RESPONSE TO HM TREASURY OPEN CONSULTATION: REGULATIONS IMPLEMENTING A NEW REGULATORY AND TAX FRAMEWORK FOR INSURANCE LINKED SECURITIES 18 January 2017 Simmons & Simmons LLP CityPoint One Ropemaker Street London EC2Y 9SS United Kingdom T +44 20 7628 2020 F +44 20 7628 2070 DX Box No 12 www.simmons-simmons.com 1 RESPONSE TO HM TREASURY OPEN CONSULTATION: REGULATIONS IMPLEMENTING A NEW REGULATORY AND TAX FRAMEWORK FOR INSURANCE LINKED SECURITIES 1. Introduction Simmons & Simmons LLP is an international law firm which advises an international client base which includes major insurance and reinsurance companies and financial institutions, multinational corporate groups and investment funds. We welcome the opportunity to comment on HM Treasury’s further consultation on regulations implementing a new regulatory and tax framework for insurance linked securities (“ILS”) to be issued by insurance special purpose vehicles (“ISPVs”) established and regulated by the Financial Conduct Authority (the “FCA”) and the Prudential Regulation Authority (the “PRA”), as set out in the Treasury consultation paper published on 23 November 2016 following the Autumn Statement 2016 (the “Consultation Paper”). We have discussed our proposed response with a number of clients who are interested in ILS. Those clients are drawn from various segments of the industry – insurance and reinsurance companies structuring and transferring risk via ILS into the capital markets, financial institutions structuring ILS and helping insurers access the capital markets and investors in ILS. Our response contains and reflects their input, in addition to our own observations. We would be happy to discuss any of this response further with HM Treasury if it would be of assistance. For any queries relating to our comments on the Consultation Paper, please contact: Mark Sheiham Pollyanna Deane Direct dial: 020 7825 4146 Direct dial: 020 7825 4303 firstname.lastname@example.org email@example.com Carol Wakefield Michael Dodson Direct dial: 020 7825 4111 Direct dial: 020 7825 4083 firstname.lastname@example.org email@example.com 2. General comments 2.1 General In this paragraph, we set out our general comments and key concerns that we and our clients have regarding the new framework, before moving on to address some of the specific questions set out in the Consultation Paper. We will be responding to the PRA/FCA consultation paper separately. We and our clients view this initiative very positively. A tax free UK ISPV regime which allows protected cell companies (PCCs) to undertake multiple ILS issuances each out of a separate liability, ring-fenced compartment is key for the UK to provide a viable alternative to Bermuda and other existing ILS jurisdictions. Accordingly, the HM Treasury proposals for exemption from corporation tax and withholding tax for UK ISPVs and introduction of UK PCCs are a major and very welcome step forward. 2 2.2 Regulatory aspects Our clients are clear in their view that there is a considerable and very active interest in ILS. They also see a clear and substantial opportunity for this market to develop more in Europe, with by far the largest number of transactions to date involving US risk. Some clients have commented that to some extent a higher degree of regulation and oversight than might be applied in other jurisdictions which already have similar regimes could be off-set by the attractiveness to investors (and particularly EU investors) of having issuance within European time-zones in a well regulated European country with the degree of access to the capital markets that the UK currently enjoys. The UK’s wealth of insurance expertise is also seen as a positive reason for the UK to be developed as a centre for ILS issue. However, whether that trade-off is one which the market will in practice accept and work with inevitably depends on whether the regulatory burden is significantly higher in comparison with the regulation in other ILS jurisdictions which currently garner the bulk of this market. When compared to issuance through, say, Bermuda or Guernsey, the proposed regulatory framework for ILS issuance in the UK still falls short in terms of speed and ease of authorisation. This impacts transactional cost and convenience and if it is overly burdensome, participants in the market will simply continue to use the existing regimes in other jurisdictions. Taking lessons from past experience, the Bermuda jurisdiction, which has ‘equivalence’ to Directive 2009/138/EC (“Solvency II”), was able to take much of this business away from the Cayman Islands and the Channel Islands by establishing a speedy and streamlined authorisation and supervision process. This process allows an ISPV application to be submitted to the Bermuda Monetary Authority (the “BMA”) by close of business on a Monday, including a 3-4 page business plan, an ISPV checklist, draft transaction documents, service provider acceptance letters and other relevant information, and in most cases the BMA will be in a position to approve the application later the same week. This process is administered by a regulator (the BMA) which has good contacts with market participants, and good knowledge and expertise in how this business can be successfully transacted. Confidence, therefore, is generated on all sides: issuers, investors and regulator, by familiarity, expertise and speed. Meanwhile Guernsey has announced its own user-friendly regulatory regime in which insurers or arrangers can be granted a single regulatory consent for the formation of future ISPVs without requirement for a separate regulatory authorisation for each ISPV, intended to allow new ISPVs to be established within a single business day. Given that ILS are in essence hybrid products, which transform insurance risk into issued securities and which are fully funded and sold only to sophisticated investors, we strongly believe it is not necessary to impose so much weight of Solvency II regulation on them. Were they an ordinary securitisation of bank risk, not insurance risk, there would be a much more light-handed approach. There is an established market in these investments involving sophisticated investors. Without a radical rethink of some of the regulatory issues, over-burdensome requirements will turn this into a wasted opportunity, particularly considering the scale of positive changes on the tax and protected cell company aspects that are being undertaken to support the initiative. We believe a well-regulated and successful market can be established with much reduced requirements than those proposed. In particular we put forward the following observations and suggestions based on our knowledge and experience of this market: 3 • Solvency II - The level of proposed regulation for ISPVs and the assumption that a Solvency II regime is required sits oddly with the “fully funded” requirement. These are ISPV’s dealing with sophisticated investors – is Solvency II really the right regime? As part of this, the proposed non-recourse position should be reviewed. • Speed & Efficiency – The lead time for approvals for ISPV PCCs is up to 6 months. In Bermuda, approvals can be given the same week an application is made. 6 months is not realistic as the issuers will need to submit close-to-final documentation for approval, yet will be tempted to submit early, working back from the 6 months. This will lead to a longer process (as documentation evolves) and the risk that PRA time will be inefficiently used because of the need to review and then re-review. • Corporate Governance - Could this not be simplified by: 1) taking out the need for the SIMR for ISPVs; 2) relying on ordinary corporate governance principles for an ISPV (and PCC); 3) focus development of the UK market with a more simplified regime for single deal ISPVs, if it is the concern about management liability and insolvency complexities for PCCs which is driving the more burdensome requirements overall? • “Fully Funded” and life business - In order to enable long term business to participate equally in the new regime, the capital requirements need to be addressed, particularly to ensure that ‘fully funded’ requirements are not more than a basic assessment of assets exceeding liabilities. • Dual Regulation - The involvement of both FCA and PRA seems unduly burdensome. Given that there will be limited need for on-going supervision, the PRA would seem to be the logical choice of regulator. A single regulator throughout will help concentrate regulatory expertise. • Life and pensions business – Client feedback indicates that life business risk can be transferred into the capital markets through the proposed UK ISPVs (at a push), though the current proposals do not work for pensions business. Ie UK ISPVs will not be able to transact directly with pension schemes so any access to pension risk will need to be indirect via an intermediate insurer. This is unnecessarily complex and hence unlikely to be attractive. By contrast, there are examples in the market of Guernsey ICCs/PCCs transacting directly with pension funds. 2.3 Tax The proposed tax regime for ISPVs is generally sensible and a very welcome development – a tax free UK ISPV regime is key for the UK to provide a viable alternative to Bermuda, as is the ability to undertake multiple ILS issuances each out of a separate liability, ring-fenced compartment. Overall the tax proposals represent a welcome and substantial step forwards towards making the UK a suitable jurisdiction for ILS issuance. Three key tax requirements broadly successfully addressed by the proposals are: • Corporation tax exemption for profits of a UK ISPV; • Withholding tax exemption for payments made by a UK ISPV; and • No UK tax for non-UK investors on income, profits or gains from investments in UKILS securities. 4 There however some aspects which still need to be addressed. The remainder of this tax section focusses on those aspects: (A) Scope of UK corporation tax exemption The UK corporation tax exemption should also apply to all activities ancillary to insurance risk transformation – i.e. so that it is clear that a normal ISPV doing what ISPVs normally do is fully within the exemption. (B) Exclusion for administrative or management activities It should be clarified that the exclusion from corporation tax exemption for administrative or management activities relates to the ISPV being paid for providing administrative or management services to other companies, not for the ISPV administering or managing its own affairs and/or securities it holds as collateral to the insurance risk transformation activity to ensure it meets the fully funded requirement. Any ISPV will need to do (or have done for it) its own administration and management of its own affairs, and that should not lead to its activities being partly taxable. (C) Amounts “reasonably required” to meet the “fully funded requirement” It is understandable in principle to exclude from the corporation tax exemption investments, in excess of what is reasonably required to satisfy the “fully funded requirement” –i.e. to prevent ISPVs being used to extract profits on investments unrelated to transformer activities. However it would be helpful to clarify (perhaps in guidance) how this will be approached. In particular, cedants, arrangers and investors will want to be reassured that they can take a prudent approach to collateralising ILS investments (ie over-collateralising to a reasonable extent to ensure the “fully funded requirement” continues to be met despite normal market fluctuations in the value of the collateral securities) without risking an ISPV’s tax position. (D) Scope of withholding tax exemption In addition to the existing proposed exemption from interest withholding tax, payments by ISPVs should also be exempted from s.901 ITA 2007 withholding tax on annual payments. (We note that express exemption from this withholding tax charge on annual payments is currently being introduced for payments by UK securitisation companies.) (E) Anti-avoidance measures The desire to prevent ISPVs being used for tax avoidance is sensible and understandable. However the current draft regulations propose a “cliff edge” in which even a single minor issue automatically causes permanent loss of ISPV exemptions. This is too draconian. The proposed test requiring less than 20% investor connection to the cedant is a reasonable idea in principle. However it seems unreasonably harsh to permanently lock out an ISPV from the tax exemptions for even a minor unintended breach of the 20% test. For example if an investor purchases a large portfolio of securities including ILS investments and a due diligence oversight fails to pick up that the portfolio includes ILS investments in respect of which a connected party is the cedant, it would not be reasonable for this to cause permanent loss of the ISPV’s 5 tax exemptions, particularly if the position is rectified by selling the offending ILS investments promptly after the issue comes to light. Perhaps similar flexibility could be applied to the proposed 20% test as is applied to the 20% test applicable to the UK’s investment manager exemption? Another approach might be to give HMRC a discretionary power to exclude ISPVs from tax exemption following a breach of the 20% test (together with published guidance as to how that would be applied in practice). This would allow HMRC to exercise proportional judgment rather than a hard and fast rule that even a minor breach automatically causes tax exemptions to be lost. It would also be helpful to clarify how the 20% test applies if there are different classes or tiers of ILS investments (such as different classes of notes with an order of priorities). Ie does the 20% test apply by reference to all the classes together in aggregate? Or by reference to particular classes? (F) Compliance errors The current proposals appear to confuse compliance errors with tax avoidance. Permanent exclusion of an ISPV from the tax exemptions on which it depends, does not seem a proportionate sanction for routine compliance issues (eg late filing of a tax return, errors in a tax return or HMRC disagreeing with a tax return). If penalties need to be a basis for disqualification from the ISPV tax regime at all, this should be limited to the most series and egregious matters (eg conduct involving fraud or intentional misstatement rather than unintended error). Or ISPVs with a tax avoidance purpose could be excluded from the regime (in a similar manner as already applies to UK securitisation companies). Again it may be preferable for HMRC to have a discretionary power to exclude ISPVs from tax exemption following a compliance issue (coupled with guidance on how it would apply) to allow proportionate judgment to be exercised rather than a hard and fast rule that applies automatically. (G) Interaction of tax rules with PCCs The introduction of protected cell companies (PCCs) is helpful, even though there remains some concern over their insolvency robustness and whether the liability limitation of each cell is respected in all potentially relevant legal jurisdictions (even if it is in the UK). However, the need for cells to be bankruptcy remote and not at risk of contamination by other cells also needs to be factored into the tax proposals. If a particular cell is not able to comply with the requirements for ISPV tax exemption, only that cell should lose its tax exemptions, rather the entire ISPV including unrelated cells and transactions. 2.4 PCC structure (A) General comparisons and suggestions Guernsey introduced legislation to govern PCCs in 1997, with Bermuda following suit in 2000 in respect of Segregated Account Companies (“SACs”). Now over 30 jurisdictions have this type of legislation and the UK can learn from their experience. The Channel Islands have also introduced the Incorporated Cell Company (“ICCs”) which can be seen as more robust from an insolvency point of view, but potentially less attractive from a tax perspective as it is hard to see as a single entity for tax purposes. 6 As the UK proposes, Bermuda currently restricts application of these structures to insurance and mutual funds, while Guernsey and Jersey have no such restriction. Note that the use of PCC type structures may prove helpful to other financial institutions and therefore the possibility of using them more widely should not be completely ruled out. There is a requirement in Guernsey that the PCCs/ICCs are administered by a regulated person. This is of particular interest in the light of the recent announcement by Guernsey that their legislation will be extended so that, in principle the GFSC will approve multiple deals without further reference to the regulator (i.e. the need to submit any new business plan etc.) provided that they fall within the same set of criteria. This is clearly designed to ramp up efficiencies in the Guernsey market and makes the case for the speed and efficiency of the Guernsey systems. It is presumably the identity of the regulated person and the GFSC’s oversight of him/her, that enables the GFSC to act so broadly. In the case of Incorporated Cell Companies (ICCs) each cell is a separate company in any event so is no different to a set of SPV's from a legal personality or regulatory perspective. Bermuda’s SAC structure can provide efficiencies similar to the new proposal in Guernsey if the proposed extension of the structure and creation of new SPVs form part of the pre-agreed governing instrument. Given the competition which the UK faces, reduction in regulatory process will be key and clearly Guernsey is considering regulation of the applicant as its means of control, while the SAC arrangement can incorporate the creation of further vehicles without the need to revert to the regulator and thus hold proceedings up. We have reviewed the Bermudan SAC, the Guernsey PCC/ICC and the Jersey ICC/PCC to see what advantages they have and whether or not the current UK proposals should be amended to include these. This section of our response provides a high level view and a further more detailed review will be undertaken as part of the regulatory submission we make on 23 February. (B) Jersey PCC Advantages Jersey PCCs have two clear advantages: (1) the ability to create binding relationships between their cells by entering into contracts; in contrast, UK PCCs are not able to contract with other cells or their core (see section 53 of the proposed Risk Transformation Regulations 2017 (the “Proposed RTRs”)), but only with third parties; (2) the ability of a PCC cell to become a stand-alone company by incorporation. Jersey PCC cells can create binding obligations between one another under Jersey law as if they were separate legal entities, akin to treating the cells as if they were separate companies. However this creates the inherent risk that a foreign court might consider the PCC cells to be separate taxable entities for tax purposes, and tax the profits of a cell as if the cell were a close company to the cell owner. There is always a tension between the single entity treatment and segregation. Cells in Jersey PCCs also have the ability to incorporate into separate stand-alone companies, which offers an extra layer of protection particularly in the event of another cell’s insolvency. The insolvency issues and how a cell company might be affected are regularly cited as reasons for avoiding the use of cell company, although UK leading insolvency counsel thought that it would not be contrary to UK 7 public policy or so offensive to English law principles that the segregation would be ignored. One challenge that Jersey PCCs may face is where there are different directors for different cells. While this certainly assists in clearly establishing segregation between different cells, there is a difficulty inherent in having separate directors for each cell. One way which this could be managed is through a main board at the core with committees. Currently, section 59 of the Proposed RTRs suggests at least one director, but makes no distinction as to whether this should be an individual. Accordingly, the management of the company could be through a corporate. Guernsey PCCs put single legal entity first and foremost. This single legal entity approach provides administrative savings and tax advantages, which are seen as substantive advantages and are therefore unlikely to be changed. Nevertheless, the Guernsey legislation seeks to protect its PCC structures by providing for its law to have extra-territorial application. The position of creditors, liability of cellular and core assets, arrangements between cells, core and the company is extra-territorial under Guernsey Company law. (C) Bermudan SAC Advantages In relation to Bermuda SACs, the SAC Act establishes a regime for the conduct of inter-account contracts and transactions by and within the same SAC. A Segregated Account (“SA”) does not have legal capacity separate from the SAC and cannot create binding relationships with another SA, transactions are permitted as if they were between the company and a third party. The SAC governing instrument sets out scope of business and contracts to be entered into – thus if the SAC determines the transactions it wishes to enter into in advance, it can make its contractual arrangements accordingly AND the regulator will not need to approve every single transaction – this undoubtedly assists the speed and efficiency of the arrangements. (D) ICC Advantages The ICC structure has proved useful in achieving economies of scale, as the ICC is responsible for administrative duties associated with all of the individual cells (something which a conventional group company structure can also achieve), but in the case of the ICC, this can also include statutory duties. The ICC can own its cells or the cells can be owned by third parties – which allows for multiple ownership of multiple companies – this provides flexibility and is possibly useful for other uses for a cell company, such as different issuers piggybacking on the same approved structure and/or “rent-a-captives”. The ICC structure is clearly seen as most robust in the event of insolvency. (E) UK Advantages The current proposals in the UK reflect the fact that the purpose for which the PCC vehicle is to be used is that of a transformer, rather than an investment fund or a captive insurer. Thus transparency is obtained by using the incorporation documents and registration at the FCA. Transparency in Bermuda for example, is impacted by SAC governing instrument not being publicly available. Nevertheless, having a governing instrument that can be used for multiple applications would have its advantages. 8 Proposals as to corporate governance and solvency need to be robust and the focus on the existing corporate governance regime is sensible, although while a solvency regime is needed, there should be some consideration given to the proportionality of the Solvency II approach. UK reputational advantages – a well-regulated financial services jurisdiction with a stable business environment - should not be underestimated in terms of attractiveness. It is critical that the UK is able to identify those areas which it needs to be competitive in and those in which it should differentiate itself. In choosing a jurisdiction, a number of criteria need to be considered. In order to compete against established domiciles that already offer market leading propositions relating to taxation, regulation and capital efficiency, the UK needs to be close to or equivalent to the incumbent jurisdictions on the primary criteria and ideally the secondary criteria below: Primary Criteria • Capital efficiency • Tax efficiency • Regulatory burden • Legislative approach • Access to licences Secondary Criteria • The quality of the labour pool • Accessibility • Reputation • Set up time and costs – licence requirements • Infrastructure requirements 3. Question 1 – directors’ duties – views on the extent to which the proposed framework for directors’ duties is acceptable for PCCs We agree with the proposed regime insofar as directors’ duties in respect of an ISPV should generally be no different from those in relation to a conventional company incorporated under the Companies Act. We also agree with the additional duty on directors to comply with the Proposed RTRs and that the Companies Directors Disqualification Act 1986 should apply to directors of ISPVs. In general, we also agree with the application of Article 322 of the Commission Delegated Regulation (EU) 2015/35 (the “S2 Delegated Regulation”) (and thereby, the requirements of Article 42(1) of Solvency II). We assume that these requirements would not preclude ISPVs appointing directors provided by professional service companies, in much the same way as independent directors are provided for conventional, off-balance sheet SPVs (“Off-balance Sheet SPVs”) which are used, for example, for securitisation transactions and asset repackaging structures within the EU. We would suggest that for an ISPV which will typically issue securities to purchase a pool of underlying assets which will secure its obligations under the relevant risk transfer agreement that it enters into with the relevant insurance or reinsurance company, the professional skills required for directors would match those of directors for an Off-balance Sheet SPV, rather than those that would fulfil the PRA’s Senior Insurance Managers regime (the “SIMR”). As a result, we would suggest that the 9 application of Article 324 of the S2 Delegated Regulation is reconsidered as the current proposals would introduce a regime which may be overly burdensome for an ISPV. 4. Question 2 – accounts generally – views on the extent to which the proposed framework for the production of accounts is acceptable for PCCs We agree with the proposed regime in terms of ISPVs being able to choose between IFRS and UK GAAP. Choosing IFRS would allow them to fulfil the requirements of Directive 2003/71/EC, as amended (the “Prospectus Directive”) and Commission Regulation (EC) No 809/2004 (the “Prospectus Regulation”) when seeking a listing for securities issued by an ISPV on a regulated market in the EU. We understand that it is intended that the requirements of the Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (the “Accounts Regulations”) would apply to ISPVs. We would suggest that notwithstanding the absence of any responses to the initial consultation suggesting that ISPVs would not at least meet the qualifying conditions for small companies, that this be investigated further. An ISPV (particularly an off-balance sheet orphan ISPV) might have, on the one hand, liabilities in the form of the ILSs it has issued and on the other hand, assets in the form of the collateral securities it has purchased using the issue proceeds of the ILS which secure its obligations under the relevant risk transfer agreement and ILS investments. These will in effect offset each other to leave a small (perhaps even non-existent) balance sheet total, which might mean they would not exceed the relevant qualifying condition for medium-sized/small companies relating to balance sheet total. Moreover, the covenants which typically apply to SPVs which issue securities preclude them from having any employees at all (so as to not compromise their insolvency-remote status), which would mean that they would not exceed the relevant qualifying condition relating to numbers of employees. 5. Question 3 – publishing accounts – views on whether a reduced disclosure regime is more appropriate for PCCs We make no comment in relation to this particular question. 6. Question 4 – insolvency – views on the extent to which the proposed framework for insolvency of the core and cells of PCCs provides a suitable framework appropriate for PCCs It is not clear to us why the draft regulations limit the insolvency regimes available to both the core and the cells to administration and compulsory liquidation and why a floating charge holder should not be able to appoint an administrator through out of court process. We can readily envisage circumstances where the full array of UK insolvency procedures would be advantageous, and consider that the limits to be imposed would adversely affect the returns to creditors and/or investors. 7. Conclusion We are aware that some respondents to the first Treasury consultation did make the point that certain fundamental aspects about speed and ease of transacting ILS in the UK had to be addressed to give the UK a good chance of developing as a market for this innovative, lucrative, 10 and now well-established, business. We also echo those who would encourage this Government to support the development of secondary markets for insurance risks to improve liquidity. We are very pleased to see the positive actions being taken which we have referred to above. However, we believe significant shortcomings to ensuring success do exist on the regulatory side, which require a more radical proposal. ISPVs writing fully funded insurance for sophisticated investors are inherently of a lesser regulatory risk than normal insurers and reinsurers and should therefore be regulated with speed and a lighter touch to make a UK market fit for purpose and able to compete with other ISPV regimes. One of our clients has offered to discuss involvement in the possible ‘trialling’ of the new regime for the UK to help develop an attractive and workable regime. Please let us know if HM Treasury and/or the PRA/FCA would like us to set up a discussion forum for this. Simmons & Simmons LLP 18 January 2017 Simmons & Simmons is an international legal practice carried on by Simmons & Simmons LLP and its affiliated practices. Accordingly, references to Simmons & Simmons mean Simmons & Simmons LLP and the other partnerships and other entities or practices authorised to use the name “Simmons & Simmons” or one or more of those practices as the context requires. The word “partner” refers to a member of Simmons & Simmons LLP or an employee or consultant with equivalent standing and qualifications or to an individual with equivalent status in one of Simmons & Simmons LLP’s affiliated practices. 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