Insurance companies have been a fundamental backbone of CFO and rated note feeder structures from the start. For them, the rating sets their capital charge. But the protections that secure it can vary between deals.
Why the Rating Is the Deal
An insurer's regulatory capital charge for a private note relies on the NAIC designation, which in CFOs and rated feeders, comes from the private rating. Enter the rating cliff: since non-investment grade assets carry significantly higher capital charges, if the rating is not maintained, or a ratings downgrade pushes the notes below IG, the cost of capital to an insurer spikes.
What We Are Seeing
Our review of recent CFOs and rated note feeders shows that rating protections are built from three components, documented in different combinations:
An annual rating review is close to universal. Almost every deal requires the issuer to obtain and pay for an annual review of the rating, either as a standalone covenant or as an obligation to deliver an updated rating letter and rating rationale report at least annually. The deadline varies: some deals set a hard December 31 outside date, some combine that with a grace period in respect of the rating rationale report, and others key off the anniversary of the closing date or of the most recent rating update. From an insurer’s perspective, the most robust formulations require the rating letter and rating rationale report before December 31, in a form that can be shared with the SVO, to line up with year-end statutory reporting.
Many, but not all, deals add a covenant to maintain a rating. In some deals the issuer must maintain a rating at all times while the debt is outstanding, with a window (typically between 30 and 90 days) to replace a withdrawn rating. A breach can then lead to an Event of Default after the cure period. But these types of maintenance covenants requires only “a rating” at any level, so a downgrade, even well below IG, would not trigger a covenant breach.
Most deals include a rating event, which leads to a cash sweep, but not a default. The rating event is triggered if the senior notes are downgraded below IG, the rating is withdrawn, or a new IG rating has not been issued within 364 days. The strongest formulations also test the Class B notes. We typically see a 30 to 90-day window to obtain a replacement rating with a December 31 backstop. Even if there is no separate covenant to maintain a rating, the rating event does the work, because it is triggered by a failure to “obtain or maintain” an IG rating. The consequence is a cash sweep with sequential paydown in accordance with the Priority of Payments. It is rarer to see a rating event also triggering an Event of Default.
Sponsors are pushing for CRE. Sponsors sometimes propose that the issuer use “commercially reasonable efforts” to maintain a rating or obtain annual reviews. This is a risk allocation issue. Efforts standards are hard to enforce at law. If, for example, the rating agency never responded to review requests, the issuer could potentially point to its commercially reasonable efforts, leaving an insurer to hold an unrated note with no contractual remedy.
Why the Rating Event Matters
Without a rating event, an issuer can continue making distributions to equity (provided there is enough cash in the system on a payment date) and drawing commitments (subject to draw stops, which we are starting to see). All the meanwhile, the senior notes have fallen below IG and the insurer's capital charge is soaring. The rating event addresses this by tying the insurer's regulatory exposure to the deal's cash flows.
The Bottom Line
Insurers are pricing the notes on the basis that the rating will hold at investment grade. For that reason, insurance companies are resisting commercially reasonable efforts standards and insisting on maintenance of IG ratings for the life of deal.