Understanding Contingent Capital Researcher: Kailan Shang FSA, CFA, PRM, SCJP February 2013 Prepared for: Casualty Actuarial Society © 2013 Casualty Actuarial Society. All Rights Reserved. Understanding Contingent Capital Understanding Contingent Capital Kailan Shang FSA, CFA, PRM, SCJP ________________________________________________________________________ Abstract. This paper is a response to the Casualty Actuarial Society’s request for proposals on "Contingent Capital". In light of the recent financial crisis, contingent capital, a type of hybrid security, is seen as an innovative way of recapitalization given the occurrence of a specified event, such as the capital adequacy ratio falling below the threshold. Although it has gained prominence among regulators, there are some doubts from market participants. The effectiveness of this automatic bail-in hybrid security is still too early to tell given the limited market experience and unclearness of the impact on the share price when the conversion is triggered. The goal of this research is to explore the key features of contingent capital, its market, the appropriate pricing and valuation tools, and its application in insurance industry. It is hoped that the research will increase our understanding of contingent capital and facilitate the assessment of its value and risk. Motivation. As a new alternative of raising capital automatically under stressed situations, contingent capital is expected to have more weight on insurers' balance sheets in the future. It is important for actuaries to understand contingent capital and have the necessary tools to assess its risk. Method. This paper provides an overview of the contingent capital market, its features, and its potential impact. It also discusses the pricing and valuation models for certain contingent capital instruments. A case study is included to illustrate the quantitative analysis for a contingent capital instrument. Results. A spreadsheet model is built and used in the case study. It is capable of pricing and valuing certain types of contingent capital. Quantitative risk analysis and model calibration function is also included. It could serve as good education materials to understand the role of contingent capital, quantify its risk and assess its effectiveness of absorbing loss. Conclusions. Contingent capital is a promising candidate to improve the capital position of the financial industry with a smaller cost than additional rights issuance. However, further analysis and test are needed to find out the appropriate design and better understand its potential impact and related stakeholder behavior. There is still a journey to go before the success. Availability. The spreadsheet “CONTINGENT CAPITAL QA TOOL” that illustrates the quantitative analysis of contingent capital is available together with the report. Keywords. capital management, contingent capital, CoCo bond, systemic risk © 2013 Casualty Actuarial Society 2 Understanding Contingent Capital Table of Contents UNDERSTANDING CONTINGENT CAPITAL .......................................................................... 1  EXECUTIVE SUMMARY ............................................................................................................ 4  1. INTRODUCTION ...................................................................................................................... 5  1.1 Research Context .............................................................................................................. 5  1.2 Objective ........................................................................................................................... 5  1.3 Outline............................................................................................................................... 5  2. CONTINGENT CAPITAL MARKET ....................................................................................... 6  2.1 Market Overview .............................................................................................................. 6  2.2 Do We Need Contingent Capital? ..................................................................................... 7  2.3 Designs of Contingent Capital .......................................................................................... 8  2.4 Stakeholder Analysis ........................................................................................................ 9  2.5 Some Doubts about Contingent Capital .......................................................................... 13  3. KEY FEATURES ..................................................................................................................... 15  3.1 Trigger event: rule based or discretionary ...................................................................... 15  3.2 Trigger event: institution level and/or industry level ...................................................... 16  3.3 Trigger event: based on book value or market value ...................................................... 17  3.4 Conversion Price ............................................................................................................. 18  3.5 Market Manipulation ...................................................................................................... 19  3.6 Multiple Equilibria .......................................................................................................... 20  3.7 Proposals ......................................................................................................................... 21  3.8 Post Conversion .............................................................................................................. 24  3.9 Contingent Capital versus Other Risk Transfer Instruments .......................................... 24  4. EFFECTIVENESS AND POTENTIAL IMPACT ................................................................... 27  4.1 The Impact on Systemic Risk ......................................................................................... 27  4.2 Dilution of Shareholder Value ........................................................................................ 28  4.3 Capital Admittance and Accounting Treatment ............................................................. 28  4.4 Tax Deductibility ............................................................................................................ 31  4.5 Disclosure Requirement .................................................................................................. 31  4.6 Counterparty Risk Assessment ....................................................................................... 32  5. PRICING, VALUATION, AND RISK ASSESSMENT .......................................................... 33  5.1 Pricing Models ................................................................................................................ 33  5.2 Valuation Models and Assumption Setting .................................................................... 40  5.3 Risk Assessment ............................................................................................................. 43  6. CASE STUDY .......................................................................................................................... 45  6.1 Pricing ............................................................................................................................. 46  6.2 Valuation ......................................................................................................................... 53  6.3 Risk Assessment ............................................................................................................. 54  7. CONCLUSION ......................................................................................................................... 57  Acknowledgment .................................................................................................................. 58  Supplementary Material ........................................................................................................ 58  APPENDIX A. QUICK GUIDE FOR CONTINGENT CAPITAL QA TOOL ........................... 59  APPENDIX B. MORE FORMULAS USED IN THE CASE STUDY ........................................ 59  8. REFERENCES ......................................................................................................................... 64  Biography of the Author ....................................................................................................... 67 © 2013 Casualty Actuarial Society 3 Understanding Contingent Capital EXECUTIVE SUMMARY The financial industry was quite successful in financial instruments innovations to meet the needs of investors. The wide development of the financial derivative market has been providing hedging tools to transfer financial risks for institutional investors. The insurance industry provides risk transfer as well, built on pooling the individual insurance risks together, and provides protection at a reasonable and affordable price. Using reinsurance and alternative risk transfer instruments that are normally linked with catastrophe risk, risk mitigation activities are prevalent in insurance industry. However, they may not be sufficient to survive a financial crisis. Firms failed for different reasons but clearly they held insufficient capital for the risks they took. A huge amount of money was paid by taxpayers to keep some systematically important firms merely alive. The cost was supposed to be borne by the investors. The regulators and the financial industry are taking steps to adopt a more stringent capital rule. Contingent capital caught a lot of attention as a candidate to strengthen the capital position, reduce the cost of financial crisis borne by the taxpayers, and limit the increasing cost of capital due to more stringent capital requirements. Generally speaking, contingent capital provides automatic recapitalization by converting the debt instrument to equity when the issuer is in trouble. The trigger of the conversion is based on pre-specified condition such as equity price dropping below a certain amount or regulatory capital ratio dropping below a certain level, etc. This innovation links the automatic bail in with the capital position of the company, covering a much broader scope of risks than ever before. Several companies issued contingent capital instruments, either as a solution for the stressed financial condition, or as an action to boost up the capital buffer for future adverse events. There are many proposals of contingent capital design from the academic community as well. The prevalence of different opinions of the appropriate trigger event for conversion implies the complexity of contingent capital and the immaturity of the market. There are concerns about the stakeholders’ rational behaviors that may push the firm down to an even worse situation. This is exactly opposite to what the contingent capital is designed for. Other concerns include the softening of debt’s disciplining power and its effectiveness. There is a lot to explore and test in the market before contingent capital becomes a widely accepted instrument for prudent capital management and risk management. This paper introduces the background of contingent capital, its key features, the potential impact, and the models for pricing, valuation and risk assessment. It explains the reasons for issuing contingent capital as well as the major concerns about it. It also includes a case study illustrating the pricing, valuation, and quantitative risk analysis of a sample contingent capital instrument. © 2013 Casualty Actuarial Society 4 Understanding Contingent Capital 1. INTRODUCTION This paper is a response to the request for proposals on contingent capital by the Committee on Valuation, Finance, and Investments (VFIC) of the Casualty Actuarial Society (CAS). 1.1 Research Context Insurance industry has been utilizing non-traditional capital instruments to transfer risks for a long time. Some of them helped insurers absorb losses and retain their capital in adverse events. For example, catastrophe bonds or catastrophe equity put arrangements protect the insurers from catastrophe losses. Those instruments are normally related to insurance risk, such as natural disasters, mortality, and longevity. In the recent financial crisis, systemic risk caught a lot of attention. Much discussion happened on how to prevent or mitigate systemic risk. Regulators are also changing their ways to regulate those too-big-to-fail, or systematically important financial institutions. Contingent capital, an innovative type of automatic bail-in hybrid security, is considered as a candidate for providing capital at a predetermined cost in stressed situations and for mitigating systemic risk. Contingent capital instruments are similar to non-traditional capital instruments used by insurance companies except that the trigger is based on financial conditions instead of insurance risk. Different designs of contingent capital have been proposed and some of them are implemented. Though their effectiveness is still too early to tell, it is important for us to understand them and be equipped with knowledge and analytical tools for valuation and risk assessment. 1.2 Objective The objective of this paper is to explore the key features and characteristics of contingent capital instruments, their effectiveness in risk transfer, and the pricing and valuation tools for them. A quantitative illustrative tool is made available for contingent capital evaluation and risk assessment. It is hoped that the tool will aid the actuarial community in understanding contingent capital from the perspective of risk transfer and capital management. 1.3 Outline The remainder of the paper proceeds as follows. Section 2 will give us an overview of the contingent capital market. Section 3 will discuss the key features of contingent capital instruments. Section 4 will present their impact and effectiveness in risk mitigation and capital management. Section 5 will explore modern finance theory and quantitative models used in pricing, valuation, and risk reward analysis. It is followed by a case study of evaluating a sample contingent convertible bond in Section 6. Section 7 will conclude the paper. © 2013 Casualty Actuarial Society 5 Understanding Contingent Capital 2. CONTINGENT CAPITAL MARKET Contingent capital instruments, also known as contingent convertible bonds (CoCo bonds), contingent surplus notes, or enhanced capital notes, provide a mechanism that automatically convert the instruments to equity upon the occurrence of some specified trigger event. These instruments began to attract attention and gain popularity during the financial crisis in 2008. Before that, insurance companies protected themselves from capital deficiency under stressed situations by reinsurance arrangements, hedging programs, and capital raising. Those seem effective when systemic risk is mild in the financial system. However, the recent financial crisis told us that when systemic risk is prevalent, the cost of raising capital may be unaffordable. Much higher liquidity risk and counterparty risk might still put the company in a weak solvency position. Contagion impact is material and the market and regulators have been looking for capital instruments that provide better insulation. Contingent capital appears to be the most promising solution although doubts about it are not rare. 2.1 Market Overview The insurance industry has been utilizing contingent capital instruments for around two decades. Catastrophe equity puts and contingent surplus notes are the most common types. Catastrophe equity puts1 give the insurer the right to sell stocks at a fixed price in case a specified trigger event happens. Contingent surplus notes2 give insurer the rights to issue surplus notes in exchange for liquid assets upon the occurrence of a predefined trigger event. The size of the transaction ranges from a few million dollars to around half a billion dollars. However, the trigger events, or in other words, the risks from which the companies have been protected are normally catastrophe risk related. The term of the protection is also relatively short. Contingent capital with a trigger event based on regulatory solvency ratio instead of insurance risk caught public attention in Lloyds Banking Group's exchange offer announced in November 2009. It intended to exchange certain existing securities3 for enhanced capital notes or rights issue4. The enhanced capital notes (ECNs) will be converted to ordinary shares if the core tier 1 capital ratio falls below 5%. Not only the unprecedented size for contingent capital issuance but also the 1 CEIOPS, “Insurance Linked Securities,” 5. 2 CEIOPS, “Insurance Linked Securities,” 5. 3 Existing securities subject to exchange offer comprised of "Upper Tier 2 securities in an aggregate principal amount of £2.52 billion, innovative Tier 1 securities in an aggregate principal amount of £7.68 billion and preference shares (or equivalents) with an aggregate liquidation preference of £4.09 billion", Lloyds Banking Group, “Exchange Offer,” 2. 4 The package was supposed to "(i) generate at least £7.5 billion in core tier one and/or nominal value of contingent core tier 1 capital through the Exchange Offer and/or related arrangements; and (ii) raise £13.5 billion (£13 billion net of expenses) by way of a Rights Issue, Lloyds Banking Group, “Exchange Offer,” 1. © 2013 Casualty Actuarial Society 6 Understanding Contingent Capital government's big stake in the company made this transaction very special. Contingent capital is considered more favorable than old fashioned hybrid securities such as convertible bonds and preferred shares under stressed scenarios. These traditional hybrid securities are not as good as contingent capital instruments in loss absorbing. In addition to conversion to equity if the trigger event happens, some other arrangements were also experimented. In 2010, Rabobank issued €1.25 billion 10-year Senior Contingent Note. Once the capital ratio falls below 7%, the face amount will be written down to 25% and paid back to investors. Liability value will be reduced given the trigger event happens, which effectively is a capital injection. This is different from contingent convertible bonds where only the debt/equity ratio changes but the amount of capital remains the same if conversion is made at market price. The €500 million deal of contingent convertible bonds between Allianz and Nippon Life in Mid 2011 demonstrated the high interest of the insurance industry in using contingent capital to improve its capital position and reduce its risk exposure. Not only banks and insurance companies, other financial institutes have used contingent capital. In the merger of Yorkshire Building Society and Chelsea Building Society in 2009, £200 million subordinated securities of Chelsea Building Society were planned in exchange for contingent convertible bonds. Once the core tier 1 capital ratio falls below 5%, they will automatically be converted into equity. 5 2.2 Do We Need Contingent Capital? Before diving into the details about contingent capitals, it is worthy understanding the reasons for bringing contingent capital into the capital structure. From the regulators' perspective, it is hoped that contingent capital could solve the too-big-to-fail problem and reduce the loss paid by taxpayers instead of the investors. Compared to issuing new stocks, investors want to take advantage of the debt-like feature of the contingent capital: tax deductibility before the conversion and upfront and fixed recapitalization cost at conversion. As seen in the financial crisis since 2008, lots of too-big-to-fail companies needed government bailout to merely survive. The bad outcomes of writing riskier business than that the available capital can support were borne by the taxpayers, not the investors who made the business decision. Higher capital requirement could certainly reduce the chance of going default. However, as Bolton and Samama (2011) pointed out, the foreseen increased capital requirement for bank industry according 5 A list of contingent capital instruments issued in the past few years is given in Goldman Sachs, “Contingent capital Possibilities,” 17-18. © 2013 Casualty Actuarial Society 7 Understanding Contingent Capital to Basel III may make it more difficult to earn the required return on equity (RoE) if the increased capital requirement needs to be met by the issuance of stocks. In addition, a sudden shift to a much more stringent capital requirement might also result in a credit crisis as the banks hold a much less buffer above the required capital than before or have to raise capital to meet the capital requirement. Contingent capital seems to be a promising solution. (1) As a debt instrument before conversion, it limits the increase in weighted average cost of capital (WACC). It will not cause the concern of higher required RoE in normal circumstances, which happens when financing with common equity. (2) The tax deductibility of the debt instruments is also an argument for investors to utilize contingent capital in their financing. The disciplining power of creditors might also be preserved before conversion by maintaining the same leverage level as before. (3) Firms normally try to sell troublesome assets and get rid of troublesome liabilities instead of issuing new stocks due to its high cost. Issuing contingent capital in good time fixes the recapitalization cost at a reasonable level in a future distressed situation. Apparently it is a cheaper way than raising capital in bad time. (4) It can reduce the default probability without government bailout. Upon conversion, the capital base of the company will be increased so that it will have a stronger capital position than that before the conversion. The loss will be borne by the investors of contingent capital instead of the taxpayers. Therefore, it helps fulfill the goal of applying more stringent capital rules to too-big-to-fail firms. Bankruptcy and government bailout are very costly. Contingent capital can lower the chance of going through those expensive processes. 2.3 Designs of Contingent Capital Despites the skepticism, there is a high and increasing interest in contingent capital instruments. Many designs of contingent capital have been proposed in trying to address the issues mentioned above. The key differences between different designs so far are about the trigger event and the way of loss absorbency. Scope of the trigger event. Trigger event can be based on the issuer's financial condition or on an industry wide indicator. Industry wide indicators, such as an aggregated market loss index or financial industry loss index, may be more suitable for mitigating systemic risk. However, it is hard to implement in an objective way and may convey an adverse message to the market. Type of the trigger event. Trigger event can be related to the stock price, regulatory capital adequacy ratio such as core tier 1 ratio, credit condition such as credit default swap (CDS) spread, or © 2013 Casualty Actuarial Society 8 Understanding Contingent Capital even at the regulator's discretion. Double trigger contingent capital has also been proposed. Level of the trigger point. Going-concern contingent capital normally has a high threshold while gone-concern contingent capital has a low threshold such as the point of non-viability. Besides the conversion of contingent capital, regulator's intervention is normally expected at the point of non- viability. The way of loss absorbency. After the trigger event happens, contingent capital instruments will be converted to common equity, or have a write down of face amount and therefore liability. The impact is considered to be different. Write-down liability is similar to a capital injection while conversion to equity is considered as capital restructure. Details of those proposals and their different impacts will be explored in Section 3 and Section 4. 2.4 Stakeholder Analysis Regulators have shown great interest in utilizing contingent capital to absorb losses under stressed conditions. It is expected to reduce the need of a government bailout and therefore taxpayers' support. After a sizable market is developed for contingent capital, the value of issuers, buyers, and existing stockholders and their roles in corporate governance will also be impacted. Rating agencies have also considered the rating methodology for this new type of hybrid securities and to what extent it can boost the issuer's financial strength. 2.4.1 Regulators Regulators have been busy improving the capital adequacy rules to address the issues emerging from the financial crisis since 2008. In addition to a higher level of capital requirement, the qualification standard of hybrid securities to meet the additional capital requirement is also one of the major focuses. Though the future success of contingent capital is uncertain, it is very likely that contingent capital will become a part of the capital structure to meet regulators' requirement. (1) In October 2010, Financial Stability Board (FSB) recommended that global systematically important financial institutions (SIFIs) should have higher loss absorbency6. One of the candidates that can be used to meet the stringent requirement is contingent capital which absorbs loss at the point of non-viability. It was later endorsed by the G20. (2) Basel Committee on Banking Supervision (BCBS) released a rule about the additional loss absorbency requirement for global systematically important banks (GSIB) in late 2011. BCSC has considered different forms of contingent capital and carefully decided the minimum 6 FSB, “Reducing the moral hazard,” 3. © 2013 Casualty Actuarial Society 9 Understanding Contingent Capital requirements for going-concern contingent capital in order to meet additional requirements for GSIB. Contingent capital will have to be converted to Common Equity Tier 1 when the Common Equity Tier 1 falls below at least 7% of risk adjusted assets, which is a high threshold. It is also required to have a cap on the new shares and the full authorization of the issuers for an immediate conversion. The rule is expected to be phased in between 2016 and 2018 and become effective in 2019. (3) European Union amended its capital requirements directive (CRD) in 2009, known as CRD II, which highlighted the importance role of hybrid capital instruments in capital management. Instruments that absorb losses on a going-concern basis and that must be converted to core tier 1 capital are regarded as equity capital. In 2010, a consultation paper (CRD IV) was issued including possible further changes. It states that the European Commission will consider the potential need for all non-core tier 1 instruments to have a mandatory principal write-down or conversion feature, the potential triggers for conversion, and alternative mechanisms and triggers of contingent capital7. (4) US regulators are also interested in the idea of using contingent capital. As one of the provisions in the Dodd-Frank Wall Street Reform and Consumer Protection Act, Federal Reserve may establish heightened prudential standards for contingent capital requirement. It "authorizes the Board to require each Board-supervised nonbank financial company and bank holding companies with total consolidated assets of $50 billion or more to maintain a minimum amount of contingent capital convertible to equity in times of financial stress."8 The Fed is in discussions with bankers. Unlike the existing contingent capital deals that have trigger events related to the issuer's own capital ratio, the Fed is also exploring a system wide trigger. (5) Office of the Superintendent of Financial Institutions Canada (OSFI) issued its final advisory on Non-Viability Contingent Capital. Seen as a fast movement on implementation of Basel III, it requires that the regulatory capital of all federally regulated deposit-taking institutions (DTIs) must have loss absorbing quality when the DTI fails. All the non-common Tier 1 and Tier 2 capital must satisfy the requirement for non-viability contingent capital (NVCC). Unlike CoCo bonds, the trigger event of NVCC is dependent on the regulators' announcement, either from OSFI, or federal/provincial government. Though it sounds like regulators have a lot of discretion, non-viability is determined based on clearly defined criteria which would mitigate the chance of discretion. Interestingly, this is more like a low trigger 7 COMMISSION SERVICES STAFF WORKING DOCUMENT, "POSSIBLE FURTHER CHANGES," 18-19&23. 8 Sec 165, “Enhanced supervision,” H.R.4173 © 2013 Casualty Actuarial Society 10