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Thursday, 25th April 2024 |
| Capital markets techniques come to the world's insurance markets |
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By: Conor Hynes, Conor Hynes
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| With the growth of the securitisation sector, the area of insurance securitisation has expanded considerably. Conor Hynes explains the various aspects of the sector and argues the advantages of Ireland as a jurisdiction for this business. |
Although securitisation is a relatively recent phenomenon within the insurance industry, the process has existed in the banking industry and capital markets for some time. The insurance securitisation process normally involves the following key elements:
• The transformation of underwriting cash flows into tradable financial
securities
• The transfer of underwriting risks to the capital markets through the trading of those securities.
Instead of an insurance company transferring its underwriting risk to a reinsurance company within the insurance industry, the risk is transferred to the broader capital markets. This approach diversifies risk for investors by giving them a different asset class and provides liquidity and funds to the insurance sector.
There are a number of kinds of insurance securitisations, along with certain reasons why insurance securitisations are established.
Catastrophe bonds
After significant catastrophe losses in the first half of the 1990s, the insurance industry reassessed the catastrophe risk to which it was exposed. At the same time, the capital markets are always on the lookout for new asset classes and asset backed markets. This securitisation structure involves the set up of a special purpose vehicle which issues loan notes/securities to investors and uses this money to take on catastrophe risk.
Investing in catastrophe bonds also has the distinct advantage that catastrophe exposure is uncorrelated with movements in the capital markets and therefore provides diversification potential.
Regulation XXX securitisations
In the US, Regulation XXX defines how life insurance companies set aside reserves for life insurance with level term premium structures. The statutory reserve requirements under the regulations are considered conservative and exceed the economic reserves which an insurance company would normally provide.
The securitisation structure involves the reinsurance of the risks with a special purpose vehicle. Broadly, the 'excess' reserves are funded by the vehicle through the issue of notes to the market. The risk taken on by investors is that actual insurance payments will exceed the economic reserves which would mean that investors may lose some or all of the capital invested which would be paid to the insurer to cover the losses arising.
Releasing the economic value of insurance business
This type of securitisation generally allows the insurance company to monetise the profits/economic value of blocks of insurance business, such as a closed block/value in force/embedded value transactions.
Releasing value from existing business in this way raises funds which can be used to generate further profits.
Other reasons for insurance securitisations include providing capital relief (such as securitising re-insurance recoverables), to assist in financing new business and to provide capital to fund acquisition activity.
Advantages of insurance securitisations
Some of the potential benefits/advantages of insurance securitisation include:
• Increased liquidity
• Lower cost of capital
• Much larger capacity of the capital markets
• Possibility of reducing capital requirements
• Price could be cheaper/arbitrage opportunities
• Remove credit risk of reinsurance
• Greater choice of reinsurance markets
• Reduced volatility
• A source of finance to fund new business and acquisition activity
However care does need to be taken. The success of a securitisation will significantly depend on being able to deliver clearly defined, reliable and quantifiable cash flows to the marketplace. Also, achieving pricing transparency is one of the challenges that must be overcome if insurance securitisations are to continue to grow. Modelling techniques in this regard have advanced significantly. However, there is no doubt that accurate pricing is crucial for the insurance securitisation market.
Irish tax regime for securitisations
The Irish securitisation tax regime offers many advantages, such as:
Tax treaty network: Ireland has an extensive double tax treaty network. Currently Ireland has 44 double taxation agreements, while another 9 treaties are currently under negotiation. This offers an important advantage over offshore locations.
Tax neutrality: A key imperative for any securitisation vehicle when it is being established is achieving tax neutrality in the location in which it is resident. Irish securitisation legislation (Section 110 TCA 1997) has been drafted to ensure that this can be achieved, so that the securitisation vehicle pays minimal tax, as the expenses payable by the vehicle broadly match the income earned by the vehicle. Tax deductions are available for a wide range of expenses which are incurred by the securitisation vehicle including funding costs, service fees and - importantly - a deduction is available for profit participating debt.
Taxation of noteholders: Irish legislation permits interest to be paid to certain noteholders without withholding tax applying. No withholding tax should apply on interest payments if the interest is paid to an individual or company resident in either the EU or a country which has a double tax treaty with Ireland or if the interest is paid on a quoted Eurobond. Broadly, quoted Eurobonds are notes which are quoted on a recognised stock exchange and carry a right to interest.
Ireland - other advantages as a securitisation location
Some of the other advantages which Ireland offers as a location for securitisations include:
• Member of the Eurozone and OECD
• Well developed tax and legal framework
• Acceptable jurisdiction from the perspective of the rating agencies and sponsors
• Flexible regulatory and tax environment
• Quality pool of experienced service providers and advisors
• Ability to list on the Irish stock exchange in a timely and cost efficient manner
Regulation
Ireland has opted for early adoption of the EU Reinsurance Directive. The Directive means that, once enacted by each Member State, reinsurance will become a regulated activity throughout the EU. Specific requirements will govern the treatment of special purpose reinsurance vehicles (SPRVs) such as the requirement that securitisation SPRVs must be approved by the Irish regulator. Prior to commencing business an SPRV will be required to maintain a minimal solvency margin. In addition, there are a number of other conditions which must be satisfied. |
Conor Hynes is a tax partner in Deloitte.
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