Hong Kong moves to create regional hub for insurance-linked securities

29 Jul, 2020 02:15
source: Reuters

Singularity Financial Hong Kong July 29, 2020 – Hong Kong is on track to soon join the UK and Singapore as newly minted hubs for insurance-linked securities. This is a field long dominated by offshore jurisdictions such as Bermuda.

The Hong Kong government introduced in March the Insurance (Amendment) Bill 2020[here]. The bill provides a regulatory framework for insurers to transfer risk to the capital markets by issuing insurance-linked securities in Hong Kong through special purpose insurers, or SPIs. Special purpose insurers are essentially the same as the dedicated special purpose vehicles that are authorized in other jurisdictions to issue insurance-linked securities, or ILSs.

There is no precise timeline of passage of the bill, but a second reading will likely take place no earlier than October, 2020, after the Legislative Council election, said TL Lim, an insurance law partner in the Hong Kong office of Mayer Brown.

If passed, the bill would be a first step to fulfilling the Hong Kong government’s goal of revitalizing the city’s insurance industry and capturing a share of the ILS market to support China’s significant investment in global infrastructure projects, including China’s international “belt and road” initiative.

The bill authorizes a new class of insurance business (“special purpose business” or SPB) to be conducted by special purpose insurers, whose insurance contracts are fully funded through insurance securitization. The bill defines “insurance securitization” as “any debt or other financing arrangement entered into by the insurer with an investor, under which repayment or return to the investor is linked to a contract of insurance effected and carried out by the insurer.”

The bill’s approach, Lim said, “allows for greater flexibility in the development of an ILS regime in Hong Kong … In this regard, reference should be made to section 129A, which allows the Insurance Authority (IA) to issue detailed requirements by way of subsidiary legislation and guidelines. It is important to have a regulatory process that is efficient and quick to enable Hong Kong to be a competitive ILS hub.”

The bill thus paves the way for the development of an ILS marketplace that will provide an alternative to commercial reinsurance for insurers to manage their insurance risk, particularly arising from natural disasters, and expand their insurance capacities. Hong Kong is “uniquely placed by virtue of its proximity to mainland China and the growth of the (south China) Greater Bay area. It also has sophisticated and well-developed debt capital markets,” Lim said.

MECHANICS OF ILSs

There are several kinds of ILS. The most prevalent is the catastrophe bond (cat bond), which transfers insurance risk for specified natural disasters, such as hurricanes. A cat bond transaction transforms an insurer’s insurance risk, via securitization, into fixed-income debt securities — the cat bonds — to be issued by a dedicated special purpose vehicle (“special purpose insurers” in Hong Kong) to capital markets investors. Those investors ultimately bear the reinsurance risk in exchange for a coupon payment.

In a standard transaction, the insurer (sponsor or cedant) establishes a special purpose vehicle, and transfers specified insurance risks to it by entering into a risk transfer contract, a kind of reinsurance contract. The insurer essentially purchases reinsurance from its captive, the special purpose vehicle, instead of purchasing commercial reinsurance from a third-party reinsurer.

The special purpose vehicle then re-transfers the risk by issuing cat bonds to investors based on terms and conditions that generally reflect the terms and conditions of the reinsurance contract. The vehicle holds the proceeds from the sale of the bonds in a separate collateral trust account and invests the proceeds in low-risk investments. The proceeds are used to reimburse the cedant – the party who passes on the financial obligation for potential loses to the insurer — for any claims made under the reinsurance contract.

Forming the special purpose vehicle to issue the bonds, instead of the cedant directly issuing them, helps to protect bond investors from the bankruptcy risk of the cedant. Putting the proceeds from the sale of the bonds into a separate account helps to ensure that enough funds are available to pay the reinsurance claims of the cedant. This also protects investors because any funds remaining in the account after paying reinsurance claims are returned to the investors upon maturity.

The coupon payments are funded by the income earned from the investments made in the collateral account, and from the reinsurance premiums paid by the cedant to the special purpose vehicle.

Reinsurance payments made to the cedant are subtracted from bond payments to be made to investors. If no reinsurance claims are paid to the cedant, the face amount is returned to the investors upon maturity.

KEY FEATURES OF THE BILL

For investors, insurance-linked securities offer an opportunity to diversify their portfolios with investments that are not directly correlated to the general economy or to the credit risk of the cedant. ILSs, however, are typically viewed as risky investments suitable only for sophisticated investors.

The bill reflects this sentiment by featuring a variety of protective measures.

The specified business must be “fully funded.” This means that the special purpose insurer’s assets, principally the proceeds from the sale of the insurance-linked securities, must be enough to cover actual or potential liabilities “under all reasonably foreseeable circumstances.” Both the obligations of the special purpose insurer towards the cedant under the risk transfer contract and the special purpose insurer’s expected expenses are taken into account.

The Hong Kong government will not authorize a new special purpose business unless the special purpose insurer satisfies a series of conditions. The company must appoint at least two competent directors and a competent administrator, who alone or with others is responsible for the administration of the business of the company.

The company must comply with the government’s relevant financial, solvency, investor sophistication and other requirements. The company must only conduct the special purpose business and no other class of insurance business.

Section 129A of the bill authorizes rules that prohibit the offer or sale of ILS to any person other than the specified types of qualified investors, that specify minimum investment amounts, and that set out criminal penalties for violations. An open issue for now is what role the Securities and Futures Commission of Hong Kong (SFC) will play and its interaction with the Insurance Authority in the issuance of ILS, Lim said.