Stephen Tacey looks at recent capital-raising activity in the re/insurance sector
The last twelve months have been relatively quiet in terms of capital-raising initiatives on the part of reinsurers around the world. The level of activity has certainly been modest in comparison with the frenetic round of capital replenishment that occurred in the two years after 9/11, when the combined effects of the World Trade Center and the equity market slump deprived the reinsurance sector of around $120bn.
There have been exceptions of course, and one in particular stands out.
Just eight months after its record-breaking EUR3bn subordinated bonds issue in April 2003, European giant Munich Re went one better, increasing its capital by almost a quarter with a massive EUR3.8bn rights issue.
At the time, in November last year, Munich Re Chairman Dr Hans-Jurgen Schinzler described it, with a typically European sense for the long historical perspective, as the largest corporate capital-raising exercise since the San Francisco Earthquake. Munich Re's capital increase stands head, shoulders and a good portion of torso above any similar moves in the market during the current year so far.
Notwithstanding any formulaic corporate protestations to the contrary, the timing and the scale of Munich Re's capital-raising activities were clearly dictated more by past affliction than present opportunity. In this respect, Munich Re exemplifies one of two distinct categories of capital raiser in today's reinsurance market.
On the one hand there are established, typically European or North American reinsurers primarily seeking to rebuild capital bases depleted by recent losses and continuing reserve strengthening measures. On the other are newer, typically Bermudian companies looking to access development capital, to optimise their debt structures and provide an exit route to financial investors sensing a turn in the market and eager to seek new opportunities.
The first half of 2003 saw a flurry of security ratings downgrades in the sector. Ratings agency Standard & Poor's downgraded seven of its top 20 reinsurers. With buyers still focussing strongly on security, major European carriers can ill-afford to countenance any diminution in their perceived claims-paying ability.
French reinsurer SCOR came under intense pressure from analysts in the latter part of last year and suffered palpably from decreased credit ratings - losing a considerable amount of business as a direct result. Its EUR750m share issue in January 2004, just a year after a previous rights issue, was vital to restoring confidence in the company's future.
Hannover Re and Swiss Re both undertook hybrid capital initiatives during the year, the former issuing EUR750m in subordinated debt during February and the latter EUR640m of three-year mandatory convertible securities in July. In the same month SCOR was back to take a modest step down the same path with the issue of EUR200m convertible/exchangeable securities.
The real pressure currently is on Swiss reinsurer Converium. The company surprised the market with the scale of a potential $400m reserve increase flagged up in July. CEO Dirk Lohmann insisted that "... the last legacy issues from the old Zurich Re have been eliminated. Over the next few weeks we will explore all options for maintaining Converium's strong capitalisation, including the raising of additional capital ..."
At the time of writing, a decision on the precise nature of Conversion's response awaits the conclusion of a major external actuarial review of the reinsurer's reserving position, but Mr Lohmann has indicated that it may take the form of a capital increase of between $250m and $400m, along with the purchase of retro coverage for some of the company's reserves.
Whilst the majority of capital raised outside Bermuda has gone to replace losses, the situation mid-Atlantic is markedly different. Most of the Bermudian reinsurers are unencumbered with the legacy issues that have been the primary drivers of capital-raising in Europe and the US. Though modest in comparison with the estimated $9bn of capital raised in the two years following 9/11 (half of this from financial investors outside the insurance industry), there has been continuing capital raising - and, increasingly, capital management - activity on the island against a background of steady capital growth through profitable operations.
In April, ACE completed the IPO of a 65% stake in Assured Guaranty (the operation that combines ACE Guaranty Corp and ACE Capital Re International) to raise $840m. Chairman Brian Duperreault said at the time that the deal would leave the company more strongly positioned than ever to take up future business opportunities.
XL is another of the longer established Bermudians, and more exposed to adverse reserve developments than most companies on the island. Having been admonished by rating agency AM Best back in January that it needed to raise capital to maintain its ratings, XL issued $750m of equity secured units (a hybrid reckoned to constitute 75% equity and 25% capital) in March.
Also in March, Axis arranged an unsecured credit agreement allowing it to issue up to $750m in Letters of Credit and to borrow up to $300m before undertaking a $580m secondary public offering in April. More recently, Axis filed a universal shelf registration allowing it to issue up to $750m in equity debt, debt, trust preferred and other securities - fuelling suggestions that one or more of the company's original capital providers might eventually be seeking to diminish their holding.
In September last year, Arch took out a $300m 364-day revolving credit facility, convertible on expiry to a two-year loan. Then, in March, the company netted proceeds of $179m from a share offering, earmarked for the standard 'general corporate purposes' and to support underwriting operations. Proceeds from a $300m public offering of senior notes in April were directed to repaying all outstanding amounts under the previous borrowing facility and again to support underwriting.
Having raised over $200m from its IPO back in February 2003, Endurance has been another of the more active players in capital terms, acquiring the property/casualty business of LaSalle Re and HartRe's reinsurance book, and then raising an additional $340m through a secondary public offering in March this year. In May, the company announced two capital management initiatives with a repurchase programme of up to two million of its shares and the immediate repurchase of $65m shares owned by original investors Lightwater Capital. Then in July Endurance took out a $850m revolving credit facility, placed an offering of $245m of senior notes ($103m of which went to repay a previous term loan), and announced its acquisition of the capital stock of Overseas Partners US Reinsurance Co (OPUS) for $43m.
The mixture of debt, equity and hybrid forms apparent in Bermudian capital-raising activities over the past year reflects an environment in which external investors perceive diminishing opportunities for strong returns on equity as the next soft market approaches, as well as reinsurers' desire to take advantage of a closing window of opportunity debt-wise as the prospect of the Federal Reserve increasing interest rates looms.
To the extent that a significant proportion of this activity reflects capital management initiatives primarily relating to investors' desire for a timely exit, it is questionable whether it should be regarded as new capital in the true sense. Significant amounts of capital have translated into increased underwriting capacity however, and rating agencies are starting to encourage Bermudian reinsurers to consider hastening the return of capital to investors in expectation of future pressure on rates.
As noted in Benfield's Bermuda Quarterly review published in May: "With prices stablising or falling ... (and) cedants retaining more risk, opportunities for organic growth will become scarcer. Consequently, it will be harder to generate and sustain satisfactory returns on enlarged capital bases, and initiatives to enhance return on capital through share repurchases, higher dividends, special dividends, greater use of debt or hybrid capital or consolidation of companies may increase."
Activity in London has again been muted over the past twelve months.
Bermuda-registered Alea raised £165m through its listing on the London Stock Exchange back in November last year - funds intended as then-Chief Executive Dennis Purkiss noted at the time to allow the company to "capture the significant expansion opportunity that exists by leveraging (our) capabilities and infrastructure." Catlin's London IPO in April this year netted £190m. Again, the proceeds were primarily intended to support underwriting "while continuing to maintain adequate regulatory and economic capital." But such initiatives come relatively late in the day.
The general feeling now is that the reinsurance market is adequately capitalised. On the back of strong underwriting results over the past two years, stabilising reserving positions and some signs of recovery in the equity markets, reinsurers are beginning to experience strong cash flows (reflected in reduced demand for letters of credit) and becoming more focused on optimising rather than building their capital bases. Ratings remain generally lower now than in the pre-9/11 environment, but this may well prove a state of affairs with which buyers and sellers alike will simply have to come to terms.
In a special report, 'Reinsurers Strive to Balance Returns, Capital Adequacy Success Will Determine Stability of Ratings' published in July, ratings agency AM Best identified the challenge of balancing shareholders' returns against the maintenance of risk-based capital adequacy, noting that this will be "a more acute process than in previous cycles as reinsurers carry less redundant capital into the downside of the cycle whilst having a greater degree of pressure from investors to deliver a risk-adjusted return on the capital they do hold." As a result, the rating agency now doubts that restoring former levels of capital adequacy is a current or likely future management objective.
The need to manage capital efficiently, whilst balancing divergent shareholder and investor interests, could conceivably act to moderate the downturn in the cycle as carriers feel constrained to hold the line more diligently on rates. Certainly, the pressure to compete for volume in an attempt to service large amounts of surplus capital looks set to be less of a feature going forward. At the same time, an increasingly rigorous economic focus is likely to foster a more fluid and opportunistic market compared with the more proportional, relationship-oriented approach common in the past.
As the market currently stands, few observers expect to see a great deal more activity on the capital-raising front in the near future. A variety of factors, however, could potentially change this.
When Converium alerted the market to its reserving gap in July, the company maintained that this was an industry-wide problem which it was simply ahead of the rest in tackling. The industry begged to differ, broadly supported by informed opinion. But it could yet turn out that a further round of reserving hikes precipitates renewed activity on the capital-raising front.
Another potential trigger could be regulatory requirements. The European Commission's planned new solvency regime, Solvency II, could upset current game plans by imposing new capital requirements. It has been a relatively quiet period of late in terms of mergers and acquisitions in the reinsurance sector, for the obvious reason that reinsurers are preoccupied with making profits through the Indian summer of the hard market. A marked downturn in rates could quickly change this, prompting renewed interest in building M&A war chests.
For the present, however, the reinsurance industry appears to have regained some kind of capital equilibrium. Whether this turns out to be the calm before yet another storm remains to be seen. Of course, a large unexpected loss can also trigger capital-raising initiatives, and the development of Charley-related losses may refocus minds. Should these - or other major losses - materialise, we could be in for more interesting times ahead.