During 2015 we have witnessed some interesting developments that should have a substantial impact on how the reinsurance markets will access capital in the future. Each, on their own, is not of major significance but a combined view provides a glimpse of an underlying struggle between the traditional reinsurance market and its convergence or alternative capital markets counterpart and also of the ongoing battle between London and Bermuda for supremacy as the insurance capital of the world.
London has for long donned the cloak of the leader and the centre of insurance for the world. However, with the introduction of super mono line reinsurers during the early naughties such as the “class of 2001” and “class of 2005” and the recent uptick in Insurance Linked Securities (“ILS”) Bermuda has flexed its muscles and has come a long way as the new kid on the block to rival London and the other major European centres. But just as one thought that the pendulum was swinging towards Bermuda, with the likes of Omega, Hiscox and Lancashire with others moving from London to set up in Bermuda, Europe retaliated with the introduction of Solvency II which came into force on 1 January 2016 after a fairly long gestation period.
However, Bermuda has not just sat idly by and watched but has recently announced that its regulatory regime, along with Switzerland, are to become the first international jurisdictions to receive Solvency II equivalence. Along with announcing the Americas cup for 2017 this would have taken the wind right out of the Europeans’ “Solvency II” sails. Bermuda and Switzerland are the only two jurisdictions to date that have been recognised as being equivalent under the EU initiative. Announced on 26 November, the Bermuda Equivalence Delegated Act now stands for a 90 day consultation period with the European Council and the European Parliament. In a recent article Robert Paton, President of the Bermuda Insurance Management Association stated that the announcement of the Delegated Act in relation to Solvency II equivalence is a “further example of the leading role taken by the Bermudian Monetary Authority (“BMA”) in ensuring that the Bermuda insurance and reinsurance market remain at the forefront of global supervision.”
One area where Bermuda is already ahead of the rest of the reinsurance domiciles is ILS and the collateralised or alterative market. For a while now it, together with Cayman Islands, has been the leading jurisdiction cajoling convergence of the collateralised alternative markets with the traditional reinsurance market. Not only with respect to catastrophe bonds, where the Bermudian Stock Exchange is the leading exchange for listing the underlying debt instruments, but also in the wider collateralised reinsurance market. A combination of initiatives over the past years have aided this evolution (a Segregated Account Companies Act 2000, the introduction of Class 3A & 3B insurers that draw a distinction based on premium income size and also the introduction of special purpose insurers) combined with appropriate regulation and an effective regulator in the BMA, Bermuda has been able to attract most of theILS market investors and pre-eminent ILS service providers.
The ILS or alternative capital market is growing and is clearly making inroads into the traditional market. Currently situated at around 20% of the US$565 billion reinsurance capital market, it is growing by more than 7% per annum, and in its recent review, AON stated that the alternative capital market should reach US$120 billion to US$150 billion by 2018. A very important market indeed and one that a serious reinsurance jurisdiction cannot ignore.
So, over to London. Bermuda’s growth has not gone unnoticed in London and earlier this year, in its March 2015, budget the government announced plans to promote the UK as a hub for the ILS and collateralised alternative capital market. The London Market Group has been established as an industry task force to assist and advise the Government and Treasury on what needs to be done for the UK to achieve this goal not only in the ILS but also to collateralise reinsurance where London sees it has the greatest advantage over the rest of the world. In line with recent reports, the Treasury is all set to start drafting the required legislation to introduce a form of protected cell companies (similar to what is being used in the Channel Islands at present) to accommodate ILS and collateralised structures.
It is also ready to introduce changes to the tax regime to encourage major institutional investors to participate in UK domiciled ILS and collateralised structures. One of the current proposals being mooted will be to tax investors when they exit such a collateralised or ILSstructure and link the tax between the investors domicile and the jurisdiction in which the underlying risk is situated. London, it would appear, is prepared to pull out all the stops in rivalling Bermuda for this growing market and market participants are quietly confident that London could just be successful in its goal. After all it has been the custodian of the Lloyd’s market since the seventeenth century and is therefore no stranger to facilitating investor participation directly at the underwriting level or the capitalisation of underlying insurance risks through third party investors.
Up to now, Lloyd’s has taken a somewhat cautious approach to the new phenomena but, during the last two years, first Nephilla (the dominant ILS fund) and now also Credit Suisse has joined the Lloyd’s market. Also recently another ILS fund, Securis, announced a tie up with Novea to set up special purpose syndicate to provide their investors access to write US property casualty business. Hiscox has increased its ILS exposure to over US$600 million and, with the likes of Lancashires’ Kinesis and XL Capital (Catlin) with its ILS outfit New Ocean, most of the dominant reinsurers have alternative capital or ILS platforms to access that market and it would appear that the traditional reinsurance market is gearing up for a fight.
The one area that raises a potential hurdle for London in its efforts to establish itself as an ILSor alternative capital market centre may be its regulatory environment and more particularly the PRA. In the aftermath of the banking crisis and the introduction of the Solvency II regime we have witnessed a surge in prudential regulation in the insurance industry. The PRA has established itself as a rigorous and no nonsense regulator in its task of ensuring that what has gone on in the past in the banking arena won’t be repeated in the insurance industry. Could it be that the success of the PRA could yet prove to be London’s Achilles heel? Will the regulator be able to adapt to the requirements of sophisticated institutional investors and become a facilitating regulator without sacrificing the quality in regulation that it seeks to achieve? This has been a balance that the BMA has appeared to be able to master. There is great reputational risk. No regulator wants to oversee a failed reinsurer on their watch…collateralised or otherwise.
London’s prospects for success appears to be tied up with the approach of the regulator who will have to facilitate, yet not be too relaxed on, for instance, the types of collateral to be used in ILS or collateralised structures, the knowledge of the investors, information and transparency as to modelling and understanding of and ability to properly assess the underlying risks. It will take the PRA time in coming to terms with the drivers for ILStransactions and a full appreciation for the extent to which risk is actually being transferred. But most of all, and in order to rival Bermuda, it is the speed at which these structures and arrangements can be set up and authorised by the regulator that will prove the ultimate test.
However, it would appear that some clouds could be gathering on the horizon for London. Disconcerting was the recent adoption of the Diverted Profit Tax (“DPT”) in the March 2015 budget speech and, particularly, the guidance by HMRC on the impact on captive and single quota share reinsurance arrangements. Traditionally designed to capture the large internet providing corporate retailers hence the common term “the Google Tax” the impact on the insurance market at first appeared as an unintended consequence…but was it? In its guidance the HMRC specifically set out instances whereby the DPT would impact on captive arrangements as well as on quota share reinsurance arrangements. All intended, indeed. Before DPT the transfer pricing regime was the major test for these arrangements whereas the DPT has introduced a further economic substance test. No doubt companies will have to look carefully at their capital structures and their captive, as well as quota share, reinsurance arrangements to offshore jurisdictions to avoid the potential 25% DPT.
But the storm has not yet set in and the EU commission is currently considering the DPT. Also under the ongoing base erosion and profit shifting (BEPS) process an agreed international solution could well be reached whereby each jurisdiction would receive its “fair share of tax”. There would not then be place for the DPT as the UK has jumped the gun and pre-empted this by unilaterally going ahead and introducing the DPT.
So the pressure is on for the treasury, the government and the regulators and it is setting up 2016 as a very exciting year for the London (re)insurance and ILS market…with the outcome eagerly awaited by all.