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Insurance linked securities (ILS) are an alternative form of risk mitigation for insurers and reinsurers. ILS transactions are transactions that securitise insurance returns into assets that traditional capital market investors can invest in.
ILS structures are typically used by insurers and reinsurers (known in this context as “sponsors”) to transfer risks on their balance sheets to capital market participants, such as pension funds, hedge funds or other managers of assets. In exchange for this transfer of risk, investors are paid a return linked to the sponsors’ income and profits from the underlying insurance business.
The most common type of ILS has historically been the catastrophe bond (CAT Bond), which established ILS as a significant technique for risk transfer in the 1990s. CAT Bonds are usually used by sponsors to raise capital to cover losses associated with natural catastrophes, such as extreme weather conditions or other natural catastrophic perils.
Another common ILS-type deal is collateralised reinsurance (CRe), which is similar in form to conventional reinsurance arrangements but usually includes the interposition of a fully collateralised special purpose vehicle (SPV). These transactions tend to be smaller in scale than CAT Bonds (and are often privately placed) but deal size can be larger in certain markets, such as life longevity swap transactions.
In this article, for ease of reference, the term ILS refers to both ILS and CRe deals, unless stated otherwise.
As the ILS market has grown, so has the deployment of specialist expertise in the arrangement of ILS deals. Capital market investors have become increasingly sophisticated and are using specialist reinsurance expertise and sophisticated modelling techniques to select ILS investment opportunities. Of particular importance in recent times has been the growth of specialist ILS investment funds, which specialise in ILS deals and often act as intermediary between cedants and end investors.
London is the largest global market for commercial insurance and reinsurance, a fact recognised by the UK government which, in 2016, committed itself to the creation of a fit-for-purpose framework to compete in the growing market for ILS. Having been first announced in the 2015 Budget, HM Treasury published its first consultation on its ILS proposals in March 2016. The timeline below sets out the development of the ILS proposals since that date:
The final draft of the UK legislative framework for the ILS proposals, published in July 2017, creates a corporate, regulatory and tax regime for UK domiciled insurance special purpose vehicles (ISPVs), which sponsors and arrangers can use in ILS and CRe transactions. The ISPV regime adopted by the government is closely based on the insurance special purpose vehicle regime in the Solvency II Directive (2009/138/EC) (Article 211) and Articles 318 to 327 of the Solvency II Delegated Regulation (EU) 2015/35, which provides for a simplified regulatory regime for EU-based special purpose reinsurers entering into fully collateralised reinsurance contracts.
Broadly speaking, the ILS proposals make changes to UK law in three areas:
The proposals have been promulgated through a corporate and regulatory legislative structure (The Risk Transformation Regulations 2017) and tax legislative structure (The Risk Transformation (Tax) Regulations 2017) (collectively the Draft Regulations). HM Treasury has published final drafts of the legislation, which will make their passage through the UK Parliament this autumn. The PRA and the FCA, the UK regulators responsible for the supervision of the ISPVs and their business, have both responded to the proposals and given guidance as to changes to regulatory handbooks that will be required as a result of the proposals.
We have set out an analysis of the UK ILS proposals below, divided into the three areas mentioned above. In summary, although further clarification is needed regarding a number of aspects of the Draft Regulations and feedback on the PRA and FCA consultations remains unpublished at the time of writing, ultimately the proposed regime is a welcome step in the right direction. The UK is not alone in seeking to capture ILS business. Coupled with the continued uncertainty surrounding Brexit, it is crucial that the final rules create the necessary incentives to attract investors and provide the robust regulatory framework to place London as the market leader for ILS transactions.
The new corporate and insolvency framework for UK ISPVs is one of the more radical changes to UK company and insolvency law for some time.
An ISPV is a company that assumes insurance or reinsurance risks through a risk transfer contract (which may be a reinsurance agreement or other risk transfer mechanism having a similar effect) from a sponsor. ISPVs usually do not have any assets or liabilities other than those required to enter into the risk transfer contract. ISPVs fund their exposure to pay out under a risk transfer contract through a debt issuance or other financing mechanism, usually notes or preference shares in a Cat Bond type ILS transaction or cash or letter of credit in a CRe deal.
A common feature of the ILS market is that the same ISPV may be used for a number or series of different deals, saving set-up time and administrative expense. Such a multi-arrangement ISPV (mISPV) differs from a traditional ISPV in that it can take on multiple contracts for risk transfer; accordingly an mISPV is an ISPV through which a series of ILS or CRe deals can be managed.
MISPVs are permitted under Solvency II, but the risk transfer contracts must be strictly segregated from each other under the Solvency II regime to avoid cross contamination of one transaction with other transactions that are not related. The UK proposes to ensure such segregation through a new protected cell company (PCC) regime.
A PCC will be a private company limited by shares and will only be available for use as mISPVs used in ILS transactions. PCCs will not be able to be public limited companies. A PCC comprises a “core” and “cells”. The PCC as a whole has legal personality; the cells do not individually have legal personality.
Notwithstanding a lack of separate legal personality, assets and liabilities assigned to a cell are strictly ring-fenced from other cells in the PCC and also the PCC core. This is set out in regulation 48(1) of the draft Risk Transformation Regulations 2017: the assets held on behalf of one cell may not be used to discharge a liability or obligation incurred on behalf of, or attributable to, another cell within the PCC or a claim brought in respect of another cell. A creditor of one cell, therefore, will not be able to claim against the assets of another cell or set off such a claim against a claim made by another cell. Further, where assets or one cell (Cell A) are used to discharge a liability of another cell (Cell B), those assets would be held by the recipient on trust for Cell A.
In practice, therefore, each ILS deal that an mISPV undertakes will be allocated its own cell, meaning that if there are insufficient assets available to support the liabilities of one transaction, none of the other transactions are affected. Accordingly, the accounting requirements imposed on a PCC under the draft Risk Transformation Regulations 2017 include a duty to keep records and accounts at all times that distinguish the assets held on behalf of, and obligations incurred on behalf of or attributable to, each individual cell of the PCC.
A standard insolvency regime, modified for PCCs, is proposed for both the core and cells. The modified regime excludes company voluntary arrangements, voluntary liquidations and receiverships but does enable a cell or the core to be put into administration as if it were a company under Schedule B1 of the Insolvency Act 1986 (IA 1986). The administration procedure in the IA 1986 is modified by the draft Risk Transfer Regulations 2017 to reflect the principle of segregation: where the procedure applies to a cell, it is applied as if that cell had separate legal personality to the core and the other cells, and the appointment of an administrator is confined to that cell.
The core provides the management and administrative function of the PCC. The cells are (among other things) used by a PCC to enter into risk transfer contracts, issue investments and hold property for ILS transactions. A PCC will be able to issue securities, both debt and equity, on behalf of each cell, to fund the risks they assume. These instruments will be restricted to non-voting shares.
The core is responsible for entering into transactions on behalf of the cells. New cells can be added as needed by a simple resolution of the PCC board of directors and can similarly be dissolved by a PCC’s board. No separate incorporation procedure is required for a cell. A cell can, moreover, if necessary, be dissolved, while the rest of the PCC remains intact.
Investment in PCCs will be limited to “qualified investors”, (based on the concepts in the MiFID II Directive (2014/65/EU)), which broadly restricts investment to wholesale investors and persons who pass a qualitative and quantitative test to ensure they are suitably qualified.
The FCA will be responsible for registering PCCs, new cells and recording the details of any cells that are dissolved. Once satisfied that the registration requirements have been fulfilled, the FCA will inform the PRA, register the documents delivered to it and issue a certificate that the PCC is incorporated. A PCC must give written notice to the FCA of any proposed amendments to its instrument of incorporation.
To create new cells, firms are required to provide the information set out in the Draft Regulations, including the names or numbers of the cells created and the cell creation date.
Respondents to HM Treasury’s consultation urged the government to enable arrangements between cells, for example, to enable the tranching of risk between different groups of investors. Under the Draft Regulations, limited movement of assets may be possible subject to strict procedural requirements (to ensure that the principle of segregation is not undermined).One important restriction is that cells that are party to such arrangements are considered to be a ‘group of cells’, which can only enter into one contractual arrangement (that is, one ILS transaction: see regulation 43(6) of the draft Risk Transformation Regulations 2017).
It will be a requirement for the PCC to keep clear records and accounts distinguishing the assets and obligations of the different cells. Any such arrangements must be consistent with the Solvency II fully funded requirement applicable to ISPVs (Article 319 of the Solvency II Directive) (as described in more detail in Solvency Requirements below).
In addition, where a PCC intends to make use of such arrangements, a proposal should be included in the scope of permission granted by the PRA for an mISPV (see Authorisation and supervision below).
A PCC will have one board of directors subject to broadly the same duties as a conventional company incorporated under the Companies Act 2006, with one exception. Directors of a PCC shall be subject to an additional duty to exercise diligence to ensure that a PCC complies with the Risk Transformation Regulations 2017, and acts in accordance with any enforceability arrangements made between cells.
One area that still requires clarification is that, as ISPVs can raise funds from investors other than by issuing debt, it is possible that such arrangements could constitute a collective investment scheme (CIS) under section 235 of the Financial Services and Markets Act 2000 (FSMA) and an alternative investment fund (AIF) under the Alternative Investment Fund Managers Directive (2011/61/EU) (AIFM Directive or AIFMD).
A new regulated activity of “insurance risk transformation” under FSMA is introduced by the Draft Regulations and will be defined in section 13A of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544) (RAO). This activity is defined as:
”… a transformer vehicle to assume[s] a risk from an undertaking where: (a) the undertaking assumes a risk under a contract of insurance (”the underlying risk”); and (b) the assumption of risk by the transformer vehicle has the legal or economic effect of transferring some or all of the underlying risk to the transformer vehicle.”
The way that insurance risk transformation has been defined has two effects. First, it means ISPVs in the UK can only carry on reinsurance business, not direct insurance business. Second, the regime is flexible enough to allow for risk transfer contracts using non-indemnity triggers (such as parametric or index linked triggers) to be used to transfer risks to an ISPV.
A joint consultation paper was issued by the PRA and FCA on the authorisation and supervision of ISPVs (PRA CP42/16 / FCA CP16/34 – Authorisation and supervision of insurance special purpose vehicles), which closed on 23 February 2017. Both the PRA and FCA have yet to publish the responses to the consultation.
Prospective ISPVs will need to apply to the PRA for permission to perform the regulated activity of “insurance risk transformation”. Applications will consist of a bespoke ISPV application form and application forms for certain specific individuals.
The PRA expects final documentation to be submitted with applications. ISPVs will only be authorised by the PRA where they meet the requirements in Article 318 of Solvency II Delegated Regulation (EU) 2015/35. Article 318 sets out the solvency and supervisory requirements applicable to the authorisation of insurance special purpose vehicles under Solvency II.
Although the PRA will be the lead regulator when authorising ISPVs, it will carry out any assessment alongside the FCA with regard to the FCA’s Threshold Conditions. The FCA will assess each application against its “threshold conditions” (Schedule 6 of FSMA and in Threshold Conditions (COND) in the FCA Handbook). Once satisfied that the Threshold Conditions have been met, the FCA will give the PRA consent for its authorisation. ISPVs will need to comply with the relevant Threshold Conditions on an ongoing basis.
ISPVs will be subject to the senior insurance managers regime (SIMR) and, where applicable, FCA controlled functions. In relation to SIMR requirements, the PRA expects applicants to nominate individuals for the following senior insurance management functions (SIMFs):
All individuals who effectively run the ISPV, including SIMFs, are responsible for providing oversight of its activities and key functions, whether in-house or outsourced.
Depending on the type of the business undertaken and size of the board, ISPVs could have FCA controlled functions. Life insurance transformation ISPVs may need to seek approval for a money laundering reporting officer (CF11) and a compliance function (CF10). Additional controlled functions that may be required in certain circumstances include, CF1 Director (if the firm has directors who are not approved as PRA SIMFs); CF28 Systems and Controls; and CF29 Senior Management.
For more information on the SIMR and the FCA controlled functions, see Practice notes, Hot topics: Senior insurance managers regime (SIMR) for insurers and Approved persons regime: overview.
The PRA has stated that it will determine applications within six months of receipt. The proposals include the possibility of pre-application engagement to provide expedited timeframes. The PRA has said that straight-forward proposals supported by good quality documentation that have had the appropriate level of pre-application engagement should be determined within six to eight weeks.
Responses to HM Treasury’s consultation called for the PRA to clarify whether it will be able to “guarantee” authorisation where it has agreed a timeline with applicants at the outset of a deal. ILS transactions are often time-sensitive and many established ILS jurisdictions are able to set up an ILS vehicle within a matter of days, so it is important that the regulators can provide stakeholders with confidence to avoid putting the UK at a significant disadvantage.
Respondents to HM Treasury’s consultation raised concerns about the proposed requirement for pre-transaction notification to the PRA of new mISPV cells. HM Treasury has now proposed that a post-transaction notification regime is appropriate, requiring mISPVs to notify the PRA within five working days of any new assumption of risk. The approach to the creation of new cells or risk transfer deals should be defined in the application for authorisation of the mISPV. Accordingly, the PRA will give permission to enter particular types of transaction in the future where they fall within the parameters of the permission granted. Any assumption of risk that is not within the original scope of permission will require a variation of permission.
The FSMA controller regime (in Part XII FSMA) will not apply to ISPVs. However, applicants are expected to ensure the fitness and propriety of shareholders or members with a qualifying holding in the ISPV, and to carry out an assessment of all qualifying holding investors in the vehicle.
All ISPVs are expected to be “fully funded” consistent with the Solvency II Directive (Article 319). It is the responsibility of the applicant to demonstrate that the ISPV is, and continues to be at all times, fully funded. Contingent assets will not count towards the fully funded requirement.
Under the proposals, the proceeds of the ISPV’s debt issuance or other funding mechanism are required to be fully paid-in (that is, the ISPV should have actually received the proceeds of the debt issuance or other mechanism by which it is financed). The ISPV must at all times have assets the value of which equal or exceed its aggregate maximum risk exposure, and must be able to pay the amounts it is liable for as they fall due.
The PRA has not provided definitive guidance as to how ISPV applicants can satisfy the fully funded requirement. There are areas that require further clarification. For example, the market has developed customs that mean, at times, the theoretical exposure of the ISPV or cell to a transaction exceeds the assets paid in to support that transaction. These include where collateral is only posted in respect of one period of cover; where a contract is written with “restatements”; where investors only pay in the amount of assets into the relevant collateral or note account equal to the limit of the contract, less the “premium” expected to be paid to investors over the term of the relevant contract period; and where, if non-cash assets are invested, the assets held by the ISPV may not equal the ISPV’s exposure if the value of such assets depreciates after the date they are paid in.
To address the exposure to the ISPV not being fully funded, limited recourse provisions are included in the context of ISPV arrangements by virtue of which the ISPV exposure under the reinsurance content is limited to the assets or collateral supplying it. However, the PRA has indicated that such clauses will be irrelevant to its initial assessment of whether the ISPV is fully funded because it considers such clauses, if imprudently relied on, can undermine effective risk transfer to the ISPV. This is a recognised protection for the ISPV and is particularly important in the context of ISPVs with cells undertaking different transactions with different pools of investors. As a result, it will be important to have clarity over the level of assets an ISPV will be required to maintain.
Each cell of an mISPV is expected to meet the requirements of the Solvency II Directive in respect of:
ISPVs will be subject to a bespoke taxation regime in the UK. There will be no corporation tax for so called qualifying transformer vehicles (QTVs). If an ISPV does not have authorisation to carry out insurance risk transformation it cannot qualify as a QTV (see regulation 3(1)(c) of the draft Risk Transformation (Tax) Regulations 2017).
There will be a complete withholding tax exemption for debt and equity payments made from ISPVs to investors. Imposing a withholding tax at the level of the ISPV would make the UK less competitive than established jurisdictions and would be inconsistent with the treatment of the ISPV as a tax neutral vehicle. UK investors will be taxed as normal according to their facts and circumstances, with non-UK investors being taxed according to the regime in their home country.
This QTV tax treatment will be strictly limited to ISPVs and will be contingent on regulatory rules being met and vehicles receiving authorisation to carry out “insurance risk transformation”. If an ISPV is used as part of a tax avoidance scheme, the tax advantages will not be available. The tax regime will only be available where there has been a genuine transfer of risk to an ISPV. It will not be available where risk is effectively retained through a cedant’s investment in an ISPV.
Following comments submitted in consultation, the government has decided to extend the period within which assets can be distributed (after the satisfaction of insurance liabilities) out of the ISPV from 30 days to 90 days.
For more information on the arrangements that constitute CISs and AIFs, see Practice notes, Investment funds: overview: What is a collective investment scheme? and Alternative investment funds (AIFs).
Reproduced from Practical Law Financial Services with the permission of the publishers.
The United States Occupational Safety and Health Administration (OSHA) has announced a new online portal for submitting applications to its Voluntary Protection Programs.
© Norton Rose Fulbright LLP 2021