Moody's introduced its baskets in 1999. As hybrid volumes increased and deals got more complicated, it refined them last November.
To calculate an issuer's financial ratios, hybrid securities are now put in one of five baskets according to maturity, call options, priority in a liquidation, and other features.
Hybrids in basket A constitute 100% debt, those in basket B are 75% debt and 25% equity, and so on through to basket E, where a hybrid is deemed to consist entirely of equity for ratio calculation. So Allianz's C basket deal is half debt and half equity.
Once its hybrid securities are put in their basket, an issuer can then work out its new financial ratios. For an insurer, these include its ratio of total debt to total capital, and the ratio of its equity investment in subsidiaries to its own equity.
Strengthening Allianz's capital base and keeping its AA financial strength rating is one part of CEO Michael Diekmann's "three plus one" strategy, alongside boosting operating profits and simplifying Allianz's portfolio. Like a lot of insurers, Allianz has had a tough start to the millennium.
Capital enhancement began a year ago with a e4 billion equity rights issue. By the beginning of 2004, this and sales of shareholdings had closed the gap. But management decided to issue e1 billion in undated subordinated hybrid capital fixed-to-floating callable notes.
"The best time to raise capital is when you don't need it," says Stephan Theissing, Allianz's head of corporate finance. Low interest rates and high liquidity meant that the time was right. "It also gives us the opportunity to refinance short-term liabilities with long-term debt under very good conditions."
The notes have a 5.5% fixed coupon for 10 years. Allianz can only terminate the notes after 10 years. If it chooses not to, the interest rate becomes variable and the original interest spread rises by 100 basis points over the initial credit spread.
"When Moody's implicitly said that the C basket was the maximum possible equity classification for insurers within fixed-income options, everyone wanted to hit that," says Anandh Haridh, director, capital markets origination, at Dresdner Kleinwort Wasserstein.
To attract fixed-income investors, the hybrid notes needed to be senior to Allianz's share capital. But while Moody's sets out the trigger for a mandatory deferral or non-payment of interest on the notes, German law prohibits management undertaking not to pay dividends to shareholders when this happens.
"A situation where the shareholders get dividends but the bondholders don't get interest payments is a complete no-no," says Haridh. To achieve a compromise between Moody's
and the investors, if triggers are breached and interest payments are to be suspended, Allianz will issue new or treasury shares to fund substitute payments to bondholders, although management cannot legally commit itself to this or to non-payment of dividends to shareholders. "The investors take a bet that management will ensure that they will always get paid," says Haridh. "Management credibility is the key to investors accepting the structure."
Allianz placed the notes at the end of February. The banks went out with price guidance of 140bp over mid-swaps. After a day's bookbuilding, they dropped this to 130bp to 135bp over. The deal priced at 130bp over, was nearly four times oversubscribed, and was increased from e1 billion to e1.5 billion, with 353 different accounts buying.
Allianz timed the deal well ? equity markets were high and there were concerns about a lack of debt supply. "Ninety-two per cent of the book was not price sensitive," says Dresdner syndicate manager Cormac Hollingsworth. "It was clear once we started the roadshow that this was the trade that investors had been waiting for to reposition themselves regarding insurer credit."
Allianz's hybrid structure should be easy to copy, although Europe's insurance regulators could complicate future deals. As banking and insurance regulation converge, hybrid issuers will have to satisfy their regulators as well as the rating agencies. That has already proved difficult for such UK insurers as Friends Provident, which has structured hybrid issues that successfully qualify as tier 1 capital under Financial Services Authority (FSA) rules but have not got C basket treatment from Moody's.
"There's going to be a mismatch between the ratings agencies and the regulators for some time," says Haridh. The EU's Solvency II project on the financial strength of insurers should help them develop a joint approach.