Christopher Anderson, a partner at Carey Olsen in Guernsey, takes an in-depth look at ILS.
The recent disastrous floods in the UK were caused by a succession of European windstorms (the latest being Windstorm Ulla). While devastating for those unfortunate enough to be affected by the floods, European windstorms and other natural disasters can provide a unique opportunity for others to invest in the pure insurance risk associated with the chance occurrence of natural catastrophes. Such investments are often structured through a somewhat esoteric investment called an insurance linked security (ILS). These investments involve the convergence of both investment and insurance expertise. For that reason, it is perhaps not surprising that Guernsey has seen an increase in ILS transactions in the last year or so. This article considers why Guernsey is such an attractive jurisdiction for ILS.
What is ILS?
An ILS is an instrument that provides investors with the opportunity to obtain exposure to pure insurance risk, usually over a short timeframe. Pure insurance risk (which depends on whether or not an uncertain future event occurs) is often entirely uncorrelated to traditional investment assets. For that reason, an ILS can be avery attractive investment during times when traditional investments (eg, the stock market and interest rates) are providing poor returns.
The classic example of an ILS is a catastrophe reinsurance bond. In a cat bond, investors lend money to an special purpose vehicle (SPV) in the form of bonds that are often listed on a reputable securities exchange. The SPV writes an insurance or reinsurance contract (or even an International Swaps and Derivatives Association (ISDA) documented swap) under which it receives a premium in return for agreeing to provide cover to specified assets in respect of a particular risk (usually a natural catastrophe such as European windstorm) for a specified period (usually a year). If the windstorm season passes without incident, investors receive back their principal plus the stated coupon in full, which is funded out of the unspent premium received by the SPV. If not, investors may receive a reduced coupon or even lose some or all of the principal amount of the bonds they acquired.
Since they are often listed securities, cat bonds are available for investment to a wide range of investors. In the current economic climate, an increasing number of specialist investment funds (some established in Guernsey) are targeting ILS as an asset class. However, those funds are not limiting their investments to cat bonds. Instead, these highly sophisticated investors have established a number of "private placement" structures in Guernsey to obtain more direct exposure to the risk. Those private placement structures typically involve the establishment of an SPV, which is owned and capitalised by the fund. The SPV directly writes the relevant risk, often through a reinsurance contract or an ISDA documented swap. Since there are fewer parties involved and no listing requirements to meet, the structure involves lower frictional costs than a cat bond. As a result, the fund stands to make a gain in excess of the amount of the coupon stated on a cat bond if the risk does not eventuate.
Guernsey is the leading European captive domicile and the fourth largest such domicile globally. It has been providing captive expertise for almost 40 years, and yet continues to show remarkable growth—there were 737 international insurers licensed in the island at the end of December 2012 compared with 687 a year previously. All of the major insurance brokers are represented, as well as a number of independently owned insurance managers.
Since the SPV in an ILS transaction is accepting risk on to its balance sheet, it may require to be regulated if it is conducting insurance business. Where the risk is accepted under an ISDA documented swap, on the other hand, such regulation may not be required. It is worth noting that there is no prohibition on a Guernsey-licensed insurance company entering into an ISDA documented swap. Indeed, a large number of transformer transactions have been conducted in Guernsey over the last 10 to 15 years.
In many jurisdictions, obtaining authorisation to conduct insurance business can be a lengthy process. However, in Guernsey where the business is to be transacted through a protected cell of an already established Guernsey protected cell company, the necessary approval can usually be obtained in a matter of days. A number of insurance managers in Guernsey have already established protected and incorporated cell companies with cells that are available to third parties that wish to utilise them in this way and many ILS transactions have already been conducted through Guernsey cell companies. SPVs utilised in ILS transactions are invariably fully funded.
Accordingly, the Guernsey Financial Services Commission (GFSC) is able to take a pragmatic approach to solvency requirements. Indeed, in some circumstances a self-certification process may be available for SPVs that meet certain specified criteria. If the SPV meets the eligibility criteria, the local Guernsey appointed insurance manager can obtain the necessary regulatory permission without having to wait for the GFSC to respond to an application.
The speed and certainty with which this process provides gives Guernsey a key advantage over many competitor jurisdictions.
Guernsey has a world-class reputation as an investment fund domicile. As at Q3 2013, the net asset value of funds under management and administration in Guernsey was £267 billion. As noted above, a number of those funds invest in ILS products. For example, Carey Olsen advised on the establishment of DCG Iris Limited, a London-listed and Guernsey-registered closed-ended investment scheme that raised £40 million in 2012 to invest in ILS. Carey Olsen is also advising on the establishment of another listed fund that will invest in Lloyds' capacity through the cell of a Guernsey protected cell company. There are a number of other such funds and, for practical reasons, an investment fund already established in Guernsey is likely to use an SPV located in that jurisdiction, all other things being equal. However, the growth seen in Guernsey ILS transactions has largely been due to the proximity of fund managers in London and Zurich that are familiar with Guernsey as a well regulated international finance centre. To them, Guernsey's combination of both insurance and investment fund expertise can be compelling.
Although traditionally cat bonds have been launched through the Caribbean jurisdictions, Guernsey is well placed to accommodate this business, too. Guernsey's dominance of the listed sector is well documented—it remains the domicile of incorporation for more non-UK entities listed on the London Stock Exchange than any other jurisdiction globally. Indeed, the establishment of a Guernsey holding company in order to facilitate the IPO of an overseas trading group on the London Stock Exchange is common.
Guernsey has recently introduced the continental legal concept of a foundation. Many SPVs used in ILS transactions must be "orphaned" and the foundation is an additional tool that can be used to achieve this, instead of the traditional common law trust. One of the key benefits of using a foundation instead of a trust is that its legal basis is often more readily understood in continental jurisdictions where the concept of a trust is unfamiliar.
Express company formations
Since the introduction of the online Guernsey Companies Registry in 2008, it has been possible to form a Guernsey company within a very short period of time. Standard formations are guaranteed to be turned around by the registry within 24 hours (but, in practice, are often approved the same day). For a slightly higher registration fee, four-hour and even 15-minute formations are possible. It is not yet clear what impact this season's flooding in the UK will have on returns to investors in ILS transactions. However, what is clear is that the ILS has become a fixture of the investment and insurance landscape demonstrating the agility and value that a product created through the convergence of the insurance and investment sectors can have. Its strength in both sectors and the pragmatic approach of the regulator should mean that Guernsey's position at the centre is assured.
An original version of this article was published in Captive Insurance Times, February 2014.
For more information about Guernsey's finance industry please visit www.guernseyfinance.com.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.