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US Insurers Issue European Medium Term Notes

During the last few years, a number of insurance companies have established European Medium Term Note programs and have been issuing off these programs in ever-increasing volume to reach both European and Asian investors. This article briefly discusses the markets into which EMTNs are sold, the structures being used to reach the investors in these markets, why the products are attractive to the issuers and the investors, and what has been issued thus far and by whom. It will also touch on what we can expect to see in the immediate future.

Background on the EMTN Markets

Exhibit I shows the growth in annual issuance volume of EMTNs from $148 billion in 1989 to greater than $750 billion in 1999. Issuers include a variety of borrowers including banks, US and Foreign Corporations, foreign governments, government institutions, and entities with government guarantees, just to name a few.

Exhibit 1
Medium Term Note Issuance Ex US (1989-1999)

The EMTN programs established by the US insurance companies are similar in many respects to the programs established by other frequent issuers of EuroBonds. The notes are sold in bearer note form and distributed by investment bankers to banks, asset manager, insurance companies and retail investors. Public deals generally run the gambit of $100 million to several billion for a single issuance; while private deals are generally $5 million up to $100+ million and generally purchased by a single investor. Exhibit II shows a breakdown of 1998 issuance of all EMTNs by dollar amount for both public and private deals as well as by number of issues.

Exhibit II
1999 EMTN Issuance by Currency

EMTN Structure

Suppose John Hancock Mutual Life Insurance Company (JHMLICO) wanted to issue a $100 million (USD) 5-year fixed rate note in the Australian Market. Assume the exchange rate is 1.5 AUD to 1 USD. Exhibit III shows the steps taken to execute this transaction.

Although most of the steps take place almost simultaneously, it is perhaps clearer if discussed as a sequence of events. First, ABC Co. issues a 5-year funding agreement to Global Funding Limited (GF), a special purpose vehicle specifically created to issue MTNs. The special purpose vehicle allows ABC Co. to issue a funding agreement, yet the MTNs are issued as a note or Eurobond, a structure familiar to investors around the world. In the second step, ABC Co. and GF enter into a swap contract where ABC Co. pays a 5-year fixed rate on a face amount of $300 AUD and receives 5-year floating rate payments on $200 USD (the same cashflows it pays on the funding agreement). GF then issues the MTN, which is underwritten by the investment banker. In the fourth step, ABC Co. enters into a swap agreement with a third party that mirrors the previous one with GF. Often, the investment banker is the counterparty on the mirror swap as part of the package including the placement mandate for the MTN issuance. ABC Co. receives a 5-year fixed rate on a face amount of $300 AUD and pays a 5-year floating rate on $200 USD. Finally, the investment banker sells the notes in the public or private market.

The public EMTNs are listed on one of the European or Asian exchanges. This listing, and the secondary market made by the bankers, provides liquidity for these public EMTN issues. Private trades may or may not be listed on an exchange and the investment bankers do not provide a secondary market.

For the insurer, the balance sheet impact of this transaction would be the same as issuing a GIC in the Stable Value market, with the addition of two offsetting currency swaps. The net proceeds are used to purchase fixed income investments as part of spread lending operations. The Funding Agreement is subject to statutory minimum reserve requirements, cash flow testing, and of kinds of sensitivity analysis just like a GIC. Since the net proceeds are used in matched funding operations, the rating agencies have treated these as operating leverage, like other insurance liabilities, and not as financial leverage (like debt acquired for acquisitions).

Benefits to Insurers

From the insurer perspective, the EMTN markets provide an excellent fit with existing skill sets, an improvement in the corporate risk profile, a lower cost of funds and an opportunity for growth. Many of the skills that made insurers successful in the Stable Value Market are fully transportable into the EMTN market, such as credit risk management, asset liability management, large contract capabilities, and the ability to analyze complex structures.

The improvement to the corporate risk profile is the result of the ability to more closely match the maturity date of the assets and liabilities. With the EMTNs, the issuers are able to issue large volumes in long dated paper, choosing at any point in time which part of the maturity spectrum of the various markets to target. Eventually, this should alleviate most concerns the rating agencies may have with liquidity ratios and exit strategies.

Lower cost of funds is an outgrowth of flexibility, expansion and diversification of issuance markets. The numbers in Exhibit IV below shows indicative All-In cost of funds over US Dollar LIBOR of EMTN issuance at various currencies and maturities as of March, 1999. The four center columns represent the major currencies of the European markets while the last column represents the best execution available at that maturity in any currency. Exhibit IV is just a snapshot at one point in time. The relative attractiveness of EMTN issuance for a specific currency will change with market conditions. Likewise, market conditions at any point in time will determine the attractiveness of EMTNs relative to domestic issuance (GICs, FA's, etc.).

Exhibit IV
All-In Issuance Cost over US Dollar LIBOR, March, 1999

The source of the numbers are indications from investment bankers that are based on secondary market trading levels, market conditions, swap levels, and feedback from key investors.

Benefits to Investors

The primary buyers of EMTN's are banks, insurance companies, asset management groups, corporate and government pension plans and retail investors in Europe and Asia. Common drivers of demand for all these investors are diversification of credit, movement away from sovereign risk, dearth of high quality domestic credits along with high quality investment quality constraints, and a disappearance of currency plays caused by currency union.

Banks are generally the largest buyers of floating rate debt, while investment and pension plans are the largest buyers of long fixed rate debt. Retail participation is generally strong up to the 5-year point, then declines with increasing maturity.

Recent Issuance by US Insurers

The chart below shows the issuance in 1999 by US insurers issuing Funding Agreement backed debt into the European and Asian debt markets by currency along with the US dollar equivalent.


Source: Capital Data Bondware, Warburg Dillion Read

Market Impact of the Yankee Invasion

The impact on the European markets caused by these insurers issuing debt in Europe is mixed. The immediate impact issuers have on the market is primarily a function of how well advised they were by their bankers, how they are planning on using the EMTN program and how patient they are with the markets. Some bankers fear the additional supply in these markets will cause spreads to widen. Others feel that more investor attention will be focussed on the sector because it's now big enough to generate interest with the middle market investors.

All bankers feel that a deal that is not well placed with investors or not well priced is bad for the market. The new issuers are particularly susceptible in that if they price a deal too tight, it will subsequently sit on the bankers books, or price a deal too wide, it will generate a higher trading level for all their future issuance.

It's important to remember the size of the markets is measured in trillions while the size of the issuance of the insurers is measured in billions. The impact of a bad deal on the sector is generally short lived, especially for issuers within the sector with well established franchises like SunAmerica and John Hancock, but can stick with the issuers who access the market less frequently.

Where the larger number of insurers could have a more significant and permanent impact is on private trades where only a couple of insurers were quoting several months ago, now there will be a half-dozen or so. Insurers with high annual issuance plans may drive up the spreads for all issuers.

Recent Developments

There have been two recent developments that will enhance issuance of the FA/GIC backed structures. The first is that the New York Insurance Department recently blessed issuance of 144(a) debt issued to Qualified Institutional Buyers (QIBs) in the U.S. This is expected to expand the investor base into the largest market in the world where many of the issuers have great name recognition. The impact on spreads should be positive from the issuer's perspective.

The second development is that a proposal by the Bank of International Settlement (BIS) on risk capital requirements for banks would reduce the risk capital weighting on AAA and AA rated corporate debt from 100% to 20%. Banks are by a wide margin the largest buyers of debt. The impact of this development on spreads should also be positive, but will take some time to develop.

EMTNs have received positive reviews not only by market participants but also from the rating agencies and other outside constituencies. These developments, along with the expanding market opportunities overseas and an increasing sophistication dealing in these markets, should provide a positive environment for insurers' spread lending operations in the foreseeable future.

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