Article

interview: Proposed Middlesea rights issue ‘will be fully subscribed’ Noel Grima 26 November 2009

All three main institutional shareholders in Middlesea Insurance plc, namely Bank of Valletta, Mapfre Internacional and Munich Re that in aggregate hold 62.5 per cent of issued share capital, had given their irrevocable commitment that they shall support the Rights Issue and have agreed to subscribe for their proportionate entitlement. This would account for EUR26m of the proposed rights issue of EUR40.2m. In addition, both Bank of Valletta and Mapfre Internacional confirmed their willingness to further support the Rights Issue and have given their written commitment to subscribe to any new ordinary shares not taken up by eligible shareholders and to apportion such acquired shares between themselves so as to secure the equalisation of their respective shareholding in Middlesea Insurance. As a result of these undertakings it was assured that the proposed rights issue would be fully subscribed. This was announced by Middlesea chairman, Mario Grech, speaking at last week’s extraordinary general meeting. The EGM was held due to the considerable problems encountered by Middlesea subsidiary Progress Assicurazioni Spa which, in turn, affected the group’s financial results. In an interview on Tuesday, Mr Grech confirmed that the take-up of the 37.5 per cent of issued share capital held by other than the three main institutional shareholders is doing quite well. Not all these shareholders are private citizens: there are also collective investment companies and small interest held by companies (local and foreign) Even so, however, the guarantee that BOV and the largest Spanish insurance group Mapfre will take up all the remaining ordinary shares not taken up by shareholders and share such equity so that they end up holding an equal shareholding, is reassuring, especially as it comes in the middle of an international recession and considering the extent of the problems which afflicted Progress and thence Middlesea. What caused the crisis Progress is not the first international office or subsidiary held by Middlesea. Before the mid-1990s Middlesea with DTI (now FSA) authorisation opened a branch office in London City. In 2000, Middlesea decided to expand in Italy and acquired a majority interest in Progress from Corporacion Mapfre. Careful studies and research went into this project and showed such a venture would be profitable. The Italian market was at the time deregulated which enabled a free market correction. In fact, over the years from 2001 to 2006 Progress had a clear balance sheet and it registered a profit every year. Besides, as late as in 2008 Progress generated over 72 per cent of the general premium income of the group. The problems, one can say, began with the law identified with the person who is now the Leader of the Opposition in Italy, Luigi Bersani. The Legge Bersani affected the way that the car insurance market was carried out, through its introduction of direct payment (risarcimento diretto). The intention behind this law was good, and over time losses and gains would even themselves out. Still, the way it worked and in the short term affected the viability of small-sized companies like Progress, besides the adverse effect these had on the whole Italian car insurance (RCA) market, Progress registered business amounting to EUR85m in 2008, of which EUR70m were RCA. Now Progress, though a giant by Maltese standards, is a very small fish in Italy, with 0.01 per cent of the whole market. In his speech to the EGM, Mr Grech explained the confluence of a number of complex factors which had such a devastating impact on the financial performance of the company. He explained that these included the impact of the newly introduced direct settlement process (CARD), the down cycle in the motor business sector (RCA), a disproportionate RCA portfolio mix, the adverse run off arising after 31 December 2007, structural deficiencies in the bonus-malus system operation, the marked deterioration in the quality of business from a number of agents, especially in the Campagna region, the increase in the moral hazard risk experienced by the market as a whole, the agency cancellation costs and the prevailing market conditions resulting from the global financial crisis and the consequent impact on investments performance. While the consolidated pre-tax profits generated by Middlesea’s Malta operations amounted to EUR6m, the challenges posed by Progress contributed to a pre-tax loss of EUR28m to the group’s results as at September 2009. In other words, the impact of the subsidiary more than wiped out the positive performance of the companies in Malta. The figures given by the chairman at the EGM were based on actual but unaudited figures as at 30 September but as regards Progress the management accounts as at 30 June have been audited together with a report by the statutory actuary on the adequacy of reserves. Middlesea’s forecast and projection, what it expects to be the situation at the end of December, is a loss of EUR41.75m for the full year. The pre-tax loss is of EUR38m but it goes up to EUR41.75m as the group has to pay taxes on the profits registered in its Malta companies. The fourth quarter of 2009 results was the only subjective forecast in the financial data submitted in the prospectus to shareholders Remedial measures In view of these negative developments, the group moved to take corrective action as from 2008 through a series of measures. These included: Rightsizing the portfolio through the termination of non-performing agents, which were reduced from 164 to the existing 39. So far, in Progress’ expansion, the network of agents covered Sicily and southern Italy up to Rome. This entails an expected decrease in premium income from EUR85m in 2008 to approximately EUR15m projected for 2010. In addition premium rates (tariffs) of the RCA portfolio were increased by five per cent in November 2008 and a further 10 per cent during June 2009. Progress is also increasing tariffs by a further 17 per cent as from 1 January 2010 subject to the regulator’s approval. Motor claims management specialists have been appointed and a management restructuring process was implemented, including the separation of the claims and agents monitoring operations. An Anti-Fraud unit has been set up to monitor the increased moral hazards Furthermore, additional reinsurance cover was negotiated for claims reported in 2009 (both for 2009 business and unexpired 2008 risks), a protection for loss ratios exceeding 105 per cent up to a maximum of 130 per cent. In view of the damage caused by the Progress results and the impending Rights Issue, the board of directors sought a safety net against the further deterioration of the claims position in respect of business written through to December 2008. Specialised negotiations were undertaken for the purchase of an appropriate reinsurance treaty and the EGM was informed that Progress successfully concluded an agreement for an Adverse Development Loss Reinsurance treaty with a reinsurer of international repute. This reinsurance contract will cover any deficiency in reserves with a cover of EUR 40m over and above the existing reserves on open claims for the period between 1 January 2001 up to 31 December 2008. At a cost of EUR14m this reinsurance is expensive, Mr Grech admitted, but does serve to provide a degree of peace of mind. This ring-fences the damage. It could not be made to cover the 2009 losses for this is the current year. For 2009, the additional reinsurance cover mentioned in the preceding point was negotiated. Remedies cost money. The full cost of the remedies put in place is EUR21m of which, as stated, EUR14m are for the reinsurance and a further EUR7m have to be paid as an indemnity to the non-performing agents who were cancelled. Besides, any positive effect of the measures taken could require 18 to 24 months to be reflected in the results. There were a number of other factors, apart from the financial ones, which affected the result of Progress. A recession usually increases the number of fraudulent claims. Over the past months there have been increased instances of the frequency and severity of claims. With Progress’ network ranging south of Rome the risks of moral hazards is, to put it in such words, potentially higher. At that time, one must add, Progress was on a strategy of growth, as evidenced by the increase from EUR56m to EUR80m in 2008. This conjunction of causes caused an accelerated downcycle, which was not so evident in 2008 but became clearer this year. Structural changes This widespread damage, even if now ring-fenced, has caused a general rethink of the whole group’s structure. When it was set up in 1980, Middlesea was a re-insurer. It was only in 1994 that Middlesea became an insurance company operating in primary insurance markets. With hindsight, it should have become a holding company: in fact, however, it became Malta’s largest group holding operation. Had it been a holding company from the beginning anything that happened in a subsidiary company would have been ring-fenced and no impact would have affected the rest of the group’s companies. If Middlesea had a holding company, Middlesea, IIMS and Progress itself would all be subsidiaries of the holding company and the losses registered by Progress would not affect the group as a whole. Nonetheless Middlesea Valletta Life Co. being an associate company within the group was never affected by Progress’ results When all this turbulence is over, the structure of the group must be changed. Some ask: why does the group not exit from Italy? The reply is that Middlesea cannot do that: as a financial institution its operations are built on trust. Besides, as stated, Middlesea went to Italy to generate growth for the group and in fact between 2001 and 2006 it generated annual profits. Then the Italian operation was faced with all these changes – of the economy, of the financial sector, the Legge Bersani … The management and staff were not well prepared enough for all this Perfect Storm. Could there have been early warnings? Insurance is not like a switch: it usually takes up to 24 months for a trend to appear. Middlesea began to see the early warnings in the second half of 2008 and started taking immediate remedial action. The Legge Bersani started to impact the whole Italian RCA business in 2008. Two options The losses sustained by Progress during 2008 and 2009 have placed an unprecedented strain on the capital resources of the group, with its capital base reducing from EUR85.8m as at December 2007 to EUR40.1m as at September 2009. This reduced capital base is inadequate to support the operations of the group. Accordingly, the group faced two options. The two options included: either to inject new capital to enhance the holding company’s (MSI) balance sheet to its previous strength; or to liquidate assets in the balance sheet. The group chose the first option. The first option would have entailed the group selling part or all of its 50 per cent holding in Middlesea Valletta. Middlesea Valletta Life together with its subsidiary company Growth Investments have registered a significant improvement of 413 per cent in profitability. MSV’s profit after taxation as at September 2009 amounted to EUR4.85m, compared to EUR1m in the comparative financial period. Furthermore, the turnaround of the international capital markets has had the major impact on the results of this company and in the strengthening of the life fund in favour of policy holders. The fund attributed to policy holders increased by EUR90m to EUR830m as at September 2009. The value of future profits that will accrue to shareholders on the current portfolio has also increased by EUR1.4m during the period. Total shareholders’ funds of MSV increased by EUR8.76m to EUR98.8m at the end of September 2009 reflecting the increase in capital injected by the shareholders (Middlesea and BOV) and the increase in the retained earnings. The group felt that MSV has huge potential growth and any sale of part of it would impact on future group profits. MSV also exploits to perfection the synergy that has been built between Middlesea and BOV. Having considered well both options, the group held informal consultations with the institutional stakeholders and found that they still saw potential in the group as a whole. It thus called and held the EGM last week and, after a discussion, obtained approval for a call for capital of EUR40m through a Rights Issue in order to re-establish the strength of the group’s balance sheet and thus provide for the future sustainable growth of the group within the statutory and regulatory parameters. Middlesea Insurance is thus issuing 67,000,000 new ordinary shares of a nominal value of EUR0.60 each at a share issue price of EUR0.60 per share. These shares are being offered to eligible shareholders on the basis of 2.68 new ordinary shares for every one existing ordinary share (subject to rounding up or down to the nearest share) held at the record date being 12 November 2009. This is the first new capital increase asked from shareholders since 1994 as the capital base was built up over the years through reinvesting of profits, apart from the EUR40m dividends that were paid. The share price – EUR 0.60 per share – was calculated on the net asset value of the group taking into consideration the projections of the situation as at the end of this year, and even then this figure was likely to have a discounted effect. This was a very brave approach, Mr Grech told me: it is not usual that an equity issues a share offer and at such times of recession and international financial crisis besides going through a most challenging scenario. Every eligible shareholder is these days receiving a letter including an application form detailing the shareholder’s holding of ordinary shares as at the record date together with the shareholder’s entitlement to subscribe to new shares. Together with instructions on how the shareholder is to complete the application form, the shareholder will be given three options: Either take up the right to the new shares; or assign/trade their new shares with third parties; or signify their interest in acquiring additional shares to their rights. All eligible shareholders are receiving the mini prospectus that contains all the required explanations in summary. The full prospectus is available in hard copy from authorised financial intermediaries and from the Middlesea offices in Floriana. It can also be downloaded from the corporate website. The proposed capital injection, Mr Grech told the EGM, together with the current negotiations for bank financing of a subordinated loan of EUR8.5m, will enable the group to re-establish an adequate capital base for operational requirements and to maintain a level of prudential capital, commensurate with the scale of the business. The subordinated loan may need adjustments to reflect the actual consolidated performance as at the end of December 2009 “Having taken action to address the problems at Progress, the group is reasonably confident of its prospects for profitable growth, capitalising on the opportunities that present themselves across the range of its operations. The group will primarily focus on a strategy to strengthen its position in Malta by consolidating its participation in a market which has potential space for substantial growth. It will be guided by a philosophy of underwriting discipline and prudence,” Mr Grech concluded.