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.
Total costs to participate in a pooled capital offering include a placement agent fee of approximately 3% of gross proceeds (the amount the insurance company sells to the special purpose vehicle), plus legal fees of $15,000 to $30,000 and various other trust and administrative fees of about $10,000 per year.
What to Look for In a Pooled Capital Offering. What should an issuer look for in a pooled offering? Obviously there are some challenges to participating in a pooled capital offering. One of the conceptual flaws with this style of offering is that companies that have a higher financial or claims paying rating (such as an “A” rating from A.M. Best), and have a diversification of revenues streams via multiple product lines and geographies pay the same rate for the capital as companies with a lower rating.
If you are thinking about participating in a pooled capital offering, you want to find out the types of companies that will be issuing with you (property-casualty vs. life/health, mutual vs. stock, lines of business and geographies) and the composition of the collateral (trust preferred securities vs. surplus notes). You may also be participating in a pool with a competitor unless you ask the right questions.
One of the issues that is still somewhat unclear relates to how the rating agencies analyze default rates for the special purpose vehicle. If a company had completed a bond offering and subsequently missed a payment on the bond, then the company may be in default on its obligations to the purchasers of the bonds. With a pooled capital offering for the insurance industry, there are multiple definitions of default for insurance companies. And there is no more important concept in entering into a pooled capital offering than understanding the assumptions for default rates for the special purpose vehicle.
Based upon our analyses, and the broadest definition of default, the various sectors of the insurance industry have had an average annual default rate of approximately 0.65% of all insurers during the time period 1973 to 2002.
Default rates impact how the underwriter will need to structure the collateral and prepayment waterfall associated with the offering. In conjunction with input from potential investors the structure is then priced and tranched to suit investor needs.
In a typical pooled capital offering, there is a series/tranches of AAA rated senior notes (the best credit), BBB (or marginally higher) rated subordinate notes and unrated income notes, also known as the “equity tranche” (the residual risk for investors). The cash flows are applied to each tranche so that the most risk for an investor is in investing in the “equity tranche,” where rates of return can be north of 20% if there are no defaulting assets.
The more tranches that you see in the structure, the greater the degree of investor and rating agency influence over the structure and the greater degree of conservatism surrounding the analyses done by all parties. The result is that you, the issuer, may be paying more than you should.
Going Forward. Based upon our analyses of premium growth, reinsurance premium increases, underwriting capacity, capital base and financial strength and claims paying ability of the various sectors of the insurance industry, and coupled with the interest rate environment and general economic conditions, we believe the total pooled capital offering levels for this underwriting and economic cycle are somewhere in the neighborhood of $2 billion to $3 billion.
Many companies believe that they can raise capital whenever they want; contrary to popular belief, windows of opportunity open and close in the capital markets and the pooled capital offering vehicle is no exception.
When contemplating joining a pooled capital offering, an insurance company needs to understand its strengths in making the pool more attractive for investors. It is best to negotiate and look for opportunities to commoditize the product for the underwriters. The result is cost-effective capital for the insurance company.
F. Laughton Sherman, Principal of WFG Capital Advisors. He can be reached via e-mail at Lsherman@wfgca.com.
Reproduced from National Underwriter Life & Health/Financial Services Edition, October 10, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.