The UK's Financial Services Authority is making insurance special purpose vehicles a viable option for the London market. Dr Thomas Huertas explains why.
Hurricanes, Typhoons, Earthquakes, floods and pandemics are but a few items on the list of possible catastrophes that could confront the world over coming years. Insuring businesses and households against the adverse economic consequences of such events is vital if economic growth is to continue. Indeed, without such insurance, economic activity could contract.
Insuring against such risks requires adequate amounts of capital. To date, such capital has largely been equity provided to insurance companies. The capital markets have played a relatively small role in the direct assumption of insurance risks. This does not make sense.
A solution is now to hand though. As part of its effort to create "the regulatory platform of choice", the Financial Services Authority (FSA) is introducing a separate fit-for-purpose regime for insurance special purpose vehicles (ISPVs) in the context of its implementation of the EU Reinsurance Directive in the UK. ISPVs are companies that specialise in reinsuring risk from primary insurers or from other reinsurers and which must be fully funded. Essentially, the ISPV will access funds from the capital markets to invest in assets that will be available to pay claims, should the events insured against occur. It is anticipated that ISPVs will finance themselves predominately through the issuance of debt securities. A typical, simplified structure of an ISPV is illustrated in the figure below.
ISPVs have several advantages. For investors, they create the opportunity to assume insurance risk directly and to benefit from the return this may generate. Should the reinsured events not occur, the bonds would be repaid on par with the full amount of interest on offer. Should the events occur, the reinsurance claims would be deducted from the interest due to the bondholder, and, if necessary, from the principal. It is anticipated that ISPVs would issue bonds in tranches, with junior tranches being liable to pay claims in advance of more senior tranches, similar to the liability structures used in securitisations.
For insurance companies, ISPVs create the opportunity to generate more business and to manage their own capital more effectively. Many insurers have the capacity to generate significant volumes of premium income from their clients, but may confront capacity problems, particularly if the insurer's equity capital is limited, or if the risks are highly correlated with one another. By using an ISPV, the insurer or reinsurer can underwrite a larger amount of risk, knowing that a suitable portion of this can be transferred to the ISPV. This will facilitate optimal risk management for the ceding company and enable it to maximise its risk-adjusted return on equity.
For policyholders, there are also advantages. ISPVs will effectively increase the capacity of the insurance industry to underwrite risks and facilitate efficient risk management. This should result, over time, in greater availability of coverage and/or lower prices.
ISPVs are quite flexible in the forms that they can take. We envisage that some will accept risks from a single underwriter while others will reinsure multiple underwriters. They will take on risks on a quota-share or excess-of-loss basis. Where the ISPV accepts risks from a single underwriter, investors in debt issued by the ISPV are likely to scrutinise the underwriting record of the ceding company closely. If the ISPV deals with multiple underwriters, the selection criteria of the ISPV itself is likely to be important. Similarly, if the ISPV writes quota-share coverage, investors will look primarily to the underwriting records of the ceding company or companies. If the ISPV writes excess-of-loss coverage, its own underwriting criteria and performance are likely to be important to investors.
From a regulatory perspective, there are three key aspects to the use of ISPVs:
- The transfer of risk. Transactions must be effective at transferring the risk they purport to transfer. Firms must ensure there has been a transfer of risk in relation to the benefit taken in the regulatory balance sheet. This may be on a full or partial basis and will be determined by the documentation of the specific transaction, which will determine the level of risk transferred;
- The solvency of the ISPV itself. ISPV solvency is regarded as sufficient if the ISPV simply has assets that are greater or equal to the liabilities. A more substantial solvency margin is not required as the ISPVs liabilities are, by nature, limited to its assets (the assets of the ISPV must be greater than or equal to the coverage written by the ISPV). The ceding company cannot post a claim on the ISPV for an amount greater than the coverage provided under the reinsurance contract; and
- The impact this will have on the capital requirements of the ceding firm(s). Firms will need to determine the economic effect of the transfer of risks to the ISPV when assessing their capital requirements following this transfer. Any residual risk retained by the ceding firm using an ISPV will need to be taken into account in the ceding firm's individual capital assessment (ICA).
In combination these three factors ensure that policyholders are adequately protected when ISPVs are used. The ceding company can exclude from its capital calculation the risks reinsured with the ISPV. Effectively, the ceding company is utilising debt capital raised by the ISPV to meet the capital requirements of the business originating from the ceding company. This can be a useful supplement to, or replacement for, traditional reinsurance. And, for reinsurance companies, an ISPV can, in effect, provide retrocession cover that might not otherwise be available.
To facilitate the formation of ISPVs, the FSA is setting up a streamlined authorisation process. This will enable firms to access capital quickly in response to market opportunities. Less information will be required from an ISPV than from a traditional reinsurer, with greater emphasis on self-certification. Appropriate safeguards will be maintained by placing the onus on the ceding firm to provide information on the impact of using the ISPV on its ICA. The authorisation process will treat ISPVs accepting risks from firms supervised outside the UK in the same way as ISPVs accepting risks from UK-supervised cedants.
Whilst ISPVs are already permitted in the UK, they are subject to the requirements applicable to reinsurers. The implementation of the Reinsurance Directive gives the FSA the opportunity to introduce a much more proportionate supervisory regime. In order to minimise the burden on firms and to minimise duplication of effort, the FSA is proposing that its supervision of ISPVs will be largely covered through the supervision of the ceding insurer. Any residual risks will be reflected in the cedant's ICA.
Finally, a word about tax. Simultaneously with the introduction of ISPVs, the UK fiscal authorities are instituting a new regime for the taxation of special purpose vehicles generally. Essentially, the new regime taxes SPVs on a pass-through basis, so that the SPV itself is taxed only on retained profits.
For an ISPV, this means that the vast majority of the ISPVs income will be taxed at the investor level. Revenue for the ISPV is the reinsurance premium received plus the investment earnings on the assets held by the ISPV. Expenses are claims paid plus the interest paid to the debtholders plus any administrative expenses (claims paid serve to reduce the amount of interest and principal due to the debtholders).
In summary, ISPVs are an excellent way for insurers to use the capital markets to supplement their own resources and respond quickly to new opportunities with access to more diverse sources of capital. We believe that our proposed regime demonstrates the FSA's ability to respond to market innovation and develop appropriate regulatory responses. It will offer considerable benefits to insurers and investors whilst also being beneficial to policyholders.
- Dr Thomas Huertas is director, wholesale firms division of the UK's Financial Services Authority.