With interest rates up significantly since the beginning of 2022
and equity markets having turned negative and volatile with the
S&P 500 closing out the first half of 2022 down nearly 21%,
insurance company investment and equity portfolios have been and
may continue to be adversely affected. Against this negative market
backdrop, insurance companies may require additional financing to
shore up their regulatory capital, to augment available liquidity
until markets stabilize and improve, or more generally to finance
the day-to-day operations of the business and pursue other business
opportunities. Ultimately, the most appropriate and optimal means
of raising necessary additional capital depends on a range of
factors including the then-current composition of the company’s
capital structure, the intended use of proceeds, and regulatory and
rating agency considerations. At a basic level, straight equity
financing is optimal from a regulatory capital perspective while
straight debt financing is generally less expensive than equity
financing and non-dilutive. Sitting between the pure equity and
debt ends of the financing spectrum are “hybrid”
securities (e.g., debt capital that is structured such that it
qualifies for rating agency equity capital credit). In the
following brief note, we have summarized a number of the common
forms of debt and equity financing utilized by insurance companies
in connection with capital raising activities.

Surplus Notes

Surplus notes are instruments unique to U.S.-domiciled insurance
companies. Over $7 billion in aggregate principal amount of surplus
notes were issued in 2020 and 2021. A surplus note is similar to a
typical “vanilla” senior debt security other than in one
important respect: regulatory approval is required prior to the
issuance of or payment on a surplus note. In addition, to be
treated as a surplus note, the instrument must be expressly
subordinated to all policyholder, beneficiary and creditor claims.
Key features of surplus notes include:

Regulatory Approval. Both the initial
issuance of a surplus note and any payment of interest or principal
on a surplus note must be approved by the relevant state insurance
regulator. Payments on the notes may be approved by the regulator
only if it deems surplus to be sufficient to safely do so. Further,
the form of the agreement under which a surplus note is issued
(e.g., a fiscal agency agreement) and the form of the note itself
must be approved by the relevant state insurance regulator.

Covenants and Defaults. Surplus notes
typically have few, if any, covenants; and the failure to obtain
regulatory approval for the payment of interest or principal is not
typically a default or event of default.

Maturity. The maturity of a surplus
note can vary from a relatively short-term tenor of five to 10
years to a tenor as long as 50 to 60 years.

Optional Redemption. An optional
redemption feature is common, with the notes optionally redeemable
at a make-whole prior to a par call date, which is typically one to
six months prior to maturity, depending on tenor. Surplus notes are
also regularly structured to include a tax event optional
redemption at par. This type of redemption provision typically
dictates that a tax event occurs when there is a change in the tax
law such that there is more than an insubstantial increase in the
risk that interest payable on the surplus notes will not be
deductible for U.S. federal income tax purposes.

Offering Document/Marketing. Insurance
companies commonly issue surplus notes to investors in a Rule
144A/Regulation S marketed offering or in a one-off privately
negotiated transaction with institutional investors. Marketed
offerings of surplus notes require the preparation of an offering
memorandum that may include U.S. GAAP or statutory financial
statements. The associated marketing effort may include a formal
“roadshow” by senior management to investors and may
include a pre-marketing “wallcrossing” process whereby
institutional investors are subject to selective discussions under
cover of confidentiality for a limited period of time to gauge
potential interest. Surplus notes are also frequently issued in a
directly negotiated private placement with one or more
institutional investors and are regularly used by insurance
companies to move capital internally, including between an
unregulated holding company and a regulated insurance
subsidiary.

Regulatory Capital. From a regulatory
capital perspective, surplus notes are treated as surplus, or
equity, and are included as part of the insurance company’s
total adjusted capital under risk-based capital (“RBC”)
calculations. Surplus notes are similarly treated as surplus or
equity for statutory accounting purposes and the proceeds thereof
are treated as assets of the insurer. By contrast, under U.S. GAAP,
these instruments are treated as debt and reported as a liability
on the insurer’s balance sheet. Surplus notes are also eligible
to be treated as regulatory capital under the capital adequacy
requirements of the Board of Governors of the Federal Reserve
System, if applicable. Surplus notes issued by an insurer to an
upstream parent will ordinarily qualify for capital treatment even
when the parent uses proceeds from a third-party financing to
purchase the note.

Tax. While surplus notes are treated
as equity from a regulatory capital perspective, they may be
treated as debt for tax purposes (despite the requirement of
regulator approval for payments), if they possess a sufficiently
debt-like character under case law and Internal Revenue Service
(“IRS”) guidance. Debt treatment typically is desirable,
as it allows for tax deductions on interest payments and generally
permits interest payments to non-U.S. holders without withholding.
A key distinction looks to whether the noteholder reasonably
expects payment from the cash flows of the business as a lender
would, or instead is taking on the entrepreneurial risk of the
business in order to be repaid, as an equityholder would. While
very long maturity dates can put pressure on this analysis, issuers
have treated surplus notes with maturities as long as fifty or
sixty years as debt where the maturities were tailored to the
expected liability profile of the business and repayment
expectations were considered strong.

Senior Debt Securities

Senior debt securities are commonly unsecured and issued by a
top-tier holding company in an insurance company group structure.
The proceeds from these types of issuances are generally available
for “down-streaming” (including by means of an internal
surplus note) to operating companies with operational or capital
needs. While these securities will have a priority in the case of
an issuer bankruptcy event over holders of the issuer’s equity
or more junior debt securities, these securities will be
structurally subordinated to obligations (including policyholder
obligations) of the company’s insurance operating
companies.¹ Key features of senior notes include:

Covenants and Defaults. Like surplus
notes, senior debt securities typically include few, if any,
restrictive covenants and basic default events.

Maturity. The maturity of senior debt
securities can vary from relatively short-term tenors of 3, 5 or 7
years to longer term tenors such as 10, 20 or 30 years.

Optional Redemption. An optional
redemption feature is common, with the notes optionally redeemable
at a make-whole prior to a par call date (typically one to six
months prior to maturity depending on tenor).

Offering Document/Marketing. Senior
debt securities are commonly issued to investors in a Rule
144A/Regulation S private offering or through an SEC-registered
offering. A Rule 144A/Regulation S private offering for public
companies requires the preparation of an offering memorandum with
U.S. GAAP financial statements, or if issued by a regulated
insurance company, statutory financial statements. An offering
registered with the Securities and Exchange Commission
(“SEC”) must be effectuated under an appropriate
registration statement form (e.g., a Form S-1 for a new or
unseasoned registrant or a Form S-3 for a more seasoned issuer),
with each such form setting forth requirements regarding
qualitative and financial disclosure to be included in the relevant
prospectus and the extent to which such disclosure may be
incorporated by reference from the insurer’s other SEC filings
(if any). Senior notes issued under Rule 144A/Regulation S by an
insurance holding company that is an SEC registrant may require the
registrant to ultimately provide investors with SEC registered
notes in exchange for such previously privately placed notes via an
“A/B” exchange offer. As is the case with the sale of
surplus notes, the marketing process associated with the sale of
senior notes may include an associated “roadshow” and
“wall-crossing” process.

Regulatory Capital Treatment. From a
regulatory capital perspective, senior debt securities do not
generally receive any equity credit for regulatory or rating agency
capital purposes.

Subordinated Debt Securities

“Vanilla” subordinated debt securities have similar
attributes to senior debt securities other than the fact that by
definition such securities sit behind senior debt securities in the
case of an issuer bankruptcy event (and as such typically carry a
higher interest rate). By virtue of this junior position,
subordinated debt securities are commonly referred to as junior
subordinated debt securities. Junior subordinated debt securities
may also carry with them additional features that make them more
equity-like and, as such, earn equity credit from rating agencies.
These types of equity-like junior subordinated debt securities are
commonly referred to as “hybrid notes” and have been a
mainstay in the insurance company financing arsenal. Key features
of typical “hybrid notes” include:

Interest Rate. These instruments
typically have an interest rate that resets every five or 10 years
based on an applicable benchmark (e.g., the applicable U.S.
treasury rate at the reset time) plus a pre-determined margin.

Interest Deferral. This feature goes a
long way to giving a subordinated debt security an equity-like
flavor and commonly permits the issuer to defer the payment of
interest for one or more consecutive interest periods that do not
exceed five years for any single deferral period. The quid pro quo
for the deferral feature is covenant restrictions that limit the
issuer’s ability to pay dividends or repurchase its capital
stock or make payments on any pari passu or junior debt securities
during a deferral period.

Optional Redemption. An issuer’s
ability to redeem outstanding hybrid notes is typically limited,
with the optional redemption feature coming in two primary flavors.
The first permits the issuer to redeem the notes at par during the
three months prior to an interest reset date or redeem at a
make-whole at any other time. The second permits the issuer to
redeem the notes at par on any interest payment date (i.e.,
semi-annually) beginning with the first interest reset date and
redeem at a make-whole at any time prior to the first interest
reset date. The issuer will also typically have the ability to
redeem outstanding notes following the occurrence of certain events
that typically include a tax event, a rating agency event and a
regulatory capital event.

• A “tax event” is commonly defined to generally occur
  if there is a change in applicable tax law such that there is more
  than an insubstantial increase in the risk that interest payable on
  the notes will not be deductible for U.S. federal income tax
  purposes.




• A “rating agency event” is commonly defined to
  generally occur if there is a shortening of the length of time that
  the notes are assigned a particular level of equity credit from the
  length of time the notes would have been assigned that level of
  equity credit initially or the amount of equity credit assigned is
  lowered.




• A “regulatory capital event” is generally defined to
  occur if the notes no longer qualify as capital under applicable
  capital adequacy guidelines.

Upon the occurrence of a tax event or a regulatory capital
event, the issuer will typically be permitted to redeem the notes
at par, and, in the case of a rating agency event, the issuer will
typically be permitted to redeem the notes at a premium to par.

Any ability to optionally redeem some forms of hybrid notes,
particularly those that qualify for greater equity credit and are
issued by insurers that are subject to particular solvency regimes
(e.g., Solvency II), may be subject to regulatory approval and/or
related replacement capital obligations.

Offering Document/Marketing. The
offering and marketing process for the sale of hybrid notes is
analogous to the process associated with the offer and sale of
senior notes described above.

Rating Agency Treatment. The extent of
equity credit afforded to an insurer by a rating agency in
connection with the issuance of hybrid notes is highly dependent
upon the exact terms of the notes. At a very basic level, the
extent of equity credit granted to any particular instrument is a
function of:

• the “permanence” of the instrument (i.e., its
  redemption structure);




• the provisions governing the “servicing” of interest
  and principal payments (e.g., does the instrument require interest
  to be paid currently, may the issuer defer payment of interest and
  on what terms and is payment of principal subject to regulatory
  approval or the satisfaction of other conditions); and




• the extent of the instrument’s
  “subordination.”

Hybrid notes typically receive equity credit from rating
agencies up to a specified percentage of the company’s total
capital, which credit will depend upon the specific terms of the
hybrid notes and the particular rating agency’s criteria. This
benefit can help an insurer manage its overall debt-to-capital
ratio and, to the extent that an insurer is subject to a
restrictive covenant that limits its ability to incur senior
indebtedness (e.g., a consolidated indebtedness to total
capitalization financial covenant), hybrid notes are typically not
included in the required calculation of consolidated indebtedness
to the extent of the equity credit afforded to such notes by the
rating agencies. As a result, hybrid notes provide an insurer with
additional flexibility to finance its business without incurring
the full impact on its ratings or financial covenants that senior
or vanilla subordinated debt would have.

Tax. While subordination can be an
unhelpful factor in a tax debt/equity analysis, hybrid notes may
still be structured to be treated as debt if, as with surplus
notes, they possess sufficiently debt-like features overall (an
investment grade rating is particularly helpful). While some
instruments that permit deferral of cash interest payments (such as
“PIK” notes) or have uncertain payment schedules can
require holders to include interest income prior to the receipt of
cash under the “original issue discount” or
“contingent payment debt instrument” rules, the interest
deferral feature of a hybrid note generally may be ignored at
issuance if the likelihood of actually exercising the deferral
right is seen as remote.

Pre-capitalized Trust Securities (or “PCAPs”)

PCAPs are a capital markets-based structure that functions like
a contingent capital facility with some key features analogous to
those found in a revolving credit facility, but PCAPs can be much
longer dated with minimal counterparty risk. These key features
include:

General Structure. Generally, in a
PCAPs transaction, the sponsoring company creates a new Delaware
statutory trust or other special purpose vehicle. That trust issues
trust securities to qualified institutional buyers in a Rule
144A/Regulation S offering. The proceeds from the issuance of the
trust securities are invested by the trust in a portfolio of
principal and interest strips of U.S. Treasury securities (the
“Eligible Assets”) that, together with the facility fee
described below, matches the expected payments on the trust
securities.

Concurrently with the issuance of the trust securities, the
trust enters into a facility agreement with the company. The
facility agreement provides the company with an issuance right (the
“Company Issuance Right”) that permits the company, at
its option, to issue senior notes to the trust and require the
trust to purchase such senior notes with an equivalent amount of
the Eligible Assets. The company is required to exercise the
Company Issuance Right in full upon certain automatic or mandatory
triggers, including events of bankruptcy, certain payment defaults,
or if the company’s consolidated net worth falls below a
threshold amount. In return for the Company Issuance Right, the
company pays the trust a facility fee. The facility fee together
with the income from the Eligible Assets is equal to the coupon on
the trust securities.

Ratings. The trust securities are
typically rated in line with the company’s senior notes ratings
and are designed to mimic an investment in the company’s senior
notes, providing investors a risk profile equivalent to a direct
investment in the company’s senior debt.

Exercise of PCAPs Facility. If the
company wants to exercise the Company Issuance Right and receive
the Eligible Assets, it delivers a notice to the trust. Assuming
full exercise of the Company Issuance Right, the trust’s sole
asset will be the company’s senior notes. Most PCAPs facilities
permit the company to exercise the Company Issuance Right in part,
in which case the company would issue a portion of the
contractually agreed maximum aggregate principal amount of senior
notes to the trust and receive the equivalent amount of Eligible
Assets. The trust’s assets would then comprise the remaining
Eligible Asset and the senior notes so issued. The facility fee on
the unissued senior notes, the coupon on the senior notes and the
income from the remaining Eligible Assets would provide sufficient
funds to pay the coupon on the trust securities.

Leverage Neutral. One of the key
benefits of PCAPs is that PCAPs are leverage neutral day one and
are generally viewed positively by rating agencies. Until the
senior notes are issued to the trust, the PCAPs are not reflected
on the company’s balance sheet and not included in the
company’s financial leverage. The off-balance sheet nature of
the PCAPs structure enables the company to proactively prepare for
contingencies, while ensuring the company does not advertise an
artificially inflated leverage level or breach any leverage-related
financial covenants prior to issuance. Rating agencies generally
view PCAPs as a credit positive because it improves the
company’s access to liquidity, especially in times of
stress.

Refreshable. The PCAPs facility is
also refreshable, which allows the company to repurchase the senior
notes with Eligible Assets and then later reissue the senior notes
in return for the Eligible Assets.

Other Structural Features. There are a
number of structural features designed to provide the company with
additional flexibility and optionality, including as a backstop to
letter of credit facilities. See our article “The Financing
Flexibility of P-Caps” available here for more detail on the structure and
available options.

Tax. PCAPs facilities are complex
arrangements, and raise technical questions as to the correct
characterization of the relevant payments for tax purposes. There
are multiple paths to concluding the company is entitled to a
current tax deduction for its payments, which typically is the main
focus in these arrangements. Assuming the relevant criteria are
met, the company should obtain a net deduction equal to the spread
between the coupon on the senior notes and the return on the
Eligible Assets (an amount equal to the pre-draw Facility Fee) both
before and after the facility is drawn.

Funding Agreement-Backed Notes

Funding agreement-backed notes (“FABNs”), like surplus
notes, are another financing option unique to insurance company
issuers. FABNs are typically issued through programs that are
designed to accommodate periodic or regular issuances.

General Structure. In this structure,
a special purpose vehicle (an “SPV”), typically a
Delaware statutory trust, issues multiple series of notes to
institutional investors in Rule 144A/Regulation S offerings or to a
single institutional buyer in a private placement. The SPV uses the
proceeds from the sale of each series of notes to purchase one or
more funding agreements from the insurance company issuer (funding
agreements are akin to guaranteed investment contracts or
“GICs”). The insurance company issuer deposits the
proceeds from the sale of the funding agreement into its general
account or a separate account to be invested in other assets. The
insurance company issuer then earns the spread differential between
the cost of its obligations under the funding agreement and the
yield on its invested assets. The funding agreement is pledged and
collaterally assigned to the indenture trustee to secure the
SPV’s obligations under the relevant series of notes. The notes
may be listed on a foreign exchange (e.g., Euronext Dublin).

Flexibility. FABN programs are
flexible and can be structured to accommodate issuance of notes
with fixed or floating rates of interest, with interest rates tied
to nontraditional assets, in multiple currencies, with various
redemption/put options and other customized features. It also
allows for reverse inquiries from institutional investors or
corporations with the funding agreement and related notes
customized to a specific investor request. Once a program is
established, takedowns can be accomplished quickly if the program
is kept updated, including with respect to disclosure and due
diligence.

Benefits. The benefit of the FABN
structure is that it functionally allows the insurance company
issuer to “convert” a non-tradable insurance product into
marketable and more liquid securities with a lower funding cost
than senior notes due to the higher priority of the funding
agreement in insolvency. In addition, each issuance is from a
separate series of the SPV, which is considered to be legally
distinct for insolvency purposes. Investors receive the
“pass-through” benefits of an insurance product, namely
higher priority in a rehabilitation or liquidation as a
policyholder than they would have as a holder of senior notes. The
ratings on the notes typically correspond to the underlying
insurance company issuer’s financial strength rating.

Tax. Although the funding agreement is
regulated as an insurance product, it generally is treated as debt
for tax purposes, similar to the instruments described above. Thus,
no reserve deduction should be expected upon sale of the funding
agreement, but no premium income is recognized on receipt of the
proceeds, and the issuer generally should obtain deductions equal
to the FABN interest.

Depositary Shares.

A form of equity financing frequently used by insurance company
issuers is depositary shares that represent a fractional interest
in a share of preferred stock issued by the company and deposited
with the depositary. The depositary shares pass through the terms
of the underlying preferred stock to investors on a fractional
basis. From 2017 through 2021, over $11 billion of depositary
shares were issued by insurance companies.

Dividends. The underlying shares of
preferred stock are typically perpetual and pay dividends
quarterly. The dividends are not mandatory and noncumulative. If
dividends have not been paid for the prior dividend period, the
company may not pay dividends on, or redeem or repurchase, its
common stock (or other junior stock).

Voting Rights. The holder of the
shares of preferred stock has no voting rights except with respect
to changes in the terms of the securities and for the election of
two additional members of the company’s board of directors if
dividends have not been declared and paid in an aggregate amount
equal to full dividends for at least six quarterly dividend
periods, whether or not consecutive. This latter voting right is
required by the stock exchanges for listed preferred stock. To the
extent any vote is required, the depositary will vote whole shares
representing the number of fractional votes it received from the
holders of the depositary shares.

Optional Redemption. The company may
optionally redeem the shares of preferred stock at any time after a
specified initial no-call period, e.g., five years, at the
liquidation preference plus accrued and unpaid dividends. During
that initial no-call period, the company also has the right to
redeem the shares of preferred stock in the event of a rating
agency event (at a premium to par) or regulatory capital event (at
par). A “rating agency event” occurs when there is a
shortening of the length of time that the shares of preferred stock
are assigned a particular level of equity credit from the length of
time the shares of preferred stock would have been assigned that
equity credit initially or the amount of equity credit is lowered.
A “regulatory capital event” occurs when the shares of
preferred stock no longer qualify as capital under applicable
capital adequacy guidelines. A corresponding amount of depositary
shares are redeemed with the proceeds of the redemption of the
shares of preferred stock.

Offering Document/Marketing. These
transactions are typically SEC-registered transactions that are
offered and sold to retail and institutional investors and listed
on a stock exchange. As a result, the issuer will need to prepare
and file a prospectus supplement with the SEC and typically
participate in marketing efforts.

Board of Director Action. Depositary
share issuances require the establishment of an underlying series
of preferred stock, which requires action by the issuer’s board
of directors to adopt a new certificate of designations (or the
equivalent in the issuer’s jurisdiction) with the terms of the
preferred stock. Action by the board of directors or a duly
authorized committee thereof will be required for the declaration
of dividends each quarter as well.

Benefits of a Fractional Interest. The
benefit of issuing a fractional interest in a share of preferred
stock is that it allows the company to issue a much smaller number
of shares of preferred stock, of which a limited number have
typically been authorized in the company’s certificate of
incorporation and increasing the authorized number would require
shareholder approval. It also makes the securities more accessible
to retail investors given the lower par value for the depositary
shares, typically $25, rather than the $25,000 stated amount for
the underlying preferred shares.

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