Understanding Contingent Capital

This paper is a response to the Casualty Actuarial Society’s request for proposals on "Contingent Capital." In light of the recent financial crisis, contingent capital, a type of hybrid security, is seen as an innovative way of recapitalization given the occurrence of a specified event, such as the capital adequacy ratio falling below the threshold. Although it has gained prominence among regulators, there are some doubts from market participants. The effectiveness of this automatic bail-in hybrid security is still too early to tell, given the limited market experience and unclearness of the impact on the share price when the conversion is triggered. The goal of this research is to explore the key features of contingent capital, its market, the appropriate pricing and valuation tools, and its application in insurance industry. It is hoped that the research will increase our understanding of contingent capital and facilitate the assessment of its value and risk.

Motivation. As a new alternative of raising capital automatically under stressed situations, contingent capital is expected to have more weight on insurers' balance sheets in the future. It is important for actuaries to understand contingent capital and have the necessary tools to assess its risk.

Method. This paper provides an overview of the contingent capital market, its features, and its potential impact. It also discusses the pricing and valuation models for certain contingent capital instruments. A case study is included to illustrate the quantitative analysis for a contingent capital instrument.

Results. A spreadsheet model is built and used in the case study. It is capable of pricing and valuing certain types of contingent capital. Quantitative risk analysis and model calibration function is also included. It could serve as good education materials to understand the role of contingent capital, quantify its risk, and assess its effectiveness of absorbing loss.

Conclusions. Contingent capital is a promising candidate to improve the capital position of the financial industry with a smaller cost than additional rights issuance. However, further analysis and testing are needed to find out the appropriate design and better understand its potential impact and related stakeholder behavior. There is still a journey to go before the success.

Availability. The spreadsheet “CONTINGENT CAPITAL QA TOOL” that illustrates the quantitative analysis of contingent capital is available, together with the report.

Keywords. Capital management, contingent capital, CoCo bond, systemic risk