Open door: the United Kingdom is implementing new regulation that could increase the number of securitizations in the jurisdiction, and give insurers a more efficient way to use capital.

Key Points

* Insurance-linked securities are issued by special-purpose vehicles.

* More jurisdictions, most recently the United Kingdom, are establishing regulations to become more attractive to special-purpose vehicles.

* The volume of catastrophe bonds, one type of insurance-linked security, doubled in 2006, growing to $4.69 billion issued, compared with $1.99 billion the previous year.

The insurance-linked securities market is booming, and the United Kingdom could be poised to become a bigger player in the market.

According to Guy Carpenter, 2006 was another record year for catastrophe bonds, one popular form of insurance-linked securities. Following in the wake of record storm years 2004 and 2005, there were $4.69 billion of new cat bond transactions in 2006, which shattered the previous record of $1.99 billion in 2005.

But before a company can issue cat bonds, or any other form of insurance-linked securities, it often establishes a special-purpose vehicle. This is an off-balance sheet entity, with a limited or temporary purpose, that holds the assets and liabilities related to the securities being issued.

Historically, locations such as Bermuda, the Cayman Islands and most recently, Ireland, have been popular jurisdictions for insurance special-purpose vehicles, also called special-purpose entities. The United Kingdom now has joined the club.

Effective Dec. 31, 2006, the U.K.'s Financial Services Authority has created rules allowed trader the European Union's Reinsurance Directive that make it easier and faster to establish insurance special-purpose vehicles.

The reinsurance directive is "an attempt by the European Union to modernize and standardize the financial systems of member countries," said Jeff Etherington, a partner with the law firm of Edwards Angell Palmer & Dodge.

The new regulations treat insurance special-purpose vehicles with less onerous supervision than other types of insurers or reinsurers, and also speed tip the time needed to establish one. ISPVs will be monitored based on their sponsoring company, and won't be required to file an annual return with the FSA the same way that a regular reinsurer would.

"We intend to help develop a U.K. market for ISPVs by ensuring the authorization requirements are proportionate to the risks posed," the FSA said on its Web site. "We will require less information from an ISPV than a conventional insurer or reinsurer and put greater emphasis on self-certification and senior management responsibility. Protection for consumers will be maintained through supervision of the ceding insurer."

Because ISPVs are set up with the full collateral for the risks they insure, "they aren't like other reinsurance companies, and don't need the same level of regulation," Etherington said.

New Efficiencies

Insurance special-purpose vehicles can be used for securitizations, but also can just be used by a company that wants to set up a more efficient capital structure and transfer risk, said Charles Garnsworthy, partner with PricewaterhouseCoopers' Actuarial & Insurance Management Solutions practice.

The FSA is basing its rules on the Individual Capital Assessment framework. Instead of setting capital based on formulaic approaches, companies are being asked by the FSA to more accurately set capital based on their specific risks.

The FSA focuses on the ICA impact on the ceding company. Within the special purpose vehicle, insurers need to ensure they have assets in excess of GAAP liabilities and demonstrate that effective risk transfer has taken place; there is no need for an additional solvency margin requirement, Garnsworthy said.

Traditionally, "if you had a commercial reason why you wanted to separate your liabilities into two companies, you would have had to set up a new insurance company within your group and reinsure your liabilities across the company. There's a limit to how much you can reduce your capital requirement--both the ceding company and the reinsurer need to meet certain solvency margin requirements. An ISPV can potentially help to eliminate those inefficiencies, although the regime is new and some of the details and implications--particularly for group usages--are still being worked through with the FSA," Garnsworthy said.

Whether or not the ISPV's risk is ultimately transferred to the capital markets through a securitization, an ISPV provides a reinsurance agreement to the ceding company, and the ceding company is able to free up capital. Under the new framework, an ISPV is faster and easier to establish than a traditional insurer or reinsurer.

The new regulations appear to have been well-received, said Vivienne de Chermont, international counsel with the law firm of Debevoise & Plimpton.

"The FSA, which has had its share of criticism in the past, should be applauded for having been proactive and for getting it on the books as quickly as it has," de Chermont said.

Some who reviewed the FSA's proposals suggested that they should be more prescriptive. The FSA responded by saying, "This is a very innovative area. Prescriptive rules would distort competition and quickly become outdated," de Chermont said.

Dual Considerations

In addition to regulation, the other important consideration when deciding in what jurisdiction to launch a special-purpose vehicle would be the financial implications.

"Taxes are important," de Chermont said. "There are still very good reasons why you might be interested in setting up an SPV in Bermuda or Ireland."

Her Majesty's Revenue and Customs, which collects the bulk of taxes in the United Kingdom, has indicated it would treat insurance special-purpose vehicles like other types of special-purpose vehicles, which have been used for other forms of securitizations such as residential and commercial mortgage-backed securities. This means insurance special-purpose vehicles would be taxed based on their profit under U.K. generally accepted accounting principles, and not taxed like an insurance company on the basis of their annual returns, de Chermont said.

But, Revenue and Customs has not opted to give ISPVs a special lower tax rate, like some other jurisdictions have done. And the final rules have not been released yet.

"It's a little bit chicken and egg. A number of companies want to use the regime but need better detail from the FSA and HMRC. But the FSA and HMRC might be waiting to see more substantiative approaches before fully developing the rules," Garnsworthy said.

So while the FSA has made some "very laudable attempts to make the regulatory environment" friendly for insurance special-purpose vehicles--and insurance-linked securitizations--unless the tax scheme is made more favorable the United Kingdom might not "compare favorably to Ireland or the Caymans from a tax perspective," de Chermont said.

The basic corporation tax in the United Kingdom is about 30%, compared to rates of about 12.5% for Ireland and no corporation tax in Bermuda, she said.

"You cannot have a heavy tax burden. If a jurisdiction like the U.K. doesn't make conditions favorable for ISPVs, they will be established in other places," Etherington said.

Market Impact

In theory, the U.K. market should be more attractive to insurers looking to issue insurance-linked securities, due to the new regulation.

"Whenever a major financial jurisdiction does something like this--and certainly, as an insurance market, London and the U.K. is a very significant market--then obviously it has the potential to attract a lot of interest," Etherington said.

London could have an advantage over Bermuda due to the number of companies and isurance professionals located there and its role as a major financial center. "While Bermuda specializes in insurance and reinsurance, it doesn't have the breadth of financial services resources that London has," Etherington said.

Locating an ISPV in London also might bring marketing advantages.

"While jurisdictions like Bermuda have strong regulatory and legal environments, investors may be attracted to investments in U.K. ISPVs because of a perception that legal protections in the U.K. are well established," Etherington said.

But because the regulations are still so new, and the tax issues still not resolved, there hasn't been much movement yet. In fact, as of Feb. 28, the FSA had not received a single application for an ISPV yet, the FSA said.

Also, market conditions on the life side may favor sales over securitization at the moment, de Chermont said.

"A number of clients in recent years have looked at securitization as an alternative to outright sale, but none of those proposals has come to fruition. And none of those clients has so far been clamoring to set up one of these new ISPVs," de Chermont said.

"The preferred option strategically for many life insurers with closed books of business was a clean sale of the book to a third party. But when the acquisition market for that kind of business was in the doldrums, and companies couldn't find a willing buyer, they'd look for alternatives ways to tree up their capital," de Chermont said.

Then the mergers and acquisition market for life business picked up in 2004 and 2005.

"When the sales option came back on the table in a big way--and, for many, it had always been their preferred option--they chose that direction instead," de Chermont said.

On the property/casualty side, Florida's recent decision to expand its Florida Hurricane Catastrophe Fund--what Willis Group has called the equivalent of unleashing a new $38 billion reinsurer in the market--has turned the wind-exposed property reinsurance market from one with a capacity crunch into one with a surplus of unclaimed coverage.

Next Step

As other members of the European Union work to implement the Reinsurance Directive, other jurisdictions may make conditions favorable for ISPVs, de Chermont said. All members have until the end of this year to accomplish this.

Germany might be the next in line to put forth ISPV regulations, she said.

"The expectation is that all E.U. member states will take advantage of the ability to establish a special regime for ISPVs, but we can't be certain at the moment," de Chermont said.

Garnsworthy of PricewaterhouseCoopers said he's aware of several companies currently considering applying for a U.K.-based insurance special-purpose vehicle. The Irish regulator also has developed a similar regime.

"We would expect to see some activity and use of these structures in the course of this year," Garnsworthy said.

Cat Bond Boom

Catastrophe bonds, a common form of insurance-linked securities, doubled in volume in 2006. Insurance-linked securities are often issued from a special-purpose vehicle, which the United Kingdom hopes to court with its new friendlier regulation.

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Within any single year, takedowns from shelf offerings are consolidated as one transaction. Takedowns from individual shelf offerings, occuring in different years, are considered to be separate transactions in the year in which the takedowns are completed.

Source: Guy Carpenter