Why did Mapfre carry out this issue? What is Tier 2 subordinated debt and why is it needed? What role do these complex financial instruments play in a multinational insurance group like Mapfre? “Transactions of this nature form part of the normal capital management activities of a global insurance group and are driven by both regulatory requirements and financial efficiency objectives,” explains Juan José Zahonero, Mapfre Risk Director and head of Risk and Capital Quantification of the Group.
The origin of everything lies in solvency. European regulations, known in the insurance industry as Solvency II, require insurers to maintain a minimum amount of eligible own funds to ensure they can meet their obligations under a variety of risk scenarios. However, regulators do not view all eligible own funds as equal. Some forms are considered higher quality because they are more permanent, more readily available, and better able to absorb losses.
Capital and more
Under Solvency II, the majority of an insurer’s eligible own funds must consist of instruments classified as Tier 1 capital, which includes share capital and reserves. These are considered the highest-quality form of capital, because they are the first to absorb losses if the company encounters financial difficulties. Moreover, they are immediately available and remain stable and permanent over time.
The next layer of capital consists of Tier 2 instruments. The regulation allows insurance groups to count a certain proportion of Tier 2 subordinated debt as eligible own funds. These instruments are often described as hybrid bonds because they combine characteristics of traditional corporate debt with features that make them behave more like capital.
As a Tier 2 instrument, investors holding this subordinated debt understand that, in principle, they rank second in the order of priority should the company experience solvency difficulties.
More risk and more profitability
This feature makes subordinated debt a riskier instrument than traditional corporate debt. Investors assume more risk than with ordinary debt and, in return, demand a higher return.
As a result, Mapfre must pay higher interest rates when issuing this type of debt than it would on other instruments, such as senior bonds. In turn, investors in this type of hybrid debt receive higher interest returns than they would typically earn from investing in traditional debt instruments.
Because it is a complex financial instrument, subordinated debt issuances are restricted to professional investors. Such investors have the appropriate tools to measure what the adequate return is based on the risk assumed.
Capital cost optimization
While it is true that subordinated debt is more expensive for Mapfre than senior debt, it is also a cheaper source of funding than equity, allowing the company to meet regulatory capital requirements at a lower overall cost.
“Subordinated debt issuances provide a highly efficient way of raising capital, particularly at a time when spreads over senior debt are at historically low levels.” This reinforces the Group’s financial strength flexibility,” explains Leandra Clark, Director of Investor Relations and Capital Markets.
However, for a multinational company like Mapfre, issuing subordinated debt has other benefits beyond simply strengthening the Group’s regulatory solvency.
Expanding the range of investors
Mapfre is a key player in the markets and therefore regularly engages with investors. The company plans in advance how often it will access the market to issue senior bonds, subordinated debt, or other types of financial instruments.
With hybrid instrument issuances, Mapfre obtains a significant benefit given its role as an active participant in financial markets. Specifically, it achieves diversification of its funding sources. Investors interested in subordinated debt are not the same as those who buy senior debt or those who invest in company shares.
In this context, the Group broadens its investor base, enhancing its ability to secure continued access to capital markets in the future. “Investor Relations maintains active engagement with fixed income investors, both senior and subordinated, with the aim of ensuring we are well prepared to access the markets at the right time,” adds Beatriz Ranea from the Investor Relations team.
Capital for rating agencies
The hybrid nature of subordinated debt is not only relevant from a regulatory perspective. Major rating agencies (S&P, Fitch, and AM Best) also treat these instruments as hybrid capital, meaning that a portion of their value contributes to strengthening the Group’s perceived solvency in the eyes of credit rating agencies and financial markets.
In short, subordinated debt is much more than a source of funding. It is an instrument that combines the advantages of both debt and equity, helps strengthen Mapfre’s solvency, improves its access to capital markets, and enables the Group to optimize its financial structure.
“In today’s demanding regulatory environment, this type of instrument has become a key component in ensuring the stability and long-term sustainability of the insurance business,” concludes Juan José Zahonero.
