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Club Circular 8/08: Hybrid Capital
I am writing to you to inform you that the Club has approved the issue of around $100 million of callable perpetual subordinated debt ("hybrid capital") to be listed on the London Stock Exchange. Just as hybrid capital has been issued by many insurance companies to bolster their solvency position without diluting shareholders' interests, the Club's hybrid capital will augment the Club's solvency position without diluting Members' interests.
The Club currently meets its objective of having at all times sufficient capital to meet its solvency requirements as agreed between the Club and the Financial Services Authority under the Individual Capital Assessment regime. However, although that Individual Capital Assessment regime is meant to anticipate the solvency requirements of the Solvency II directive, there is a risk that regulators and politicians will increase solvency requirements faster than the Club can build its free reserves between now and the anticipated implementation of the Solvency II directive in 2012. It is with this in mind that the Board decided to
approve the issue of hybrid capital.
Hybrid capital is capital that is structured as debt, but has equity-like features. It is also subordinated to all other creditors, but on winding-up of the Club ranks ahead of the Members' entitlement to the surplus remaining after all Members' claims have been paid.
As a result, the cost of hybrid capital is closer to the cost of equity than the cost of debt. The Club's proposed hybrid capital issue has a fixed coupon of 9% per annum during the first 5 years. After the 5th anniversary of the issue the rate becomes a floating rate with a pre-determined spread and at the 10th anniversary a step-up of 1% will be added to this pre determined spread. The predetermined spread will be the difference between the fixed rate coupon and the five year mid-swap rate at the time of issuance.
As mentioned above, the issue has equity-like features which are designed to absorb losses. The issue has no maturity date and cannot be called by the investors. The Club has the right to repay the issue from the 5th anniversary of the issue. The step-up of 1% at the 10th anniversary is meant to provide an economic incentive for the Club to call the issue at or after that date but the Club is not obliged to call the issue at any time.
The Club can also defer interest payments in certain circumstances, but there are certain safeguards to protect investors. For example, the Club will then not be allowed to declare a mutual dividend.
The net cost of issuing hybrid capital (excluding transaction costs) is the difference of the interest payable on the hybrid capital securities and the investment income received in respect of the proceeds of the issue. Assuming that during the first 5 years of the issue the proceeds would be invested in 5 year US government bonds, the net annual cost to the Club would be approximately $4.5 million. The net cost to the Club will be funded from the Contingency Account and will not therefore affect the calculation of Members' acceptable loss ratios.
The Club has already secured commitments from a small number of Members approached as part of a pre-marketing process. The Board recognised that many Members with a good understanding of the Club and its particular credit characteristics might wish to consider the Club's hybrid capital as an investment opportunity and therefore decided that Members who are legally permitted to do so would be given the opportunity to invest. Not all Members will be eligible by virtue of their country of residence, and having taken legal advice on the relevant securities laws and regulations, the Board has decided only to offer participation in the issue to
Members in certain jurisdictions. Those Members will receive a separate notification from UBS enclosing the formal prospectus detailing the terms of the offer.
This is the first issue of hybrid capital by a mutual P&I club, but this form of capital is common in the wider insurance industry. The Board is strongly of the view that it provides a cost-efficient way of increasing the Club's regulatory solvency capital over and above the free reserves. The Club will continue to maintain its traditional reserves at a level consistent with the operational requirements of the Club as a mutual P&I insurer. The hybrid capital will form an additional safeguard against any future requirement to increase solvency capital.
I attach to this letter a list of frequently asked questions, but please feel free to contact me or your usual contact at the Managers if you have any unanswered queries.