Keywords: insurance industry, transactions, 2012, insurance M&A
In this 2012 Year in Review report we discuss some of the more noteworthy developments and trends in insurance industry transactions in the past year in the United States, Europe, Asia and Latin America, with particular focus on mergers and acquisitions, corporate finance, and the insurance-linked securities and convergence markets. We also examine certain regulatory developments that are impacting transactions in the industry.
Developments in Mergers and Acquisitions
Against a backdrop of sluggish economic growth globally, economic distress in Europe, a shifting regulatory environment and continuing low interest rates, insurance industry merger and acquisition activity remained fairly active in 2012, although down from 2011. According to Dealogic, 2012 saw global insurance mergers and acquisitions activity fall from 724 deals worth $68 billion in 2011 to 698 deals worth $54 billion in 2012. The aggregate value of transactions in 2012 was the lowest it has been in the past eight years; however, the second half of 2012 experienced a surge in deal activity that was more than double that in the first half of the year. It remains to be seen whether this momentum carries into 2013.
Life Sector
North America
OVERVIEW
With several significant deals announced in the fourth quarter, 2012 proved to be an active year for life insurance M&A in the United States. According to SNL, aggregate announced U.S. deal value (involving U.S. targets) for the year was $4.2 billion, up from $775 million in 2011, but significantly less than the $21.6 billion reported in 2010, which was a year dominated by AIG's divestitures in the wake of the financial crisis. Although sales initiated to repay government aid continued to have an impact on the U.S. life insurance M&A market, drivers of activity in 2012 reflected basic strategic imperatives, with life insurers' exiting from non-core lines of business, several non-U.S. life insurers' exiting from the U.S. market, and the reallocation of assets to higher growth emerging markets. Financial buyers emerged in response as a source of buy-side activity.
REPAYMENT OF GOVERNMENT AID AND A FOCUS ON CORE BUSINESS LINES
In December 2012 the U.S. Treasury sold off its remaining stake in AIG in an underwritten public offering, the last step in transforming the insurer back into a fully private enterprise. (At one point, the government owned 92% of the company.) Another recipient of government aid in the financial crisis, Hartford Financial, managed to repay the government by 2010, but has suffered the adverse effects of the financial crisis on its annuities business, which had caused its share price to hover at depressed levels, in turn instigating shareholder activism and calls for action to improve share values. In response, the company initiated steps to redirect its focus to its core operations, primarily its property and casualty business, and embarked on an ambitious round of divestitures in 2012. By the end of the year, it had announced the sale of its individual annuity business to Forethought Financial Group at an undisclosed price, the sale of Woodbury Financial Services, its broker-dealer, to AIG for $115 million, the divestiture of its retirement plans business to MassMutual for $400 million and the sale of its individual life business to Prudential Financial for $615 million. Hartford continues to own significant blocks of its legacy annuity business.
NON-U.S. INSURERS EXITING THE U.S. AND THE EMERGENCE OF FINANCIAL BUYERS
In 2012, we witnessed the continued retreat by non-U.S. insurers from the U.S. annuity and life insurance markets. In particular, several Canadian and European insurers have followed this path, partly due to the need to shore up capital under heightened regulatory capital requirements and the uncertainty around the impact of Solvency II and partly due to the adverse impact of local or IFRS accounting rules applicable to certain types of U.S. annuity business. In addition, the lackluster U.S. economy and prevailing low interest rates have dampened prospects for growth. In 2011, Manulife Financial, the Canadian financial services group, sold its life retrocession business to Pacific Life Insurance Company, and in 2012, through its subsidiary John Hancock, ceded a multi-billion dollar block of U.S. fixed deferred annuities to Reinsurance Group of America in a 90% coinsurance transaction. In the latter part of 2012, following an extensive auction process, Sun Life announced the sale of its U.S. annuity businesses to a Delaware life insurer controlled by Guggenheim Partners for $1.35 billion in cash. The deal was structured as a sale of stock of Sun Life's Delaware and New York operating insurance company subsidiaries. Among European insurers and reinsurers, in 2012 Swiss Re announced the sale of its Admin Re U.S. life insurance business to Jackson National Life for approximately $660 million in cash, and Aviva agreed to sell its U.S. life and annuity businesses to Athene, a portfolio company of Apollo Global Management, for $1.55 billion in cash and $257 million of assumed debt. Aviva disclosed that the transaction is expected to improve its capital surplus coverage ratio by 17%.
As revealed by the Sun Life and Aviva divestitures, financial buyers have readily filled the shoes of exiting non-U.S. insurers. According to Beacon Research, private equity-owned insurance companies' total market share rose from 2.8% in 2011 to 9% in 2012. Their share of indexed annuity sales grew from 5% in 2011 to 15.4% in 2012. The trend is likely to continue as low valuations of insurance assets persist and private equity players become more comfortable with the insurance regulatory framework. For private equity firms there is an obvious allure to purchasing spread-based annuity businesses and increasing assets under management. Apollo, through Athene, has been a prominent example of this trend in the past few years. In addition to the Aviva acquisition, in 2012 Athene acquired Presidential Life, the New York annuity, life and health writer, for $414 million. In 2011, Athene had acquired Liberty Life Insurance Company for $628 million. For Guggenheim Partners, the Sun Life acquisition is its third significant life insurance acquisition in three years. In 2011, it acquired EquiTrust Life from FBL Financial Group and in 2010 it acquired Security Benefit Life.
EYE ON EMERGING MARKETS
Insurers faced with economic headwinds in more mature markets are increasingly looking to Latin America and select markets of Asia to find new growth opportunities. In 2012, U.S. life insurer Principal Financial lead the charge through its $1.5 billion acquisition of AFP Cuprum, a Chilean pension fund manager. As the mature U.S., European and Japanese markets present growth and expansion limitations, we would expect to see U.S., European and Japanese insurers looking to the Latin American and Asian markets where the penetration is relatively low among an expanding middle class.
Europe and Asia
The largest insurance deal of 2012 by some margin was the UK Bank HSBC's sale of its entire 15.6% stake in the Shenzen-based general insurer Ping An Insurance to companies controlled by Thailand's Charoen Pokphand Group and billionaire Dhanin Chearavanont for $9.4 billion.
Not only does this Asian deal rank as the 6th largest M&A deal globally across all sectors, it is yet another example of a significant transaction with roots in a disposal program triggered by the financial crisis. The Ping An deal is in line with HSBC's retreat from insurance to concentrate on core banking operations and bolster capital ratios. One point to note on valuation is the healthy premium and return booked by HSBC on its initial investment. There have been other recent disposals where vendors have exited at knock-down prices and certainly at a discount to book value. For regulatory and financing reasons, the sale was structured in two tranches. The first tranche representing 20% of HSBC's stake has closed. As of this writing, the second tranche remains subject to Chinese regulatory consent and is dependent on financial support of the China Development Bank.
HSBC was not the only global financial institution selling insurance assets during the year. Several other financial institutions also continued the path of ridding themselves of non-core assets in order to repay government aid. Dutch financial giant ING, which in 2011 had sold its Latin American insurance operations to Groupo de Inversiones Suramericana for EUR 2.65 billion, announced in 2012 the sale of assets including life insurance lines of business across Hong Kong, Macau and Thailand to Pacific Century Group for $2.14 billion along with a planned spin-off of its U.S.-based retirement, investment and insurance business. Similarly, The Royal Bank of Scotland, as part of the agreement to receive government assistance in 2008, floated its shares in Direct Line Group in an IPO on the London Stock Exchange in October 2012. In addition, ING announced the sale of its Malaysian life insurance business to AIA for $1.7 billion in a significant deal for AIA in its quest to retain its lead in the region over UK headquartered Prudential plc. Had the aborted attempt by Prudential to buy AIA from AIG in 2010 been completed successfully, the landscape might have been quite different. Now, with AIG's sale of its final stake in AIA at the end of 2012 raising $6.45 billion, we anticipate that AIA and Prudential will continue to compete to grow both organically and through acquisitions into 2013.
Notwithstanding the collapse of the deal to buy AIA, the Prudential has consistently focused on the growth potential of the pan-Asian life insurance market. Indeed, the UK-listed group now derives the biggest share of its profits from Asia. In November 2012, Prudential announced its purchase of the Thai life insurer, Thanachart Life Assurance, for $584.5 million. An interesting aspect of this transaction was the 15 year partnership with the Thai selling bank to jointly develop and market bancassurance products and business in Thailand. It is not uncommon to find banks selling insurance assets but wishing to retain an interest in a revenue relationship with the buying entity. It can also prove invaluable to the buyer as a ready-made distribution network.
The domestic markets of Europe's largest life insurers remain challenging for a variety of reasons, not least the continuing Eurozone financial crisis. This goes some way to explain the focus on targeting the high-growth potential economies beyond Western Europe. For instance, Dutch insurer Aegon announced the acquisition in December of Ukrainian insurer Fidem Life from Horizon Capital Fund and Generali has recently turned its attentions towards expanding its presence in the emerging markets of central and eastern Europe while marking a retreat in more developed markets.
Meanwhile, Aviva, the UK's largest composite insurer, has in the last year announced a number of disposals as part of a strategic overhaul following a period of share price under-performance leading to a change in senior management. In addition to the sale of its US life insurance and annuities operations to Athene described above, in 2012 Aviva announced the sale of its Czech, Hungarian and Romanian businesses to MetLife.
Brazil
2012 saw one of Brazil's major transactions in the health insurance sector, as the U.S.-based UnitedHealth Group acquired 90% of publicly traded Amil Participações, one of Brazil's largest health care companies. The controlling stake was acquired by the U.S. group for US$4.9 billion, making it one of the largest Brazilian M&A transactions of 2012.
In 2012 we also witnessed the continuation of a so-called "roll-up feast" involving Brazilian non-bank distribution channels, and we would expect this activity to continue in the coming year. Brasil Insurance Participacoes e Administracao S.A., a public company which made its initial offer at the end of 2010, has been an active acquirer of small brokerage companies throughout Brazil in stock/cash-for-stock deals, spreading its footprint both geographically and in terms of range of products offered. More transactions are expected to take place in the insurance brokerage sector, as the companies continue to pursue enlargement of their distribution channels through brokerage houses in lieu of the already exhausted bank branches and other traditional channels.
Property-Casualty Sector
North America and Bermuda
OVERVIEW
In the United States, acquisition activity in the property-casualty sector was significantly lower in 2012 than in 2011. According to SNL, aggregate announced U.S. deal value for 2012 was approximately $6 billion (including the $3.1 billion acquisition of Alterra Capital Holdings Ltd. by Markel Corp. announced in December 2012), down from approximately $10 billion in 2011. 2012 was characterized by small and medium-sized deals, with half of the announced deals at or below $200 million and 13 of the 16 announced deals under $500 million.
With a few notable exceptions discussed below, P&C M&A activity was driven primarily by geographic or product expansion as well as by run-off transactions involving strategic decisions by companies to exit lines of business. CNA Financial Corporation's $227 million acquisition of Bermuda-based Hardy Underwriting Bermuda Limited gave CNA access to the Lloyd's market. ACE Limited signed three M&A deals in 2012, agreeing to acquire Indonesian personal lines carrier PT Asuransi Jaya Proteksi for approximately $130 million, Mexican surety company Fianzas Monterrey for approximately $285 million and ABA Seguros, Mexico's sixth-largest property and casualty insurer, for approximately $865 million. With American Family's acquisition of the Permanent General Cos. for $239 million, American Family was able to expand into the non-standard market for the first time as well as gain expertise in direct sales. Enstar Group Limited's acquisition of SeaBright Holdings, Inc. for $252 million represented the first time the run-off company has purchased an ongoing company. OneBeacon Insurance Group continued its repositioning as a specialty insurer by selling its run-off business to Bermuda-based Armour Group Holdings Limited for an undisclosed amount.
Near historic low valuations, with many insurers trading below book value, revealed a discrepancy between management's and the market's perceptions of value. According to SNL, the average purchase price paid in the P&C sector in 2012 represented a discount to book value. Lower valuations also discouraged acquirers from using their stock as acquisition currency. At the same time, lower interest rates resulted in lower borrowing costs for cash acquisitions. These factors contributed to all but two of the M&A transactions in the P&C sector in 2012 being cash transactions.
NOTABLE TRANSACTIONS
The following briefly describes notable transactions involving U.S. and Bermuda companies.
Validus/Flagstone
In November 2012, Validus Holdings Ltd. acquired Flagstone Reinsurance Holdings S.A. for $623.2 million in cash and stock. Validus is a Bermuda-based property, marine and specialty lines insurer and reinsurer. Flagstone is a Luxembourg-domiciled property and short-tail focused reinsurer.
In an effort to distinguish itself from a crowded field of Bermuda-based reinsurance companies, Validus has expanded aggressively through acquisitions over the past several years, acquiring Talbot Holdings Ltd. in 2007 and IPC Holdings Ltd. in 2009. The bolt-on Flagstone acquisition allowed Validus to expand its market share in the property catastrophe business, becoming one of the largest property catastrophe reinsurers in Bermuda.
In 2011, Flagstone's performance suffered due to significant catastrophe losses, which wiped out 40% of Flagstone's equity. While the purchase price represented a significant discount to Flagstone's book value, it still allowed Flagstone's shareholders to exit the company at a premium to the market price of the stock at a time when the company was under capital pressure.
Validus may best be remembered for its hostile attempt to disrupt Allied World Assurance Co.'s agreement to buy Transatlantic Holdings Inc. in 2011. In that transaction, Validus launched a hostile tender offer (and proxy contest) to acquire Transatlantic after it had entered into an agreement to combine with Allied World. Transatlantic ultimately terminated its agreement with Allied World and agreed to be acquired by Alleghany Corp.
Markel / Alterra
In late December 2012, specialty insurer Markel Corp. announced a merger agreement with Bermuda-based Alterra Capital Holdings Ltd. for aggregate consideration to Alterra shareholders of stock and cash valued at approximately $3.13 billion, the largest P&C deal of 2012. Upon completion of the transaction, Alterra will become a wholly-owned subsidiary of Markel. The transaction is subject to shareholder approval and certain other conditions, including Alterra receiving a $500 million dividend from its operating subsidy so that the holding company has no less than $500 million in unrestricted funds on the closing date and that each party has an A.M. Best rating of at least "A". The agreement also contains a minimum book value provision which permits either party to terminate the contract if the other party's book value is less than 80% of a specified amount. The deal has a break-up fee of $94.5 million.
The transaction will establish Markel as a significant presence in the global reinsurance market and provide additional size and scale with the aim of improving its expense ratios and further diversifying its premium base. Also, the combined company will have two established Lloyds' platforms. The use of stock as acquisition currency in both the Markel and Validus transactions demonstrates a willingness to overcome low market valuations to achieve strategic goals.
ACE Mexican Acquisitions
In 2012, ACE Limited agreed to acquire the second half of two Mexican insurers. In September 2012, ACE agreed to acquire Fianzas Monterrey from New York Life Insurance Co. for $285 million in cash. Fianzas Monterrey is the second-largest surety company in Mexico and the third largest in Latin America.
The acquisition allowed ACE to expand its surety business, a growth area for the company, as well as its Mexican operations. New York Life acquired Fianzas Monterrey in 2000 as part of its purchase of life insurer Seguros Monterrey and had decided to sell the company because it was non-core for New York Life and outside of its primary focus.
In October 2012, ACE announced that it had agreed to acquire ABA Seguros from Ally Financial Inc. for $865 million in cash. ABA Seguros is the sixth-largest P&C insurer in Mexico.
The acquisition allowed ACE to take greater advantage of growth opportunities expected in Mexico. The sale was part of Ally's announced plan to divest its international businesses and focus on U.S.-based automotive services and direct banking franchises and to return capital to the U.S. Treasury, which owned 74% of Ally after providing financial assistance during the financial crisis.
Enstar/SeaBright
In August 2012, Enstar Group Limited agreed to acquire SeaBright Holdings, Inc. for approximately $252 million in cash. Enstar is a Bermuda-based company that acquires and manages run-off companies and portfolios of business in run-off. SeaBright is a specialty underwriter of workers' compensation and related types of insurance.
The acquisition significantly expanded Enstar's presence in the U.S. market and added expertise to assist in managing Enstar's existing book of workers' compensation business. Significantly, it also marked the first time Enstar acquired an ongoing business as opposed to a business in run-off. Given Enstar's focus on running-off businesses, it was not surprising that Enstar announced that it was discussing opportunities with third-party insurance companies for the assumption of SeaBright's policy renewals. In the merger proxy, SeaBright cited among the reasons for the transaction, the prospect of a ratings downgrade, weak investment returns, the challenges as a smaller, independent company and limited prospects for profitable growth.
CNA/Hardy
In July 2012, CNA Financial Corporation acquired Hardy Underwriting Bermuda Limited for approximately $227 million in cash. Hardy is a specialist insurer and reinsurer in the Lloyd's market and was Bermuda-domiciled and listed on the Main Market of the London Stock Exchange. Bucking an industry trend, the price was at a premium-to-book value, reflecting relatively high values placed on the Lloyd's franchise.
The acquisition was implemented by way of a merger under the Bermuda Companies Act. Until the Companies Act was amended in December 2011, Bermuda did not recognize the concept of mergers, where two companies combine with one being recognized as the "survivor." Previously, combinations of Bermuda companies would typically be accomplished by means of an amalgamation where the two companies would amalgamate into one company with both companies continuing as a new combined and amalgamated company.
The acquisition represented CNA's entry into the Lloyd's market and significantly expanded CNA's foreign operations. It also continued CNA's focus on specialized underwriting. The acquisition of Hardy continues a trend of acquisitions of smaller Lloyd's underwriters resulting from weak insurance prices weighing on their share prices, concerns over forthcoming stricter regulatory capital requirements and heavy losses from the New Zealand earthquake, Thailand floods and other catastrophes in 2011. We discuss more about this deal and the Lloyd's market next.
P&C OUTLOOK
Looking ahead, most industry observers expect organic growth rates of P&C insurers to remain modest. We thus expect to see a continuation of 2012's theme of small- and medium-sized "bolt-on" acquisitions, as companies look to product and/or geographic expansion and economies of scale for growth. We also expect to see U.S. companies continuing to look for accelerated growth opportunities in faster growing foreign markets, especially selected markets in Latin America and Asia.
Many of the larger P&C companies still have excess capital notwithstanding Hurricane Sandy and can be expected to use M&A as a means to increase returns to shareholders. These companies will also be in a better position to take advantage of opportunities arising out of "distressed" situations where reserve inadequacies or statutory capital pressures drive some companies to the sales block.
Notwithstanding the Markel and Validus transactions, we believe that continued low valuations are likely to discourage buyers from using their stock as acquisition currency and sellers from selling their companies below book value, resulting in average deal size remaining relatively low. In addition, some industry observers believe that M&A activity may be slower in the first half of 2013 as buyers wait until companies' Hurricane Sandy exposures are clarified.
Europe
OVERVIEW
The Eurozone re-entered recession in the third quarter of 2012 with the UK already enduring a "double-dip" recessionary environment by the end of the first half. Against this backdrop of macro-economic headwinds it comes as no surprise to find M&A activity in the region generally subdued. Fears of a Eurozone meltdown and the potentially chaotic effects of a unilateral exit of a troubled EU Member State may have receded in recent weeks, but many of the underlying issues remain unresolved. A prolonged period of low investment returns looks set to continue and confidence, itself a real driver of M&A activity across any industry, is fragile.
The property and casualty sector has generally weathered the macro-economic and natural storms of recent years well. For Lloyd's of London and the wider London market, the message is again one of resilience and when compared to the banking sector the industry remains well-capitalized and in relatively good shape. Without the effects of Hurricane Sandy, the industry-wide losses would have been well below average for the year and certainly lower than the unprecedented level of losses experienced in 2011 and, to a lesser extent, 2010.
The general picture emerging from the important January renewals season is not one of significant rate increases across the market, rather such increases are confined to particular classes and geographies. S&P recently estimated that it would take a loss event in excess of $50 billion to move the market or lead to serious capital erosion. As a percentage of shareholder funds and on current estimates, Sandy related losses look to be in the manageable range. Full-year 2012 reporting season for the publicly listed insurers is almost upon us and ought to be a good point from which to gauge possible M&A activity going forward into the rest of 2013. We expect a strong set of results – certainly, the Lloyd's listed vehicles' stock prices have generally performed well over the last few months and particularly in the final quarter, possibly in anticipation of a good set of numbers and a healthy dividend.
LLOYD'S MARKET
Looking back to the half year results for the Lloyd's market as a whole, it swung from record first half losses in 2011 to the best first half performance in five years for 2012 – a pre-tax profit of £1,530 million against a loss of £697 million. Solvency levels are at record highs and the capital base remains strong.
2012 saw three main changes of ownership at Lloyd's – the sale of Hardy to CNA (discussed above), Canopius' purchase of Omega for £164 million and Flagstone's sale of its Lloyd's platform to ANV for $48 million. These sales followed a competitive auction process which, in the case of Omega, marked the end of a long drawn-out process including an aborted partial cash offer for up to 25% of the company in late 2011 with Mark Byrne's Haverford investment vehicle. The latter part of Omega's time as a publicly listed company was a turbulent period involving a board and shareholder clash. One of the interesting aspects of the aborted Haverford offer was that the two boards agreed to not apply provisions of Omega's byelaws replicating certain aspects of the UK Takeover Code. Omega was incorporated and had its registered office in Bermuda and so, like others including Hardy, the UK Takeover Panel did not have jurisdiction over the offer. We examine in more detail below the UK Takeover Code Committee's proposals to extend the jurisdiction of the Code to all companies listed on the London Stock Exchange and how this may impact the insurance sector in particular.
The Omega, Flagstone and Hardy deals each show that, despite having announced heavy underwriting losses, valuations were close to or at a premium to net tangible assets, particularly in the case of Hardy at 1.5x book. We believe that this again demonstrates the value of the Lloyd's platform and its attractiveness to new entrants and investors.
BANK DIVESTITURES
Elsewhere in the UK and Europe, 2012 saw banks and some large insurers selling non-core insurance assets. One of the largest deals was KBC's sale of its Polish insurer Warta to Germany's Talanx at the beginning of the year for $994.5 million. In addition to selling life insurance operations, Aviva continued its disposal of non-core lines as part of its strategic overhaul with its exit from Dutch insurer, Delta-Lloyd, raising $566 million. Meanwhile, Aviva's UK-listed rival, RSA, marked further overseas expansion in certain key markets with the $150 million purchase of L'Union Canadienne, the Quebec-based motor insurer. RSA has also been expanding its footprint through acquisitions in Latin America.
Again, as we have seen in the life sector, the retreat of certain banks from owning insurance assets was evidenced by HSBC's sale of its Asian and Latin American insurance divisions to QBE for $420 million and to AXA for $494 million. In early 2012, Goldman acquired the Bermuda-based operations of Ariel Re to further augment its reinsurance group, which reported $1 billion in revenue in 2012. With the start of 2013, however, it was reported Goldman is seeking to sell a 75% stake in its reinsurance business. This appear to leave Lancashire as the only one of the "class of 2005" to not have engaged in M&A activity, in some form or other, during the last 12 months.
We believe disposals with roots in the financial crises of recent years, whether directly or otherwise, will continue to be a driver of M&A activity through 2013.
BROKERAGE
On the broker side, AJ Gallagher has been expanding with quite a number of acquisitions on both sides of the pond. Similarly, this has been the case with Ryan Specialty Group. In the Lloyd's space, Hyperion Group's (Howden) purchase of Windsor for £95 million in June was much commented upon around the market. This deal propels Hyperion up the tables in terms of brokerage income and may mark the start of a trend of further consolidation in the London and Lloyd's market. Notably, Lightyear Capital's significant recent investment into Cooper Gay Swett & Crawford has given the acquisitive broker the capital to fund both organic growth and purchases.
The largest global brokerage acquisitions of the year were Onex's acquisition of U.S. broker USI for $2.3 billion and KKR's acquisition of Alliant Insurance Services for $923 million.
RUN-OFF TRANSACTIONS
In the run-off segment, despite market conditions continuing to remain challenging, there was a rallying of M&A activity in 2012. This pickup in activity looks set to continue into 2013. Notable deals last year included Riverstone's acquisition of Brit Insurance, which was probably the year's stand-out run-off deal in the UK. In addition to Armour Group's acquisition of OneBeacon's run-off business mentioned above, other deals included Compre's acquisition of a Norwegian business, and Catalina's acquisition of HSBC's Irish legacy business and Catalina's agreement to acquire certain reinsurance businesses from Tawa.
The renewed activity in the run-off sector may well be a result of the much talked-of pent-up M&A demand finally beginning to be met. The gap in price expectations between sellers and buyers does appear to have narrowed of late. Also, whereas the focus of players in the market may in the recent past have been on balance sheet management and cost-cutting, there are signs now that the focus may be shifting for some to M&A activity as a way for buyers to grow their book of run-off business and seek to maximize economies of scale and for sellers to exit a line of business which may no longer be core to their overall business or which may proving to be too much of a capital strain.
OUTLOOK FOR EUROPE
With general market conditions remaining challenging, low investment returns and shrinking reserve releases, the focus will continue to be on sound underwriting discipline. The search for synergy benefits flowing from a well-executed acquisition may drive M&A activity going forward into 2013. Equally, we expect to see opportunistic purchases of books of business bolted on to existing platforms. Often such deals can result from regulatory pressures and a need to balance risk taking against efficient use of capital. In this context, insurers and brokers alike can "acquire" books of business through the hire of key individuals and/or teams. One such recent team move, however, highlights the risks of such an approach, which we discuss in more detail below.
TEAM MOVES: QBE MANAGEMENT SERVICES (UK) V. DYMOKE AND OTHERS
The insurance sector, like many others within financial services, is one where clients (and indeed entire books of business) are often likely to follow certain key individuals if they leave a company. This is particularly so where a sufficient number of individuals leave at the same time, thus creating a critical mass. Given this fact, it can be tempting for businesses to look at hiring a team of individuals (in the belief that the business will follow) as an alternative to renewal asset deals or full-blown M&A. Why pay for the business if it will come to you anyway?
A word of caution, however: team moves are notoriously difficult to pull off without becoming exposed to sometimes substantial legal risks. A number of such cases have come before the courts in the UK in recent years and 2012 saw the outcome of one involving the insurance sector. It has become a leading case due to the guidance given by the Judge as to the legal principles that should apply in team move situations.
Mayer Brown represented QBE in the case which involved a group of employees (led by three key individuals) who left QBE together to set up a competing business. The Judge found that the most senior departing employee was a fiduciary. As such, aside from his duty of fidelity as an employee, he had a positive duty to inform QBE of any activity which may damage its interest. In these circumstances, he should have informed his superiors when he was approached by his number two with the idea of the team move out of QBE. He was also found to be in breach of an express provision in his contract requiring him to keep his employer informed of all affairs concerning the QBE group.
One key point in the case relates to the use of springboard injunctions. The team leaders had solicited various employees while still employed by QBE. They also solicited broker clients and misappropriated QBE confidential information for the purposes of their business plan. In these circumstances, it was held that their activities had placed them in a position to launch their rival business far earlier than would have been the case had they acted lawfully. As a result, a springboard injunction preventing any launch or preparatory activity was granted until April 2012. Given that the team leaders had resigned in April 2011 and would otherwise have been free under their contracts to start work at the end of October 2011, it is clear that a springboard injunction can be a powerful remedy.
If anything, this case confirmed that achieving a team move, without there being breaches of contract, will be difficult to do in the UK. However, the practical point to take away from this case is that it is prudent in the UK to have an express clause in all employees' contracts requiring them to inform their employer of potential team moves as the employer will then have a remedy for any wrongdoing, whether or not the individual is a fiduciary. Furthermore, if acting for the "poacher," a carefully planned strategy will be vital before taking any action.
IS THE UK TAKEOVER CODE BOUND FOR BERMUDA?
It is more than a year since four major changes to the UK Takeover Code (the "Takeover Code") were implemented, notably the general prohibition on break fees and other deal protections, the requirement to identify potential bidders, the automatic 28-day "put up or shut up" period and enhanced disclosure in offer documentation. These changes were largely driven by a sense that, in the aftermath of the highly publicized takeover of Cadbury by Kraft, the balance was too much in favor of a potential bidder. While those changes have a direct impact on those quoted insurance companies that fall within the jurisdiction of the Takeover Code, a number of insurance groups have, over the years, redomiciled to overseas jurisdictions such as Bermuda.
Perhaps as a result of recent takeover activity in the sector, this has not escaped the attention of the UK Takeover Panel (the "Panel"). There is no suggestion that in moving to Bermuda or elsewhere companies were seeking to take advantage of falling outside the jurisdiction of the Takeover Code – quite the contrary, as those companies sought to replicate certain of the fundamental principles of the Code into their byelaws.
The scope of the Takeover Code's jurisdiction is currently the subject of a Panel consultation paper. The most common application is where the target has its registered office in the UK (including for this purpose the Channel Islands and the Isle of Man) and its securities admitted to trading on the main market of the London Stock Exchange. Currently, it is less clear if the Takeover Code applies under the second limb – that is where the target is registered in the UK and its securities are not admitted to trading on the main market of the London Stock Exchange and instead, for example, on the AIM market. In such a case, as to whether the Takeover Code applies depends on whether the target company is considered by the Panel to have its place of central management and control in the UK. This requirement is currently referred to as the "residency test." The main argument in favor of removing the residency test is to provide greater clarity and certainty as to when a target company is subject to the Takeover Code. The principal argument against removing the residency test has related to the ability of the Panel to enforce the rules of the Takeover Code and to monitor their compliance where the offeree company does not have a sufficient nexus with the UK.
The removal of the residency test may not have a significant effect on quoted insurance companies. What is perhaps of much greater interest to those quoted insurance groups is the fact that the Panel has noted in the consultation paper concerns that overseas companies which have their securities admitted to trading on the London Stock Exchange's main market are not currently subject to the Takeover Code and has specifically identified Bermuda as an example of where companies have redomiciled. The Panel states that it intends to investigate whether it might be feasible for some measure of the Takeover Code protection to be extended to shareholders in such companies while acknowledging that it is mindful of a number of potential difficulties in relation to the regulation of such offers, particularly as to compatibility of the Takeover Code with local laws and the Panel's ability to enforce the Takeover Code.
Such an extension of the Takeover Code's jurisdiction would represent a significant departure from the current state of play and brings up a number of questions, not least whether the Panel would have the necessary resources to police a greater number of companies. It would also take the jurisdiction of the Takeover Code in a direction of travel well beyond that set out in the underlying EU Takeovers Directive. In addition, would the Panel limit its jurisdiction to offers in relation to companies that had redomiciled having formerly fallen within the jurisdiction of the Takeover Code or would it extend to all overseas companies with a listing on the main market of the London Stock Exchange?
The impact would be felt far beyond the insurance market but, going forward, a group's board may take into account the application of the Takeover Code in addition to insurance regulatory and other factors in determining optimal group structure.
Brazil
While Brazil continues to be a growing market for the property and casualty sector - due mainly to the increased consuming power of its population and the low rate of natural catastrophes and casualties - M&A activity in this sector during the year of 2012 was subdued. Brazilian property and casualty insurance companies have been reporting the existence of downward pricing pressure caused by intense competition in this sector. The specific trend is that insurance carriers may be sacrificing profit margin to gain market over competitors. Should this trend continue or increase in 2013, it is possible that a number of companies, especially local insurance companies, will not have sufficient financial capabilities to compete with the stronger financial conglomerates and this may spur consolidation activity.
In 2012, Ally Financial's selling of its global business of auto finance and insurance to General Motor's financing arm had a significant Brazilian component. Ally Financial's Brazilian operations were included in the US$4.2 billion deal to sell Ally Financial business throughout the world as part of the divesture plan of the United States Government.
Developments in Insurance Corporate Finance
Equity Capital Markets
United States and Bermuda
According to SNL, the amount of common equity capital raised by U.S. insurance companies in 2012 was approximately $46.6 billion, compared to $16 billion in 2011. The biggest factor was the government's continuing divestiture of AIG shares. During 2012 approximately $45.75 billion of AIG shares were sold in underwritten public offerings, resulting in the government's complete exit from the company's shareholder rolls by year-end. In November, Primerica, Inc. completed a public offering of 3.6 million shares owned by Warburg Pincus private equity funds, which will continue to own approximately 14% of the company's shares. As part of the offering, the company purchased a third of the shares being sold. The only other public equity offerings completed in 2012 were two small primary offerings by Florida-based P&C companies, United Insurance Holdings and Homeowners Choice. While there were no initial public offerings completed in 2012, ING US Inc. filed a registration statement for its initial public offering in November in furtherance of ING Group's plan to split its life insurance and banking operations.
Four Bermuda insurers issued an aggregate of just over $1 billion of non-cumulative preferred stock intending to constitute Tier 2 capital under the group insurance requirements of the Bermuda Monetary Authority ("BMA") which came into force on January 1, 2013. Because the BMA did not rule that securities constitute Tier 2 capital prior to their issuance, all of the securities included provisions allowing the issuers, without preferred stockholder consent, to vary the terms of the preferred shares or exchange the preferred shares for new securities to comply with the BMA's rules as long as the changes are not less favorable to the preferred stockholders than before. Certain terms, such as the redemption provisions, liquidation preference and dividend rate, could not be changed in any event.
One of the more noteworthy U.S. insurance industry equity offerings in 2012 was the Rule 144A initial public offering by NMI Holdings, Inc. of $550 million of common stock. FBR Capital Markets managed the offering. NMI is a newly-formed national provider of mortgage insurance. At the time of the offering, NMI was awaiting state insurance regulatory licensing and approval from the Federal Home Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Association (Freddie Mac) to be an eligible mortgage insurer. The mortgage insurance industry has seen a significant depletion of capital since the financial crisis. The offering provided for the return of investor monies if approvals were not obtained within a finite period. Since the offering, these required approvals have been received. Last month, approvals had been obtained from Fannie Mae and Freddie Mac and it is now licensed in a substantial number of states, as well as in the District of Columbia.
Deploying new capital to the capital-starved mortgage industry, without the burden of legacy liabilities, hearkens back to the post-catastrophe formations of the Bermuda classes of 1994, 2001 and 2005. Though the licensing process for mortgage insurers in the U.S. poses challenges, the ability to enter a market with a clean slate offers competitive advantages.
Europe
In London, Royal Bank of Scotland successfully completed the initial public offering of auto and personal lines insurer Direct Line, raising approximately £905 million. RBS will continue to own approximately 65% of the company's shares but has a directive to reduce its ownership to under 50% this year and to divest the remaining shares by the end of 2014.
Just ahead of Direct Line, in Germany, Talanx, Germany's third-largest insurer and reinsurer, successfully completed its IPO on the Frankfurt Stock Exchange after several delays in the face of challenging market conditions.
Brazil
Recently, one of Brazil's most appealing insurance industry sectors is online brokerage, especially in connection with the offer of insurance and microinsurance for the lower and middle-income population. This growth is because it is imperative for insurance companies to expand distribution channels in Brazil, a country of continental proportions. The large investment in utilizing already-existing channels, such as bank branches and other sources, has shown signs of saturation and insurers are now seeking alternative distribution channels.
This trend has caught the attention of investment funds that have shown a strong appetite for investing in small and midsized online insurance brokers. In the last year, for example, a Brazilian online insurance broker reported to have received 42 offers from investment funds from Brazil, Europe and America.
As the online insurance brokerage market is expected to grow more in the next few years, especially because of SUSEP's regulatory incentives to expand the microinsurance market, it is possible that the activity in the private equity sector will increase. Also in 2012, the Brazilian health insurance company, Qualicorp, which focuses on companies and professional associations, made a secondary public offering following its initial public offering in 2011.
Other than Brasil Insurance's initial public offering in 2010 and the Qualicorp offerings in 2011 and this year, Brazil has not seen any offerings by an insurance sector entity. However, Banco do Brasil - Brazil's largest financial institution - has announced plans to segregate its insurance business to create a new insurance company named BB Seguridade. It is reported that BB Seguridade may go public in 2013. Other competitors, such as Itáu and Bradesco may follow the same path, especially given the implications and compliance obligations of Basil III.
The IRB-Brasil Resseguros S.A. ("IRB") has also recently returned to the spotlight. The long-awaited and repeatedly frustrating attempts to privatize the State-owned reinsurance company now appear to have gained momentum and the State should soon cease control of the company. The privatization plan provides for IRB's corporate capital to increase up to 15% by issuing new shares that will not be subscribed by the State. Per the plan's conditions, IRB must go public within the maximum limit of five years after concluding the privatization process.
Debt Capital Markets
United States
The insurance industry took advantage of the historically low interest rates and robust debt capital markets in 2012. According to SNL, an aggregate of over $42 billion was issued in 2012, compared to approximately $30 billion in 2011. Most of the transactions were senior notes with maturities ranging from five to thirty years. Over 35 different issuers came to market.
In 2012, six insurers raised over $5 billion of long-term subordinated debt in the United States, including approximately $2 billion by Prudential Financial in three separate offerings and approximately $900 million by Protective Life Corporation in two different offerings. The subordinated debt qualified under the rating agency criteria for hybrid treatment. Where the securities allowed for deferral of interest for one or more periods of up to five consecutive years, the securities would qualify for "intermediate content treatment." The companies took advantage of the low-cost hybrid capital to redeem or retire higher cost debt. This trend continued into 2013 with Allstate publicly offering $500 million of subordinated debt qualifying for "intermediate content treatment" in the first week of January.
Euromarkets
In August 2012, Beazley plc, the specialist insurer, became the first insurer to launch a retail bond on the London Stock Exchange's electronic Order book for Retail Bonds (ORB). Retail bonds have been growing in popularity as an alternative source of funding for UK corporate issuers since the London Stock Exchange opened the ORB platform at the beginning of 2010. The ORB offers trading in corporate bonds in "retail" denominations of £10,000 or less. Most of the recent retail bond offerings have had denominations of £100, with issue sizes ranging between £10 million and £250 million and maturities of between five and ten years. To be eligible for the ORB, retail bonds must be listed on the Official List of the UK Listing Authority and they are subject to the same disclosure and continuing obligations requirements as institutional bond offerings.
In 2012, SwissRe, SCOR and Baloise Holdings offered subordinated bonds in the Swiss market. In addition, in October, Allianz sold €1.5bn in principal amount of 30-year non-call 10 Solvency II compliant subordinated bonds. The bonds are scheduled to mature in 2042 and are callable every year from October 17, 2022. If the bonds are not called, the coupon of the bonds switches to a floating rate and steps-up by 100bp. Allianz has the option to defer coupons, subject to a dividend pusher, and the coupons are mandatorily deferrable if the company is in breach of its solvency and capital requirements.
Brazil
At the onset of 2012, one of Brazil's major insurance companies, SulAmérica, announced the offering of five-year debentures, raising R$500 million. The amount obtained through the offering of debt was used to meet cash needs resulting from the expansion of operations, enhance the company's cash position and for general corporate purposes. SulAmérica's debt offering was the most significant transaction in 2012 in the Brazilian capital market carried out by an insurance company and the majority of the debentures were acquired by only three purchasers.
Developments in the ILS and Convergence Markets
Property-Casualty Sector
The use by insurers and reinsurers of alternative forms of risk transfer to the capital markets to supplement their traditional reinsurance programs continued to expand in 2012. The capital markets have become a critical component of managing catastrophe risk for a growing number of insurers and reinsurers.
Catastrophe Bonds
The catastrophe bond market was exceptionally strong in 2012, with a total of $6.3 billion of new catastrophe bonds issued, the second highest annual issuance volume in the history of the market. While U.S. risks constituted the majority of the new issuances, other jurisdictions were strongly represented, including Canada, Mexico, Europe and Japan. Sponsoring companies included longtime annual participants (such as Munich Re, Swiss Re, USAA and SCOR), large primary insurer sponsors (such as Zurich, Travelers, Liberty Mutual and Chubb) and new sponsors (such as Citizens Property Insurance Corporation of Florida, whose inaugural Everglades transaction, at $750 million, was the largest 144A offering of catastrophe bonds in the history of the ILS market). 2013 appears poised for a continuation of this robust activity.
An important development in 2012 was the access to the catastrophe bond market gained by state residual market entities, acting either as sponsors or direct cedants. In addition to the Everglades Re transaction for Florida Citizens, Embarcadero Re, which provided collateralized capacity to the California Earthquake Authority on an indemnity basis, completed two separate issuances in 2012 raising a total of $450 million. This followed the CEA's successful inaugural issuance in August 2011 for $150 million. In addition, Louisiana Citizens Property Insurance Corporation completed an offering in early 2012 in the amount of $150 million.
A notable trend in the catastrophe bond market in 2012 was the growing acceptance among investors of indemnity-based triggers. Of the $6.3 billion of issuances in 2012, more than 50% were indemnity-triggered transactions. This market acceptance was exemplified by the final deal of the year in December: the Lakeside Re III transaction sponsored by Zurich, which utilized an indemnity-based trigger and covered North American earthquake exposures involving some of the most complex commercial risks in the history of the catastrophe bond market. Indemnity transactions require additional disclosure regarding the subject business of the offering, including exposure and historical loss data and descriptions of policy coverages, underwriting policies and claims management practices. While index or parametric triggers eliminate the relevance of this sponsor information, such transactions expose the ceding company to basis risk to the extent the synthetic coverage provided by the bond does not correlate to actual losses. With the uncertainty created by the Dodd-Frank regulations of "swaps" (as discussed more fully below), it has become necessary to structure transactions that have more of the characteristics of traditional reinsurance, including indemnification for actual losses or at least a second trigger of requiring ultimate net loss even if an index trigger is used. As a result, we would expect to see more of the indemnity-triggered deals going forward.
Following the financial crisis in late 2007 and early 2008, and the resulting investment losses that adversely impacted several catastrophe bonds, sponsors and investors have sought the most stable collateral solutions. This trend continued in 2012, with most catastrophe bonds being collateralized by treasury money market funds. As an alternative, a few transactions have been collateralized by putable debt securities issued by quasi-governmental entities, such as the European Bank of Reconstruction and Development. We would expect that the types of acceptable collateral underlying catastrophe bonds may be reconsidered once interest rates start to rise and the spread between the return on U.S. treasury-based securities and LIBOR (or EURIBOR) -based securities increases.
Collateral solutions have also been impacted in the past year by the Foreign Account Tax Compliance Act (FATCA). To address the risks relating to the implementation of the FATCA regulations, most recent transactions have provided that, if the FATCA withholding would apply to securities held in the collateral account underlying the catastrophe bond, such securities will be liquidated prior to the end of 2016 to ensure that there is no principal withholding on such securities. Last month, the IRS issued 544 pages of final regulations implementing FATCA. While these regulations are not likely to require changes to outstanding transactions, they provide the ground work for structuring transactions going forward to address the specter of withholding on principal post-2016. For more information on FATCA, please see Mayer Brown's recent FATCA Legal Update.1
In 2012, the catastrophe bond market further demonstrated its resiliency in the face of catastrophic events impacting outstanding bonds. In recent years, catastrophe bonds have experienced principal losses as a result of the occurrence of major catastrophic events, including Hurricane Katrina in 2005 and Midwest tornadoes in 2011. In each case, the sponsor has been paid (or the transaction remains in the extension period), and to date no sponsor has failed to receive the intended coverage. Moreover, notwithstanding the impact of Lehman's bankruptcy on the collateral of certain transactions, no investor has borne losses for insurance risks it did not expect to cover. It is also worth noting that despite the losses on the Muteki catastrophe bonds caused by the 2011 Tohoko earthquake, early 2012 saw the successful offering of the Kibou Ltd. Japanese earthquake catastrophe bond through Hannover Re for Zenkyoren. The devastation of Hurricane Sandy did not appear to adversely impact fourth quarter issuances nor does it appear to have disrupted the pipeline for 2013.
The ongoing implementation of Dodd-Frank regulations have had an impact on the structure of catastrophe bonds, particularly those by non-U.S. sponsoring companies. Dodd-Frank established a non-exclusive safe harbor that spells out criteria for insurance agreements to not be included in the definition of swap. One critical element of the safe harbor is that the ceding company must be subject to the supervision of the insurance commissioner of any U.S. state or the federal government. In addition, any payment under the reinsurance agreement must be limited to the ceding company's actual losses. While non-U.S. sponsoring companies are not able to take advantage of this safe harbor, in order to bolster the argument that the risk transfer contract between the sponsoring company and the special purpose vehicle is insurance and, therefore, not a swap, these agreements are typically being executed in the form of reinsurance, and not derivatives, as was common previously. For more information, see "Dodd-Frank: Insurance vs. Swaps" below.
Sidecars, Managed Funds and New Reinsurers
Third-party capital continued to flow into the reinsurance market in 2012 through the formation of sidecars and managed funds. Sidecars provide additional capacity to the reinsurance market, while allowing sponsors to leverage their underwriting platforms and investors to participate in a targeted fashion in the property-casualty market. Between January 2012 and January 2013, eleven Bermuda sidecars were formed with a total capital investment of approximately $1.9 billion. Several Bermuda reinsurers, including Alterra Capital Holdings Limited, Lancashire Holdings Limited, RenaissanceRe Holdings Ltd. and Validus Holdings, Ltd. sponsored multiple sidecars in 2012. In December Argo Re established Harrambee Re and in January of this year Everest Re established Mt. Logan Re.
Sidecars are privately negotiated transactions that can be flexibly tailored to meet the sponsoring reinsurance company's needs. The 2012 class of sidecars included both market facing vehicles (in which the sidecar directly enters into retrocession agreements with third-party reinsurers, with underwriting and management typically being performed by the sponsoring reinsurance company) and side-by-side vehicles (in which the sidecar enters into a retrocession agreement with the sponsoring reinsurance company, taking a quota share of a specified portfolio of risks of such company). Most of the recent sidecars have been formed as special purpose insurers ("SPIs") under Bermuda law. Subject to certain limitations, including that the SPI's obligations must be fully collateralized, the SPI can be formed with relative ease compared to other types of licensed reinsurers.
Another developing source of income for traditional reinsurers is management of third-party capital to invest in ILS, collateralized reinsurance and ILWs through the formation of asset managers or investment in independent asset managers. In 2012, Bermuda reinsurers Allied World, Lancashire, Montpelier Re, and Validus created or invested in asset management platforms. In addition, Tokio Millenium Re expanded its longstanding footprint in the collateralized reinsurance space with the formation of Tokio Solution Management Ltd. And Shima Reinsurance Ltd., adding a full range of ILS and reinsurance management services to its already well-capitalized transformer Tokio Millenium Re.
Several rated start-up reinsurers entered the Bermuda market in 2012. These Class 4 licensed reinsurers were launched and supported by established hedge funds. Such reinsurers are designed to take on limited underwriting risks, while taking a more aggressive investment approach. Third Point Reinsurance Co. Ltd., supported by Third Point LLC, Kelso and Co and Pine Brook Road Partners; PaCRe Ltd., supported by Paulson and Co. and Validus; and S.A.C. Re Holdings Ltd., supported by S.A.C. Capital Advisors and Capital Z Partners III LP were formed in 2012, joining AQR Re Ltd. in this market.
Life Sector
During 2012, traditional life insurance companies continued their use of alternative legal structures and capital resources to finance the surplus strain associated with underwriting certain life insurance products. Some novel approaches to alternative capital and collateral structures evolved in 2012 and new players also emerged. This occurred despite the considerable uncertainties surrounding both the lively debate among regulators over the use of affiliated captive reinsurance vehicles and the gradual implementation of the Dodd-Frank legislation.
Reserve Financing
By our count, roughly fifteen private life reserve financing transactions closed during the year, the majority of which involved closed blocks of either universal life insurance policies subject to Actuarial Guideline 38 (more commonly known as Regulation AXXX or AG38) or term life policies subject to Regulation XXX (Regulation 147 in New York). The remainder involved smaller lines of business with perceived redundancies generated by conservative statutory reserving methodologies, and a scant few transactions designed to release embedded profits from ordinary life businesses. The deals we observed ranged from approximately $150 million to well over $1 billion in total excess reserves financed, with tenors between five and twenty years. 2012 also saw a number of restructurings and refinancings of transactions that closed in prior years.
The basic coinsurance structure of reserve financing transactions has remained consistent for the past decade. By ceding a specified line of existing business to an affiliated special purpose reinsurer (captive) through coinsurance, a sponsor life insurer is able to cede the statutory reserves and isolate the cash flows generated by that line of business in the captive. The collateral supporting the ceded reserves can be divided into tranches that can be funded and/or financed through a combination of sponsor-backed capital and third-party sources. Generally, the captive's baseline or "economic" reserves are funded by initial premiums that are either paid or retained (as funds withheld) by the sponsor company, and the "excess" reserves are funded or financed by investors, banks or other unaffiliated entities. The life reserve financing market has evolved continually since such financings were first embraced as viable capital relief strategies for the life industry, and in 2012, a number of market trends continued, while some novel approaches, alternative capital and collateral structures and new players also emerged.
At its inception, the regulatory reserve financing market accessed the term note market using long term notes of up to 20 years wrapped by financial guarantees from monoline insurers. With the financial crises, monolines exited this business and investor appetite for long-term exposure to investment assets in a captive, as well as to mortality risk, abated significantly.
The most popular form of third party excess reserve collateral since the financial crisis of 2008 has been the bank letter of credit. Bank letter of credit financings were prevalent in the market again in 2012, and the trend toward "non-recourse" reimbursement structures that began in 2010 continued. Prior to 2010, a bank issuing a letter of credit for excess reserve financing typically relied on a guarantee from the sponsor life insurance company's parent holding company for reimbursement of any letter of credit draw. In such a "recourse" transaction, the bank was essentially extending an unsecured line of credit to the guarantor, and could hedge its contingent exposure under the transaction by purchasing credit default swap (CDS) protection on that guarantor. In a non-recourse deal, the bank has no guarantee and must look to future reinsurance cash flows at the captive for reimbursement. For this pure insurance risk, buying CDS protection on the sponsor provides little, if any, value. Therefore, banks have been moving toward two alternative sources of risk mitigation, which were widely used together in 2012.
The first risk-mitigation technique employed by banks active in the reserve financing arena is the use of so-called contingent letters of credit, whereby a sponsor life company must demonstrate that reinsurance claims have actually penetrated the excess layer, i.e., all other sources of surplus, capital, other funds and credits available to the captive reinsurer have been exhausted, prior to making a draw on a letter of credit. Conditions to drawing on letters of credit raise issues under many state insurance regulations governing credit for reinsurance, which require that letters of credit must be "clean and unconditional." In jurisdictions where these structures have been approved, sponsor companies have succeeded in either (i) changing the conditions precedent on the face of the letter of credit into order of draw covenants in the underlying reinsurance treaty, which sometimes require officers of the sponsor to certify compliance or (ii) obtaining special permission from regulators to use an alternative collateral form. Another approach used in a limited number of circumstances is organizing and licensing the captive in the same jurisdiction as the domicile of the sponsor company. Thereby credit for reinsurance is obtained from a captive affiliate reinsurer that is domiciled in, and therefore licensed in, the same state as the sponsor ceding company, thus eliminating the need for unauthorized reinsurer collateral.
Even a letter of credit containing all of the necessary and appropriate conditions precedent, however, does not relieve an issuing bank of real insurance risk in an excess reserve financing deal. Thus, in 2012 back-end hedges have been implemented, whereby a bank will buy mortality and lapse protection on the underlying reinsurance treaty, most often in swap form, pursuant to which floating payments under the swap would be triggered by the same contingencies that would permit a draw on the bank's letter of credit. Ultimately, the conditions attached to a letter of credit plus a back-end hedge with a creditworthy counterparty (or credit support provider) combine to protect a bank on a non-recourse transaction in a way that is analogous to CDS protection on a recourse transaction. Interestingly, the banking industry's need for creditworthy back-end hedge counterparties lured a relatively new group of participants into the life reserve financing field, i.e., large offshore life reinsurers. We have seen these reinsurers or their affiliates act as either direct counterparties to banks, or as reinsurers of "transformer" special purpose vehicles (SPVs) that face the bank in their stead.
As mentioned above, certain sponsor companies have used special regulatory permission, better known as "permitted practices," to obtain regulatory approval for alternative capital. This has been the case where third party reinsurers rather than banks acted as financiers. The use of stop loss reinsurance or contingent capital arrangements outlined above facilitate reinsurers acting in lieu of banks for life reserve financings.
Also in 2012 the first Regulation AXXX transaction was completed using so-called "limited purpose subsidiary life insurance company" (LPS) laws, which have been enacted in a few states in recent years (including Iowa, Georgia, Indiana and Texas). Under LPS rules, the admitted assets of the LPS can include, among other things, letters of credit and parental guarantees. As a result, LPS structures can potentially provide reserve relief without client use of third-party capital. Given the current positions of regulators and rating agencies regarding the use of captives, it remains to be seen whether the use of LPS's will expand.
In the annuity area, one of the drivers for the recent divestitures of annuity businesses discussed above is the challenging economics of guaranties associated with certain variable annuity products. In addition to these guaranties, the statutory reserve requirements for these products (AG43) can create further adverse economic and reporting consequences for the insurer. Looking ahead, we expect to see creative financial solutions to assist companies in addressing the reserve strains of AG43.
Embedded Value
In the early 2000s, several newly demutualized U.S. life insurers, including The Prudential and MONY, successfully securitized the embedded value in closed blocks of business created by their reorganizations. The structures were similar to the reserve financing area using reinsurance to a captive reinsurer that accessed the long-term capital markets either directly or through a holding company. Monoline financial guarantees were typically utilized. With the financial crisis, these transactions ceased. At the end of 2011, however, Aurigen Re, the Bermuda-based life reinsurer, successfully securitized the embedded value in a closed block of Canadian policies. This breakthrough transaction arranged by Credit Agricole had a 6.2-year-expected maturity and an unwrapped structure. Although in 2012 we did not see other embedded value deals come to the 144A market, with the stabilization of debt capital markets generally and developing techniques for investors to hedge mortality risk, we would expect to see an increase in investor interest in embedded value securitizations.
All of these life reserve financing and certain embedded value structures utilize captive entities, the use of which has drawn regulatory attention since the financial crisis. As described below under "Regulatory Developments of the NAIC," the NAIC commenced in 2011 a study of the use of captives to transfer policyholder risks. Whatever recommendation that may emerge from this study could have material impact on the life risk securitization markets.
Longevity and Pension De-Risking
United States
Pension de-risking by extinguishing plan liabilities is emerging as a critical theme among defined benefit (pension) plan sponsor companies of all sizes. In 2012, the following entities announced breakthrough pension de-risking: GM ($26 billion), Verizon ($7.5 billion) and Ford (potentially $18 billion).
Over the last several years, plan sponsor concerns regarding volatility in pension obligations have been heightened by changes in accounting and funding rules, as well as by volatile capital markets, a low interest rate environment and longevity risk issues. Many defined benefit plan sponsors have frozen defined benefit plans to new hires, or frozen benefit accruals completely. Some sponsors of both frozen and ongoing plans have sought to reduce the volatility of their pension obligations by pursuing in-plan investment strategies, which include the use of swaps and derivatives, as well as strategies such as "immunization" or "liability driven" investing—or the purchase of annuity contracts held by the plan as an investment. None of these approaches settles or extinguishes the plan's liabilities and the sponsor remains liable for Pension Benefit Guaranty Corporation (PBGC) premiums with respect to those benefits.
Sponsors may extinguish plan liabilities through a complete plan termination, but this is often not feasible or desirable due either to employee relations issues or the requirement that the sponsor fully fund the plan as a condition of a standard termination.
More recently there appears to be increasing plan sponsor interest in the selective settlement of plan obligations through the use of "buy-out" annuities for, or offering lump sums to, certain segments of the plan population (both in the context of an ongoing plan or frozen plan, or a spin-off/termination). This increase may be as a result of (i) concerns regarding the relative success/expense of de-risking by plan investment strategies, (ii) recent private letter rulings by the IRS that provide helpful guidance on the use of lump sums and annuities to settle pension obligations, (iii) certain changes in the funding rules made by 2012 legislation known as "MAP-21" that make it less expensive for plan sponsors to maintain target funding ratios even after settling a segment of pension liabilities, (iv) increases in PBGC premiums enacted by MAP-21, (v) the possible revision of mortality tables used by pension actuaries to reflect longer life expectancies, and (vi) the examples of the GM, Verizon and Ford transactions.
In December 2012, Verizon transferred $7.5 billion in pension liabilities to Prudential. The transfer was achieved through the purchase of a group annuity contract under which Prudential assumed the obligation to make annuity payments to 41,000 management retirees who retired prior to January 2010.
In mid-2012, GM announced that it would spin-off the portion of its plan covering active and some former employees. Most retirees would remain in the existing plan, which will then be terminated. In the course of the plan termination certain retirees will be offered the choice of a lump sum distribution of the value of their remaining benefits. The benefits of those who do not elect a lump sum (and the benefits of certain retirees who will not be offered a lump sum) will be transferred to Prudential. GM estimates that its actions will reduce its pension liabilities by $26 billion.
Under the de-risking program announced by Ford, 90,000 retired and terminated vested participants may elect to have their benefits (even if currently being paid in the form of an annuity) distributed to them in the form of a lump sum distribution. For those who do not elect a lump sum, no annuities are being purchased from an insurer at this time. Ford has indicated that the lump sum offering could reduce its pension obligations by up to $18 billion.
For many years, the buy-out annuity market has been valued at approximately $2 billion per year. That changed with the announcements by GM and Verizon, and a number of consultants are predicting that the pace of buy-out annuity purchases will accelerate in the United States (as we have already seen happen in the United Kingdom), particularly if interest rates go up even slightly.
United Kingdom
Many United Kingdom defined benefit pension schemes are aiming to reach a funding level where they can insure all their benefit liabilities through a buy-out transaction. A buy-out brings the sponsoring employer's responsibilities to an end. But this usually remains aspirational because funding levels are too low.
Instead, many schemes are developing journey plans to reach buy-out funding. These often involve changes to investment strategy, changes to benefits (for example, exchanging escalating pensions for bigger flat rate pensions) and buy-ins of groups of pensioners when pricing is attractive. Data cleansing is undertaken so that buy-ins are more likely to insure the correct benefits and trustees undertake governance training on the mechanics of a buy-in transaction so that they can move quickly when market conditions are right.
One trend for schemes which hold a significant proportion of gilts (UK government securities) is that increases in the value of those gilts relative to the cost of a pensioner buy-in can make pricing attractive. In some cases, the buy-in cost is less than the reserve for the relevant pensioners which the scheme actuary has recommended.
Interest in longevity-only transactions by UK pension schemes remains, particularly among larger schemes. Deals in 2012 included longevity-only transactions by the pension schemes of Azko Nobel (£1.4bn) and LV (£800m).
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Footnotes
Originally published February 2013
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