UK government must impress with tax changes, says lawyer

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In its March 2015 Budget, the UK government announced plans to promote the legal environment in the UK to encourage the creation of an ILS (insurance linked securities) hub in London, writes Norton Rose Fulbright senior associate Nico Berry.

An industry taskforce was established in the summer of 2015 to advise the UK government on the necessary changes to UK law that would make the UK a viable jurisdiction for ILS and CRe (collateralised reinsurance) vehicles and their managers to be domiciled. According to recent reports, HM Treasury is rumoured to have started drafting the relevant legalisation required for such changes.

ILS and CRe are two of the most prevalent forms of alternative risk transfer in the insurance and reinsurance market today and the appetite for them from both an investor and issuer and capacity provider perspective is at an all-time high because of prolonged low returns in traditional capital market investments.

2014 was a record year for catastrophe bond ILS issuances. In the same year, excess capacity in the global reinsurance market led to record numbers of CRe transactions. Given the size of the market and corresponding opportunities, the UK and other European jurisdictions are now trying to foster the development of ILS and CRe industries locally.

ILS was originally developed in the early 2000s when those managing the excess capital of pension funds and other investors were seeking higher returns than those then available in non-insurance capital markets investments.

When ILS first appeared, regulatory constraints meant that many traditional ILS funds and alternative market investors were limited to the ILS markets and were unable to undertake CRe deals, which were the preserve of traditional reinsurance capacity providers.

There has been a gradual acceleration in the influx of alternative fund capital into the CRe space and a corresponding increase in its applications as investors have sought to access CRe structures underwriting higher return risks through their own or third party licenced reinsurance vehicles.

However, this recent excess of capital has caused pricing pressure, and therefore lower investor returns, in the traditional ILS cat bond and CRe markets. From 2016 onwards, the introduction of Solvency II rules will provide an additional stimulant to the ILS and CRe market. Reinsurers will be able to reduce their “own” capital requirements under Solvency II by passing on risks to outside investors. This is likely to increase further downwards pressure on rates.

Both ILS and CRe are attractive, in comparison to traditional insurance market products, to an insured as their collateralised structures effectively work on a ‘get paid now, dispute later’ basis. Lower prices have therefore seen insureds, who would not previously have sought protection through the ILS and CRe markets, seeking to use ILS or CRe to insure particularly large risks to their business.

ILS and CRe structures are also becoming increasingly common in relation to more bespoke risks effected through private placements, which can offer higher investment returns to those willing to underwrite them.

In recent times, an online lottery company used a bespoke privately negotiated ILS structure to insure itself against the risk of a large jackpot pay-out to customers in a deal which was a first of its kind. This transaction also made use of CRe for aspects of the cover, demonstrating the ability to combine CRe and ILS to provide a comprehensive, tailored protection package.

Given the potential applications for the coverage afforded by ILS and CRe, it is likely that the market for smaller bespoke risks will grow. Despite the pricing pressures of recent times, the relatively higher returns offered by privately negotiated deals to the traditional ILS and CRe placements should mean these smaller deals will be attractive investments for traditional and alternative fund investors.

Smaller bespoke deals require innovation and pose unique structuring issues. The London market (particularly the Lloyd’s of London market) has historically been more of a hub for structuring CRe deals and is probably best positioned to take advantage of this trend.

Although many UK and Europe based investors invest in ILS transactions, these have historically been targeted at large US investors and have generally originated out of the US as Rule 144A offerings governed by US laws. The transformative reinsurance vehicles and management companies used in ILS and (increasingly) in CRe deals are usually based in established low tax jurisdictions, such as Bermuda and Cayman.

The UK is not alone in seeking to capture business from these established ILS and CRe centres. Both Gibraltar and Guernsey are currently actively pushing their protected cell companies and their tax regimes as viable alternatives to the traditional ILS and CRe vehicle domicile centres.

If the UK government is to achieve its objective of making London an ILS hub, the legislation HM Treasury is currently drafting will need to create the tax and corporate incentives necessary to enable the UK and London to be an attractive alternative to investors and issuers in this increasingly competitive market.