raise $100 million or more in a capital offering. But smaller insurers that are not public and are not well known to the investing community may need $5 million or $10 million–not $100 million like their larger brethren–in part to show agents, brokers, rating agencies and regulators that they, too, have access to capital.
It takes about the same amount of time and cost, except for underwriting fees, whether the company is looking to raise $10 million or $100 million. Now for small insurers there is an alternative to the costly process of raising capital on a stand-alone basis. Small insurers have been united to raise capital in a pooled capital offering.
The Pool Concept. If you have ever purchased a mortgage-backed security, then you have a good idea how a pooled capital offering works, except that a securities underwriter does not securitize mortgages, it securitizes trust preferred securities or surplus notes by insurance companies.
The special purpose vehicle is created to purchase securities (trust preferred securities, surplus notes, senior notes or capital notes) from an insurance company. Once the special purpose vehicle purchases enough of the trust preferred securities, surplus notes, senior notes or capital notes from insurance companies (which is referred to as collateral by the securities underwriter), the special purpose vehicle reconstitutes the collateral into a series of new securities, which are then sold to investors.
Pooled capital offerings have been wildly successful for the banking industry, with approximately 17 pools being completed since 1998. A total of over $12 billion in trust preferred securities has been raised for thousands of smaller commercial banks and savings banks. From a banks perspective the process was easy, cheaper than going it alone and the amount of regulatory capital credit that the bank received was known.
In the insurance industry, there have been three pools completed to date, having gathered approximately $1.1 billion in trust preferred securities, surplus notes, senior notes and capital notes. A number of additional pools are currently in the market.
The Advantages of Pooled Capital Offerings. Once the insurance company has determined that it has a need for capital, whether it is to strengthen a rating, support premium growth, reduce reliance on reinsurance, acquire another company or set money aside to purchase shares from shareholders, how does it go about determining the pool that is best for it?
Lets start with the advantages and disadvantages of participating in a pooled capital offering. The most distinct advantage is that a pooled capital offering allows small to mid-sized insurers to access capital markets. However, even if the smaller insurer could access the capital markets on a stand-alone basis, the pooled capital offering does provide a substantial cost advantage to going it alone.
Table 2 shows the spread of Moodys Aaa-rated corporate bonds vs. 3-month LIBOR and the spread of Moodys Baa-rated corporate bonds vs. 3-month LIBOR over the last 17 years. The pooled offerings completed for the insurance industry have been priced at approximately 425 basis points (bp) above 3-month LIBOR. The current spread for Moodys Aaa vs. 3-month LIBOR is 485bp and the spread for Moodys Baa vs. 3-month LIBOR is 565bp.
One word of caution when comparing these spreads–you will note that the Moodys Aaa credits are long-term, fixed rate issues while the pooled capital offering is generally a floating rate instrument, though insurers may obtain a fixed rate or enter into interest rate swaps to obtain a fixed rate. Should a small insurance company wish to enter into a fixed rate, it should expect to pay close to 8% to 9%.
In addition to the interest rate being cost efficient vs. 3-month LIBOR, due diligence for a pooled capital offering is like a trip to the ice cream parlor vs. the maze often associated with a stand-alone offering. Due diligence in a pooled capital offering is minimal and data is gathered from an insurance company via a questionnaire. Ongoing data requests are minimal so ongoing time spent on the process is minimal. And documents are standardized across issuers in order to keep legal costs down.