CoCo evolution poses "Catastrophic" issues

Fri Mar 1, 2013 10:32am EST

* Swiss Re pushes boundaries on CoCos

* Total-loss feature raises concerns about unquantifiable risks

* Investors divided on CoCo future

By Aimee Donnellan

LONDON, March 1 (IFR) - Swiss Re's plan to sell the first total-loss contingent convertible instrument from a reinsurer has drawn parallels between the product and catastrophe bonds, and prompted concerns that investors might misjudge the risks they are taking.

Swiss Re was the first to test CoCos from the insurance and reinsurance industry when it sold a deal with a more investor-friendly equity conversion structure last January, and the incentive for it to do more is clear.

Compared with traditional cat bonds, CoCos not only offer longer duration and larger sized deals, but also provide access to a more diverse investor base - one that banks such as Barclays and KBC have already taken advantage of to issue permanent write-down deals.

CoCos are also a useful tool for reinsurers seeking to cover their risks effectively.

"CoCos arguably offer more flexibility than a catastrophe bond by covering losses across an insurer's portfolio of insurance and asset risks rather than one or a few specified perils," said Daniel Bell, head of EMEA DCM capital products at Bank of America Merrill Lynch.

"I don't think CoCos will replace cat bonds, but they might make a good supplement."

For investors, however, the fact that potential losses are linked to Swiss Re's whole business rather than a single event, or a handful of events, as in the case of a cat bond, makes for a more complicated picture. Some experts fear that investors may fail to assess the risks adequately.

"The catastrophe bond world is very specific and investors tend to be very well versed on the risks they are taking. With CoCos it's about the whole capital structure of an issuer, which can be more difficult to analyse," said a London-based capital hybrid banker.

Although it is rare for a catastrophe bond to be wiped out, with only eight of around 210 property deals issued since 1997 having been triggered, CoCos have no such track record.

SWEPT AWAY

The market rally that has driven spreads on many FIG bonds hundreds of basis points tighter since last summer has forced investors into riskier instruments, and it is easy to understand the attraction of CoCos in this type of current low-yield environment.

Belgium's KBC and the UK's Barclays offered yields of 8% and 7.625% respectively on their CoCos.

Swiss Re, the world's second-largest reinsurer, is coming to the end of an investor roadshow this week, having mandated Bank of America Merrill Lynch, BNP Paribas, Credit Suisse, HSBC and RBS as lead managers.

Despite the aggressive structure, investors are showing a lot of interest - although they have some concerns about the deteriorating market, according to bankers on the deal.

The high credit ratings of Swiss Re, at A1/AA-/A+, are also likely to provide some comfort to investors, particularly as they are at a similar level to Australian banks, considered to be among the safest banks on a global basis.

Swiss Re also has a strong track record of repaying securities at first call.

"If you are comfortable with the overall capital level and rating of an insurance company, and the trigger is low, it can make sense to buy into them," said Dierk Brandenburg, a senior bank credit analyst at Fidelity.

Swiss Re, however, is expected to include a high trigger. In addition, there are some concerns about the reinsurance business as a whole, which covers claims on catastrophes such as floods, hurricanes and earthquakes that the ordinary insurance market is unwilling to take on because of the unknown nature of those types of events.

Reinsurance companies have also been left badly burnt by some investment decisions in the past. In 2007, Swiss Re reported a shock USD1.07bn write-down due to the sub-prime crisis. The losses stemmed from protection that Swiss Re sold to a client against a fall in the value of a portfolio.

With the potential for unexpected losses like this, it might not take much to go wrong to reach the conversion trigger.

DIVIDED INVESTORS

Investors are aware of these concerns, but have been more willing to buy into insurance and reinsurance companies than banks over the past year.

Insurance companies' minimal reliance on capital markets has been one of the factors behind their resilience to the financial crisis, analysts say. That stands in sharp contrast to banks that have needed to meet higher capital requirements from January 1 2013 as they grapple with the potentially damaging effect of proposed resolution regimes.

On this point, investors seem divided on CoCos, as some say they are focusing on ratings, triggers and overall capital, while others want to be paid handsomely for the risk.

"There are still a number of institutional investors that have a tough time with permanent write-down features and they will always drive spread conversations for that reason," said a London-based hybrid capital banker.

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