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The Third Way

16 January 2017 by Gordon Shannon

Today, Phoenix Group, the UK’s largest specialist consolidator of closed life funds is in the market with the first sterling issuance of Tier 3 insurance debt.  We like the credit and are considering an investment in this new transaction, and thought this would be an opportune time to discuss the merits of Tier 3 insurance paper in general.  Tier 3 is an area we have touched on in the past and now that it appears to be gaining traction it is worth revisiting.

To date insurers have made use of the issuance of Tier 1 and Tier 2 debt when fulfilling their Solvency Capital Requirement (SCR).  But as the changes resulting from Solvency II are being further clarified, the option to use Tier 3 for up to 15% of their capital requirement is becoming more attractive to issuers.

Tier 3 debt has a dated final maturity, non-discretionary coupons and only suffers a mandatory deferral of coupons and suspension of repayment if its Minimum Capital Requirement (MCR) is breached.  SCR and MCR are both based on the capital required for a worst loss expected under normal conditions over a period of time but the SCR looks over a so called 1-in-200 year event vs the MCR’s 6.6 years (Value at Risk – 99.5% confidence vs 85%).

The key point is, while Tier 3 ranks above Tier 2 and below senior debt – its trigger is based on the MCR while Tier 2 debt’s trigger is based on the SCR, and therefore gives the investor a greater degree of comfort.  Senior debt should only suffer loses in an insolvency event, its coupons and principal must be repaid as they fall due. If an insurer suffers a MCR breach, it is highly likely it is already insolvent and being wound-up – thus senior bond holders will also be taking losses.  Therefore the extra spread you gain for being invested in Tier 3 over senior is a premium which overcompensates given the lack of excessive additional risk.

So far we have only seen two Tier 3 issuances, a Euro CNP and a Canadian dollar Aviva, which have both performed well.  We get the sense from looking at spreads and how these are being discussed that currently the market is pricing Tier 3 new issues at a discount in spread to Tier 2 paper rather than a premium to senior debt.  As more Tier 3 issuance comes into the market Tier 3 spreads will converge closer to senior.

We think Tier 3 debt currently represents a great opportunity to deploy cash.  We like where it sits in the capital structure, investors are not accepting much more than senior risk and the lack of issuance to date gives it scarcity value.  Therefore both the fundamentals and technicals are positive for Tier 3 bonds.

In more general terms, we also see increased Tier 3 issuance as a useful option for insurers.  Unlike the structural requirements of lower Tier 2, Tier 3 debt only needs a minimum maturity of 5 years allowing insurance companies to issue relatively short dated debt which should be well received in a market where long duration exposure looks increasingly risky.  It is also cheaper for insurers to issue compared to Tier 2 and should help reduce anxiety in the market surrounding upcoming calls on insurance paper.

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