A long-sustained trend of deleveraging – or debt reduction – among insurers and reinsurers is set to reverse over the next two years, according to ratings agency Moody’s, as firms in the sector prepare to intensify M&A activity and steel themselves for the upcoming Solvency II regulation.
Drafted by the Prudential Regulatory Authority to cover insurers and reinsurers across Europe – including offices of firms that are headquartered elsewhere – Solvency II is one of the most controversial packages of rules to have been unveiled in the finance industry in recent years.
One of its key stipulations is that firms must clearly separate all their various lines of business and ensure that each one is capitalised to the fullest extent against relative risks. This aims to ensure that there will always be enough funds in each line to settle up with claimants.
Firms are also required to ensure they have capital buffers in place against their premium-income investments – again, relative to the risks of those deals – so that organisations will remain stable if something goes wrong.
Critics of the package have argued that it is difficult to gauge risk to that level of detail across such a large number of business areas, with 76% of senior executives in the industry saying in a Grant Thornton survey last year that their projected compliance costs are disproportionate.
In the new Moody’s report Deleveraging Trend is Tapering Off as a Result of Solvency II and M&A, the ratings agency suggests that those costs are likely to trigger an industry-wide hunt for cheap debt to offset the requirement for capital buffers.
Analyst Helena Pavicic said: “We expect further new debt issuance over the next two years… By replacing equity with hybrid debt and locking in the current, very low, servicing costs, insurers can maintain their solvency coverage ratios while simultaneously reducing the cost of capital.
“As a result, return on equity – which is suppressed by the low-interest rate environment – improves.”
Moody’s notes that the average adjusted financial leverage of its rated cohort of insurers and reinsurers was at a historically low level of 23.7% at year end 2014 – down from 25.9% as at year end 2013. Indeed, it points out, leveraging in the sector is now at its lowest level since the dawn of the financial crisis in 2008 and 2009.
However, the ratings agency expects that any resurgence of leveraging will be modest at first, until firms become more certain of their positions in relation to Solvency II – set for implementation on 1 January.
In the wake of that, Moody’s predicts that even though the increase of debt issuance may steadily accelerate, most firms will continue to be cautious with regards to the quality of their capital, “mindful that leverage will be adversely affected as and when interest rates rise”.
On the role of M&A – which is already on the rise – Moody’s notes that any further deals are likely to boost activity in the debt markets, as firms are set to part-fund their moves with hybrid issuance.
The ratings agency expects that an increase of M&A on current levels will be driven mainly by the need for firms to build scale, plus adjust to depressed economic growth across Europe and absorb the impact of regulatory changes, including Solvency II.
Moody’s subscribers can download the full report from this link.