Kevin Egan considers whether Dublin is en route to becoming the ART centre of Europe.
The connection between banking, securities and insurance is a triangle that hasn't been totally exploited yet. I'm fairly interested in that space.” This view, articulated by Peter Hancock, former CFO at JP Morgan, on announcing recently that he is to participate in the launch of a new venture with General Re, powerfully summarises a proposition that has been common currency for some years now.
Press reports suggest that Mr Hancock's new venture will focus on the interplay between derivatives and risk management. This is understandable. The growth of financial derivatives has made the banking industry increasingly dependent on the quantification of risk. Reinsurers understand risk; they measure it, price it, trade it and hedge it. The logic of the fit seems compelling.
But this proposition, that the banking industry can leverage from the expertise of reinsurers, is probably less mature than a complementary view, that the capital markets represent a new distribution channel for risk.
There seems to be broad agreement on why the traditional insurance and reinsurance markets need the capital markets but also why the capital markets should embrace this new opportunity. Consider the following:
Again, the fit seems – in theory at least – to be persuasive. The leading global reinsurers certainly seem to believe so. In recent years, they have aggressively responded to these challenges by expanding their business models in an attempt to maintain control over this evolving business segment. They are not alone. Investment banks have been quick to form transformer vehicles, the major global brokers now offer ART services and boutique structuring and consulting houses have emerged.
Health of the market
A great deal of money has been spent equipping this new space, but whether the deal flow to date justifies the spend is a hard question to answer. Certainly, a large number of high profile deals have been completed over the last five years or so. However, it seems that market messages are mixed; overall it's hard to avoid a general impression that notwithstanding the considerable efforts of market participants in recent years, volumes and values of deals have been low compared to aggregate target exposures and available risk capital.
Rating agency AM Best has estimated that loss portfolio transfers and other finite risk products have been the areas of greatest growth in recent years, driven by M&A activity and the need by acquirers to limit exposure to past liabilities of target entities. But many of these deals, while innovative, don't test the proposition that there is an appetite in the capital markets for new forms of risk.
The market for insurance-linked securities although established has, in contrast, failed to reach previous expectations. While additional catastrophe capacity of $5bn+ has been created over the last five years through capital market instruments, take up on other stable and predictable lines of business apparently suited to securitisation has been limited.
On the derivatives front, while US experience in recent years has demonstrated that a market can be created for over the counter (OTC) credit and weather derivative solutions, the development of standardised exchange products has been hampered by a lack of liquidity. Derivative activity in Europe to date has been very limited.
The soft insurance and reinsurance markets which have prevailed for a number of years may be at the root of the problem. Tailored solutions can be expensive to put together and often need substantial scale to absorb these fixed costs. Cheap and plentiful capacity, it can be argued, has absorbed most of the ready demand.
Perhaps the safest and most sensible conclusion that can be reached at this time is that the market for ART solutions remains at an early stage of development. It may be that ultimately, rising demand, healthy supply and greater price transparency and liquidity will create markets which will rival the existing insurance/reinsurance providers. Alternatively, it may be that many ART solution sets will remain niche areas which will be supported primarily within the product lines of traditional reinsurers and perhaps a small number of investment banks.
However, the feeling remains that there is something big to play for. Reinsurance rates, by all accounts, rose significantly during the most recent renewal season and capacity, especially for natural catastrophe, appears to have been cut further. Perhaps these developments presage the emergence of a medium term hard market and if they do, perhaps that will be the catalyst for creating the demand necessary to take the global ART market to the next level.
So, is Dublin a player in the current ART marketplace and what can it offer to prospective market participants?
There is already a critical mass of market players with significant operations in Dublin. Centre Solutions, XL Capital, Swiss Re, Hannover Re, GeneralCologne Re, ERC, ACE and Gerling are all important participants in the city's International Financial Services Centre (IFSC).
Market information indicates that many of these have been active in structuring ART solutions for international clients from their Dublin operations in recent years. LPTs and finite risk solutions may account for the majority of deals to date but securitisations have also been achieved. It is also known that Dublin is one of the centres to which statutory UK life reserves have been reinsured under the cashless ‘time deferred' structures which have emerged in the last two years.
That Dublin has achieved market share is not surprising given its competitive positioning in Europe and several factors in its favour.
Established financial services centre
As an established European financial centre, there is a critical mass of international banking, insurance and asset management players now resident in Dublin. IDA Ireland estimates there are approximately 400 international financial services entities operating from Dublin with a further 350 managed entities carrying on business under the IFSC program. The international financial services industry sits alongside a large and sophisticated domestic sector; Ireland has one of the highest penetration rates in the world for retail banking and insurance products.
For financial services players, Dublin is therefore a business environment of significant scale, serviced by a large and skilled human capital pool including in particular, accountants, actuaries, IT professionals and lawyers. A full range of activities can also be outsourced to specialist providers.
Both the domestic and international sectors are supported by a highly developed professional services industry similar in structure to the US and UK. Given the open nature of the Irish economy and extensive direct foreign investment over the last 20 years, professional advisors are comfortable operating in multiple jurisdictional, tax and GAAP environments.
The Irish regulatory environment is internationally recognised as fair and efficient and offers ‘single passport' insurance and banking access to all EU countries.
Promotion of international financial services activity is a priority for the government, and regulatory authorities are prompt in dealing with applications for new projects. Recently, the government has unveiled a structure for the creation of a single financial regulator – the Central Bank of Ireland and Financial Services Authority – to consolidate the existing separate banking, insurance and intermediary regimes. This is expected to streamline the regulatory process for players seeking to blend the product characteristics of what have traditionally been separate sectors.
Until recently, reinsurers have not been subject to formal regulation. The Insurance Act 2000 has amended this position so that existing and new reinsurers will be required to file a notice with the regulator providing information on, inter alia, its shareholders, its directors and management, capitalisation, proposed acceptance/retrocession arrangements and its operating and staffing structures. Significant changes in the information provided in the notice must be communicated promptly to the regulator. Importantly though, reinsurers will continue to be exempt from the detailed licencing and solvency provisions which apply to the direct writing market.
Ireland offers one of the most beneficial corporate tax environments in the world. A 10% corporation tax rate applies to all IFSC trading income until 31 December 2005, where companies were approved to operate in the IFSC before 31 July 1998. All other companies, whether currently taxed at 10% or not, will benefit from the phased reduction to a 12.5% standard rate of corporation tax on trading income across all sectors of the Irish economy. The 12.5% rate will be reached on 1 January 2003.
A ‘gross roll up' regime operates for the taxation of life assurance investment return into life assurance policyholder funds. There are no insurance premium taxes or levies.
Dublin is an established asset securitisation location having attracted approximately 50 major transactions in recent years. Irish tax legislation includes specific provisions to facilitate the establishment of securitisation special purpose vehicles (SPVs) in a broadly tax neutral environment. Prior to 1999, these provisions did not extend to asset classes arising out of insurance and reinsurance contracts. However, the 1999 Finance Act extended these provisions to interests in any ‘financial asset' which has been interpreted to include insurance assets and cash flow streams. Importantly, given that Ireland is not a zero tax environment, there is no minimum profit provision in Irish law. Ireland's extensive double tax treaty network and domestic legislation enable interest payments to bondholder to be made free of withholding tax in most instances.
The potential of onshore yet tax neutral structures attracted the first UK life assurance securitisation, the 1998 NPI deal to Dublin. Interestingly, this was achieved in the pre-1999 legislative environment by interposing loans between the SPV and the life assurance reserves, which remained on NPI's balance sheet. However, it is public knowledge that a full direct reinsurance securitisation has since been achieved using a Dublin-based SPV.
In general, the costs of operating in Dublin are recognised to be lower than in most other European countries. Hourly compensation costs (including payroll taxes and social security costs) are estimated to be just 50% and 80% of average German and UK levels, respectively. In an environment where ART solutions can be seen as expensive, cost (including tax cost) advantages may be crucial in helping to develop new markets.
There is clear evidence that Dublin has, for some time, been playing a role as one of a number of European ART centres. If, as many expect, ART is a sector poised to experience significant growth in a harder reinsurance market, then Dublin is excellently positioned to benefit from this. Its combination of onshore EU location, attractive and comprehensive tax legislation and low costs will position it as a natural location in which to establish risk carriers and SPVs. Technology solutions which allow data exchange and process efficiencies will facilitate the multinational operating model which this implies.