The Treasury, together with the PRA and FCA have published the new draft framework for insurance-linked securities (ILS) business in the UK. The Treasury has published two sets of draft regulations for consultation:
- the draft Risk Transformation Regulations 2017 (draft RTR) which will introduce a new corporate structure for multiarrangement insurance special vehicles (ISPVs) (mISPVs), and propose a new regulated activity of insurance risk transformation under the Financial Services and Markets Act 2000 (FSMA); and
- the Risk Transformation (Tax) Regulations which set out the tax treatment of ISPVs.
The PRA and FCA are also consulting on their approach to the authorisation and supervision of ISPVs in the UK (the PRA/FCA Consultation) . The PRA/FCA Consultation introduces:
- a draft PRA supervisory statement;
- a draft FCA statement;
- proposed amendments to the PRA Rulebook; and
- a draft application form.
ILS are already an important part of the global specialist reinsurance market and are seen by many as the future to allow insurers to transfer risk whilst accessing new sources of funding through capital markets.
In a post-Brexit world, the proposals aim to establish the London insurance market as a key centre for ILS and demonstrate confidence in its future. The proposals aim to establish a “fit-for purpose corporate, tax and regulatory framework” to allow the UK to compete in the growing alternative risk transfer market.
The ILS market has grown significantly in recent years and is now an established part of the global reinsurance market. ILS provide an alternative form of risk mitigation for insurers and reinsurers by allowing them to transfer risk to the capital markets. For buyers, ILS provide an option of cover without the same high degree of exposure to counterparty default as traditional reinsurance. Investors benefit from diversification and potential higher yields in the current low interest rate environment. The Treasury states that ILS or alternative reinsurance capital now stands at around $70bn which is approximately 12 per cent of overall reinsurance capital.
ILS operate by utilising capital from investors which is used to back insurance policies directly without the need for traditional reinsurance. This opens a new pool of capital to insurers that is separate from the traditional reinsurance pool. ILS have historically been issued in offshore locations such as the Cayman Islands, Guernsey and Bermuda. The new rules will allow ILS to be issued from the UK and will allow the UK to compete in the ILS market.
ILS can take a number of different forms. The most common forms however, arise in the non-life sector with catastrophe bonds (cat bonds) leading the way. Cat bonds are used to raise capital to cover losses associated with natural catastrophes ie extreme weather events or non-natural catastrophic perils. Other non-life forms of ILS include catastrophe derivatives, collateralised reinsurance and quota shares or sidecars. The Treasury has largely focused its attention on cat bonds and collateralised reinsurance which are more akin to conventional reinsurance arrangements. On the life side, ILS may take the form of mortality bonds, reserve financing or embedded value securitisations.
A typical cat bond ILS transaction involves an insurer or reinsurer, seeking protection for a specific event (the Event), entering into a risk transfer contract with a special purpose vehicle (an SPV) that is established specifically for the transaction. The SPV is capitalised by issuing notes to investors in an amount equal to the limit as set out in the risk transfer contract. The proceeds from the offering of the cat bonds are usually invested in securities which are hedged to match the expected payments on the cat bonds. If the Event occurs during the risk period (as defined in the risk transfer contract), the securities are realised and the funds required to pay out to the insured are paid to the insurer or reinsurer, with the balance (if any) being used to repay the investors. If the Event does not occur the investments are realised and the principal invested (plus interest) is paid to the investors. Cat bonds offer a high degree of diversification as, provided the credit risk on securities in which the SPV invests and on any associated hedge arrangements is substantially eliminated, their value is not correlated to the financial markets but to the risk of occurrence of the specified Event.
‘London… a leading market for alternative risk transfer’
At the March 2015 Budget, the Chancellor announced that the Treasury would work with the PRA, FCA and the London insurance market to design a new framework to attract ILS business to the UK. The government believes that “with the framework, London can make a major contribution to the continued growth and development of ILS business” and that “London should be well placed to become a leading market for alternative risk transfer”. The new proposals cover the authorisation, supervision, corporate structure and taxation of ILS vehicles in the UK.
Corporate Structure for multi-arrangement ISPVs
ISPVs can take different forms. They can be created for the purpose of a single contract of risk transfer; or an ISPV may concurrently take on more than one contract of risk transfer from one or more cedants (referred to as a multi-arrangement ISPVs or mISPVs). The concept of an mISPV is permitted within the Solvency II framework provided that it complies with the requirements of Articles 318-324 and 326-327 of the Delegated Regulation (and is capable of meeting the requirements of Article 325 of the Delegated Regulation).
The government has now set out its approach to the corporate structure of mISPVs. Following the government’s initial consultation on ILS, the government proposes to create a protected cell company (PCC) regime for mISPVs. The draft RTR (set out in Annex A of the Treasury consultation) aim to create this new regime.
The draft RTR provide for the form of a PCC under the new regime which includes that the PCC must have the following features:
- it must be a private company limited by shares; the government’s view is that public offerings for investment in ISPVs would be not be appropriate, therefore PCCs will not be available as public limited companies;
- a PCC will comprise the core and any number of cells needed to manage the ILS deals it takes on;
- the cells do not individually have legal personality (it is the PCC as a whole that has legal personality);
- the core is the administrative function of the PCC, which manages all of the cells and enters into transactions on behalf of the cells;
- cells can be added or removed as needed with a simple resolution of the PCC board of directors;
- no separate incorporation procedure is required for a cell;
- a PCC will have one board of directors. The duties of the directors will be largely the same as directors’ duties in relation to a company incorporated under the Companies Act 2006, except where beneficial to the regime – for example, there is an additional duty on directors to comply with the Risk Transformation Regulations 2017. The Companies Directors Disqualification Act 1986 will apply to directors of PCCs, with appropriate consequential modifications for PCCs;
- the assets and liabilities assigned to a cell will be strictly ring-fenced from other cells in the PCC;
- PCCs will be able to issue securities on behalf of the cells, whether equity or debt instruments, in order to fund the insurance risk they take on. However, as ISPVs need to be operated in a way which delivers reliable protection for cedants, investors in an ISPV will have no voting rights and no means of influencing the management of an ISPV. This is reflected in the RTR for PCCs which restrict shares that can be issued on behalf of a cell to non-voting shares;
- PCCs can choose whether IFRS or GAAP is the more appropriate accounting standard for preparation of individual and / or consolidated financial statements. The government anticipates that the relevant accounting framework will be the ‘Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008’ and is welcoming views on whether modifications to these rules are required to make them applicable to PCCs;
- Insolvency legislation will be amended to allow for the liquidation and administration of individual cells. Cells are treated as if they are separate legal entities for insolvency purposes. The modified regime excludes company voluntary arrangements, voluntary liquidations and receiverships; and
- PCCs are only available as a corporate structure for insurance risk transformation, not wider financial services activities. The government has however stated that it will keep this under review.
Carrying out the regulated activity of insurance risk transformation
Anyone wishing to operate in the United Kingdom as an ISPV will need to apply to the PRA for permission to perform the new regulated activity of insurance risk transformation set out in Regulation 13A of the Financial Services and Markets (Regulated Activities) Order 2001 (RAO).
PCCs introduced under the RTR will only be available for use as authorised mISPV and applicants wishing to use a PCC will need to include a PCC application as part of the application to the PRA to carry out the regulated activity of insurance risk transformation. If the PRA, with the consent of the FCA, decides to grant authorisation to carry out insurance risk transformation through an mISPV, the FCA may permit that ISPV to be incorporated as a PCC. If the PRA refuses authorisation for an mISPV, the FCA will not incorporate an associated PCC.
ISPVs will be subject to dual regulation by the PRA and FCA, but it is the FCA that will be responsible for the incorporation and registration of PCCs in the UK. An applicant wishing to use a PCC to carry out insurance risk transformation will need to apply for a PCC as part of the mISPV application it submits to the PRA. The PRA will lead the authorisation process but will require the FCA’s consent before granting approval.
In order to be authorised by the PRA, the applicant also has to demonstrate that the ISPV is fully-funded (further information on this requirement is set out below). Consequently, the ISPV application should make clear how the following factors work together to ensure that the ISPV will remain fully funded and achieve an effective risk transfer throughout its existence:
- the contractual arrangements;
- the ISPV’s funding arrangements;
- the ISPV’s investment strategy;
- any off-balance sheet support arrangements such as guarantees or other forms of market/credit risk mitigation;
- the ISPV’s risk management framework including stress testing, liquidity risk, and all other quantifiable risks; and
- any other relevant factors.
In terms of timing, the PRA states that it will determine complete applications for authorisation as an ISPV within six months of receipt, however it will endeavour to determine applications more quickly where possible.
Applicants for authorisation are encouraged not to apply speculatively. Applications should be made at the time when they include sufficient information for the PRA to make an assessment. However, applicants may contact the PRA to discuss well-developed applications prior to formal submission to receive early regulator feedback. This should hopefully accelerate the authorisation timetable set out above.
The Solvency II Directive recognises that ILS cover provided by ISPVs can be a valid risk mitigation technique. It also recognises that ISPVs are different both in substance and form to insurers or reinsurers and therefore the solvency requirements and extent of supervision of ISPVs should differ as compared to insurers or reinsurers under the Directive.
As defined in the Directive, a ‘special purpose vehicle’ is any undertaking, whether incorporated or not, other than an existing re(insurer), which assumes risks from (re)insurers and which fully funds its exposure to such risks through the proceeds of a debt issuance or any other financing mechanism where the repayment rights of the providers of such debt or financing mechanism are subordinated to the reinsurance obligations of the undertaking. In addition to being authorised and subject to regulatory supervision, under the Solvency II framework, it must comply with the following:
- The ISPV must be fully funded The PRA expects all ISPVs to be fully funded. In accordance with the Solvency II rules, the PRA expects the ISPV to recognise and value its assets in conformity with the international accounting standards adopted by the European Commission. This will determine the extent to which assets may be recognised and taken into account for the purposes of satisfying the fully funded principle. On this basis, the PRA does not expect contingent assets to be counted for the purposes of satisfying the fully funded requirement. Accordingly, ISPVs should not count legally binding commitments that could be treated as ancillary own funds by insurance or reinsurance undertakings as assets for the purposes of satisfying the fully funded requirement. The proceeds of the ISPV’s debt issuance or other funding mechanism must be fully paid-in. The PRA considers that to be fully paid-in, an ISPV should have actually received the proceeds of the debt issuance or other mechanism by which it is financed.
- The rights of investors should be subordinated Where the ISPV assumes risks from more than one (re)insurer, it must remain at all times protected from the winding up proceedings of any one of the (re)insurers which transfer risks to the SPV.
- Governance arrangements Assessments of fit and proper requirements for shareholders or members having a qualifying holding in the SPV and for persons who effectively run the SPV should, where relevant, take account of similar requirements applying to (re)insurers. Pursuant to the RTR, the FSMA Controller Regime does not apply in respect of ISPVs. However, the PRA expects applicants to ensure the fitness and propriety of shareholders or members with a ‘qualifying holdings’ (a direct or indirect holding in an undertaking which represents 10% or more of the capital or of the voting rights or which makes it possible to exercise a significant influence over the management of that undertaking) in the ISPV. Under the proposed rules, the PRA has made it clear that the senior insurance managers regime (SIMR) requirements apply to ISPVs and that individuals are required to occupy the following mandatory PRA SIMR roles for each ISPV:
- Chief Executive (SIMF1);
- Chief Finance (SIMF2); and
- Chairman (SIMF9)
Where an ISPV has someone fulfilling an additional SIMR function that is applicable to ISPVs pursuant to Senior Insurance Management Functions (SIMF), pre-approval of that individual will also be required.
- Transfer of risk The transfer of risk from the (re)insurer to the ISPV and from the ISPV to the providers of debt or financing should be free of any connected transactions which could undermine the effective transfer of risk, for example contractual rights of set-off or side agreements designed to reduce the potential or actual losses incurred as a result of the transfer of risk to the providers of debt or financing to the SPV.
Taxation of ISPVs
The government proposes to introduce a bespoke taxation regime for ILS in the UK. The regulations (set out in Annex B of the Treasury consultation) set out what this will involve, including:
- exempting the profits of insurance risk transformation by ISPVs from corporation tax; and
- disapplying the obligation to deduct UK income tax from payments of interest made to non-UK investors.
The tax treatment will be strictly limited to ISPVs and will be contingent on regulatory rules being met and vehicles receiving authorisation from the PRA and FCA. If an ISPV is not authorised to carry out insurance risk transformation under FSMA (the new regulated activity) then the bespoke tax treatment for ISPVs will not be available. The exemption from corporation tax is limited to the profits of insurance risk transformation and does not apply to administrative or management activities, nor to the income from investments held by ISPVs in excess of the amount reasonably required to satisfy the fully funded requirements.
The tax advantages given by the regime will not be available if an ISPV is used as part of a tax avoidance scheme. The proposed ILS tax treatment should only be available where there has been ‘genuine transfer of risk’ to an ISPV.
Ahead of finalising the regulations early next year, the government has stated that it will continue to consider provisions to ensure that the tax treatment is not available where risk is effectively retained through a cedant’s investment in an ISPV.
Implications of Brexit
In the current climate of uncertainty in the financial services sector, the new ILS framework provides a positive opportunity to prove that London will remain a key centre for carrying out insurance business. It remains to be seen the extent to which the new proposals will successfully draw ILS business away from the more established ‘traditional’ jurisdictions; but the proposals should be welcomed as a sign that London is prepared to innovate and adapt to capture new forms of business.
Feedback on the Treasury consultation is requested by 18 January 2017 and feedback on the PRA/FCA consultation is requested by 23 February 2017.