As the world comes to terms with the after effects of the natural catastrophes which dominated 2011, with the earthquakes and tsunami in Japan, as well as the earthquake in Christchurch and Cyclone Yasi in Australia, massive economic losses have ensued in addition to the tragic loss of life.
For the insurers and reinsurers underwriting these risks and absorbing these losses, alternative methods of raising capital are high on the agenda, given the limited capacity for underwriting new risks, combined with the introduction of key regulatory changes in the form of Solvency II.
Spreading the risk to the capital markets through the issuance of catastrophe bonds provides one alternative to holding risk on an insurer’s balance sheet, or passing the risk to a reinsurer. CAT bonds have the benefit of offloading catastrophe risk from an insurer or reinsurer’s balance sheet, which is then passed to investors.
With credit from its home regulator, in the case of regulated CAT bonds, it is also possible for the sponsor to reduce the extent of regulatory capital it is required to maintain. Investors, meanwhile, receive the benefit of portfolio diversification from traditional financial markets, with attractive returns, provided of course that the relevant catastrophe does not occur.
With a market which has grown to reach $12 billion over the first decade of this century, investors have found their desire for yield uncorrelated to credit markets in CAT bonds and appetite has been robust for specialist CAT bond investment funds, while the bounce in the secondary CAT bond market following recent hurricane risk model changes demonstrates continued favour.
Amid expectations that this market could double in size over the next two to three years and with increased levels of issuance, the industry has turned to the Cayman Islands and Ireland as the jurisdictions of choice for CAT bond issuing vehicles.
With its traditional strengths as the domicile of choice for capital markets transactions and as a base for captive insurance companies, the rise of the Cayman Islands in becoming the leading CAT bond jurisdiction in the Americas, despite Bermuda’s strengths in the reinsurance world, is well documented.
Tax neutrality, a proven track record and creditor friendly insolvency law have all combined to support this growth, along with the jurisdiction’s experienced professional workforce and sensible framework of regulations.
As such, Cayman has housed the majority of CAT bond deals in the Americas to date, providing cover for risks as diverse as hurricane, earthquake, windstorm and wildfire exposure as well as accommodating structures addressing more esoteric areas such as medical benefits claims risk and longevity risk.
Last year’s modernisation of the Insurance Law, has presented greater opportunities in the insurance and reinsurance sector, with new classes of licences to cater for CAT bond issuers or special purpose reinsurers (Class C), as well as a Class D licence for reinsurers.
The new CAT bond licence specifically recognises the highly structured nature of insurance linked securities such as CAT bonds and enhances Cayman’s user friendliness as a jurisdiction for these structures.
The Cayman Islands Monetary Authority has used the legislative update as an opportunity to enable more proportionate, realistic and sensibly calibrated regulation of each type of insurance business undertaken in the Cayman Islands, to account for the nature of the business market expectations and relevant structure considerations.
When the new law comes into force later this year, the new regulatory framework can only enhance Cayman’s offering and further support the growth of this exciting, dynamic and evolving market.
Ireland’s traditional strengths in insurance linked securitisation transactions and the regulatory process are perhaps less obvious to regular readers of this publication and as such have been given greater prominence in this article.
Initiatives from the Irish government and the local industry, which include innovative legal and tax changes, have seen the jurisdiction utilised to provide cover against such catastrophes as European windstorms, US hurricanes and Japanese earthquakes. These changes have ensured Ireland is able to react quickly to changes in the market and maintain its competitive position.
SPV v SPRV
Ireland’s relatively flexible legal and regulatory environment permits CAT bond issuances to be undertaken by regulated entities (special purpose reinsurance vehicles or SPRVs) or unregulated entities (special purpose vehicles or SPVs).
SPVs are used in cases where the underlying risk is transferred by synthetic means using a derivative or other risk transfer contract rather than through a reinsurance arrangement, where SPRVs are used. Whether a sponsor utilises a SPV or SPRV in a particular transaction is a matter to be determined in each project having regard to what the sponsor ultimately wishes to achieve and the timeframe involved.
Recognising the role of ILS as facilitating alternative risk transfer, the European Reinsurance Directive and Solvency II provides that EEA member states must allow the establishment within their territory of SPRVs, subject to supervisory approval, and envisage that the home member state will lay down the conditions under which activities will be carried on by a SPRV established in its territory.
The European Communities (Reinsurance) Regulations 2006 (Reinsurance Regulations) define an SPRV as an undertaking that assumes risk from (re)insurance undertakings and fully funds its exposure to those risks through the proceeds of a debt issue or some other financing arrangement under which the repayment rights of the providers of the debt or financing arrangement are subordinated to the reinsurance obligations of the undertaking.
In the context of a reinsurance contract that specifies an aggregate limit, the phrase “fully funded” means that the market value of the assets or letter of credit held for the benefit of the counterparty to that contract equals or exceeds that limit. Where a reinsurance contract does not specify an aggregate limit, the market value of the collateral held for the benefit of the cedant must equal or exceed the projected economic reserve requirements of the SPRV under the contract as determined from time to time on an actuarial basis.
Applications for authorisation
The Reinsurance Regulations set out the information and documentation that must accompany an application to the Central Bank of Ireland for authorisation to operate as an SPRV. In particular, an application must be accompanied by a copy of the proposed reinsurance contract or a statement containing a description of that contract.
That description must include details of any triggering event, the aggregate limit of the relevant contract (if any) and a statement as to how the SPRV is or will be fully funded. Details must also be included of the cedant undertaking under the proposed arrangements, the trustees of the SPRV’s assets, the directors and service providers of the SPRV and those persons who will hold qualifying holdings in the SPRV.
The Central Bank of Ireland has issued guidelines and a checklist to support sponsors in establishing SPRVs. These outline the process in respect of applications for authorisation of SPRVS, the necessary systems and controls to be put in place by SPRVs and the Central Bank of Ireland’s solvency requirements.
In particular, it is worth noting that the guidelines do not impose a capital requirement on SPRVs in excess of the amount required to ensure that an SPRV is fully funded within the meaning of the Reinsurance Regulations.
In order to ensure a harmonised approach with respect to special purpose vehicles, Solvency II provides that the European Commission must adopt appropriate implementing measures. For this purpose the European Insurance and Occupational Pensions Authority (EIOPA) has published its fully consulted advice for Level 2 implementing measures on Solvency II for special purpose vehicles (EIOPA Advice).
The EIOPA Advice mirrors in many respects the requirements as already outlined in this article and it should be noted that the Central Bank of Ireland will have regard for the terms of the EIOPA Advice in the context of any application for the authorisation of a SPRV. Walkers’ ILS Group continues to maintain a watching brief for any additional Solvency II developments relevant to this area.
Ireland’s favourable tax regime for SPRVs and unregulated SPVs permit CAT bond issuances to be undertaken on a tax neutral basis provided certain conditions are complied with. While the profits of an Irish SPV will be liable to corporation tax at 25 per cent (being the passive tax rate), the tax that will be applied to the SPV’s net taxable profit can generally, with appropriate structuring, be kept at a negligible level. Withholding tax and VAT must also be considered as part of structuring a CAT bond in Ireland but, in our experience, can generally be addressed to the sponsor’s satisfaction.
Against a backdrop of robust investor demand, an increasing number of new sponsors entering the Insurance Linked Securities space, whether for diversification purposes or to complement existing reinsurance programmes, and given a product which provides competitive returns when compared to other debt securities, the ILS and CAT bond markets look set for a period of continued growth.
Both the Cayman Islands and Ireland have responded well to this potential by implementing sensible legislation and both jurisdictions are perfectly placed to service this growing demand in an efficient and effective manner and to support the continuing growth of the industry.