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Enhancing Financial Flexibility Using Contingent Capital

Contingent capital is a method to supplement existing capacity, enhance financial flexibility and diversify capital sources.

An option for raising capital
Contingent capital structures are means of providing capital when a company needs it most. They offer financial institutions or corporations the option to raise capital during a defined commitment period based upon the occurrence of a qualifying event.

These structures can be used in conjunction with traditional insurance or financial hedges as part of an overall risk management programme. Such �traditional� products can be effective in reducing earnings volatility resulting from adverse business events that occur from time to time. But for low probability, high severity events, traditional insurance may be scarce or uneconomic. Under these conditions, contingent capital can provide a cost efficient solution, providing a company post-event solvency and liquidity relief. Additionally, contingent capital structures can address risks that are unhedgeable or cannot be adequately mitigated with traditional capital markets tools.

The mechanics
Triggering events on these structures are generally incidents that have a negative impact on the company's credit strength or liquidity position such as traditional insurance losses, credit losses, financial market dislocation and adverse macroeconomic volatility. Triggers can be highly customised, combined to accommodate specific risk objectives and could reference a company's individual results, or else, could reference publicly available indexes or independent data in order to mitigate moral hazard concerns.

Once a qualifying event has occurred, a company has the option of having the contingent capital provider purchase specific securities with predefined terms. Securities can be issued in various forms, including senior debt, subordinate debt and preference shares. Terms and conditions can be highly tailored to dovetail with bank credit facilities and bond indentures, address rating agency criteria and/or accommodate company-specific financing preferences. Structural provisions could include payment deferral mechanisms, conversion options, maturity extension features and other elements designed to enhance a company's financial flexibility and infuse liquidity.

Addressing creditor concerns
In many cases, company stakeholders and rating agencies accept the possibility that certain remote, uncontrollable and adverse events could impact particular industries. These risks may be inherent to the company and its industry or indigenous to where it operates. Stakeholders often assume these risks, pricing the uncertainty into their valuation analysis.

When an extraordinary event occurs, however, lenders will penalize a company if the event adversely impacts its financial position and thwarts its ability to do business going forward. If the company is forced to draw down on working capital facilities (if such facilities are available to the company after such an event) or approach the capital markets (which may be inhospitable at that time), it would be tapping critical financial resources that may be needed to grow the business in the future. Contingent capital facilities are specifically designed to inject liquidity in such adverse situations. And there is no stigma associated with the use of these facilities, as may be the case with bank credit facilities, particularly backup lines of credit.

Contingent capital is not a substitute for commercial banking credit facilities. It is a supplemental capital source that should be used in co-ordination with other financing products. Contingent capital facilities can supplement existing capital resources and complement bank facilities by virtue of its structural flexibility.

Diverse applications
Contingent capital facilities have been deployed opportunistically by sophisticated corporations, financial institutions and municipalities globally.

Insurance and reinsurance companies have used contingent capital as an alternative to traditional protection against catastrophic events. If such an event occurs, the company would suffer a loss of income but its balance sheet would be protected and the company would be in a good position to benefit from the premium rate increase pressure to follow such an event.
Rated companies have used contingent capital as part of their overall capital management programme to help make rating agencies comfortable with their operating and leverage ratios.
Manufacturing companies have relied upon contingent capital as a source of capital during economic downturns, rather than holding expensive capital in reserve.
Municipalities have used contingent capital as a source of liquidity under adverse circumstances rather than raising taxes or issuing bonds.
Service companies have utilised contingent capital to supplement liability insurance.
Offshore reinsurance companies have used contingent capital for regulatory purposes as an alternative to posting expensive letters of credit in order to receive �admitted� reinsurance treatment.
Banks have employed contingent capital, in conjunction with regulatory approval, as an alternative to increasing their reserves.
Financial guarantee companies have used contingent capital in conjunction with rating agency approval, as a source of �soft capital� to help reduce operating leverage ratios.

Role of insurers
Contingent capital is a balance sheet and cash flow product � not insurance. Hence, contingent capital facilities do not provide earnings protection. Yet it is insurance companies that are uniquely positioned to provide contingent capital, for several reasons.

First, insurance companies have the orientation and core competency to probabilistically assess the likelihood of a qualifying event.
Second, since insurance companies are traditionally buyers of structured paper and private placements, securities can be structured with unconventional features that could otherwise be difficult to sell in the standardisation-insistent capital markets or the syndicated bank market.
Third, insurance companies active in this market have developed the requisite credit evaluation skills and structuring expertise necessary to structure, price and execute contingent capital transactions.
Lastly, contingent capital structures provide important diversification benefits to insurance companies. They provide incremental business possibilities by broadening the product scope and, combined with traditional insurance products, enable insurers to offer a more comprehensive solution to a client's risk management needs.

It would also be relevant to note that finite risk programmes, a variant of contingent capital, have been structured and underwritten by insurance companies for many years. The synthesis of event, market and credit risk produces a product, which while having a bank/capital markets execution format, retains many of the economic features familiar to the insurance industry.

Contingent capital's full potential may not yet have been tapped. It could be a cost-efficient device to enhance asset-backed securities or project finance programmes. Or, it could make an excellent source of capital for mutual companies that would otherwise have limited capital resources. Contingent capital's potential can only be limited by a lack of risk financing challenges � as every risk and financial officer knows, such circumstances rarely occur.

For now, contingent capital is a capital product customised for corporate and municipal financing needs. And in these times of selective bank markets, challenging insurance markets and volatile capital markets, it is a compelling source of supplemental capital: one that companies must not overlook.

Source: Chubb Financial Solutions, Inc via Incisive Media Investments Ltd 2006

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