Subordinate debt and preference share

Subordinate debt and preference share

Subject : Economy

Context:  The IRDAI permits foreign investors to invest in preference shares and subordinated debt issued by Indian insurers.

Details:

• The investments by foreign investors in these two instruments — preference shares and subordinated debt— cannot exceed the sectoral cap (specified under FEMA).
• Total quantum of the instruments under ‘other forms of capital’ taken together should be lower of (i) 50 per cent of the total paid-up equity share capital and securities premium of an insurer or (ii) 50 percent of net worth of the insurer.
• Issue of subordinated debt would either have to be perpetual, or the maturity/redemption period should not be less than ten years for life insurance companies, general insurance companies and reinsurance insurance companies. The maturity/redemption period should not be less than seven years for health insurance companies.
• Insurers have not been permitted to issue either preference shares or subordinated debt with “put option”.

Concept:

Preference shares

• It is commonly referred to as preferred stock, are shares of a company’s stock with dividends that are paid out to shareholders before common stock dividends are issued. If the company enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common stockholders.
• Most preference shares have a fixed dividend, while common stocks generally do not. Preferred stock shareholders also typically do not hold any voting rights, but common shareholders usually do.
• Preference shares fall under four categories: cumulative preferred stock, non-cumulative preferred stock, participating preferred stock and convertible preferred stock
  • Cumulative preference share: Cumulative preference shares are a special type of shares that entitles the shareholders to enjoy cumulative dividend payout at times when a company is not making profits. These dividends will be counted as arrears in years when the company is not earning profit and will be paid on a cumulative basis, the next year when the business generates profits.
  • Non-cumulative preference shares: These types of shares do not accumulate dividends in the form of arrears. In the case of non-cumulative preference shares, the dividend payout takes place from the profits made by the company in the current year. If there is a year in which the company doesn’t make any profit, then the shareholders are not paid any dividends for that year and they cannot claim for dividends in any future profit year.
  • Participating preference shares: These types of shares allow the shareholders to demand a part in the surplus profit of the company at the event of liquidation of the company after the dividends have been paid to the other shareholders. In other words, these shareholders enjoy fixed dividends and also share a part of the surplus profit of the company along with equity shareholders.
  • Convertible Preference Shares: Convertible preference shares are a type of shares that enables the shareholders to convert their preference shares into equity shares at a fixed rate, after the expiry of a specified period as mentioned in the memorandum.

Subordinated debt

• It is known as a subordinated debenture.
• It is an unsecured loan or bond that ranks below other, more senior loans or securities with respect to claims on assets or earnings.
• Subordinated debentures are thus also known as junior securities.
• In the case of borrower default, creditors who own subordinated debt will not be paid out until after senior bondholders are paid in full.
• It is riskier as compared to unsubordinated debt and is listed as a long-term liability after unsubordinated debt on the balance sheet.

Call option and Put option

• An option is a derivative, a contract that gives the buyer the right, but not the obligation, to buy or sell the underlying asset by a certain date (expiration date) at a specified price (strike price). There are two types of options:
• Call options-Calls give the buyer the right, but not the obligation, to buy the underlying asset at the strike price specified in the option contract. Investors buy calls when they believe the price of the underlying asset will increase and sell calls if they believe it will decrease.
• Put options-Puts give the buyer the right, but not the obligation, to sell the underlying asset at the strike price specified in the contract. The writer (seller) of the put option is obligated to buy the asset if the put buyer exercises their option. Investors buy puts when they believe the price of the underlying asset will decrease and sell puts if they believe it will increase.