Description

This is a special situation investment idea for Equitable Life bond (ELFIN Corp – Bloomberg ticker for the bond.) The specific event is the company buying back the bond at a significant premium. The catalyst for the event is regulatory capital requirements for insurance companies in the UK.


Background

Equitable founded in 1762, was the UK's first life insurer. It is now the second largest life insurer and largest mutual insurance company in the UK.

The roots of the present crisis dates back to the 1950s, when the highly regarded mutual insurance society started selling policies with a guaranteed annuity rate (GAR) that allowed policyholders to opt for minimum pension payouts and a bonus when their policy matured. In a typical case, such policies would yield £12,000 a year for £100,000 in pension savings. The guarantees were made by many life insurers to attract customers as the policies offered higher than average rates. The society stopped selling guaranteed policies in 1988.

Equitable is in a bind. It is locked into paying out high interest rates promised at a time of high inflation - in the 1970s. But now that inflation and interest rates are low, Equitable is finding it hard to fund those commitments. It tried to renege on the guaranteed payouts in an attempt to maintain payments to the majority of its 1m customers who do not hold guarantees. But the House of Lords in July last year ruled that Equitable had mistreated the 90,000 guaranteed policyholders. Equitable’s liability is about £1.5bn, which the company says it does not have. It closed its doors to new business in December 2000 and has been trying to find a buyer. There are no takers, because of Equitable's liabilities. A new management team has been trying to forge a compromise that would satisfy the guaranteed policyholders and those without guarantees

Investment Strategy

Buy the only outstanding debt on the company, the 8% perpetual. The issuance is for £350 mil. The bonds have traded as low as 24 and are current trading at 35-37. The carry on the trade w/ a price of 35 is over 20%. The main event is the company buys back the bonds at a premium – around 55. The secondary event is the firm continues to pay interest and as the outlook (portfolio, regulatory) improves and the bonds appreciate. The worst-case negative event is company goes into winding up/liquidation. Alternative negative event is the firm suspends payment of coupon and the outlook turns for the worse.

The equitable member action group (the policy holders/primary claimant representative) in their actuarial analysis (Cazalet Consulting – to date one of the main critics of Equitable Life) has stated that the bonds are worth around 60p per pound sterling and should be bought by the company at a discount price of 60p per pound sterling.

Event Catalyst w/ Risk-Reward Profile

$64K Question – Does Equitable Life go into Winding Up or Administration?

It does not seem to be in anyone interest to take the company into administration/liquidation. There are four main players are government regulators, policyholders, company/management and bondholders. Bankruptcies are usually triggered by creditors, which haven't been paid. In this case, it will either be the regulator or the policyholders who call time, though it will be in almost nobody's interests to push for a wind-up.

Regulator: Officials at the regulator, the Financial Services Authority, are likely to resist pushing for insolvency because bankruptcy/liquidation in just not a desired scenario for Equitable Life. Equitable life is a not in a good regulatory environment to be reorganized or liquidated. Financial Services Authority has other regulated insurers that are in a similar financial and regulatory situation to Equitable.

The Financial Services Compensation Scheme, should it accept liability without question, would pay back 100% of the first £2,000 and 90% of the remaining value of the contractual entitlement under a scheme policy (including future benefits declared before the date the society became insolvent). This might sound like quite a good deal (especially given the 20% cut imposed by the board on people leaving) but the liquidator can decide the contractual element of the policy is only a fraction of what it's worth on paper – not a FIDC kind of guaranteed government insurance.

An administrator is usually appointed when a firm goes bust and they then try to sell parts of the business as viable, ongoing units to rivals of Equitable or third parties. This has already been tried, and failed. Liquidation could be achieved through an agreed scheme, but given the recent history; agreement is not very likely at Equitable.

A formal liquidation with a "stop order" from the courts is one scenario and is more like a fire sale. However, before any winding up order can go ahead, there will be, according to the legal advice given to Equitable's board, "a substantial period of provisional liquidation where the provisional liquidators would make an assessment of the options during which period all the assets of the society would be frozen (unless a court order to the contrary was obtained) and all payments to scheme policyholders, including annuitants would be suspended".

The Financial Services Compensation Scheme is likely to test all avenues in the courts as well before making decisions about who gets what. When it comes to a conclusion, compensation cash from the Financial Services Compensation Scheme could be delayed given that it comes from Equitable's rivals, none of which are feeling very rich at the moment.

Equitable warned that as a result of volatile investment markets and other potential strains on its finances there was a possibility it may not meet its Required Minimum Margin (RMM), set by the FSA. The RMM is the level of extra capital the FSA requires firms to hold after they have made provisions for their future liabilities to policyholders.

FSA Official Statements on Equitable

"We deal with the possibility of insolvency very much on a firm by firm basis as it's not sensible to have a knee-jerk reaction."

"The priority is to make sure that the company doesn't become insolvent, which in the case of Equitable hasn't happened yet.

"The RMM we set is designed to act as a buffer and something that the company should work to stay above. Equitable has only said that there is a possibility that it might fall below this level and that because of the legal uncertainties surrounding its position it can't put its hand on its heart and say that it will be able to stay above this buffer in the future."

Policy Holder:

With Profits Pension
Equitable policyholder with-profits pension. It puts you in the worst position. The more savings with-profits pension policyholder have built up based on annual bonuses, the more likely you are to suffer from liquidation proceedings. Many members could get back less than 50% of their money when a final settlement formula is worked out between the liquidator, the regulator and the court's interpretation of the law. Nobody really knows, because a life company as large as Equitable has never gone administration/ liquidation.

There is every reason to believe that the five or six main policyholder action groups will stand together, or separately, against the liquidator and go back to court to rewrite a settlement in their favor. Any court action will add time and extra charges to the estimated £100m costs of the liquidation.

Guaranteed Policy
Guaranteed policyholder situation is similar to with-profits policyholders should the company become insolvent. The liquidator will decide how to calculate what is due to guaranteed policyholder the fund after all the other calls on the funds have been taken into consideration - in the first instance, the £100m estimated cost of the liquidation.

Unit-linked
The bank bought the unit-linked business last February and says policyholders' money is separate and not at risk.

Political Environment: Politicians are almost certain to get in on the act. Further inquiries by parliamentary committees into the affair could result in a payout from the treasury, especially if the Penrose inquiry into the government's handling of the guaranteed annuity row shows negligence on the part of ministers and the regulator. But again, any payouts will only come after years of fighting.

Management/Company: The company has stated that declaring itself bankrupt is the worst possible solution. A spokesman for Equitable says it is the company's view that a wind-up of the with-profits business remains the worst solution for members.

"At all times the board is interested in one task and that is doing the best for policyholders. There would not only be the £100m wind-up costs but also the prospect of litigation. I believe the legal implications would be horrendous. There is no precedent for a wind-up or a transfer of business or whatever is suggested. We would be setting precedents. Then there is the problem of liquidating a £15bn fund, which would be a fire sale generating enormous costs."

Equitable Portfolio Risk

Equitable Life Assurance--Historical Asset Mix

1995 1996 1997 1998 1999 2000 2001 1H2002 2002E
Equity 51.0% 52.0% 53.0% 51.0% 57.0% 51.0% 25.0% 13.0% 5.0%
Fixed Income 39.0% 38.0% 35.0% 36.0% 32.0% 35.0% 58.0% 70.0% 80.0%
Real Estate 7.0% 6.0% 6.0% 6.0% 7.0% 7.0% 9.0% 9.0% 9.0%
Cash 3.0% 3.0% 6.0% 7.0% 3.0% 7.0% 8.0% 8.0% 6.0%

Between 2000 and 2002, Equitable has reduced its equity exposure and now has primarily a fixed income and real estate portfolio. The portfolio is significantly more conservative and market risk is reduced. There is also over $1.6 billion of cash on balance sheet to pay for any debt restructuring.

Regulatory Event Catalyst

The meeting by Equitable of its required minimum margin of solvency is complicated by the fact that up until now, the £346m subordinated debt liability has been left out of account as a result of a Section 68 Order.

Section 68 Order - For the purpose of regulatory reporting, UK life assurance companies may apply for what is known as a Section 68 Order, so as effectively to ignore (to some extent) the requirement to repay when calculating the amount of capital available to a life office to meet its statutory solvency requirements. On 19 August 1997, Equitable Life duly was granted a Section 68 Order by the Secretary of State for the Department of Trade & Industry (which then was the supervisory body for life assurance companies) to disregard amounts owing to Equitable Life Finance PLC up to an amount not exceeding 50% of the Society’s required minimum margin of solvency.

The bottom line is that Equitable’s reported solvency margin takes no account of the need to repay its indebtedness, although it should be noted that the undated nature of the debt means that repayment would be at the option of Equitable.

In the 2001 regulatory returns the required minimum margin was £917m and, given that the subordinated debt liability of £346m was less than 50% of that amount it was not accounted for as a liability. However, as Equitable shrinks in size (and its required minimum margin along with it), the subordinated debt liability comes ever closer to emerging (on a gradual basis) as a liability that needs to be taken account when calculating statutory solvency. (It should be noted that, in Equitable’s MSS accounts, the fund for future appropriations is arrived at after deducting the subordinated debt liability.)

In terms of the coupon, the issuer is obliged to maintain payments unless Equitable is either insolvent or would become insolvent by such a payment. In a winding up the claim of the bondholders most likely would be subordinate to policyholder liabilities.

Notwithstanding that Equitable does not have to repay its debt anytime soon, it is likely that its debt will become more of an issue for the Society over the coming years. The reason for this is that the Section 68 Order serves to make invisible Equitable’s indebtedness only up to an amount not exceeding 50% of the Society’s required minimum margin of solvency. The problem for Equitable is that, as it shrinks in size, so does its required minimum margin, which number has been of such a size so as to comfortably exceed 200% of the loan amount but is now trending to the point where it will be less than twice the size of the loan, meaning that it is likely that more and more of the loan gradually will have to be accounted for as a liability in the Society’s regulatory returns to the FSA.

There could (and, indeed, should) be some mitigation for the Society against the emergence of its subordinated debt as a “real” liability, in that any decline in the required minimum solvency margin (arising from shrinkage in the book of liabilities) should help free up capital and improve Equitable’s position, which supposes that such freed up capital is not entirely used to enhance members’ claims values.

Quoted exactly from the actuary report by Cazalet Consulting (for policy holders)

“The Offering Circular (which is dated 4 August 1997) in respect of the Bonds contains statements relating to the financial condition of Equitable. These statements make no mention whatsoever of any extraordinary liability. The only specific financial health warning related to the Society’s potential liability in respect of pension mis-selling. Given the long-standing nature of the guaranteed annuity option problem and the prospective proceedings against the Society from persons who assert that they would not have joined the Society had the risks in respect of guaranteed annuity options been known to them, we are inclined to speculate as to whether any of the bondholders now might consider that the offering circular was something of a false prospectus.”

“Equitable’s bonds, which have a nominal value of £346m have “distressed debt” status and, in recent times, have been trading at about 50p per pound sterling of face value before falling to 35p immediately following the publication by the Society of its 2002 interim results, making for a market value of £120m or so. Given the perpetual nature of the subordinated debt (repayment is at the option of the issuer, but contractually no earlier than 2007), the large disparity between the issue’s nominal and market value and the uncertain prospects for the payment of interest, it might be in Equitable’s interest to make an offer to bondholders to redeem the bonds at a discount to their nominal value. An offer to redeem at, say, 60p in the pound would benefit Equitable by £100m in statutory accounting terms.”

Debt Repurchase Event

The company can buyback the bonds using the assets on its balance sheet. The firm current has over £15 billion pounds of assets with a significant allocation in cash. The bonds at par are only £365 million pounds.

Risk Analysis

Administration - this is the second worst state of the world. The bond documents have not been written for a world with administration. Where to bondholders rank in the capital structure? Are bondholders entitled to interest? Bondholders will get an option to litigate.

Any reorganization is going to cost at least $100 million and will be litigated in court for years before there is a settlement. The litigation is taking place in a legal environment with no legal precedent under a reorganization law that has not been applied. No one has an incentive to seek administration. Every pound spent on the reorganization process reduces policyholder payout.

Winding Up/Liquidation - one state of the world you really don’t want to end up in. I don’t think this state is likely to occur because nobody really wants to liquidate Equitable – not the policyholders, not the regulators, not the politicians and definitely not the bondholders or the management.

Negative Headline Risk – There is a lot of headline risk as every newspaper in Britain reports on the happenings at Equitable Life. There is also headline risk as politicians become involved in the process and have political agendas.

Future Interest Payment: On the face of it, holders of Equitable’s subordinated can do little but sit and take the pain if coupon payments are suspended. With regard to arrears of interest, my understanding is that the position to be that these automatically would become due and payable (in full, or in part, depending on the relevant circumstances) upon the earliest of: Equitable’s appointed actuary determining that the Society would be “solvent” (i.e. able to meet its required minimum margin of solvency) after the payment or all or part of such arrears; the fixed date for any redemption or purchase of the Bonds; or the commencement of the winding-up of Equitable.

FX Risk: Long a Sterling Pound denominated instrument.

Catalyst

The specific event is the company buying back the bond at a significant premium. The catalyst for the event is regulatory capital requirements for insurance companies in the UK.