UK sets sights on insurance-linked securities market rich in U.S. investors

June 22, 2016

By Lawrence Hsieh, Practical Law for Regulatory Intelligence

(NEW YORK) – One of the most intriguing questions for meteorologists — and insurers — at the beginning of this hurricane season is whether the United States is due another big one. It has been about four years since Sandy, and more than 10 years since the Big Four of 2005 (Dennis, Katrina, Rita, and Wilma) made landfall.

Severe wind events such as hurricanes, typhoons, and cyclones kill thousands of people, cost hundreds of billions of dollars of direct damage, and wreak untold economic dislocation.

But meteorologists and insurers are not the only ones asking questions. The UK is contemplating bold regulatory moves that aim to make London a hub for insurance-linked securities (ILS), and snatch an advantage in a market dominated by U.S. investors.

ILS are esoteric structured finance instruments that insurers and reinsurers use to offset hurricane and other insurance risk as an alternative to commercial reinsurance and retrocessional reinsurance. The securities can even be used by operating organizations such as multinationals and municipals as alternatives to commercial property and casualty insurance.

The main type of ILS is the catastrophe bond, which “transforms” insurance risk via securitization, and then transfers that risk to investors who buy the bonds in the capital markets. The term ILS is a subset of, but sometimes used interchangeably with, the term alternative risk transfer (ART) instruments, a rapidly evolving family of financial innovations that also include collateralized reinsurance, industry-loss warranties, and sidecars.

Delaware and Vermont are among several states that have ILS-friendly environments. But the states have not made significant inroads in attracting ILS business even though U.S. institutional investors are the main investors in these instruments, which cover predominantly U.S. property-casualty perils.

One reason may be that the states’ regulatory jurisdiction extends only to insurance law. They cannot compete with the panoply of integrated tax and other benefits offered by offshore jurisdictions that have purpose-built comprehensive regulations issued by their central governments to attract ILS business.

Therefore, most ILS emanate offshore, from places such as Bermuda and the Cayman Islands. The wild card, however, may be the UK, whose government aims to implement new proposals to bring some of the business back onto its shores.

Basic structure of catastrophe bonds

Cat bonds predominate the ILS market and cover a variety of disaster risks. Covered perils traditionally include hurricanes and earthquakes, but recent deals have covered previously unmodeled risks such as volcanic eruptions and meteor strikes.

In a typical transaction, an insurer or reinsurer (sponsor) buys protection for the specified risk by entering into a reinsurance or retrocessional contract with a special purpose vehicle, sometimes called a “transformer.” In the UK, SPVs are known as insurance special purpose vehicles, or ISPVs.

The SPV transforms the risk into fixed-income securities, which are sold to bondholders to raise sufficient capital to cover the insurance risk taken on by the SPV. The SPV collateralizes the risk by investing the proceeds in low-risk securities.

Coupon payments are financed by the reinsurance premiums paid by the sponsor and the earnings generated by the collateral and compensate the bondholders for taking on the risk. The bondholders get their principal back if the insured event does not occur during the specified time period, which is typically three years, but trending longer.

If the insured event occurs, the bondholders relinquish the right to receive part or all of the coupon payments and repayment of principal, and the forgone amounts are used to pay the protection buyer to cover its losses.

Any balance is returned to bondholders. Risk pricing is pegged to the size of the insured event or the amount of claims that arise from the insured event during the specified time period.

UK insurance-linked securities hub

The UK government is working with the London insurance market to craft a new regulatory and tax framework to make the UK a hub for ILS and collateralized reinsurance business. They hope to maintain the UK’s status as a leading hub for specialist reinsurance business and talent. The government recently solicited public comment on its proposals and hopes to produce draft legislation by year-end.

The new legal framework will govern the authorization, structure, and taxation of UK transformer/ISPV companies. One of the main features of the proposed framework is the introduction of the protected cell company (PCC) structure for onshore ILS transactions.

Also called a multi-arrangement ISPV (mISPV), the protected cell company structure is a technology that is already in place in jurisdictions such as Bermuda and Guernsey. A PCC is a single legal entity consisting of any number of cell units that house assets and liabilities that are ring-fenced from the creditors of the other cells.

An expedited one-time pre-authorization process will allow sponsors to quickly set up additional cells that will act as transformers to transact new ILS business without having an impact on the other cells. ILS issuers will be exempt from UK corporate income tax; any income will be passed through to the shareholders for UK income tax purposes.

Interest payments from UK ISPVs will be subject to withholding tax for bondholders in jurisdictions that are not covered by a tax treaty that allows withholding tax relief. This could impede efforts to market UK-domiciled ILS to bondholders in countries that do not have a UK tax treaty.

Previous efforts by the UK to catch up have been greeted equivocally by the market and the current effort may be too little too late; the havens have a tremendous head start and still have the tax advantages. From the U.S. perspective, however, the UK effort offers more proof that London has no qualms about harnessing regulatory divergence to suit its needs, an approach it has taken before to attract corporate relocations and investment in intellectual property.

If the United States, which has a passive aggressive relationship with regulatory competition, wants ILS business it must compete with foreign governments, including that of its most trusted ally, to go get it.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters and author of the Corporate Transactions Handbook. The views expressed here are his own.)

(This article was produced by Thomson Reuters Regulatory Intelligence and initially posted on June. 13. Regulatory Intelligence provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 400 regulators and exchanges. Follow Regulatory Intelligence compliance news on Twitter: @thomsonreuters)

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