Catastrophe cashpoint: the latest facility for contingency capital

A contingent capital facility launched by Société Générale Corporate & Investment Banking (SG CIB) could replace some of the existing reinsurance and retrocession agreements, according to Thierry du Boislouveau, head of equity corporate finance at the bank.

SG CIB launched its event-driven guaranteed equity facility – or Edge – in September, describing it as a multi-year alternative source of risk mitigation for listed insurers and reinsurers. Under the initiative, the bank will buy new shares in the protected company if a trigger event hits, thus providing it with fresh capital.

Du Boislouveau says that each mid- to large-cap insurer could easily consider implementing solutions such as Edge for 5% of their total share capital.

The launch of Edge closely followed the news that French reinsurer SCOR had taken out a contingent capital facility with Swiss bank UBS. The timing was no coincidence – SG CIB had advised SCOR on the deal.

It could be argued that now is a bad time to set up an alternative source of capital for insurers and reinsurers. While the retrocession market remains tight, supply of traditional reinsurance capacity is outstripping demand and the industry is overcapitalised – as reinsurers’ efforts to return capital to shareholders through buy-backs or increased dividends proves.

There are also a number of alternative sources of capital already in existence, in particular catastrophe bonds and industry loss warranties, which insurers and reinsurers can tap to protect themselves against events.

However, du Boislouveau believes Edge has several features that set it apart from other options, including traditional reinsurance or raising capital by issuing equity or debt.

Capital relief benefit

The main advantage it has over traditional capital raising, says du Boislouveau, is that it provides capital relief without diluting existing shareholder stakes in the firm. In a traditional equity capital raising, a company would issue shares in return for cash, increasing the number of shares in the market, thus reducing the value of existing shareholders’ stakes – assuming they do not participate in the capital raising.

But with Edge, users get capital relief for having guaranteed buyers for their shares without having to issue any shares. For regulators and rating agencies, the capital is as good as there. Shares are only issued if the pre-defined trigger event hits, which, according to du Boislouveau, is unlikely.

“The event we envisage is remote,” he says. “The beauty of the structure is that you have the effective benefit of a capital increase and the flexibility of a banking facility without any of the disadvantages, such as dilution.”

Catastrophic consequences

If an event big enough to trigger a share issue hit, argues du Boislouveau, the company would be in such need of capital that dilution of stakes would be the least of shareholders’ worries. In addition, a company badly affected by a catastrophe may struggle to raise fresh capital.

Investors such as private equity firms are turning their backs on the insurance industry in search of better returns and may not feel inclined to bail out the industry if trouble strikes.

Traditional capital raising is also unattractive given the current low valuations of insurance and reinsurance stocks relative to book value. Rating agency Moody’s expressed concern in a June report that the industry may struggle to recapitalise after a major catastrophe because of the low share price to book value ratios of listed reinsurers. Edge, however, guarantees fresh capital when it is needed most.

The facility also offers price benefits, says du Boislouveau – although he declined to give its price. “Because of the price, some clients would be interested in replacing some of their existing agreements with Edge.”

Having an investment bank as a counterparty, rather than a reinsurer or capital markets investor, also allows users of Edge to diversify their sources of capital. A bank, by its very nature, is unlikely to be heavily exposed to the catastrophic events that trouble reinsurers, potentially making it a more stable counterparty.

While catastrophe bonds, in theory at least, offer diversity of counterparties, they tend only to cover specific risks. The focus has been on natural catastrophes in specific territories because it is easy for investors to quantify a loss quickly. However, du Boislouveau says Edge could apply more generally.

“There is a price for everything and we believe we can structure a large range of trigger events,” he says. “This means we can complement the classical kinds of events covered by cat bonds with the Edge contracts.”