Committee on Valuation, Finance, and Investments Issues Request for Proposals on Contingent Capital
- Casualty Actuarial Society (CAS)
The CAS was organized in 1914 as a professional society with the purpose of advancing the body of knowledge of actuarial science applied to property, casualty and similar risk exposures. This is accomplished through communication with the publics affected by insurance, the presentation and discussion of papers, attendance at seminars and workshops, collection of a library, funded research activities, and other means. The membership of the CAS includes over 4,600 actuaries employed by insurance companies, industry advisory organizations, national brokers, accounting firms, educational institutions, state insurance departments, the federal government, and independent consultants. Additional information about the CAS can be found at www.casact.org.
- Committee on Valuation, Finance, and Investments
The Committee on Valuation, Finance, and Investments (VFIC) is charged with providing direction, guidance, and support to the profession, regulators, and others regarding valuation and financing of property and casualty risks and investments. The Committee is also responsible for monitoring and coordinating activities with other organizations or CAS committees working in areas related to property and casualty valuation, finance, and investments. VFIC will sponsor the research to be conducted under this RFP on behalf of the CAS.
- CAS Interest in the Subject
Capital and liquidity standards as well as a new structure for capital market regulation have been discussed since 2007-2009 in the United States, the United Kingdom, Europe, and Asia. There has been considerable interest in debt securities that convert into equity in periods of distress.
Contingent Capital is such an alternative capital source that relies on issuance to capital market investors. CoCo bonds are similar to traditional convertible bonds except that the conversion into equity is not at the option of the bondholder, but is triggered when certain capital thresholds are breached or to stave off bankruptcy.
Recent activity by European insurance companies and banks shows that there is a market for loss absorbing bonds. The results have shown volatility, however. One contingent capital facility may convert successfully while another debt-for-equity swap may result in a significant share-price slump.
Much study has been done within the banking industry on the topic of contingent capital. The existing literature in the insurance industry is not as readily available.
Organizations in the United States which have performed research on the topic of contingent capital include the New York Federal Reserve, whose issuance of a Staff Report in June 2011 defines the mathematical equilibrium under which stability in a portfolio may be achieved.
On June 25, 2011, the Basel Committee stated that they “will continue to review contingent capital, and support the use of contingent capital to meet higher national loss absorbency requirements than the global minimum, as high-trigger contingent capital could help absorb losses on a going concern basis. Classification of contingent capital has become more detailed under Solvency II but a complete understanding has not yet been incorporated.
The IMF Staff Discussion Note of January 2011 states that “Contingent capital instruments should be considered as part of a comprehensive and consistent crisis prevention and management framework.”
- Research Problem Description
The purpose of this RFP is to extend the theory and actuarial tools currently available to evaluate and structure alternative risk capital forms to traditional reinsurance and equity or hybrid capital. Contingent capital is another tool which actuaries should understand in managing risk and capital. Some of the key questions that need to be researched are:
- The types of triggers proposed: insurance events, capital ratios, market metrics, or regulatory discretion. Benefits and drawbacks of various triggers.
- Rights to issue capital securities triggered by insurance events.
- Who retains control of the company in the event of a trigger?
- How should contingent capital be compared to traditional reinsurance paying off on the same triggers? to multi-year reinsurance?
- How can actuaries evaluate the correlation between the insurance triggers and the capital base or share prices of the insurance enterprise issuer?
- The roles of liquidity and leverage, underwriting market cycles, mark-to-market, cash flows, counter-party risk, tail-risk, and moral hazard.
- The roles of price manipulation, inefficient capital allocation, market uncertainty, timeliness of conversion, and unreliability of conversion.
- How does contingent capital compare to other capital market solutions, such as industry loss warranties or reinsurance sidecars?
- How should additional provisions be evaluated? What if the shares issued have no set strike price, but are at the "then" market prices? Is this truly contingent capital? What if the share price could trigger a "knockout" of the issuance option? Does the defeat the purpose of the contingent capital?
- How can financial engineering and actuarial mathematics merge to derive a cogent approach to evaluating the risk and rewards of these sorts of transactions?
- Does the contingent capital have a countercyclical effect on the firm’s balance sheet that is a viable alternative to minimum regulatory capital requirements? Can the coco bond prevent a spiraling of systemic risk?
- In “punitively dilutive” conversion, shareholders would be automatically diluted. How effective is this incentive to moderate risk? Will bonds fail to absorb losses if the agents are unwilling to penalize bondholders?
- Which economic agents choose the conversion policy? Should regulators have the flexibility to halt a trigger and conversion in disorderly markets?
- Is contingent capital a risk management tool in that there is a reorientation of management and shareholder incentives?
- Under what conditions does a transfer of value between equity holders and contingent capital investors exist?
- A comparison of proposals for going-concern vs. gone-concern contingent capital, bail-ins, and orderly liquidation.
- How large could the issuance of loss-absorbing securities be if they are to be a viable solution to “too big to fail”?
- How should disclosure requirements be standardized? How will triggers relate to stress testing?
- Is contingent capital potentially a significant capital solution for Solvency II requirements?
- How to assess both the issuers and the potential investors for such products.
- Proposal Requirements
Proposals should include a clear outline of the work that will be performed and the time frame in which it will be performed (including key dates). The more specific the proposal covers the goals the better. A cost estimate or range should accompany each proposal.
Although original research will not be discouraged, the report should primarily be viewed as an educational monograph. Summarizing current and past developments in as many as practical of the topics mentioned above is strongly encouraged.
The report should include R code or Excel spreadsheets that can be used by other researchers to perform similar analyses using a model or a variation of it. Spreadsheets, programming code and other practical work products which can be distributed with the research paper should be included. Approval of the Final Report may be delayed without submission of concrete work products.
This proposal will be reviewed in conjunction with the attached Research Agreement which defines the terms and conditions under which the work is performed.
The proposal should be accompanied by the resumes of the researcher(s), indicating how their background, education, and experience bear on their qualifications to undertake the research.
Respondents should demonstrate their interest in and familiarity with the literature on the evaluation of credit risk by including a resume (if a firm, of the principal consultant(s) performing or directing the work) showing relevant work/research experience and professional accomplishments (e.g., papers published).
Receipt of proposals will be acknowledged in a timely manner.
All decisions regarding the evaluation of responses to the RFP will be awarded entirely based on the information provided in the written proposals. The CAS will award the contract to the respondent who, in the judgment of VFIC, is best able to perform the work as specified herein. If VFIC determines that no proposal meets the requirements of the RFP, then no contract will be awarded.
When a respondent is chosen by VFIC and the contract awarded, respondents not awarded the contract will be so informed shortly thereafter.
Interested researchers should submit their proposals and any questions in writing to:
- Casualty Actuarial Society
Attention: Chairperson, VFIC
4350 N. Fairfax Dr. Suite 250
Arlington, VA 22203
Phone: (703) 276-3100
Fax: (703) 276-3108
The proposals will be reviewed by members of a subcommittee of VFIC.
- Proposed Schedule
October 21, 2011
Deadline for questions (must be written) from researchers regarding the RFP.
November 4, 2011
All written questions together with their answers will be distributed to all proposers.
November 18, 2011
Proposal deadline - end of business day
December 2, 2011
Proposal selection by VFIC
Draft Report and Final Report due date to be decided by researcher and included in proposal. It is expected that interim review due dates will be agreed upon by the Committee and the researcher(s) after the proposal selection is made. Optimal interim review discussions may be spaced two to three months apart.
A maximum total of $25,000 is available to be awarded to one or more researchers. Payment of award(s) will be contingent upon delivery of an acceptable research product.
- Presentation, Ownership and Publication of Report
If asked, the researcher(s) agree to be available to present the report at a CAS meeting or seminar. If travel is required, reasonable expenses will be paid in addition to the compensation provided in Section 8. The researcher(s) are also encouraged to make sample calculations available in spreadsheets or code for a widely used analytical language such as R.
As a condition of selection, the CAS requires that all right, title, and interest, including copyright and patent, in and to the report be owned by the CAS. The selected researcher must sign a formal Agreement (attached) that assigns all such rights to the CAS. Of course, in any publication of the report, the researcher will receive appropriate credit. The CAS may publish the report in any CAS publication, including electronic versions such as on its Web site or on compact discs.
- Research Agreement
A standard research agreement will be provided to the researcher(s).