This article was written by Minny Siu and Angus Sip
On 18 February 2019, the State Council announced the Outline Development Plan for the Guangdong-Hong Kong-Macao Greater Bay Area. The insurance sector is set to be one of the pillar industries under the Greater Bay Area blueprint, which seeks to promote cross-border Renminbi reinsurance business and explore the development of a trading platform for innovative insurance elements, among other things. The Outline Development Plan also supports Hong Kong in strengthening its status as a risk management centre.
Against this background, we expect the Hong Kong Government will proactively implement these strategies in accordance with the guiding directions set forth in the Outline Development Plan. In the 2018 Hong Kong Chief Executive's Policy Address and the 2019 Hong Kong Budget Speech, the Hong Kong Government has already identified the importance of insurance-linked securities ("ILS") as a key driver of the future growth of Hong Kong reinsurance industry, and recommended allowing the formation of special purpose vehicles for issuing ILS in Hong Kong by amending the Insurance Ordinance (Cap. 41) with a view to enriching the risk management tools available in the Hong Kong market.[1]
This article provides a brief overview of the ILS structure, and explores the potential opportunities arising from this important initiative for Hong Kong in its role in the Greater Bay Area.
What are ILS?
ILS are a form of alternative risk transfer (also known as "ART") which gives protection buyers (who are usually insurers or reinsurers seeking to get protection and are commonly known as "sponsors") new options to transfer risk to the capital markets investors. The most common form of ILS is catastrophe bonds (usually abbreviated as "cat bonds"), which are generally privately placed risk-linked securities of which all, or a portion of, the repayment of the principal is linked to a specific set of risks (generally natural disaster and catastrophe risks in a specified geographic region) – for example, the occurrence of one or more wildfire in California or earthquakes in Japan resulting in losses to the sponsor exceeding certain specified thresholds.
ILS allow sponsors to obtain reinsurance protection from a new pool of capital separate from traditional reinsurers. ILS become increasingly attractive to a large pool of institutional investors, ILS funds, money managers and pension funds due to their relatively stable market return during the financial crisis and their liquidity profile.
How do ILS work?
The diagram below illustrates how a typical catastrophe bond work:
Initially:
1. A special purpose vehicle (SPV) specifically designed for the cat bond issuance is established and enters into a reinsurance agreement with the sponsor. Pursuant to the reinsurance agreement, the SPV will receive premiums and provide coverage to the sponsor upon the occurrence of a "trigger" event.
The most commonly used trigger type in the cat bond market is an indemnity trigger, which is the actual loss incurred by the sponsor following the occurrence of a specified catastrophe event, in a specified geographic region, for a specified line of business – for example, a trigger event may occur if the sponsor's commercial property insured losses from a single earthquake in Japan exceeds U.S.$50 million, in the time period from 1 November 2018 to 31 October 2021.
2. The SPV issues the cat bond to investors in the capital markets. The cat bond contains default provisions that mirror the terms of the reinsurance agreement.
3. The proceeds from the sale of the cat bond are deposited into a segregated collateral account and invested in highly rated money market instruments to provide a stable return.
In the interim:
4. The SPV makes periodic coupon payments to investors of the cat bond. The coupon payments are derived from the investment return on the collateral and premiums the sponsor pays.
At maturity/ upon the occurrence of a trigger event:
5. If no "trigger" event occurs during the term of the cat bond (typically three years) then the collateral is liquidated at the end of the cat bond and cat bond will be redeemed at 100% of face value.
6. If a trigger event has occurred, the SPV will liquidate all or part of the collateral required to reimburse the sponsor, and the redemption price of the cat bond is reduced accordingly.
Why choose ILS?
ILS offer a viable alternative to traditional reinsurance for risks that are hard to model.
For reinsurers, ILS provide multi-year capacity and pricing certainty. They are more secure due to their fully collateralised nature and ability to be rated, and are capital-efficient.
For investors, ILS' low correlation with other asset classes make them an effective asset diversification instrument. Further, in comparison to equities and bond markets, ILS have relatively low volatility and stable returns to offer investors a liquid investment option in secondary markets.
ILS market overview
Bermuda in the lead
Bermuda is the leading domicile for the issuance of ILS in recent years, underlined by the fact that 74.5%, or US$24.8 billion of total outstanding ILS capacity was issued in Bermuda, as at the end of the first-quarter of 2018, according to the Bermuda Monetary Authority.
The growth of the ILS in Bermuda was sparked by its introduction of the legislative framework to support the creation of "special purpose insurers" (SPI) in 2009 for ILS issuance. SPI enjoy an overall lighter and more efficient regulatory regime, with a minimum capital requirement, ability to waive the requirement for an audit and low licensing fees, to name a few.
In addition to this legislative and infrastructure advantage, Bermuda is also renowned for its speed to market, investor familiarity and tax friendliness.
Asia ILS market
There is currently no established market in Asia for ILS given their relatively novel nature to the Asian based reinsurers and investors. ILS are generally recent instruments employed by reinsurers operating in Asia in the capital market. For example, the first-ever cat-bond covering China earthquake risk was only issued in 2015.[2]
Singapore has been hoping to encourage ILS and catastrophe bond business to its shores for some years now, having developed special purpose reinsurance vehicle (SPRV) legislation, taken step of offering an ILS grant which funds 100% of the upfront costs incurred in issuing catastrophe bonds in the country and provided tax neutrality for ILS vehicles.
Hong Kong ILS market
We are yet to observe the further development and growth of ILS market in Hong Kong. Hong Kong insurers tend to use ILS to help manage the risks of their business by arranging deals with offshore vehicles, such as Bermuda[3].
Hong Kong is well-positioned to tap opportunities in promising growth of the Mainland China's reinsurance market, with the broader policy drive for the "Belt & Road" and "Greater Bay Area" initiatives in becoming the largest Asian ILS hub. Reports show that Mainland China's reinsurance market was valued at HKD273 billion in 2013 and is expected to reach up to HKD1,544 billion by 2020, fuelled by explosive growth in the primary general and life insurance markets.[4] Swiss Re has estimated that Belt & Road Initiative related commercial insurance premiums of USD28 billion could be generated by 2030.[5]
However, in the lack of a robust regulatory and tax framework specifically designed for ILS, Hong Kong's current ILS regulatory regime could be viewed as restrictive in comparison with the established ILS market leader Bermuda and other new jurisdictions looking to develop their ILS capabilities, such as Singapore and the United Kingdom[6].
What's next for Hong Kong?
We welcome and are excited to see the proposed legislative amendments to promote ILS transactions within a new specially designed framework in Hong Kong. This will provide fresh impetus to Hong Kong's development as a reinsurance and captive centre in the Greater Bay Area[7]. Leveraging off Hong Kong's very well established and stable financial infrastructure with global recognition, Hong Kong is in a unique position to tap into the ILS markets in this region as part of the Greater Bay Area initiatives, so as to attract more insurance and reinsurance companies to efficiently replenish and diversify their own capital base through issuing ILS from Hong Kong. A specially designed ILS regime in Hong Kong will provide a significant opportunity to strengthen Hong Kong's influence in the Asia reinsurance market and secure a strong position in this rapidly evolving and expanding sector.
We look forward to the upcoming legislative process to establish the ILS legal framework in Hong Kong this year.
King & Wood Mallesons has a dedicated team across our network focusing on derivatives and structured finance over a wide range asset classes including insurance-linked instruments. We look forward to working with our clients on these exciting initiatives. We will keep a close eye on the developments on this front and provide a further update once the details of the proposed legislative changes are published. Please speak to us if you have any questions.
[1] See paragraph 118 of the Chief Executive's 2018 Policy Address and paragraph 57 of the 2019-20 Budget Speech. This echoed the Hong Kong Financial Services Development Council (FSDC)'s observations on the importance of ILS as a driver of the future growth of Hong Kong reinsurance industry back in 2017. See section 1.3.2 of the FSDC Paper No.27 entitled "Turning Crisis into Opportunities: Hong Kong as an Insurance Hub with Development Focuses on Reinsurance, Marine and Captive" (the "FSDC Paper").
[2] The Panda Re Series 2015-1 cat bond was issued by a Bermuda domiciled SPI and sponsored by China Property and Casualty Reinsurance Company. The cat bond uses an indemnity trigger and has a three-year term.
[3] Over 75% ILS transactions still being completed in Bermuda. See paragraph 1.3.2 of the FSDC Paper.
[4] See paragraph 1.3 of the FSDC Paper.
[5] See the March 2017 Report entitled "China's Belt & Road Initiative: the impact on commercial insurance in participating regions" published by Swiss Re Institute.
[6] The United Kingdom government has recently enacted ILS regulatory and tax framework with a view to attracting China to gain access to greater disaster insurance or reinsurance protection.
[7] Hong Kong is already well placed to attract mainland enterprises in establishing reinsurance and captive business. From the year of assessment 2018/19 onwards, a tax concession for reinsurers or captive insurers to enjoy a 50 per cent reduction in the profits tax (from 16.5 per cent to 8.25 per cent) on their insurance business has been extended to cover on-shore risks in addition to the offshore risks. In July 2018, the China Banking and Insurance Regulatory Commission announced a preferential arrangement to Hong Kong reinsurers that when a mainland insurer cedes business to a Hong Kong qualified reinsurer, the capital requirement of the mainland insurer will be reduced.
