Patrick Devine looks at how the impending EU Reinsurance Directive will pave the way for insurance special purpose vehicles, or sidecars, to take-off in Europe.

The convergence of capital markets and reinsurance which began in the 1980s will be given increased momentum through the introduction of insurance special purpose vehicles (ISPVs) under an EU-wide and, therefore, internationally recognised regulatory environment.

Previously only found in offshore jurisdictions and EU countries that did not regulate reinsurance, the Reinsurance Directive, due to be implemented by the end of this year, will allow member states to introduce a new regime. This will not only put ISPVs on a sound regulatory footing but will also facilitate access by insurers and reinsurers to more diverse sources of capital and provide an alternative to the conventional reinsurance and retrocession market for balance-sheet protection.

In its consultation paper on the implementation of the Directive in June, the FSA makes it clear that it plans to introduce a lighter touch, "fit for purpose" regime for ISPVs with reduced authorisation requirements compared with those applied to traditional insurance and reinsurance companies.

One of the objectives of the proposed ISPV regime is to attract new capital to the UK market. The key factors determining the location of an ISPV are the regulatory environment and taxation. On 13 June HM Revenue and Customs proposed the implementation of a new taxation regime for ISPVs involved in the securitisation of financial assets, to take effect from 1 January 2007. The FSA is seeking industry views on whether ISPVs should also be brought within the scope of that regime.

In contrast to their traditional counterparts, ISPVs must be fully funded, usually by issuing debt. The holders of the debt will be repaid both principal and interest by the ISPV at regular intervals. The ISPV also issues one or more reinsurance contracts to a cedant insurance company. The loss experience on the reinsurance contract translates into reduced interest and principal repayments by the ISPV to the debtholders. In that way, insurance risk is transferred through the ISPV and is borne by the capital market noteholders. The noteholders are in a position similar to equity investors in a company. If the company has a bad trading year they may not receive a dividend and may lose their entire investment.

As the ISPV is fully funded, the noteholders effectively bear the losses and, as the value of the assets available to fund its reinsurance liabilities is capped, the ISPV cannot become insolvent. There is therefore no need for it to protect its balance sheet by purchasing retrocession.

Multiple uses

Thus far, the Reinsurance Directive has been silent on the ways in which an ISPV may be employed.

They can be used to carry both life and non-life risk and it is clear that they may be established to issue cat bonds with the advantage to the sponsoring insurer that, except where it invests as initial sponsor, it will not put its own capital at risk. Taking a lead from developments in Bermuda, an insurer or a Lloyd's syndicate could establish an ISPV as a subsidiary, or sidecar, bearing high value risk for a limited duration.

As with the George Town Re securitisation in the UK in the mid 1990s it may be possible for a direct insurer to cede its marine, aviation and transport book (or any other book of business) to the ISPV for a multi-year period, thereby locking in protection and stable capacity and price.

Whilst there are many examples to be drawn upon from the previous use of ISPVs in Bermuda and elsewhere, the key to success will be in persuading investors (whether from the capital markets or other reinsurers) that the ISPV will pay them a competitive rate of interest on their loan and that their principal will be returned to them. Innovation will be the order of the day.

Lighter touch approach

In a marked departure from current practice, the FSA propose to employ a simple solvency rule: that the assets of the ISPV must always be equal to or greater than its liabilities. Those assets must be either retained within the ceding company or within the ISPV.

For "pure reinsurers" the current detailed "admissable assets" rules will be disapplied and replaced with five broad "prudent person" investment principles, intended to ensure sufficiency, liquidity, security, quality, profitability and the matching of assets to liabilities. This new freedom is intended to encourage investment in more innovative financial products and instruments. The notification requirements in the current supervision manual will ensure that ISPVs will have to notify the FSA if the simple solvency rule is breached. The FSA would also be able to take regulatory action.

A leaner faster authorisation process is envisaged with less information demanded from a new ISPV than from a conventional insurer or reinsurer. The emphasis is on self-certification supported by opinions provided by legal advisors. The light touch regulatory regime is continued in the proposal that the supervision of ISPVs will be affected indirectly through supervision of the ceding insurer.

When calculating the cedant's solvency margin requirement, amounts recoverable from the ISPV are treated as reinsurance or retrocession. Amounts outstanding from the ISPV may be treated as reducing or included as assets covering the cedant's technical provisions. In each case the cedant has to apply for a waiver from the FSA to benefit from this treatment with supporting documentation providing an analysis of the extent to which risk transfer takes place. An analysis of the potential for risk to revert to the cedant or its related companies under foreseeable adverse scenarios, and for unprovided for liabilities to arise, must also be supplied.

The risk transfer principle

The new regime will be allied to a risk transfer principle, designed to ensure that the economic substance of the transaction is accurately reflected in the legal documentation as well as in the regulatory and accounting treatment. The objective is transparency fuelled by a desire to avoid the lack of clarity (whether deliberate or otherwise) associated with some highly-publicised financial (or finite) reinsurance transactions, particularly in the US. The FSA is consulting on whether to extend the risk transfer principle to all reinsurance contracts, not just those issued by ISPVs.

This high level principle-based rule will be used to assess the extent to which there has been a genuine transfer of risk against the benefit taken in the balance sheet. If the test is satisfied a non-life insurer or reinsurer will be allowed to include the ISPV as a reinsurance asset whilst a life insurer or reinsurer will be entitled to deduct any liabilities covered by the ISPV from its gross liabilities.

Getting the thumbs up

By permitting individual EU member states to establish a standalone regulatory environment for ISPVs the EU has placed them firmly on the agenda for both insurers, reinsurers and potential capital markets investors. It has also firmly stamped its seal of approval on innovative insurance practices and capital markets risk transfer transactions.

It is encouraging that the FSA has seized this opportunity to benefit the UK insurance industry. But there is the potential for the UK to be one of the last places one would want to establish an ISPV. The main reason for this is taxation. The UK will not be the jurisdiction of first choice if it taxes ISPVs at a higher rate than Ireland or Luxembourg within the EU, or Bermuda, the Cayman Islands and the Channel Islands outside the EU. Both a flexible UK regulatory and tax environment are key if ISPVs are to take off in Europe. Despite the "legitimisation" of ISPVs by the Reinsurance Directive, without a conducive tax environment, it will only be a benefit to competitor jurisdictions.

- Patrick Devine is a partner at Reynolds Porter Chamberlain.


An ISPV is defined by the Reinsurance Directive as: "Any undertaking, whether incorporated or not, other than an existing insurance or reinsurance undertaking, which assumes risks from insurance or reinsurance undertakings and which fully funds its exposure to such risks through the proceeds of a debt issuance or some other financing mechanism where the repayment rights of the providers of such debt or other financing mechanism are subordinated to the reinsurance obligations of such vehicles."

SOURCE: Reinsurance Directive.