27 July 2020

Greater Bay Area Series – Developments for Hong Kong insurance linked securities

This article was written by Minny Siu, Angus Sip and Cindy Shek.

The Hong Kong* Government has been actively preparing legislative amendments to facilitate the issuance of insurance linked securities (ILS) in Hong Kong[1]. On 17 July 2020, the Insurance (Amendment) Bill 2020 (Bill) passed its second and third reading and the aim is for new subsidiary legislation to be implemented by early 2021. One of the key amendments (Amendments) under the Bill is to facilitate the issuance of ILS in Hong Kong.

With privileged access to the Mainland China market and the “Belt & Road”, “Greater Bay Area” and “Wealth Management Connect” initiatives as broader policy drives, Hong Kong is well-positioned to tap the growing opportunities in the Mainland China’s reinsurance market where Mainland Chinese insurance companies are likely to take advantage of the newly proposed regime to issue ILS in Hong Kong. This is also supported by the 16 policy measures introduced by the Mainland Government after the third meeting of the Leading Group for the Development of the GBA[2], one of which explicitly provides the support for Mainland insurers to issue catastrophe bonds in Hong Kong and Macao Special Administrative Region.

This article examines the new regulatory regime introduced by the Amendments as it applies to ILS.

What is an ILS?

ILS is a financial instrument that allows protection buyers (who are usually insurers or reinsurers who are commonly known as sponsors) to transfer their insured risk to the capital markets investors through securitisation.

ilsintro

How does ILS work?

  1. In a typical ILS transaction, a sponsor (typically an insurer) will arrange for the establishment of a special purpose vehicle (SPV) for ILS issuance.
  2. The sponsor will then transfer its insurance risk to the SPV through a reinsurance agreement between them.
  3. The SPV then issues ILS (for example in the form of a catastrophe bond) to investors in the capital market to finance the full amount of the risk assumed by the SPV under the reinsurance agreement.
  4. Repayment or return to the investors is linked to the underlying insurance risk – any claims made by the SPV to the sponsor triggered under the reinsurance agreement will be subsumed in the payout to the investors.

Why are ILS attractive?

Given the increase in climate change-related catastrophic events, there has been an increasing demand in catastrophe bonds, one of the most popular forms of ILS. Global issuance of ILS has grown substantially in recent years, reaching approximately US$11 billion in 2019[3].

ILS are attractive to insurers and institutional investors alike for a number of reasons:

ilsattractive3

What are the Amendments about?

In a Legislative Council discussion paper in relation to its initiatives to promote the development of the insurance industry in Hong Kong[4], the Hong Kong Government noted that the purpose and nature of ILS business, which is essentially the transfer of insurance risks to the capital markets, are very different from the conventional insurance and reinsurance businesses currently regulated under the Insurance Ordinance (Cap. 41) (IO).

In particular, applying the existing stringent regulatory requirements under the IO (such as the capital and solvency requirements, reporting requirement, corporate governance requirement, etc.) to ILS business makes issuance of ILS in Hong Kong extremely costly and cumbersome, if not impractical. Accordingly, the Hong Kong Government has recognised the need to create a unique regulatory regime under the IO for ILS.

“Special purpose insurer”

Against this backdrop, the Amendments seek to provide for the regulation of “special purpose insurer” (SPI), a new type of authorised insurer which is set up solely for the purpose of carrying out a new class of insurance business, namely the “special purpose business”.

spb1

Authorisation as a SPI is subject to the following requirements:

spi

Under the Amendments, the Insurance Authority (IA) is empowered to specify the form in which an SPI submits information to the IA, and modify or vary the reporting or corporate governance requirements under the IO in relation to an SPI. It is anticipated that the existing regulatory requirements under the IO will be relaxed with respect to a SPI such that a light touch regulatory regime can be created to promote Hong Kong as an attractive domicile for issuing ILS.

Restrictions on the sale of ILS

Under the Amendments, the IA will also be empowered to formulate rules to restrict the sale of ILS, such as prescribing requirements relating to the financial condition, solvency and sophistication of ILS investors. Given the nature of the underlying risks of investing in ILS and the potential losses that may arise upon the occurrence of a designated trigger event, it is intended that ILS should only be allowed to be sold to certain qualified institutional investors (such as Mandatory Provident Fund Schemes, occupational retirement schemes and authorised retail funds) and not ordinary retail investors.

When will the Amendments become effective?

With the passing of the second and third reading of the Bill, the Bill is expected to come into operation shortly, on a day to be appointed by the Secretary for Financial Services and the Treasury by notice published in the Gazette. The Secretary for Financial Services and the Treasury also confirmed at the Legislative Council meeting that the new subsidiary legislation will be implemented by early 2021, and such rules made under the proposed new section 129A of the IO will be tabled at Legislative Council for negative vetting.

What’s next?

The new ILS regime represents significant business opportunities emerging in Asia’s insurance market. We expect that the IA will introduce detailed rules and procedural requirements for the authorisation of an SPI to carry on “special purpose business” in due course. Together with the recent GBA initiatives to facilitate cross-border insurance investments, the new ILS initiatives will facilitate further connections and integration of market players in Mainland China and Hong Kong, leveraging off their respective expertise and knowledge.

King & Wood Mallesons has a dedicated team across our network focusing on financial regulations and structured finance over a wide range of asset classes including insurance-linked instruments. King & Wood Mallesons is well positioned to advise you as to the requirements of obtaining a special purpose insurer licence and together explore the opportunities provided by the new ILS regime. We look forward to working with our clients on these exciting initiatives. We will keep a close eye on this front and provide a further update as and when there is further development. Please speak to us if you have any questions.


*Any reference to “Hong Kong” or “Hong Kong SAR” shall be construed as a reference to “Hong Kong Special Administrative Region of the People’s Republic of China”.


[1] Please refer to our previous publication in April 2019 for further details.

[2] https://www.info.gov.hk/gia/general/201911/06/P2019110600764.htm

[3] The Artemis Catastrophe Bond & Insurance-Linked Securities Deal Directory.

[4] LC Paper No. CB(1)175/19-20(07) dated November 2019 entitled “The Government’s Initiatives to Promote the Development of the Insurance Industry in Hong Kong”.

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