Andrew Pincott looks at some of the regulatory complications for English and European insurance companies developing alternative risk transfer products to protect businesses against natural catastrophes.

In April 2002, Tokio Marine & Fire Insurance Co unveiled its new typhoon derivatives, a retail product designed to appeal to businesses exposed to the risk of economic loss from typhoons in Japan. This appears to be the latest in a line of innovative products designed to transfer risk using techniques more familiar to the capital markets than to conventional insurance. In essence, under the Tokio Marine product an agreed amount will be paid to a protection buyer if a typhoon (or a number of typhoons) hits Japan during the four-month season commencing 1 July each year, regardless of the occurrence or otherwise of actual physical loss or damage to property.

While the product design shows some innovative thinking, not least in the design of its geographic triggers, two features are of particular note. First, as the news release by Tokio Marine explicitly mentions, in conventional insurance against this sort of risk the payment of a claim is made on condition that physical assets are lost or damaged by wind or flood.

However, with this new product it is the fact of a typhoon hitting a specified area that triggers payments, not the occurrence of physical damage or loss. Typhoon derivatives do not indemnify the protection buyer against losses actually suffered. The protection seller pays up simply on the happening of the event. The second notable feature is that the protection is being provided by an insurance company.

It remains to be seen whether typhoon derivatives develop into a commercial success as retail products. What can be said is that they appear to respond to a demand from commercial enterprises for cover for business interruption from actual or threatened natural catastrophes. This, of course, is one of the mantras of the modern `structured solutions' industry, which castigates the traditional insurance market for failing to provide business interruption cover other than as a supplement to cover for material damage.

In truth, this was more of a perceived problem than a real one. It is correct that, in English law at least, there are a number of cases which display a certain equivocation as to whether or not loss of revenue can be insured without loss or damage to the revenue-producing asset. But it is doubtful that these indications would find resonance in a modern Commercial Court in London. After all, the Commercial Court judges seem comfortable with residual value insurance and have given judgments, without demur, on disputes on film finance insurance, both of which quintessentially insure business risk unconnected with loss or damage to the revenue-producing asset. Pluvius insurance, too, was always directed at loss of revenue rather than material damage.

Capital market techniques
However, Tokio Marine has resorted to capital market techniques to provide this form of protection, called `derivatives'. Typhoon derivatives are not contracts of insurance in a conventional sense - indeed, they are probably not contracts of insurance at all. True, there is a premium. Moreover, Tokio Marine says that it is marketing these products to commercial enterprises that run the risk of loss of revenue from actual or threatened typhoons. The requirement that a policyholder should have an insurable interest, therefore, would be met, but the distinguishing feature is that the protection seller pays up whether or not the buyer suffers actual physical loss or damage.

Historically, the parallel most closely lies with old-fashioned tonner contracts, where a reinsurer would promise to pay an agreed sum on the happening of every total loss, usually of marine hulls, excess of a specified number, whether or not the reinsured underwriter had insured that vessel. But the possibility that tonner contracts were no more than wagers led them to be criminalised, at least in the marine insurance field, by the Marine Insurance (Gambling Policies) Act 1909.

It is an irony that modern financial theory has now retrospectively vindicated - and made respectable again - the principles underlying those old tonner contracts. This is ironic, in that the statutory prohibition on marine tonners remains in place, whereas Section 412 of the Financial Services and Markets Act (FSMA) 2000 combined with the FSMA (Gaming Contracts) Order 2001 legitimises what is essentially the same transaction, provided at least one of the parties has entered the contract by way of business.

Insurers and contracts
Looked at from the English or - given the common regulatory approach within the European Union (EU) - European perspective, typhoon derivatives would probably be classed as contracts for differences rather than futures or options, two better-known classes of derivatives. Contracts for differences are now listed as a regulated investment under Part II of Schedule 2 to the FSMA. They comprise contracts whose purpose, real or professed, is to secure a profit or avoid a loss by reference to fluctuations in the value of any type of property or in an index, or some other factor designated for that purpose in the contract.

That simply serves to throw into relief the second noteworthy fact about Tokio Marine's typhoon derivatives - they are being sold by an insurance company. Three important points need to be made about that. First, enthusiasm for melding capital markets techniques with non-life insurance and reinsurance solutions often ignores fundamental distinctions in the UK and Europe between the regulation of investment activity on the one hand and the regulation of insurance on the other. Convergence may be the watchword for the insurance industry and capital markets, but it is not yet a significant factor in regulatory oversight. In particular, one of the principles which underpins the European system for insurance regulation is that insurers must stick to their business of insurance.

In the UK, this constraint was previously contained in Section 16 Insurance Companies Act 1982. Following the entry into force of the FSMA on 1 December 2001, the restriction is to be found in a rule in the Interim Prudential Source Book for Insurers. This states: `An insurer must not carry on any commercial business in the United Kingdom or elsewhere other than insurance business and activities directly arising from that business.'

The Regulated Activities Order made pursuant to the act, defines insurance business - somewhat unhelpfully - as `the business of effecting or carrying out contracts of insurance as principal'. So the assumption of risks by contracts which are not themselves contracts of insurance is not permitted. Therefore, UK insurers or, for that matter, insurers elsewhere in the EU, will not repeat the initiative of Tokio Marine in developing typhoon derivatives.

Secondly, there is a potential problem for intermediaries. To arrange protection by way of contracts or products which, by definition, are `investments', an intermediary in the EU must be authorised to carry on investment business. In the UK, the requirement extends also to intermediaries which simply advise on such products, and to advise on or deal in investments without prior authorisation is a criminal offence. For intermediaries wishing, therefore, to advise on the full range of `financial solutions', authorisation by the Financial Services Authority (or its equivalent in other EU member states) is an essential pre-requisite.

The third point is this; although the protection seller might be, as in the case of Tokio Marine, a conventional insurance company, payments made by the insurer on these capital markets-style contracts will not fall to be recovered on that insurance company's reinsurance protections. This is not simply a question of the scope of cover provided by reinsurance, which conventionally is an indemnity or partial indemnity for liability incurred by the cedant under a contract of insurance. If, as in the UK, the reinsurers are brought within the regulatory remit of the insurance supervisory authority, it is arguably possible that by indemnifying companies for claims on capital markets products, the reinsurer itself contravenes the prohibition on carrying on any commercial business other than insurance (including reinsurance) business.

By Andrew Pincott

Andrew Pincott is a Partner in the London law firm Elborne Mitchell. Email: pincott@elbornes.com .