I (Gary Hirst) have written quite a bit about financial innovation and its effect on the insurance industry. With Solvency II coming into effect in the European market I have also written about the new reserve requirements on equities that will have to be carried by insurers. Thus it is certainly no surprise to me that the financial innovators already have a product ready to combat the new capital reserve requirements.
Cocos (1) have been on the market for a little while now mainly to deal with the new banking regulations born out of the credit crisis. Contingent Convertible Capital Notes are debt instruments that pay a small coupon that can be forcibly converted into equity if the bank’s risk weighted assets fall below a certain level; a perfect tool for bankers looking to deal with their new higher capital ratios.
I find this deliciously charming since I remember the manager of a closed-end fund assuring me that my preferred stock was quasi-debt therefore my investment had priority over the simple common shareholders. Now what we have is debt that is quasi-equity? Such a distinguished role this new security should play in the financial landscape of the future. And, since I am in the insurance business, I wonder what if any role the coco may land up playing in scooting around the Solvency II rules.
For right now the cocos on the market are of the Tier-2 variety not providing much help to the banks capital ratios. But Tier-1 cocos are already in the works and the rumors say they will have: discretionary coupons with no incentive to pay, a perpetual maturity with no incentive to call, and loss absorption. It does not sound like quasi equity to me, it sounds like preferred shares. Yet everything looks different when it is dressed for the ball.
The banks themselves are dealing with their own issues. The question I have is whether we will see the issue of cocos in order to recover insurance company investments that are sure to be lost to the reserve requirements on Solvency II? And is this a type of hand grenade that the CDS’s and MBS’s became during the credit crisis? My contention, of course, is that the reserve requirements of Solvency II are misplaced to begin with; therefore, if companies do indeed take this circuitous route to insurers’ money the effects are unlikely to be pernicious and may actually create value for both sides.
Which is, after all, the purpose of the capital markets.
Note 1. Regular contingent convertible notes or bonds (known as coco’s) are convertible debt instruments that restrict the ability of the convertible debt holders to convert the instruments into equities. Typically, restrictions have been based on the underlying stock price and/or time, but recently some coco issuances of banks have provided for mandatory conversion to equity based on the capital ratio dropping below a predefined level.