Chris Garrod discusses the emergence in the past 20 years of Bermuda as a leading player in the insurance industry, earning the label of ‘World’s Risk Capital’ and boasting a streamlined and flexible approval and incorporation process.
Bermuda has, in the past 20 years or so, emerged into an insurance powerhouse that rivals New York and London. Often now referred to as the ‘World's Risk Capital’, Bermuda is the third-largest reinsurance market in the world, the centre of international catastrophe reinsurance business and underwrites a third of global premiums.
In addition to being known as the World's Risk Capital, Bermuda is also commonly referred to as the ‘Insurance Laboratory to the World’. This laboratory has fostered the development of sophisticated ILS products such as cat bonds, sidecars and other fully funded reinsurance vehicles. This article will explore the growing use of special purpose insurers in Bermuda and will also examine why Bermuda has become the most popular jurisdiction for ILS vehicles in both the reinsurance and funds industries.
The Rise of the SPI
Four years ago, having recognised the sophistication and potential of the insurance-linked securities (ILS) market, the Bermuda Monetary Authority (BMA) introduced amendments to Bermuda's insurance legislation to create a new class of Special Purpose Insurer (SPI), which, in a nutshell, is an insurer set up specifically to write sophisticated, fully funded reinsurance transactions.
The introduction of the SPI category has led to a paradigm shift in the Bermuda catastrophe reinsurance market. Looking at the numbers, 23 of these entities were set up in 2011, 27 in 2012 and as of the end of August 2013, 29 SPIs have been registered, comprising well over half of all new insurance formations in Bermuda.
They have gained in popularity for a variety of reasons. Certainly, one of the main attractions for setting up an SPI is the fact that they enjoy a much lighter, more efficient regulatory regime in Bermuda, a regime which recognises the fact that these entities only operate on a sophisticated, fully funded basis (eg, by way of cash collateral, subordinated debt or other mechanisms such as letters of credit and reinsurance), and therefore the risk profile of an SPI is not one which warrants excessive regulation.
As such, the minimum capital requirement for an SPI is just US$1. There are no return of capital restrictions to which other commercial insurers may be subject. SPIs may also apply to the BMA to seek a waiver from the requirement to file audited statutory financials with the BMA. There are no investment restrictions imposed on an SPI. And finally, they are subject to relatively low insurance licensing fees.
SPIs can also be set up very quickly — usually no more than three to four weeks in total. This speed to market will continue to make Bermuda an attractive home for these structures.
The two most popular structures where SPIs are utilised are reinsurance sidecar vehicles and cat bonds.
Sidecars are specialised reinsurance vehicles which are usually formed by reinsurers that are seeking greater capacity in the reinsurance market. A large number of sidecars set up after Hurricanes Katrina, Rita and Wilma in 2005, when catastrophe reinsurance capacity shrunk dramatically.
A sidecar SPI will usually only underwrite certain specified risks of the reinsurer, usually of a catastrophic nature such as Florida Wind, and usually for a limited time, eg, a particular hurricane season. The investors in these vehicles sometimes include the cedant itself, but are dominated by the capital markets. The ILS market is now seen as a more attractive investment prospect, not only from a diversification perspective, but also from the standpoint of yield. Institutional investors view it as a position that is non-correlated to the capital markets with a risk-reward profile that is very attractive. With a sidecar, the risk of payout depends wholly on whether the cedant in question suffers a reinsurance loss.
Cat bonds are typically used by reinsurers as an alternative to obtaining traditional catastrophe reinsurance, and they typically cover high-severity but low-probability events, California or Japanese earthquake being an example.
A typical structure would have an SPI set up as a stand-alone vehicle under a purpose trust. The SPI issues the cat bonds though an investment bank to investors, the proceeds of which are held in collateral account set up for the benefit of the ceding reinsurer. The cedant will pay a premium to the SPI. The money from the premium and investment income provides interest payments owed to investors. Assuming there is no catastrophic event, or trigger event, before the maturity date of the contract, investors will receive back their principal investment at maturity on top of the interest payments they have received.
The convergence of reinsurance and capital markets has accelerated over the last 12 to 24 months.
Exposure to catastrophe risk as an asset class is increasingly gaining institutional investor acceptance for its qualities as both a diversifying asset, which is uncorrelated to existing portfolios, as well as an asset class that has the potential to produce attractive risk adjusted returns.
Insurance-linked securities and other property catastrophe-based instruments performed well generally during the subprime crisis, while the credit and equity markets lost significant value. The contrasting fortunes of these investments has served to reinforce the view that catastrophe risk as an asset class does in fact have a low correlation with the broader credit and equity markets. Institutional interest in these instruments is also being fueled by the current low interest rate environment.
Pension funds, life insurance companies, endowments, sovereign wealth funds and family offices are aggressively seeking high-yield investments in order to improve their investment performance. An allocation to catastrophe risk as an asset class is now deemed by fund managers and their consultants to be a prudent means for achieving an attractive risk adjusted return and a means for enhancing the overall performance of their investment portfolio. These entities are seeking to invest in professionally managed facilities that can provide them with properly sourced and underwritten portfolios of (re)insurance exposures.
A number of new ILS platforms and initiatives have been launched in the past few years, including Tokio Tensai and Kane SAC Limited Note Program, which are private cat bond platforms, Lancashire's Kinesis platform, and a number of others, many of which are being sponsored by traditional P&C reinsurers. Many of these platforms involve the formation of a fully collateralised segregated accounts insurance vehicle, which may be licensed either as an SPI, or alternatively, a Class 3 insurer.
All of these entrants write business on a fully collateralised basis, usually provided through a trust or through a letter of credit arrangement whereby capital is set aside capital to collateralise the risks they are underwriting. This type of reinsurance is attractive for purchasers, as the credit worthiness of the collateralised reinsurer is less of an issue than it would be when buying cover from a rated, traditional reinsurer. Indeed, collateralised reinsurance has now become a popular form of risk transfer as an alternative to more traditional reinsurance and, in recent years, demand has been significant, and growing.
The alternative market is estimated by Guy Carpenter to provide between 14 per cent and 15 per cent of capacity required by the property catastrophe market based on total limits of US$312 billion required for 2013. According to many commentators, the market share of alternative market capacity supporting the property catastrophe market is expected to grow significantly in the coming years.
Bermuda: the ILS Mousetrap
Bermuda has been the most popular jurisdiction for these new ILS platforms. Why? Its historical ties to the US and to the UK, the depth of market and service provider experience, a well-respected regulatory regime and an internationally recognized stock exchange has led to Bermuda becoming the perfect host for activities arising out of the reinsurance, funds and capital markets...
According to the Economic Impact Study 2012, Bermuda is the most important foreign provider of insurance services to the US. PwC records Bermuda as holding 19 per cent of ILS investors in the world, second to the US and tied with Switzerland — an impressive feat for a geographically small jurisdiction. Bermuda’s sophisticated infrastructure is keeping in step with the development of the ILS market. Bermuda has an extraordinary concentration of professional funds and insurance talent operating in a regulatory environment already on track to service the world’s ILS market players.
The Growing Use of ILS Funds in Bermuda
Bermuda’s funds industry is in the throes of an ILS revival. A number of the ILS platforms that have recently been set up in Bermuda have seen the creation of not only new fully collateralised Bermuda reinsurance vehicles, but also a number of new Bermuda ILS funds.
The ILS funds typically invest in cat bonds, industry loss warranties (ILWs) and a variety of opportunistic reinsurance products ranging from mortality bonds to property and catastrophe reinsurance (though reinsurance must be conducted through a licensed insurer like a SPI or a Class 3 reinsurer). The ILS insurance vehicle may typically be owned and operated in tandem with the ILS fund, with the fund allocating capital to the ILS insurance vehicle to fund specific ILS participations underwritten by that vehicle. The ILS insurance vehicle distributes earned premium and investment profits to the ILS fund.
Yet a further refinement in the above structure is to give the ILS fund and the ILS insurance vehicle the power and ability to legally segregate and profile investor class, or strategies and transactions by registering the entities as segregated accounts companies (SAC) under the Segregated Accounts Companies Act 2000. This would enable an ILS fund to issue multi‐class securities to investors tiered to individual risk profiles and investment appetites, mandates and strategies.
Registering the ILS insurance vehicle as an SAC also has the advantage of isolating and ring‐fencing the legal and financial risks in respect of each cat bond or reinsurance program within separate cell structures achieving limited or non‐recourse to the other assets of the ILS insurance vehicle, ensuring the continuity and integrity of the overall structure as a legal bulwark against adverse results, claims or liabilities — essentially creating a bankruptcy‐proofed structure.
In part due to recognition of the increasing popularity of Bermuda as a domicile for these sophisticated ILS funds, the BMA has recently pushed amendments to Bermuda’s Investment Funds Act to provide for a category of fast-track funds, the Class A Exempted Fund, which require no regulatory approvals to launch and commence operations. Open to investment managers which are authorised or licensed by a recognised foreign regulator (such as the SEC, FCA, etc) or which have gross group assets under management of US$100 million or more, this category should prove appealing to ILS fund managers with the emphasis by Bermuda regulators, again, on facilitating speed to market.
The Bermuda Government, the BMA and industry stakeholders have rallied around the ILS business with one voice and have laid the necessary infrastructural ground work to secure Bermuda’s lead position in this fast-growing sector. With the streamlined and inherently flexible approval and incorporation process, as well as the efficient and cost‐effective regulatory structure, we expect the ‘World's Risk Capital’ will continue to dominate the ILS market for years to come.
Chris Garrod Chris Garrod is a Director in the Corporate department of Conyers Dill & Pearman’s Bermuda office. He joined Conyers in 1997 and is a member of the Firm's insurance practice. Chris specialises in advising on reinsurance and ILS structures, including large commercial insurers, life reinsurers, special purpose insurers, cat bonds, sidecars and segregated account vehicles. In addition to his insurance practice, he also advises on all aspects of Bermuda corporate law, including mergers and acquisitions, takeovers, reorganisations and re-domestications.
Conyers Dill & Pearman Bermuda, British Virgin Islands and Cayman Islands.