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Investment bankers have been eyeing up the insurance market for some time. The small size of the reinsurance market estimated at no more than a few hundred billion dollars means it lacks the capacity to absorb a succession of catastrophic risks. If the capital markets, whose capacity runs to tens of trillions of dollars, can be tapped, there is money to be made by intermediating bankers. Some have invested in the development of suitable financial products, including research of the legal issues, to determine what they can sell the insurance industry. The starting point is to look at insurance companies as asset managers. Insurance, like banking, is a regulated industry. Regulators consider it their duty to protect policyholders. They restrict the assets that insurance companies can value for solvency purposes, to prevent mismatches with liabilities and ensure that assets are prudently managed. Before the implementation of the EC Third Life and Non-Life Directives in July 1994, derivatives were not widely used by insurance companies because they could not generally include them when determining their solvency margins. The directives recognize that insurers can benefit from limited and prudent use of derivative products and provide that the value of derivatives held “in so far as they contribute to a reduction of investment risks or facilitate efficient portfolio management” can be used to cover liabilities. The Department of Trade and Industry (DTI) the authority that supervises insurance companies in the UK has issued detailed guidance on the interpretation of these terms, which does not necessarily correspond with that of other regulators. Other tests also have to be satisfied. The intermeshing of EU and UK law means that insurers’ use of derivatives is heavily regulated, down to the types of derivative that can be valued, when they can be valued and the value they can be given. Admissibility rules are intended to ensure investment diversification. The underlying asset must itself be admissible. “Gold, for example, is not, so a forward contract for the delivery of gold may not be taken into account,” explains Alison Matthews, a solicitor in the insurance group at Freshfields who was previously at the DTI. The derivatives must satisfy liquidity tests designed to ensure that the insurance company could, if necessary, close out its position rapidly. The DTI imposes stringent reporting requirements and has issued guidance for systems of control that insurers are obliged to follow as part of the “sound and prudent management” principles laid down by the Insurance Companies Act 1982. In addition, s35A ICA requires insurers’ liabilities to be covered by assets “of appropriate safety, yield and marketability” having regard to the classes of business carried on; and their investments to be appropriately diversified. Banks have examined the possibilities of securitization, using a special purpose vehicle (SPV) established in a tax-neutral jurisdiction to buy insurance risk on the back of which the SPV issues bonds. Here there are two related issues. Is the SPV, in buying risk, acting as an insurance company? If so, the need to be regulated as such would make the deal uneconomic. Secondly, in issuing the bonds, is it acting as a reinsurer? Again, if so, the need to register as such would be too costly. In the UK, the Bank of England recognizes that securitization can remove assets from balance sheets but it is unclear whether the DTI would take the same approach. In the case of life companies, securitization could be used to reduce new business strain, the mismatch between accounting for the liability upfront and the inflow of premiums over the contract’s life. However, an assignment of the direct right to part of the premiums may contravene s28 ICA, which requires insurers to keep a separate account for their life business and records identifying both the assets and liabilities attributable to that business. Section 29 ring-fences long-term funds of life companies. The release of embedded value by way of a securitization could amount to a breach of the prohibition on transferring assets out of the long-term fund. Turning to insurance companies as risk managers, bankers have tried on and off to develop financial products that would increase the insurance market’s capacity. Among the earliest examples were the earthquake bonds launched by issuers such as Electrolux in the late 1980s and early 1990s. These carried low coupons but could be redeemed by the investor if, say, an earthquake occurred in Japan. These bonds were aimed at insurance companies, which in effect were buying reinsurance cover (or at least liquidity) for their risks. Other examples include exchange-traded products, such as the CAT futures on the Chicago Board of Trade (CBOT), and catastrophe bonds. Catastrophe bonds may be created to back liability to an insurer where it responds to a catastrophe, meaning that investors risk losing a corresponding part or the whole of their principal in that event. Similar legal issues arise relating to valuation for solvency purposes (for example, CBOT CAT futures could not be counted in the UK), sound and prudent management, s35A ICA (suitability of assets) and s16 which provides that an insurer may not undertake activities which are otherwise than for the purposes of, or in connection with, its insurance business. In the US, each state has its own investment requirements but, generally, insurance companies with assets of a certain value and type can count derivatives. The third area on which bankers have been focusing is the development of financial products as a substitute for insurance. The legal issue is whether risk is really transferred because, if not, the premiums will not be tax-deductible. Finite risk involves a capped (or finite) pay-out under a multi-year contract. The premiums paid fund the pay-out, together with an agreed profit for the insurer. In effect, the insured is merely provisioning by way of an insurance policy since it is bearing the full risk of the loss via the premiums. The benefit is that the insured can spread the risk over the contract period and get a current deduction for the premiums which provisioning for the same risk would not provide. Two questions arise. First, is the contract one of insurance? Secondly, does it comply with Financial Reporting Standard 5, which requires companies to report the substance of transactions? Both are difficult questions, the first because there are general definitions of an insurance contract in English case law but their application to particular types of contract is not always clear; the second because accountants and regulators are aware of finite risk contracts indeed the Financial Reporting & Auditing Group of the ICAEW (the principal accountants’ body in the UK) has issued a detailed technical release on the application of FRS5 to non-life insurance transactions. The more sophisticated transactions ensure deductibility by treating part of the premium as a true premium, ie, devoting it to buying insurance cover rather than contributing to the provisioning fund. “You have to slant that blend between tax-efficient provisioning and tax deductibility,” says Stephen Revell, a capital markets partner in the insurance group at Freshfields. The insurance company, for its part, is concerned that that receipt of the premium does not amount to deposit-taking which it would if the contract is not one of insurance otherwise it will fall foul of banking regulations. |
