The task force set up last year to decide on how to add an ILS component to London’s re/insurance market has come up with a consultation paper on regulatory and tax treatment for ILS.
“The ILS project is aimed at helping the UK maintain its position as leading global hub for specialist reinsurance,” said the London Market Group (LMG), which said it welcomed the consultation paper.
At the March 2015 Budget, UK Chancellor George Osborne announced the Treasury would work with regulators and London market stakeholders to design a new framework which would attract ILS business to the mainland UK.
The LMG has chaired the ILS task force over the past year, under Malcolm Newman, who is also chief underwriter for reinsurer Scor in London.
The paper outlined how UK regulators would approach ILS supervision.
“In relation to dual-regulated entities, the PRA is responsible for prudential requirements, for example capital and liquidity, and the FCA for the conduct of business. The PRA is the lead regulator for all dual-regulated entities under Solvency II (S2),” continued the paper.
Applicants for UK-based ISPVs would make a single application to the PRA, according to the Treasury’s consultation.
“The PRA will pass the application to the FCA and both will assess it against the S2 requirements, with meetings arranged to discuss applications as appropriate. The PRA will make the final decision on applications, but it can only authorise a dual-regulated firm with FCA’s consent,” said the paper.
The paper noted that ISPVs would evade Solvency II’s Pillar I capital requirements due to their fully funded/collateralised nature.
However, the paper suggests they would be subject to some Pillar II scrutiny – risk management – supervisory scrutiny.
“During the authorisation process, the applicant will need to demonstrate to the PRA that its risk management and internal control systems are able to monitor the ISPV’s collateral arrangements,” said the report.
The PRA estimates being able to assess and approve the more straightforward ISPV transactions within six to eight weeks.
On governance, the Treasury noted applicants would need to meet “fitness and propriety of management” standards, including details such as splitting the CEO and chairman roles.
On reporting standards – Solvency II’s third Pillar – regulators said there would be an annual reporting cycle with specific requirements imported from Solvency II.
“We would advise that potential applicants review these requirements closely…The PRA will have the power to request additional information to aid supervision and ISPVs will be required to report any breaches of the regulatory requirements to the PRA,” said the paper.
The Treasury noted for protected cell companies (PCCs) typically involved in catastrophe bonds and other ILS, an entity which creates more than one ILS will be called a multi-arrangement ISPV (mISPV).
At present, several of the world’s biggest ILS hubs are in low-tax offshore domiciles – Bermuda, Guernsey, Gibraltar – although, ironically, all are overseas British territories.
Work on changing the tax regime will take time, the paper suggested.
“Updating these regulations would be challenging, particularly within the wider project timeframe. We will need to be mindful both of ongoing work to update the main securitisation tax regulations and the ongoing consultation on implementing the OECD’s best practice recommendations on the deductibility of interest expense,” said the document.
“Both of these projects are expected to continue through 2016 and, given the government’s wider agenda, it would be difficult to take action to preempt either,” warned the paper.
The report outlined a potential taxation approach for ILS vehicles that issue equity, suggesting investors “directly exposed to the profits or losses arising from the underlying risk…should bear the tax consequences”, the paper said.
“Where the ISPV is a corporate entity it may be that the only viable way to effect this tax treatment is to exempt the qualifying ISPV (or qualifying cells within an mISPV) from tax based on a specified set of criteria,” said the document.
“Foreign investors would be taxed on these distributions according to the local tax rules in their home jurisdiction,” it added.
On dividends to foreign investors, the paper noted a withholding tax would be the typical approach, but suggested this might be avoided.
“Nonetheless, we recognise that eliminating withholding tax has been a key focus of attention from stakeholders. We would therefore welcome views on both the extent to which a withholding tax could undermine the competitive value of tax exemption for the ISPV, and ways in which the fairness and avoidance risks of a withholding tax exemption could be overcome,” said the paper.
“Although targeted at equity-backed ISPVs, we believe it is possible that the tax exemption approach outlined above could also be suitable for debt-backed ISPVs,” noting this would have the benefits of a simpler overall tax regime, while minimising time needed to amend update existing legislation.
The LMG said the consultation, the document for which can be viewed here, would run until April 29 2016.