A response to consultations on the regulatory framework for a UK market in insurance-linked securities

As we reported in the November 2016 edition of our Global Insurance Focus, HM Treasury (HMT) has been working with the ILS Taskforce, established by the London Market Group, to develop a legal, tax and regulatory framework for a UK market in insurance-linked securities (ILS).

HMT, the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) have recently completed consultations on the proposed framework. Some of our responses to the consultations are discussed in this article. A more detailed analysis can be found at Insurance linked securities – a closer look at the proposals for a new UK regime.

It had initially been hoped that the regulations would return to Parliament and a final version be published in advance of Easter. However, that date was missed and until after the forthcoming general election, Parliament will not consider the regulations after the vote.

The “fully funded” requirement

Consultation

Consultation Under the “fully funded” requirement, the insurance special purpose vehicle (ISPV) must “at all times” have assets the value of which is equal to or exceeds its aggregate maximum risk exposure and be able to pay its liabilities as they fall due. In contrast to the approach taken by regulators in a number of existing ILS jurisdictions, the PRA considers limited recourse clauses “irrelevant to an initial assessment of whether the ISPV is fully funded” and such clauses cannot therefore be “imprudently relied upon in place of a sound risk management or conservative investment strategy”.

Our response

In the context of the low or negative yield environment for UK and EU government securities, we believe that the PRA should take a proportionate interpretation of what is meant by “at all times” and should not use this requirement as a hair-trigger for regulatory non-compliance. In addition, the PRA should clarify how limited recourse provisions could undermine an effective risk transfer from a cedant (re-)insurer.

The “fit and proper” investor requirement

Consultation

ISPVs are expected to be able to assess the fitness and propriety of shareholders and investors that are qualifying holders (i.e. holders of 10 per cent or more of the capital or voting rights of the ISPV or holders with significant influence over management).

Our response

We would welcome further clarification from the PRA on its intended application of the fit and proper investor requirement, particularly in relation to debt investors. In our view, debt investors should be excluded from the requirement on the basis that: (a) they are not generally considered to be members of a company incorporated under English law; and (b) ISPVs are unlikely to be able to identify holders of bonds settled and traded through the clearing systems.

Reporting

Consultation

Protected Cell Companies (PCCs) must prepare audited financial statements on an annual basis as a whole (i.e. separate accounts are not required for individual cells).

Our response

While the requirement for PCCs to produce audited accounts as a whole brings the accounting and reporting regime for PCCs into line with comparable requirements applicable to single transaction ISPVs (e.g. under Part 15 of the Companies Act 2006 for limited liability companies), investors may consider audited accounts of PCCs as a whole of limited value in assessing the performance of transactions on a cell-bycell basis. Therefore, we expect that investors in a PCC will contractually impose reporting obligations for individual cell transactions.

Protected cell companies

Consultation

The proposed framework contains various provisions to ensure that the core and cells of a PCC are “insolvency-remote” from one another and that the assets and liabilities of one particular “part” of the PCC are segregated.

Our response

Under the proposed UK framework, insolvency procedures apply only to the PCC’s respective parts. This reduces the risk of a creditor of a single cell subjecting the other cells to a general moratorium. However, we would welcome further clarification on whether the liquidation of the core of a PCC could impact the viability of the other cells in a PCC.

Securities offering restrictions

Consultation

ILS are suitable for professional investors only and may not be “offered to the public”.

Our response

While we agree that ILS are suitable only for sophisticated investors, we consider that the public offer restriction may be unworkable, particularly for ILS issued via public markets. We would prefer to see a regime similar to the FCA’s restriction on the sale and marketing of “contingent convertible securities” (or “cocos”) issued by banks, which in our view would be more workable and effective.

Other points

Transfers of business: We would welcome clarification on whether the insurance business transfer regime in Part VII of the Financial Services and Markets Act 2000 would apply to an ISPV, i.e. whether all or part of the business of a cell could be transferred by way of a Part VII transfer.

Tax: The proposed tax regime for ISPVs includes bespoke corporation tax and interest withholding tax exemptions for the ISPV. These tax exemptions will be lost if certain stringent conditions are breached. There are also specific provisions restricting the use of tax losses made by an ISPV.

Final thoughts

There is a clear demand for a UK market for ILS and we believe that the proposals in the consultation are a good step in the right direction. Market participants will inevitably benchmark the competitiveness of a UK regime against established markets.

While we acknowledge that any onshore UK regime will need to comply with the overriding requirements of the Solvency 2 regime (at least until Brexit), there are still some aspects of the proposals that could be improved or refined. In particular, the PRA’s proposed interpretation of the fully funded requirement will be vital in ensuring that the UK market is regarded as competitive. Finally, we believe that the proposed public offer restriction should be refined.

If you would like to view any of the other articles in Global Insurance Focus – May 2017, then please follow the links below: 

Contract update 

Draft bill to streamline regulation of Spanish insurance and pension plans

Turning crisis into opportunity: the future of Hong Kong’s insurance sector

The evidential value of underwriting guidelines in minimising indemnity disputes