Drawing on the vast experience of its financial industry, Cayman has established itself as a leader in the innovative field of risk securitisation, writes Kevin Lloyd.
Over the course of the past two years, the reinsurance industry has begun to tap the capital markets, primarily through the formation of Cayman special purpose vehicles (SPVs), in order to access new sources of capital to meet potentially large insurance claims that could erode traditional reinsurance capacity.
What is risk securitisation?
Risk securitisation is simply the transfer of risk from one party to another through the transformation of assets or future cash flows into marketable securities which are purchased by the transferee. In the case of recent Cayman SPVs, insurers and reinsurers have transferred underwriting risk to investors through the issuance of debt instruments backed by the future underwriting cash flows of a reinsurance/retrocessional contract.
Basic structure of an SPV
A charitable trust is set up, through an initial contribution by the (re)insurer sponsoring the SPV, which purchases 100% of the equity in the SPV. This initial contribution is usually a minimal $5,000. The SPV will enter into a single reinsurance/retrocessional contract with the (re)insurer to cover specified risks and then issue financial instruments (primarily debt securities) to investors in which the investors assume some or all of the risk covered by the reinsurance/retrocessional contract. For accepting this risk, investors earn a return of LIBOR plus an agreed spread but may also lose a portion of all of their interest and/or principal should a loss occur on the reinsurance contract. Funds received from the investors are deposited into a Regulation 114 trust account and are invested in US treasury securities. The return on those securities is guaranteed through the use of a swap which effectively transfers control and market risk on the securities to a swap counterparty. Interest payments to the investors are funded through a combination of the investment income on the securities and the reinsurance/retrocessional premium paid by the (re)insurer. Premiums are set to cover the portion of the interest payable on the notes which is not earned on the securities and the estimated operating expenses of the SPV.
Although there is no direct ownership by a parent, these SPVs resemble single-parent captives in that they are set up by a (re)insurer specifically to serve its reinsurance needs. As is the case for traditional captives, these SPVs are set up offshore to minimise regulatory restrictions.
Securities offered by SPVs
The majority of SPVs offer two classes of notes, with one class guaranteed as to the return of principal. A portion of the proceeds from the issue of the guaranteed class notes are deposited into a defeasance account and, should a loss payment by made by the SPV, are used to purchase zero-coupon US government securities which will accrete to the face value of the guaranteed class notes within a specified period, normally about 10 to 12 years from the issue date. If a loss occurs, these defeasance securities are delivered to the Indenture Trustee and the maturity of the guaranteed class notes is extended to the maturity date of the zero-coupon securities. Once this takes place, the SPV is legally released from any obligations under the guaranteed class notes. The use of a guaranteed class of notes allows certain investors to purchase notes when they otherwise may not have been able to, due to certain restrictions from investing in securities where the principal invested is at risk.
The second and usually larger class of notes issued are not guaranteed as to repayment of principal and the proceeds are deposited into a collateral account, along with the not-at-risk portion of the proceeds from the issuance of the guaranteed class notes. These proceeds are used to satisfy any obligations of the SPV under the reinsurance/retrocessional agreement. In exchange for investing in the principal-at-risk bonds, investors receive a higher interest rate than do the investors of the guaranteed class notes.
If there is a covered loss under the reinsurance/retrocessional contract, the ceding (re)insurer has the right to extend the maturity of the notes to allow it to settle claims. During this extension period, principal is not at risk and investors are paid interest on the notes.
As investors and insurers become more familiar with the concept, structure and risks, certain recent deals have varied from the above format which was fairly standard initially. In one recent deal, an SPV issued subscription agreements to investors requiring them to purchase notes at a future date should a catastrophic loss occur. This structure provides a source of reinsurance capacity to the ceding reinsurer following a catastrophic loss. Note that in this case, investors' principal only becomes at risk for the period following the occurrence of an initial catastrophic loss which triggers the issuance of the notes under the subscription agreements.
Investors in these securities to date have included other insurers, mutual funds, hedge funds, pension funds, institutional investors, asset managers and life insurance companies. Secondary markets are beginning to develop.
The SPV will enter into a reinsurance/retrocessional contract in which it agrees to cover specified losses of the ceding (re)insurer in a covered territory during a set time period. The majority of the contracts to date have been short term, one to three years, although several deals have encompassed periods of up to 10 years. Should the ceding (re)insurer suffer a loss which it believes is covered by the reinsurance/retrocessional contract, it will submit a Proof of Loss Claim to the SPV, requesting reimbursement. Prior to making a payment under the contract, an independent claims reviewer will perform agreed upon procedures on a sample of the paid losses of the ceding (re)insurer and an independent loss reserve specialist will provide the SPV with its best estimate of the ultimate net loss that the ceding (re)insurer will ultimately be required to pay under the (re)insurance contract.
Several recent deals have tied possible loss payments to an index or magnitude of a natural disaster, and any resultant loss payments made by the SPV will not necessarily bear any direct or indirect correlation to losses, if any, actually incurred by the ceding (re)insurer from a loss event. Loss payments have been based on an index as actual losses may not be known with any kind of certainty for some time after the occurrence of the loss event.
What are the benefits to the (re)insurer?
As a result of the catastrophes of the late 1980s and early 1990s and the increasing potential size of losses generated by natural disasters like hurricanes and earthquakes, primary insurers need more capacity to transfer risk than is currently available in the traditional insurance market. The capital markets have provided supplemental capacity at a reasonable price which has allowed insurers to better manage their exposures.
The use of the SPV structure also provides the ceding (re)insurer with access to immediate financing for losses that may arise in their portfolio and eliminates the time, costs and credit risk associated from collecting recoveries from other reinsurers. It further provides the ceding (re)insurer with a stable cost of reinsurance which should allow them to better manage their portfolio of business.
Over the years, Cayman has developed a significant expertise in the capital markets, dealing with non-insurance SPVs. This experience, coupled with the insurance expertise developed through the growth of the captive insurance industry has provided Cayman with a strategic advantage over other off-shore jurisdictions which may lack expertise in either the capital markets, trust or insurance industries. The ability to list the securities of an SPV on the Cayman Islands Stock Exchange further enhances Cayman's position as the preferred domicile for risk securitisation as the listing rules of the Exchange were specifically designed to facilitate the listings of securities of SPVs and mutual funds.
In addition, Cayman Company and Insurance regulations are very flexible and as indicated above, allow for an SPV to be capitalised with a minimum of funds.
A look at the future
The initial SPVs have been designed to cover risks of catastrophic natural disasters, primarily earthquakes and windstorms, that are expected to occur on an infrequent basis. While these risks are expected to continue to drive much of the growth in this area, we also expect to see risks such as credit risk and industrial hazard risk covered. Eventually, we expect to see non-insurance multinationals using this avenue to augment their risk management programmes.Although in its infancy, the convergence of the insurance and capital markets is widely expected to continue to grow at a rapid pace, not unlike the mortgage-backed securities market which initiated the market for securitised products. Recognising this trend, many large reinsurers have created units or are forming alliances with capital market companies and brokers and securities firms have set up units which specialise in providing capital market options to the insurance industry. These strategies leave no doubt as to the importance of the capital markets to the insurance industry. The financial services industry in Cayman recognises this potential and is strategically placed to service this growth.
KPMG in the Cayman Islands
The Cayman Islands firm of KPMG is a leading provider of insurance advice and services to the captive insurance industry in Cayman. Supported by the KPMG International Insurance Committee, we are able to provide insurance solutions for our clients.
KPMG is one of the largest accounting firms in the Cayman Islands and we currently provide audit services to over 30% of the captive insurance companies licensed under the Cayman Islands Insurance Law. We are also the only accounting firm in the Cayman Islands with a resident US tax department which allows us to provide integrated, multi-disciplinary advice and services to our clients.
Our dedicated insurance professional advised on and assisted with the first capital market securitisation by a Cayman Islands' SPV and have since advised on and assisted with numerous capital market offerings securitising various insurance risks of insurers and reinsurers around the world. These engagements clearly highlight both our insurance and financial industry experience and our ability to expand and adapt our services to the demands of our clients and the changing global marketplace.
Kevin Lloyd is a partner with KPMG in the Cayman Islands.