Insurance linked securities - a closer look at the proposals for a new UK regime
On 5 December 2016, Ashurst hosted and sponsored the "Insurance Linked Securities: the New Opportunities" conference run by City & Financial Global. The conference was attended by over 60 delegates from the alternative risk transfer market and included a keynote address from Simon Kirby MP, Economic Secretary, HM Treasury.
Introduction
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"). A UK regime for ILS would deepen the risk transfer capacity of the London market and diversify the type of risk protection available: for example, even pension funds could use ILS as a way of protecting themselves from longevity risk.
On 23 November 2016, HMT, the Prudential Regulation Authority ("PRA") and the Financial Conduct Authority ("FCA") launched consultations on the proposed framework. They comprise:
- a joint consultation from the PRA and the FCA on the authorisation and supervision of Insurance Special Purpose Vehicles ("ISPVs"); and
- a consultation and draft legislation from HMT on the corporate structure and regulation of UK ISPVs, including the creation of a new UK regime for protected cell companies ("PCCs"), and the tax treatment of UK ISPVs and their investors.
The joint PRA and FCA consultation closes on 23 February 2017 and the HMT consultation closes on 18 January 2017. Further details on how to provide feedback is set out on the PRA website here and the HMT website here.
Some of the key points in the consultations are discussed below.
Authorisation and supervision - approval process and timeframes
| Question | answer |
|---|---|
| How will ISPV's be authorised? |
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| What additional requirements apply for MISPVs? |
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| How long will approval take? |
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| When can authorisation be withdrawn? |
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Commentary:
Although we consider that the proposals are a step in the right direction, speed to market (or lack of) will be perceived by some market participants as a real hindrance to creating a competitive regulatory regime in the UK. While we believe that market participants will recognise that an on-shore, Solvency 2-based regime will be more stringent than some other markets for ILS, the proposed timeframes for approval of ISPVs or new cells – and the level of information required to be provided – could prove to be unduly burdensome.
In particular, the 6-8 week timeframe for approval of new ISPVs following submission of substantially final documents seems to be uncompetitive. The PRA approval process could instead allow for a pre-issuance notification based on a reasonably developed term sheet with formal approval to follow shortly – e.g. within five business days – after submission of final form documents.
In addition, the 10 working day timeframe for the creation of new cells of a PCC seems unduly long. We would prefer to see a regime which allowed for the PCC to certify that the new cell will comply with the limitations set out in the PCC's Regulatory Business Plan with submission of final documents to follow or, if absolutely necessary, a shorter window – e.g. two or three business days – in which the PRA can raise any objections.
Also, we would welcome clarification of how the PRA proposes to interpret the ISPV RTS with regards the removal of authorisation in light of PCC structures. In particular, the overriding objective of the PCC structure is to provide a corporate structure as a platform for multiple risk transfer transactions with the assets and liabilities of the individual parts of the PCC being segregated. Applying this principle, we believe that the PRA should therefore only withdraw an ISPV's regulatory authorisation on a cell-by-cell basis: a regulatory breach which relates solely to one cell should not have consequences for other cells that fully comply with regulatory conditions.
Authorisation and supervision - the "fully funded" requirement
"The contractual arrangements … shall ensure that the special purpose vehicle is at all times fully funded in accordance with Article 326," Article 319, S2 Delegated Regulation.
| question | answer |
|---|---|
| What is the fully funded requirement? |
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| How are the assets valued for the purposes of Article 326? |
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| Can contingent assets and off-balance sheet items count towards the fully funded requirement? |
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| Will limited recourse clauses be recognised as a means of ensuring the ISPV is fully funded? |
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Commentary:
We consider that there are two key issues in the PRA's application of the fully funded requirement which will be instrumental for determining whether market participants regard it as a competitive regime: (i) the PRA's proposed approach to limited recourse clauses and (ii) the interpretation of the requirement for the ISPV to be fully funded "at all times".
Acceptance of limited recourse provisions by Solvency 2-equivalent jurisdictions in ensuring that fully funded requirements are met has been one critical step in ensuring swift access to market. We consider that the PRA's more cautious approach should be re-considered or, at a minimum, the PRA should provide further clarification on how a limited recourse provision might be considered to undermine effective risk transfer from a cedant (re-)insurer. Market participants will not, in our view, embrace a regime where the regulator has the potential to challenge a structure which fulfils the requirement that the ISPV's liability to the cedant can never exceed the value of its assets.
In light 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": in our view, this requirement should not be treated as a hair-trigger for regulatory non-compliance. The funding requirement of the ISPV should take into account all relevant factors, such as the materiality of any difference between the valuation of the ISPV's assets and its maximum exposure to the cedant; the probability and history of claims under the risk transfer contract; and the availability and quality of contingent assets and other off-balance sheet items available to meet the ISPV's obligations if a claim is made.
Authorisation and supervision - "fit and proper" investor requirements
"The assessment of whether the shareholders or members having a qualifying holding… are fit and proper shall take into account the … criteria [in Article 323]," Article 323, S2 Delegated Regulation.
| question | answer |
|---|---|
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What is a "qualifying holding"? |
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| Does it apply to debt securities? |
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| Does this impact the ISPV itself? |
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| Does the FSMA Controller Regime apply to ISPVs? |
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Commentary:
While we acknowledge that Article 323 is ambiguous, we welcome further clarification from the PRA on its intended application of these requirements, particularly to debt investors. While it may be possible for an ISPV to identify initial counterparties to a collateralised reinsurance transaction, this is not the case in a public bond settled and traded through the clearing systems. Although the ISPV (or the cedant (re)-insurer) may have influenced the original allocation of securities to investors, it will almost certainly have no visible authority on any subsequent trading.
In practice, the ISPV will therefore have virtually no ability accurately to identify investors holding its securities and to apply the criteria of Article 323 to those holding more than 10% of its capital. As a result, we believe that Article 323 should be interpreted such that debt investors in an ISPV should not be treated as "members" (as such term is interpreted under English law) or having a "significant influence" over management within the original contemplation of the S2 Delegated Regulation.
We would also encourage the PRA to clarify the application of Article 323 to PCC structures. Given the segregation principles of PCCs, we would expect the PRA to apply the requirements on a cell-by-cell basis, together with any investors in the PCC's core within the scope of Article 323.
We welcome the disapplication of the FSMA Controller Regime for ISPVs as well, which is consistent with our views above.
Authorisation and supervision - governance and reporting
"The special purpose vehicle must have an effective system of governance and meet the requirements set out in Article 324," Article 318(f), S2 Delegated Regulation.
| question | answer |
|---|---|
| What governance requirements apply to ISPVs? |
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| What are the on-going reporting requirements? |
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| Do ISPVs have to prepare audited financial statements? |
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| Are accounts required for individual cells? |
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| What information has to be publicly disclosed? |
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Commentary:
The requirement for PCC to produce audited accounts of the company as a whole (rather than on a cell-by-cell basis) is a specific requirement of the draft Risk Transformation Regulations 2017. While it brings the accounting and reporting regime 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 are likely to find audited accounts of the PCC as a whole to be of limited value in assessing the performance of transactions on a cell-by-cell basis. However, we expect that investors will still take comfort that the auditing process would scrutinise the conduct of the ISPV's directors and senior management and should identify any mismanagement of the PCC's assets.
We expect that investors in a PCC will contractually impose reporting obligations for individual cell transactions. This might include, for example, ensuring the PCC's reports submitted to the PRA under the ISPV RTS are made available on an investor website or published via the news service of a stock exchange on which the ILS may be admitted to trading.
Protected cell companies
| question | answer |
|---|---|
| What is a PCC? |
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| How are assets and liabilities segregated for PCCs? |
The draft Risk Transformation Regulations 2017 contain 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. These include providing that:
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| Which insolvency procedures are available to creditors against a PCC's core or individual cells? |
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Commentary:
Given the existence of an established corporate regime for protected cell companies in other jurisdictions, it should be no surprise to hear that the UK regime in the draft Risk Transformation Regulations 2017 builds on established and proven methods. As with overseas regimes, there remains the (theoretical) risk that foreign courts fail to recognise the UK segregation principles. However, unless a PCC has a substantial overseas presence sufficient to shift its 'centre of main interests' to an overseas jurisdiction, we consider the likelihood of such a challenge to be relatively minor.
In contrast to some overseas protected cell company regimes, the draft Risk Transformation Regulations 2017 seek to provide that insolvency procedures apply only to the PCC's respective parts, thereby reducing the risk of a creditor of a single cell subjecting the other cells to a general moratorium. We believe that this approach will be an important factor in credit rating agencies' assessment of rated transactions of UK PCCs.
We believe that the final Risk Transformation Regulations 2017 should clarify the position with regards registration of security interests. In our view, the final regulations should provide for a regime under which security created by a PCC over its assets (or its constituent part's assets) may be registered. While some ISPVs will seek to structure their security arrangements to qualify as a "security financial collateral arrangement" for the purposes of the Financial Collateral Arrangements (No 2) Regulations 2003 ("FCR") and therefore be valid against an administrator or creditors without registration, the prudent approach would be to register security. This is because of remaining uncertainties over the requirements of the FCR and the perceived advantage of giving third parties constructive notice of the security by publicly registering it.
Securities offering restrictions
| Question | answer |
|---|---|
| To whom may ILS be offered? |
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| What is an "offer to the public" |
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| What are the consequences of breaching the restriction on "offers to the public"? |
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Commentary:
While we agree that ILS are suitable only for sophisticated investors, we consider that the public offer restriction may well be unworkable, particularly for ILS issued via public bond markets. For freely transferable securities that are cleared and listed on a stock exchange, we believe that it would be difficult – if not impossible – for a PCC to ensure that the offering is not "calculated to result, directly or indirectly, in securities issued by the protected cell company becoming available to persons other than those receiving the offer."
Indeed, once the securities are issued into a clearing system or listed on a stock exchange, it would be very difficult for the PCC to restrict on-market trading in the securities without imposing transfer restrictions on the securities themselves, which would likely prejudice their eligibility for listing and admission to trading on many stock exchanges.
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 under the Product Intervention (Contingent Convertible Instruments and Mutual Society Shares) Instrument 2015. In our view, a comparable product intervention regime would be more workable and effective for a number of reasons: (1) it could apply to FCA-regulated firms selling the securities themselves (and not just the PCC); (2) it need not be a blanket restriction on the sale of ILS to investors who are not "qualified investors", as certain types of retail clients could be permitted to acquire ILS subject to conditions (as for cocos); (3) the rules could also target the dissemination of marketing materials, rather than seeking to restrict the availability of the securities themselves; and (4) the approach would be based on a regime which is proven to work and with which the international capital markets are familiar.
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 conditions are breached. There are also specific provisions restricting the use of tax losses made by an ISPV.
Corporation Tax Exemption
A corporation tax exemption will be given to an ISPV in relation to any profits arising from the activity of insurance risk transformation other than:
(a) administrative or management activities; or
(b) holding investments in excess of the amount "reasonably required" to satisfy the fully funded requirement (as discussed above) for the ISPV or the cell (if the ISPV is a PCC).
There is a short 30 day grace period where investments cease to be held for the purposes of satisfying the fully funded requirement, but can still qualify for the exemption.
Commentary:
The adoption of a blanket exemption for insurance risk transformation activities is to be welcomed and its simplicity is much more attractive than the securitisation regime which was considered as an alternative in the February 2016 consultation. ISPVs will obviously be concerned if HMRC takes a restrictive approach to the extent to which investments are "reasonably required" to satisfy the fully funded requirement and guidance on the interpretation of this would be helpful. The 30 day grace period is too short: at least a 90 day period would be preferable.
Interest Witholding Tax Exemption
There is a complete withholding tax exemption for any payment of interest made to investors in relation to insurance risk transformation investments.
Commentary:
The exemption from interest withholding tax is important to ensure that UK ISPVs will be competitive with ISPVs in other offshore low tax jurisdictions such as Bermuda or the Cayman Islands. No equivalent dividend withholding tax exemption is required as the UK does not impose a withholding tax on dividend payments.
Removal of Corporation Tax and Interest Witholding Tax Exemption
If any of the following conditions are satisfied at any time in an accounting period, the exemptions referred to above will not apply in that accounting period or any subsequent one:
(a) the investor holds more than 20 per cent. of the insurance risk transformation investments and is connected with the cedant of the risk to the ISPV;
(b) the ISPV is liable to a penalty for failure to deliver a tax return, for an error in a tax return or for failure to comply with of an information notice; or
(c) having regard to all the circumstances, it would be reasonable to conclude that the purpose or one of the main purposes of the insurance risk transformation, or of the arrangements which the insurance risk transformation forms part of, is to secure a tax advantage for any person.
Commentary:
Whilst it might be expected that HMRC would include restrictions to prevent abuse of the tax exemptions by cedants transferring risk to connected parties and more generally for tax avoidance, the loss of the exemptions for the lifetime of the ISPV as a result of incurring minor penalties for mistakes in corporation tax compliance seems very draconian. It is hoped that the latter condition will be amended significantly before the regulations are adopted. There also is some uncertainty as to how the connection test should be applied to ISPVs which are PCCs.
Loss Restrictions
Where an ISPV is a PCC, for loss relief purposes the core and each cell will be treated as separate companies and they will not be eligible to surrender or receive surrenders of group relief or consortium relief between themselves.
Commentary:
The ring fencing of losses in an ISPV is understandable given the corporation tax exemption.
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 on-shore UK regime will need to comply with the overriding requirements of the Solvency 2 regime, there are still some aspects of the proposals that could be improved or refined.
In particular, speed to market and the PRA's proposed interpretation of the fully funded requirement will be vital in ensuring that the UK market is regarded as competitive. In addition, we believe that the proposed public offer restriction should be refined.
From a tax perspective, the corporation tax and interest withholding tax exemptions will go a long way to creating a level playing field for UK ISPVs with their competitors in offshore locations. However, ISPVs will need to consider the wider tax consequences of establishing onshore balancing the potential advantages of holding board meetings in the UK and accessing the UK's network of double tax treaties in relation to investment returns against an inevitable VAT cost of being located in the UK. The relative significance of these factors will become clear through the level of use of the regime.
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