Hybrid Instruments issued by Insurance Companies
17th October 2018 (Version 1)

Executive summary:

The capital of insurance companies primarily comprises of equity capital from the shareholders. In November 2015, Insurance Regulatory and Development Authority of India (IRDA) allowed insurance companies to raise following other forms of capital to augment their capital position:

• Preference shares
• Subordinated debt

These instruments, also known as hybrid instruments, will help insurance companies to improve their Solvency Margin while growing their business and increasing insurance penetration.

The starting point for any hybrid debt rating of an insurance company is its 'Financial Strength Rating' (FSR), whether it is in general or life insurance sector. Please refer to the separate criteria available for FSR for details.Subsequently, the rating will be notched down to factor in the additional risks associated with these instruments. The risks include non-payment of dividend/interest if the Solvency Margin breaches regulatory requirements. Also, regulatory approval is required if the general insurance company reports a loss or the loss increases due to such payment of interest/dividend. Acuité will also factor in the articulation and demonstration of timely support by the parent/group to meet regulatory stipulations associated with the hybrid instruments.

Risk Features - Hybrid instruments issued by general insurance companies:

These instruments are akin to the Upper Tier II bonds issued by banks under Basel II regulations. The risk of principal and coupon non-payment on the Upper Tier II bonds is linked to the banks' overall capital adequacy ratio falling below the regulatory minimum (9%). Servicing on these bonds also requires regulatory approval in the event of a loss.

Hybrid instruments issued by general insurance companies carry additional risks because of the restriction on debt servicing on the instrument if the solvency ratio of the insurance companies falls below the regulatory stipulation. Further, in case of insufficient profit or loss, approval from IRDA is required to service these instruments.

Features of the hybrid instruments issued by insurance companies

Instrument	Preference Shares Subordinated debt
Limits on the instruments	Total quantum of these instruments shall not exceed: 1. 25 percent of total of paid up equity share capital and securities premium of the insurance company 2. 50% of the net worth of the insurance company
Maturity period	Preference Shares and Subordinated debt shall be for a tenure as follows: - Minimum Ten years for Life, General Insurance and Reinsurance Companies - Minimum Seven years for Health Insurance Companies - Subordinated debt can be perpetual in nature as well.
Call/Put options	Call option after the instrument has run for at least 5 completed years. Solvency ratio to be met before and after the exercise of the call option No put option is permitted
Return	Dividend / Interest can be fixed or floating rate linked to a market determined rupee interest benchmark rate
Servicing conditions for dividend/interest	1. Solvency position of the insurance company being above the regulatory minimum at all times including after such payment of dividend or interest 2. Prior approval of IRDA mandatory if such payment of dividend or interest results in a loss or increase the net loss of the insurance company 3. No loss absorption feature which may result in conversion of the instrument into equity
Dividend/Interest discretion	Cancellation of dividend distribution on preference shares or servicing of the subordinated debt must not impose restrictions on the Insurer except for distribution of dividend to equity shareholders
Cumulative/Non-cumulative	Dividend on preference shares shall be non-cumulative Interest on subordinated debt not paid in a particular year may be paid in subsequent years subject to compliance with the servicing conditions for such instruments Insurance companies permitted to pay compound interest on the missed interest payment on the subordinated debt
Instrument amortisation	Instruments shall be subjected to a progressive hair cut for computation of Solvency Margin on straight-line basis in the final five years prior to maturity. Accordingly, as these instruments approach maturity, the outstanding balances are to be reckoned for inclusion in capital as indicated below: Years to Maturity Included in Capital 5 years or more 100% 4 years and less than 5 years 80% 3 years and less than 4 years 60% 2 years and less than 3 years 40% 1 years and less than 2 years 20% Less than 1 year 0%
Seniority of claims	1. Claims of Preference Shareholders shall be superior to the claims ofinvestors holding equity share capital but shall be subordinated to the claims of the policyholders and all other creditors 2. Claims of the holders of the subordinated debt shall be superior to the claims of the investors in preference shares and equity shares in that order but shall be subordinated to the claims of the policyholders and all other creditors. 3. Instruments shall neither be secured nor covered by a guarantee of the Insurance Company or other arrangements that legally enhance the seniority of the claims as against the claims of the insurer’s policyholders and creditors

Rating approach:

Acuité would first arrive at or analyse the Financial Strength Rating (FSR) of the general insurance company as the claims of the policy holders are senior to the claims of these instrument holders as well as that of the equity holders. It would then notch down the FSR rating to reflect the risks associated with the hybrid instruments to arrive at its final rating on the hybrid instruments issued by the general insurance companies. Acuité would factor in the parent/group/government support based on the articulation of, and demonstration of, the support to the general insurance company.

Financial Strength evaluation to arrive at the standalone rating of the insurance company (please refer to our separate criteria on this subject):

In brief, Acuité analyses the financial strength rating of an insurance company by evaluating the following key parameters:

• Industry risk would include assessment of the industry structure and dynamics, business growth potential, regulatory environment, etc
• Business risk would include assessment of the market position of the rated entity, growth drivers and future potential, competitive positioning compared to peers, and risk management policies including for underwriting and re-insurance.
• Financial risk would include assessment of the financial strength of the rated entity through evaluation of existing capital, future capital plans, quality and stability of profitability, and asset liability management
• Management risk evaluation

Furthermore, Acuité will apply parent/group/government notch-up after factoring its assessment of financial, management, business and operational support from the promoters in line with its criteria 'Criteria For Group And Parent Support'.

Major risks associated with the hybrid instruments and its assessment:

Hybrid instruments issued by general insurance companies carry additional risks because of:

• Inability to service interest/dividend on the hybrid instruments in the event of breach of solvency margin regulatory threshold (current minimum requirement is 1.5) by the insurance company. This can be because of factors such as
  • significant growth in business and premiums, especially in segments with relatively high risks resulting in higher reserve requirements,
  • significant losses due to sharp increase in claims, or
  • Changes in regulations requiring higher reserve requirements
• Regulatory approval required if the payment of dividend or interest results in a loss or increase the net loss of the insurance company

Hence, the rating on the general insurance company shall be notched down to factor in the additional risk on the hybrid instrument as the non-payment of interest/dividend on a timely basis will be treated as an event of default.

While assessing the notch-down, Acuité will consider following factors to arrive at the final rating on the hybrid instruments:

• Historical trend in solvency ratio and the buffer maintained over the regulatory requirements
• Articulation and ability of the parent(s)/group to bring in additional capital and the demonstration of such support in the past to support the growth requirements and meet the regulatory requirements
• Historical trend and the future expectation on the insurance company's claims ratio,any vulnerability due to business concentration etc.
• For Preference shares, availability of distributable reserves to assess the ability to service the dividend payments

The extent of notch-down will be based on the assessment of the past track record of the Solvency Margin buffer and the future expectation.

The rating on the hybrid instruments will be very close to the financial strength rating of the general insurance company in a scenario of fairly high solvency margin above the minimum requirement and a strong likelihood of a sustainability in the existing buffer levels. On the contrary, lower the Solvency Margin buffer expectation, higher will the notch-down from the financial strength rating of the general insurance company. The rating on these instruments are expected to have higher transition intensity as compared to the financial strength rating on the insurance company as the rating is highly sensitive to the Solvency Margin levels and the earnings.