Insurance Linked Securities (ILS) are instruments by which insurance risk is transferred to capital markets. For insurers and reinsurers, ILS represents an alternative to traditional reinsurance and retrocession. The benefits ILS offers to insurers and reinsurers include additional ways to manage risk, additional capacity (including with respect to "uninsurable" catastrophic risks), diversification of counterparties, potential reduction of credit risk (i.e., in collateralized transactions) and, in some cases, a way to obtain financing. The benefits ILS offers to investors include the opportunity to obtain attractive returns and to diversify an investment portfolio (since the return on ILS is dependent on the occurrence of triggering events and is generally uncorrelated to the return on other asset classes).
ILS products are increasingly accepted as both a valid risk management tool by (re)insurance companies and as a stand-alone asset class by capital markets. While ILS, particularly catastrophe or "cat" bonds, are increasingly popular in Europe and the US, ILS have not yet come to Canada in a meaningful way.
Given the benefits ILS offers to insurers, reinsurers and investors, some expect to see a market for ILS develop in Canada. There is certainly interest in ILS within the Canadian (re)insurance industry and the Office of the Superintendent of Financial Institutions (OSFI) appears to be open to the development of this market, provided certain conditions are met. Julie Dickson, the Superintendent of Financial Institutions has stated, in response to questions regarding whether OSFI would consider solutions to weather risks that involve transferring risks to capital markets, that "OSFI is open to consider new approaches to risk mitigation, but any new approaches would, of course, need to pass certain tests including true risk transfer and compatibility with capital rules."
Unlike some jurisdictions, Canada has no insurance laws, regulations or guidance specific to ILS. The reason for the absence of ILS specific laws, regulations or guidance is that there has not been any real demand for ILS in the Canadian marketplace. Nevertheless, there are existing legal and regulatory requirements in Canada that would apply to ILS. As well, we understand that OSFI has developed certain principles that it will take into account in considering proposed ILS products/arrangements. Those considering ILS arrangements in Canada need to understand how existing legal and regulatory requirements and OSFI's expectations would affect such arrangements.
This article provides a basic overview of ILS and how Canadian insurance law and regulation would impact upon ILS instruments in Canada.
An Overview of ILS
The Role of Triggers
In an ILS transaction, payment is usually dependent on the occurrence of a triggering event. There are four basic types of triggers:
- indemnity triggers, which are based on the actual loss of the insurer (i.e., the cedant) or other originating or sponsoring party (referred to in this article as the "sponsor");
- industry index triggers, which are based on an industry-wide index of losses;
- parametric triggers, which are based on the occurrence of an actual physical event (such as the magnitude of an earthquake or the wind speed of a hurricane). Variations of parametric triggers include "pure" parametric triggers and parametric index triggers, which are more refined types of parametric triggers; and
- modelled loss triggers, which are based on estimated losses generated by a model.
The last three types of triggers are all types of non-indemnity based triggers. There are also various hybrid triggers composed of multiple types of the triggers listed above.
Generally speaking, non-indemnity based triggers, such as parametric and index-based triggers, are preferred by investors because they are more transparent than indemnity based triggers. Another perceived advantage of non-indemnity based triggers is that they are viewed as not giving rise to moral hazard (since the sponsor still bears risk under the contracts pursuant to which it provides (re)insurance and, thus, still has an incentive to minimize losses).
However, non-indemnity based triggers give rise to basis risk, which is the risk that the compensation received by the sponsor in the event that a loss event occurs will not match the sponsor's actual losses. This risk exists by virtue of the fact that the trigger under the relevant contract is something other than the sponsor's actual loss. According to the International Association of Insurance Supervisors (IAIS), "The degree of basis risk is a key consideration for supervisors in determining the amount of reinsurance credit to give to coverage or whether the coverage offered is reinsurance or a derivative." Basis risk is also taken into consideration by ratings agencies.
Indemnity based triggers do not give rise to basis risk, but are viewed as giving rise to moral hazard (although moral hazard has obviously not stopped the development of reinsurance market). As well, it has been observed that transactions that use indemnity-based triggers take longer on average to settle than comparable transactions that use non-indemnity based triggers.
Examples of ILS Instruments
The following is a high level summary of selected ILS instruments. This summary is not intended to be comprehensive. There are numerous arrangements that fall under the rubric of ILS that are not addressed in this article. As well, this summary does not describe the mechanics of any particular ILS transaction. Rather, our intention is to provide a basic overview of certain ILS structures or instruments in order to lay the groundwork for the discussion of the key Canadian insurance law and regulatory issues relating to ILS that follows.
A typical P&C securitization involves a bankruptcy remote special purpose vehicle (SPV) entering into a reinsurance contract with a sponsor and issuing bonds to investors. The SPV holds funds equal to its exposure under the reinsurance contract. These funds are invested in high-quality securities and held in a collateral trust. A swap may be entered into with a swap counterparty converting the investment return on the collateral into a LIBOR based rate. The SPV uses profits under the reinsurance contract and releases from the collateral trust to meet its payment obligations under the bonds. If no loss event occurs, investors receive a return of principal and a stream of coupon payments. If a defined loss event occurs, the SPV is required to transfer funds to the sponsor pursuant to the reinsurance contract. In this case, investors suffer a loss of interest and/or principal. A bond insurer may guarantee the interest and principal payments on the underlying securities. The foregoing description assumes that the contract between the sponsor and the SPV is a (re)insurance agreement (i.e., the contract involves an indemnity trigger). Where this is the case, the SPV will need to be licensed as a (re)insurer. If the contract between the sponsor and the SPV is not a (re)insurance contract, the contract will be a financial contract and the SPV will not need to be licensed as a (re)insurer. The diagram below illustrates a simplified version of a typical cat bond structure.
To see graph please click here.
Unlike asset-backed securitizations, which are common outside the insurance industry, P&C securitizations are liability-based securitizations. One difference between asset-backed and liability-based securitization arrangements is that asset-backed securitizations generally involve a "true sale" of the asset from the sponsor to the SPV whereas in liability-based securitizations the sponsor retains liability to the policyholders.
Cat bonds, which provide protection for extreme events such as hurricanes and earthquakes, have been the most popular form of P&C securitization. Insurers have been the primary sponsors of cat bond transactions. However, there are examples of non-insurers sponsoring cat bonds, such as the issuance by Oriental Land Co., the owner of Tokyo Disneyland, of cat bonds in which the triggering event is the occurrence of an earthquake meeting specified criteria.
Unlike P&C securitizations, which have focussed on transferring catastrophic risks, most life securitizations have primarily been financing vehicles. That is, they have primarily been used to generate present cash flows, not to transfer risks. That being said, life securitizations can also be designed to transfer risks. Some of the primary forms of life insurance securitizations are as follows:
- securitization of future cash flows from a block of business (which involves obtaining immediate access to the value of the in-force business);
- reserve funding securitizations (which are undertaken to ease regulatory reserve requirements); and
- life insurance risk transfer securitizations (i.e., transactions that protect insurers and reinsurers against mortality or longevity risk). For example, extreme mortality bonds transfer risk relating to large deviations in mortality (arising, for example, from a pandemic).
Securitization of longevity risk (i.e., where insurers or pension funds hedge against increases in longevity via securitization) has received considerable attention, but this market remains relatively undeveloped.
Another way to transfer risk is via a swap. In a P&C cat swap, an insurer agrees to make periodic payments to a counterparty and the counterparty agrees to make payments to the insurer based on the occurrence of an insured event. There have also been mortality swaps and longevity swaps. Longevity swap transactions have gained considerable traction over the past year, particularly related to hedging longevity exposure of UK pension funds.
Industry Loss Warranties (ILWs)
ILWs are essentially reinsurance contracts where the payoff is contingent on both the insured loss of the protection buyer and on industry loss. In its most basic form, an ILW is a reinsurance contract with 2 triggers: 1) the insured loss of the protection buyer, and 2) the insured industry loss (e.g., as determined by reference to an index). The first trigger is usually set low so that it will almost certainly be met if second trigger is met. If the indemnity trigger is removed, the product is a pure derivative (i.e., a financial contract) and is not insurance or reinsurance.
ILS encompasses various types of derivative contracts, which can be traded on an exchange or over-the-counter. For example, a weather derivative may be used by a utility company to hedge against risk resulting from unexpected weather conditions, which could result in the utility company losing money. A weather derivative may be triggered by heating degree days (HDD) or cooling degree days (CDD), being the number of degrees that the average temperature for a day varies from a reference temperature (e.g., the outside temperature above which a building needs no heating or below which a building needs no cooling).
A sidecar is a special purpose reinsurer that provides reinsurance capacity (typically via a quota share reinsurance agreement) to a ceding insurer or reinsurer. Sidecars are generally created for a limited period of time to take advantage of a short-term opportunity and then to dissolve. Sidecars are generally dependent on the sponsor or some other party for underwriting, pricing and servicing. The sidecar or its holding company raises capital through private placements, most of which is deposited in a collateral account to support the sidecar's obligations under the reinsurance agreement. If the sidecar has to pay a claim during the period during which it is exposed to risk, the assets in the collateral account are used to pay the claim. If the sidecar does not have to pay claims during this period, the assets in the collateral account are paid to the investors at the end of the period.
Canadian Insurance Law and Regulation Relating to ILS
The following discussion of insurance law and regulation focuses on issues relating to insurance securitizations since these have been the most popular form of ILS.
OSFI has not articulated any guidance specifically addressing insurance securitization, primarily because there has not been demand for it. However, we understand that OSFI has considered this matter and has developed the following principles that would guide their consideration of any proposed insurance securitization:
- securitization must not hamper the interests or rights of policyholders;
- the accounting, actuarial and capital treatment should reflect the terms of the transaction, particularly the nature and degree of risk transferred;
- transactions must not be designed to circumvent capital rules, reinsurance regulations and guidelines; and
- capital instruments created in the transaction must meet the criteria set out in the MCCSR and MCT guidelines to qualify as regulatory capital.
These principles are necessary but not sufficient conditions to an ILS product being acceptable to OSFI. In other words, while OSFI would evaluate any securitization proposal against these principles, there would undoubtedly be additional issues that would need to be addressed.
OSFI's general approach to determining whether an insurer is entitled to a capital/asset credit as a result of a transaction is to consider the transaction's economic substance, not its legal form. Accordingly, in determining whether an insurance securitization will result in capital relief, the question is whether the transaction involves effective risk transfer.
We understand that OSFI will require securitization to meet the same collateral and risk transfer requirements as unregistered reinsurance generally. Under the regime governing unregistered reinsurance, a company or foreign company that reinsures risks with an unregistered reinsurer will only be entitled to credit for the reinsurance if there is collateral held in Canada. The current regime involves collateral being vested in a reinsurance trust. OSFI has proposed a new regime that will involve collateral being subject to a reinsurance security agreement and being held in Canada by a collateral agent.
We also understand that conditions relating to effective risk transfer will require that there be no material basis risk for a sponsor to get capital credit. In other words, a sponsor is unlikely to meet the requirements for effective risk transfer and, thus, will not receive capital credit if a securitization involves a non-indemnity trigger. OSFI's approach in this regard is consistent with the approach proposed in Solvency II.
25% and 75% Reinsurance Limits
Currently, there are two rules that impose limits on P&C companies that need to be considered in connection with reinsurance arrangements. First, not more than 25% of all risks may be reinsured with unregistered reinsurers. Second, not more than 75% of all risks may be reinsured in any given year. OSFI has indicated that both of these rules are to be eliminated. The elimination of these rules will allow P&C companies greater flexibility in connection with reinsurance arrangements, including in the context of ILS.
Draft Guideline B-3 – Sound Reinsurance Practices and Procedures
In August 2010, OSFI released a draft of Guideline B-3 – Sound Reinsurance Practices and Procedures, which sets out OSFI's expectations regarding reinsurance governance and risk management. This Guideline will need to be taken into account in connection with any ILS arrangement that involves reinsurance by a Canadian (re)insurer.
Approvals for Related Party Unregistered Reinsurance
Under the Insurance Companies Act (Canada), a company (i.e., a Canadian incorporated company) or foreign company (i.e., a foreign company with a Canadian licensed branch) requires the approval of the Superintendent of Financial Institutions to cause itself to be reinsured in respect of risks undertaken under its policies by a related party if the related party is not a Canadian company or a licensed Canadian branch of a foreign company that, in Canada, reinsures those risks. This approval will not, of course, be required if the SPV is not a related party of the sponsor. OSFI has indicated that it will review the need for this approval once revised Guideline B-3 - Sound Reinsurance Practices and Procedures is in place.
OSFI Guideline B-5 – Asset Securitizations
OSFI Guideline B-5 – Asset Securitizations applies to securitizations by federally regulated financial institutions. However, this Guideline applies to asset securitizations, not liability securitizations. Guideline B-5 addresses, among other matters, the circumstances in which a FRFI that sets up a SPV in connection with an asset securitization will be required to hold capital against debt instruments issued by the SPV to third parties. To the extent that an insurance securitization is an asset securitization, regard must be had to Guideline B-5. Our understanding is that Guideline B-5 will be updated by OSFI to ensure it reflects Basel II principles.
Can Bonds Issued Pursuant to an Insurance Securitization be Characterized as Contracts of Insurance?
In an insurance securitization, investors are, in effect, assuming risk by purchasing bonds. Accordingly, there is a question as to whether these bonds could be considered contracts of insurance or reinsurance under Canadian law. If they were considered contracts or insurance or reinsurance, the investor would need to be authorized to insure or reinsure risks.
The Insurance Act (Ontario) defines insurance as follows:
"insurance" means the undertaking by one person to indemnify another person against loss or liability for loss in respect of a certain risk or peril to which the object of the insurance may be exposed, or to pay a sum of money or other thing of value upon the happening of a certain event, and includes life insurance;
This definition encompasses two types of contracts: (1) contracts of indemnity, and (2) contracts that provide for the payment by one party to another on the happening of a certain event.
In a cat bond issuance, the investors have not agreed to make a payment to the SPV if the SPV suffers loss. Rather, the investors have invested money up front that may or may not be paid by the SPV to the sponsor. If money is paid to the sponsor, the investors will suffer a loss of interest and/or principal. This loss is properly characterized as an investment loss, not an indemnity. Accordingly, the bonds should not be considered contracts of indemnity and, thus, should not be caught by the first part of the definition of insurance.
Regarding the second part of the definition of insurance (whether notes are contracts that provide for payment on the happening of a certain event), Canadian courts have adopted a purposive analysis that takes into account the intent and purposes of the Insurance Act and a particular contract. The intent and purpose of the Insurance Act is to regulate insurers to protect the public. This rationale does not apply in the case of cat bonds where the creditworthiness and behaviour of investors has no impact on the SPV (since the SPV has received funds from the investors up front). It is also relevant that the investors' intention is to invest in a security that, incidentally, may exhibit some characteristics of insurance (although, as discussed below under the heading "ILS as investments by (re)insurers", in OSFI's view it is possible that a (re)insurer could invest in such securities to gain exposure to insurance risks). There are additional differences between cat bonds and insurance contracts, including the fact that bonds do not involve any payment of premium and the SPV receives full payment for the bonds up front – there is no ongoing relationship as is the case in an insurance contract. For these reasons, investing in cat bonds is a matter for securities laws, not insurance laws.
ILS as Investments by (Re)insurers
This paper has focussed on circumstances in which an insurer or reinsurer is the sponsor in an ILS arrangement. An insurer or reinsurer may also be an investor in an ILS arrangement. The Insurance Companies Act, the regulations under that Act, and OSFI guidance impose various restrictions on the portfolio investments of (re)insurance companies, including:
- prudent person requirements;
- Guideline B-2 - Investment Concentration Limit for Property and Casualty Insurance Companies and Guideline B-2 - Large Exposure Limits (applicable to life insurers); and
- Guideline B-7 – Derivatives Best Practices.
The capital charge of an ILS product that an insurer invests in could be based on the rating of the product. However, OSFI will examine an investment closely if OSFI is concerned that an insurer is making the investment to circumvent capital requirements relating to the insurance of risks. In other words, if OSFI thinks that the investment is being used as a way to gain exposure to insurance risks without holding capital for insurance risks, OSFI may require the insurer to hold capital in respect of the investment as if the insurer had insured the relevant risk directly.
The Prospects for ILS in Canada
Some recent developments may foster the growth of ILS in Canada. OSFI has articulated significant new governance and risk management expectations regarding reinsurance practices in its Response Paper: Reforming OSFI's Regulatory and Supervisory Regime for Reinsurance, which was released in March 2010, and in Draft Guideline B-3 – Sound Reinsurance Practices and Procedures, which was released in August 2010. OSFI clearly expects insurers and reinsurers to take a hard look at their reinsurance arrangements. This may lead some insurers and reinsurers to consider ILS solutions. As well, the increased capital requirements that will apply as a result of Basel III may provide an impetus for insurers and reinsurers to transfer additional risk, including via ILS arrangements. Indices that may play a role in Canadian ILS products are also developing. For example, in March 2010 it was announced that Insurance Services Office (ISO) and MSA Research Inc. were bringing the Property Claim Services (PCS), a service that provides industrywide data about Canadian catastrophes, including man-made and extreme weather events, to Canada.
Whether and when a Canadian market for ILS emerges will depend on a variety of factors. One such factor is whether a "hard" reinsurance market develops/persists (as this may stimulate demand for ILS). Another factor is consolidation in the insurance industry. Sharon Ludlow, the CEO of Swiss Re's Canadian operations, has recently stated that M&A activity among primary insurers, which would concentrate the insurance risk relating to catastrophic events, may be a catalyst for cat bonds in Canada. Finally, it is likely that the development of an ILS market in Canada will be affected by the degree to which Canadian insurers and reinsurers are affected by severe events. In the US, the magnitude of the insured losses resulting from Hurricane Andrew was a driver for the development of ILS. While Canada has its share of severe weather events (witness the July 2010 hailstorm in Alberta that, according to PCS-Canada, resulted in a record amount of insured damage for a hailstorm in Canada), it may take a truly severe event or an increased frequency of events to jump start ILS in Canada.
The legal and regulatory regime governing ILS will likely follow the market. If an ILS market develops, OSFI may feel the need to develop and articulate its expectations regarding ILS. In the meantime, the laws, regulations and regulatory expectations described in this article will continue to govern this area.