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Just-in-Case Capital

How companies are tapping into contingent capital through, of all things, an insurance policy.
Russ Banham, CFO Magazine
June 1, 2001

Late last year, Royal Bank of Canada and the French tire maker Compagnie Financiere Michelin sought access to capital for future contingencies--in the bank's case, to absorb severe credit losses, and in Michelin's, to fund future acquisitions or expansions. Rather than access capital from the debt or equity markets, they opted for a new insurance strategy called committed long-term capital solutions, or CLOCS. According to Peter Currie, CFO and a vice chairman of the Toronto-based bank, the move allows the institution "to tap capital in those times when it normally would be difficult and costly to raise it traditionally."

The policies, marketed by Swiss Re New Markets, a division of Zurich- based Swiss Re Group, are triggered by economic metrics--a fall in a country's gross domestic product in Michelin's case, or a reduction in reserves in the Royal Bank of Canada's. And because CLOCS is insurance, it neatly sidesteps the Catch 22 of customary capital-raising--when you need it most is usually when it's most expensive. "Unfortunately, you can never guess what the cost of capital will be when the right investment opportunity arises," says Jacques Tierny, deputy CFO of the E15 billion Michelin Group, based in Clermont Ferrand, France, and Fribourg, Switzerland. "At the same time, you don't want to raise equity and have it sitting around on your balance sheet." Nor, he adds, do you always want to issue debt during a recession for acquisition or expansion purposes, since it would increase your risk profile.

Together, the two CLOCS deals, which are both off-balance-sheet, represent an entirely new way of accessing contingent capital. "Essentially, you're given standby access to money if a certain adverse event happens," says Carl Groth, managing director of enterprise risk strategies at Willis Risk Solutions, a New York­based alternative risk transfer specialist. "If the economy is doing well and you want to make an acquisition, you can go out and raise capital in the normal way. If it is doing poorly, you can trigger the insurance. And pursuing both strategies [allows] you to diversify your sources of capital."

The deals also represent the first significant incursion by insurers into a market heretofore owned by the investment banks. In much the same way that banks are offering capital market alternatives to insurance policies, insurers are now offering insurance alternatives to traditional banking strategies. More important, says Currie, is that "CLOCS was a much less expensive option than other insurance structures or more-traditional balance-sheet-mitigation strategies."

TREADING CAREFULLY

In Michelin's case, the deal is structured as a 12-year, $1.1 billion subordinated capital facility that is syndicated both to insurance companies, such as Zurich-based Winterthur, and to several European banks, including lead French bank Société Générale. The new capital facility replaces Michelin's previous 15-year, $1.1 billion junior subordinated credit facility that was arranged in 1990 by J.P. Morgan.

The capital instrument is seen as hybrid equity. It incorporates the long-term subordinated features of equity, but still allows the tax deductibility of debt. Access to it is triggered by a specified drop in GDP growth (a formula that comprises one-third U.S. GDP and two-thirds European GDP). And since Michelin's earnings are strongly correlated with the growth in both economies, rising as new car sales translate into new tire sales, such a correlation makes sense, says Tierny. "When GDP drops, that means the business for tires will deteriorate, and we might need to draw on additional credit."

According to published reports, Michelin's commitment fee is 35 basis points to the banks and 30 to the insurers. The borrowing cost is between 70 basis points and 110 basis points over LIBOR, set through a unique auction process in which each of the investors bids to hold the subordinated capital. "The bids are capped every three years at a preagreed maximum," says Thomas Skwarek, a principal in Swiss Re New Markets in London, who adds that such pricing couldn't have been done without "the combined clout of the insurance and banking markets."

Michelin, however, views the new capital approach "primarily in terms of saving equity," says Tierny. "Through this alternative financing transaction, we get a natural hedge against a recession and its impact on our revenues, without having to keep in place a costly buffer of equity."

The capital hasn't been tapped to date, but Skwarek admits that Michelin is close to being able to pull the trigger. "This is an option, remember. The value of the instrument is not in pulling it per se, but in having the ability to pull it."

BANKING ON IT

Royal Bank of Canada had a different motivation than Michelin: It wanted access to capital to replenish its Tier 1 ratios in the event of exceptional losses. Prior to engaging in the transaction, the bank held funds for such scenarios in its general reserve, which is paid out of net income to absorb both low- and high-level credit losses. "But when you look at the probability of drawing from the reserve, the first draw (the low-level credit losses) has a much higher probability of use than later draws--even though the cost of holding the reserve is the same for each," explains Suzanne Labarge, Royal Bank's chief risk officer and a vice chairman. She adds that since keeping capital on the balance sheet for the later draws isn't very efficient, and the probability of tapping it is much more remote, the bank began to think in terms of insurance.


What makes the transaction groundbreaking is that it uses Royal Bank's equity to absorb the low-probability, high-loss events, which are handed over to Swiss Re in return for the insurer's capital. Here's how it works: If the policy is triggered (it is linked to an undisclosed drop in Royal Bank's general reserves), Swiss Re will provide C$200 million cash in exchange for C$200 million in Royal Bank preferred shares. The noncumulative, perpetual shares are priced at their market rate on October 27, 2000.

If the policy is triggered and Swiss Re receives the C$200 million in preferred shares, it would represent about 1 percent of the bank's total equity. While the shares do not carry voting rights, they do pay dividends, and Swiss Re retains the right to sell them, although that would be unlikely. "They'd attract a pretty poor price right after such a serious credit-loss situation," explains David McKay, Royal Bank's vice president of portfolio management.

The bank declined to reveal the cost of the premium. "What I will say is that it's a very small fraction of what it would have cost us to put aside capital in a reserve, or take it through our income," says McKay. As in the Michelin transaction, the premium is charged against annual earnings, providing a nondilutive equity cushion in the event of losses.

The deal bodes well for the double-A-minus-rated bank, says Mark Puccia, a managing director at Standard & Poor's Rating Services, in New York. "They obtain capital protection as opposed to earnings protection, which we view favorably," he says. "This is not earnings protection--if there are write-offs, those still go through the bottom line. The difference is that the earnings losses will be offset by the newly issued equity to Swiss Re."

TWISTS AND TURNS

The two deals come in the wake of another novel policy Swiss Re recently sold to $1.8 billion United Grain Growers, a Winnipeg, Canada- based agricultural firm. That insurance, which blends UGG's grain- volume risk with its myriad property-and-casualty exposures in a single, integrated risk portfolio, is triggered when grain volume reported by the Canadian Wheat Board is less than long-term grain averages.

The similarities to the Royal Bank and Michelin deals are apparent. All three provide capital during adverse situations, such as a recession (Michelin), a massive credit default affecting multiple industries (Royal Bank), or a severe drought affecting numerous geographic regions (UGG). Says Skwarek, "From our perspective, it doesn't matter if the client is looking for earnings protection or capital protection. Our vision is to provide tools that address the real factors affecting a company's ability to leverage capital when it's needed most."

While not everyone is sanguine about contingent capital in general, until recently, investment banks held all the keys to the deals. "Contingent capital strategies whereby you inject capital at a later date offer another example of a transaction that falls short because it lacks current funding," says Solomon Samson, chief rating officer for corporate ratings at S&P's Capital Markets Services. Still, says Puccia, having insurers structure such a call on future funds adds a layer of protection banks can't offer. In short, he adds, insurers are "becoming more creative in providing capital tools that merge the risk protection elements of the insurance world with those of the banking world."

Russ Banham is a contributing editor of CFO.

ROYALTY TREATMENT

Arby's--the fast-food chain known for its roast beef sandwiches-- wanted to put a little extra meat in its capital management strategy. So it turned to Swiss Re New Markets for a recipe. In November, the Zurich-based insurer structured a private placement of $290 million of fixed-rate insured notes linked to the future revenue stream of Arby's franchises, the first time an insurance securitization has been linked to intellectual property.

Arby's operating history and performance data were key to the deal. "The royalty stream is very predictable, given our long history and uninterrupted growth--the kinds of things bond buyers and rating agencies like," says Jarrett Posner, senior vice president of corporate finance at New York­based Triarc Cos., Arby's parent.

Posner, who was searching for capital alternatives to traditional bank and high-yield financing, heard about the securitization of intellectual property by investment banks, and thought it would apply well to Arby's. "Madam Toussaud's wax museum, David Bowie, Calvin Klein, and others had securitized a stream of future income based on their individual brands--why not Arby's?" he asks.

So Posner approached Morgan Stanley Dean Witter, and it introduced him to Swiss Re. "Morgan Stanley felt the bonds would sell better and achieve a better rating if they had an insurance wrap around them," explains Posner. "We wanted to avoid that stigma and give comfort to the bondholders that they will get paid--even if something happens to cash flow from franchise operations."

Swiss Re worked out a deal with Ambac Assurance Corp., a New York­ based municipal bond insurer, to guarantee the bonds with insurance. The risk for both insurers is that a catastrophe on the order of the Jack in the Box E. coli disaster a few years ago could decimate Arby's brand image, thus eroding the value of the franchise royalties. "We're basically covering the risk of a shortfall between the actual value of the future royalties and what they are projected to be," says Thomas Skwarek, a Swiss Re principal. The latter information is proprietary.


Posner says that compared with other financing alternatives, he's saving a minimum of 200 basis points to 300 basis points of rate. --R.B.




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