Since 2014 the UK government has said it wants to bring a slice of the $70bn insurance linked securities (ILS) market to London, and in November it took action to begin creating the regulatory environment necessary to do that. However, in a market which already has established hubs, the London market and its supervisors might be facing a hard task.
Following an initial consultation in February last year, the Treasury and the Prudential Regulation Authority (PRA) have published a prospective framework for the regulation of an ILS market, designed to be a tangible policy to help London become an ILS trading hub.
The white papers from the Treasury and the PRA are detailed in their structural proposals, offering insight into the regulator’s vision, and the regulatory procedures involved. At the core is the creation of Insurance Special Purpose Vehicles (ISPVs), tax efficient structures that allow re/insurers to cede their risk and market investors to inject their capital.
Simon Kirby, economic secretary to the Treasury, offered a taste of the government’s attitude towards London ILS innovation in one of the documents: “I believe that with the right framework, the UK can make a major contribution to the continued growth and development of the global ILS market…the UK is perfectly placed to become a global leader in the alternative risk transfer (ILS) market.”
This follows a desire set out in the 2015 budget by then-chancellor George Osborne to build on the UK’s position as a world leader in the global re/insurance market: “The government will work with the industry and regulators to develop a new competitive corporate and tax structure for allowing ILS to be domiciled in the UK.”
Total ILS capital – in its broadest form encompassing catastrophe bonds plus reinsurance sidecars, and private collateralised reinsurance deals – increased to about $70bn of capital markets reinsurance business in 2016, according to Willis Re’s First View report.
But what advantages could London bring to ILS? Industry insiders are clear there are three key selling points for London as an ILS hub: its intellectual capital; its concentration of financial services resources; and its ability to innovate.
Speaking to Reactions, Malcolm Newman, CEO of Scor’s London hub and sponsor of the London Market Group’s (LMG) ILS committee, focused on this point. “As highlighted by the London Matters report <2014>, the London market is a fantastic place for re/insurers to do business, as it has a wealth of intellectual capital, and offers access to the wide range of financial capital needed for ILS to flourish. The one thing London has missed out on is an ILS market, and with a new regulatory regime we will rectify this,” says Newman.
Innovation is associated with the drive for developing London as an ILS hub. Benedict Reid, executive director, EY insurance practice, who until last November led the LMG as its temporary CEO, underlines the role an active ILS market in driving niche growth.
“ILS is a tremendous opportunity for the market to innovate and drive growth in this specialty area. It shouldn’t be a chance to duplicate, rather an opportunity to really innovate and to significantly expand the range of collateralised products we are able to offer in London,” says Reid.
But for London to compete with existing ILS hubs, innovation and niche products will likely not be sufficient. The regulatory and tax regime will need to be efficient enough to compete with offshore catastrophe bond hubs, such as Bermuda, that market themselves as quick and nimble for setting up ILS structures.
While the proposals put forward by the Treasury and PRA in November mark a step forward, they also raise a number of concerns about how the practical structure of the new regime will function in practice.
The company structures used for ILS transactions take on multiple contracts for risk transfer. In practice, this means a number of protected cell company-like entities being grouped under the broader vehicle, the multi-arrangement insurance special purpose vehicles (mISPV).
However, sources from across the market have been clear that the PRA’s proposed timescale for the approval of these vehicles is simply not “fit for purpose” as it currently stands.
The PRA’s consultation paper, published in November, states that ISPV applications supported by good quality documentation with an appropriate level of pre-application engagement should be determined within a 6-8 week period. However, the next clause in the regulator’s proposed documentation says that “the PRA will determine complete applications for authorisation as an ISPV within six months of receipt”.
The idea of the approval process for ISPV structures taking six to eight weeks is wholly unrealistic, market sources tell Reactions, and the idea of it taking six months is risible. The nature of ILS transactions means they need to take place swiftly, with company structures appearing in a matter of days rather than weeks – certainly not within the proposed timescale, which might take months.
If London seeks to compete with other jurisdictions for an ILS market the regulator must establish a schedule for approvals that allows the city to stand on an even footing with the likes of Bermuda and the Cayman Islands. The nature of ILS capitalisation requires a swift, responsive attitude from both market and the regulator.
A second difficulty presented by authorisation in its proposed state is the way sub-cells – the separate constituent parts of the ISPVs – are authorised. In other jurisdictions these do not require further authorisation but are simply managed as part of the core vehicle, however the PRA is proposing an approval period of 10 working days.
“An mISPV must notify the PRA before establishing new cells…first should not establish the new cell until either the PRA has confirmed in writing that it has no objection or ten working days have expired,” said the regulator.
Andre Perez, chief executive at Horseshoe Group, recently warned Reactions’ sister publication Trading Risk that the PRA’s proposal to approve transaction-level cell companies within 10 days would be a “non-starter”.
Again, this will not represent a competitive option for companies already operating in different jurisdictions. If the London market does not offer the ability to swiftly start up sub-cells then there will be little rationale for companies to undertake ILS transactions in the UK.
The proposed legislation also highlights the requirement – in line with EU Solvency II regulation – for ISPV vehicles to be fully funded. In practice, this has a number of practical implications. Firstly, a vehicle’s assets must be greater than its liabilities to ensure it stays solvent. This means the aggregate maximum risk exposure of the ISPV under risk transfer agreements with cedants must not exceed the amount of its assets. Debt securities or preference shares must be fully paid in, and investors must also be wholly subordinated to the cedant.
However, the proposals replicate language used in Solvency II, which lacks clarity over the exact meaning of terms. Phrases such as “fully paid in” and “at all times” – crucial for investors – are not firmly defined to investors’ satisfaction. And this makes it difficult to offer new services and attract new business.
Speaking to Reactions, a senior legal source cautions: “One of the difficulties with respect to this regime is the fully-funded risk model…there are issues around the definition of fully-funded. The supervisory statement doesn’t go far enough in defining what this means. I don’t think we’re going to get any more clarity on this. From a drafting perspective it’s really confused, and with respect to contingent liabilities it’s a bit confused,” the source adds.
The PRA faces a balancing act: its job is to facilitate a responsible, long-term market that balances innovation with prudence. The regulator’s role is particularly important in politically uncertain times, where the reputation of the regulator has the possibility of affecting how policy is implemented – not least with ongoing issues around the UK’s awaited Brexit from the EU.
Brexit is expected to create a spike in regulatory licencing processes, as restructuring insurers scramble to set up new subsidiaries to keep both their UK footprint and their EU single market access. Clive O’Connell, partner and re/insurance head at McCarthy Denning, worries that the UK regulator is facing particular overstretch in the run up to Brexit, which could put additional strain on headcounts needed for approvals to go smoothly, and which could therefore create further issues as the UK seeks to establish itself as an ILS centre.
Regulators “simply do not have the resources”, he thinks, and will face a sharply increased workload amid this expected wave of Brexit-related approvals. “All of this requires regulatory oversight. Brexit may mean Brexit but for the PRA and those it serves, it means a massive logistical problem, the answer to which is not immediately apparent,” O’Connell adds.