Hybrid Securities Remain Popular Financing Tool

For the past two years, the stars have been aligned for property-casualty insurers looking to raise capital. Interest rates have been at historically low levels, and investor demand for comparatively high-rated insurance sector debt and equity capital that could be utilized under hard market conditions has been strong.

These conditions existed during a period in which many insurers needed to raise external capital, either to support premium bases that grew substantially during the hard market or to rebuild balance sheets damaged by reserve deficiencies related to asbestos claims or the soft market conditions of the late 1990s.

Fitch estimates that more than $25 billion of capital was raised in the insurance sector during this time period. While this capital took various forms, hybrid securities which have characteristics of both debt and equity instruments remain popular among insurance company issuers. Hybrid securities may be more attractive than straight debt because of lower interest costs and features that may allow for interest deferrals. Utilizing hybrid securities in an insurers' capital structure can also help to optimize financial leverage and enhance returns-on-equity.

Another element behind the popularity of various hybrid securities is that rating agencies may attribute considerable “equity credit” to hybrid securities when evaluating an organization's balance sheet financial leverage.

In this article, we discuss the most popular types of hybrid securities, focusing on their core terms and characteristics, and provide our views as to where these securities fit relative to traditional debt obligations and common equity securities.

In general, hybrid securities are designed to provide issuers with financial flexibility approaching that provided by equity and to minimize the dilution of shareholders' interests that is created by issuing common stock. These hybrids can generally be broken down into four broad categories: traditional preferred stock, optionally convertible securities, deferrable securities, and mandatorily convertible securities.

Traditional Preferred Stock

Preferred stock is the “original hybrid” instrument. It has the longest history and is very equity-like due to the cash-flow flexibility it provides the issuer. RenaissanceRe Holdings Ltd. is among recent issuers of preferred stock, issuing $250 million of perpetual preferred in March 2004 that Fitch rated “triple-B-plus.”

Preferred stock typically includes the following features:

Long-dated maturities of over 30 years. Certain types of traditional preferred stocks, known as perpetual preferred stocks, have no maturity. Thus over the life of the security, repayment and refinancing risks are minimal.

Dividend payments, which unlike interest on debt, may be suspended without triggering a corporate default.

Preferred stock typically ranks junior to any senior or subordinated debt, and senior only to common stock.

Optionally Convertible Securities

A convertible security can be viewed as straight preferred stock with an option that enables investors to convert the security into a predetermined number of shares of common stock. Convertible securities typically include the following features:

A “strike price,” or the common stock price at which the conversion option can be exercised, is set higher than the then existing stock price, placing the option “out of the money.”

If, over time, the stock price moves above the strike price, the option would be “in the money,” making a near-term conversion more likely.

A call feature enabling issuers to call (or buy back) the securities after a given time period (often five years). The issuer's call option provides an incentive for investors to convert. Without it, most investors would prefer to continue to receive their interest and/or dividends on the underlying security while still continuing to participate in the upside of the stock through the conversion option.

The added cash-flow flexibility provided by convertible securities is most valuable in times of distress. However, since distress typically leads to declines in the issuer's stock price, conversion rarely occurs when most needed by the issuer. As a result, Fitch assigns minimal equity credit until conversion is imminent.

Mandatorily Convertible Securities

Fitch considers debt or preferred securities that require the investor to receive principal repayment in the form of common shares as “mandatorily convertible.”

XL Capital Ltd. issued $750 million of mandatorily convertible securities in March 2004 and The Chubb Corporation issued $460 million of mandatorily convertible securities in June 2003. Fitch's ratings on these securities are “A” and “A-plus,” respectively.

Mandatorily convertible securities are commonly sold as units. Units typically consist of forward common stock purchase contracts and debt securities that have the following features:

The forward common stock purchase contracts require investors to purchase a number of the issuer's common shares at a predetermined price. The number of shares is based on an exchange ratio.

The duration of the forward common stock purchase contracts is typically less than the duration of the debt securities.

The debt securities have reset features enabling their interest rate to be reset to market rates upon the forward common stock purchase contract's maturity. This allows the debt securities to be remarketed to new investors.

Proceeds from the re-marketing effort are used to fund the original investors' obligations under the forward common stock purchase agreements.

The accompanying chart illustrates transactions, in a simplified form, that take place in a mandatorily convertible issue.

Fitch views mandatorily convertible securities with fixed or reasonably limited exchange ratios as very equity-like, and those with fully floating exchange rate as more debt-like than equity-like. For those securities with a fixed or limited exchange rate, equity credit increases as the term to conversion declines.

Deferrable Securities

Although the issuance of deferrable securities has slowed somewhat after experiencing rapid growth in the mid-to-late 1990s, they continue to be popular among issuers and investors. Everest Re Capital Trust II is among recent issuers issuing $280 million of deferrable securities in March 2004 that Fitch rates “triple-B-plus.” Deferrable hybrids typically have the following features:

o Long-dated maturity (typically between 20 and 49 years).

Dividend and interest deferrals for up to five years on a cumulative basis without triggering a default on the security (subject to suspension of common stock dividends).

Explicit subordination to all senior debt and other subordinated debt of the issuer.

Call options that can be exercised by the issuer.

Compared to pure debt, the five-year dividend deferral feature, even though typically cumulative, provides a fair amount of incremental flexibility to most issuers in a time of stress. The five-year period is usually a sufficiently long time to allow issuers under financial stress to reorganize their finances and/or operations and improve their cash flows.

In conclusion, Fitch expects hybrids to continue to play a key role in insurers' financing activities since they can be used to manage financial leverage, shareholder dilution and financial flexibility. Although Fitch believes that near-term insurance sector capital raising initiatives have likely peaked due to improvements in insurers' earnings profiles and rising interest rate expectations, we believe that hybrids will continue to be among insurers' key capital management tools.

Mark Rouck is senior director at the New York-headquartered Fitch Ratings.

Reproduced from National Underwriter Edition, April 23, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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Hybrid Securities Remain Popular Financing Tool

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