As anticipated, the Autumn Statement confirmed the UK Government will introduce a new regime to enable UK special purpose vehicles (SPVs) to issue insurance linked securities. At the same time a further HM Treasury consultation was launched with a response deadline of 18 January 2017, as well as a separate regulatory joint consultation by the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).
The approach to tax seems sensible in most respects but some of the proposed anti-avoidance measures appear disproportionate, and there remains a question of whether this is too little too late to attract ILS transactions into the UK. The regulatory approach seems to have further still to go - having to obtain PRA and FCA approval for each and every cell/transaction may subject UK insurance special purpose vehicles (ISPVs) to a prohibitive level of process and delays compared to more nimble competitors like Bermuda.
There is a growing market for insurance linked securities (ILS) - ie debt or equity securities which transfer insurance risk into the capital markets. Currently, about 20% of the capital in the insurance market is supplied through these ILS - clearly they are important to the insurance market and here to stay. Traditionally, the debt or equity securities are issued into the capital markets by an SPV, which takes on insurance risk from an insurer or reinsurer under a risk transfer agreement, and uses the proceeds of the capital markets instruments to purchase high quality collateral securities which secure its obligations to the insurer and the holders of the capital markets instruments. Even though the insurance risks may sometimes relate to the UK insurance industry, so far such insurance linked securities transactions have typically used SPV issuers in offshore jurisdictions such as Bermuda, Guernsey or Jersey. The most well-known examples of insurance linked securities are publicly-issued catastrophe bonds and mortality bonds, some of which have parametric triggers and others have indemnity triggers, but many other forms exist and in practice about 50% of the market comprises privately-issued collateralised reinsurance.
The UK Government is seeking to make the UK a suitable jurisdiction for insurance linked securities SPVs (“ISPVs”, also referred to as “transformer vehicles”). Following an earlier consultation in March of this year, a further consultation was published by HM Treasury as part of the Autumn Statement (23 November 2016), with a response deadline of 18 January 2017, accompanied by draft tax regulations and draft regulations permitting protected cell companies. In addition, the PRA and FCA published a joint consultation on the regulatory aspects of ISPVs, and the Bank of England and Financial Services Bill currently going through parliament contains powers for the Treasury to introduce regulations for UK “transformer vehicles”. These ISPVs can be either single transaction SPVs using existing corporate models or the new protected cell companies (PCCs). The proposals are only for vehicles which take on insurance risk and pass it on through issuing debt or equity securities - not for example SPVs converting insurance risk into derivatives (or SPVs converting derivative or other risks into insurance).
The broad aim of creating these products in the UK and providing an alternative market to Bermuda and other offshore jurisdictions is very much to be welcomed.
Insurance regulatory issues
While the enthusiasm within the market is undoubtedly there, a number of legal and regulatory developments need to be implemented, not least the introduction of protected cell companies (as to which, see below). The proposals signal a radical change for UK company law with extensive changes to legislation being proposed to enable protected cell companies and proposals to ensure that they work within the UK governance framework and Solvency II. A new regulated activity is proposed of insurance risk transformation.
Secondly, Bermuda’s regulator is famously flexible and fast. To compete the UK would need to be able to react speedily and decisively in supporting the market and enabling the creation and authorisation of the relevant SPVs and suitable regulatory treatment of insurance linked securities for investors (many of whom are insurance companies themselves). Initial proposals suggest that ISPVs could receive authorisation within six to eight weeks of application and would be subject to simplified governance and reporting requirements, although the PRA is hedging its bets by noting the time-sensitive nature of ILS transactions but suggesting pre-application discussions to ensure fully completed applications. Clearly, however, there will be concerns that involving two regulators and needing separate approval for each and every commercial transaction is going to cause delay and overly complicate matters, which will make the UK uncompetitive and risk the whole project being a non-starter unless it can be streamlined before implementation.
The Government proposes that only qualified institutional investors should be given permission to invest in ILS through UK established ISPVs, in accordance with the expected market for these.
The UK Government recognises that for the UK to work as an ISPV jurisdiction, it needs to provide tax exemption for ISPVs - Bermuda (and Guernsey and Jersey) do not tax profits of ISPVs or apply any withholding taxes on their payments to investors (and historic UK attempts at UK insurance securitisation companies which are subject to UK corporation tax but only on small cashflow profits did not work in practice). Accordingly, UK ISPVs authorised by the PRA and FCA will be exempt from UK corporation tax on their risk transformation activities, and their payments to debt or equity investors will be exempt from UK withholding tax. UK investors will be subject to normal UK tax rules on their returns on debt and equity investments in ISPVs in the same way as other debt or equity investments. Non-UK investors will be subject to their local tax rules in the usual way (ie no additional UK taxes on non-UK investors merely because they invest through a UK ISPV). This appears to be a sensible and pragmatic approach by the UK Government paying heed to the responses to the March consultation. The March consultation indicated the UK Government believes that one attraction of UK ISPVs will be their ability to benefit from the UK’s extensive network of double tax treaties to eliminate or reduce withholding taxes on securities held as collateral. This is not repeated in the recent consultation, perhaps because ISPVs tax exemption may call into question their entitlement to treaty benefits, and in any event most high quality liquid securities commonly used as collateral are structured so as to able to pay interest free of withholding taxes, without relying on tax treaties.
Unsurprisingly given the political and media climate, the UK Government is also very keen to ensure that UK ISPVs cannot be abused for tax avoidance, and is giving further consideration to anti-avoidance provisions. In particular the tax exemptions will not apply to ISPVs unless they are authorised by the PRA and FCA, and will only apply if there is a genuine transfer of risk through an ISPV on to third party capital markets investors - for example the insurer and parties connected to it must not hold more than 20% of the ISPV’s debt or equity securities. Additionally, the corporation tax exemption does not apply to any activities of an ISPV beyond risk transformation - for example administrative or management activities, or holding investments beyond what is reasonably required to fund the insurance risks it takes on - or if obtaining a tax advantage is one of the main purposes of the ISPV arrangements. Much of that is understandable, though may create some difficulties at the borderlines and risk some innocent ISPV arrangements inadvertently losing their tax exemptions. More surprisingly the current draft tax regulations also go beyond this to disqualify ISPVs from UK tax exemption in the event of corporation tax compliance failures such as delays or errors in filing tax returns - which seems particularly draconian considering that many of the anti-avoidance provisions (including this one) trigger permanent loss of ISPV tax exemptions even if the failure is subsequently rectified. It can only be hoped that this measure is dropped or watered down following consultation responses.
UK protected cell companies
The use of protected cell companies or their equivalents such as segregated account companies have been possible for many years in leading ILS jurisdictions such as Bermuda, Guernsey and Jersey. Protected cell companies enable multiple transactions without having to set up a new company each time and can significantly reduce operating costs. The UK Government proposes to introduce UK protected cell companies - ie a company with multiple segregated cells each of which has separate limitation of liability, so that assets and transactions in one cell are not at risk of liabilities in other cells, even though under the UK proposals, the cells do not have separate legal personality from the core company. However, this may be something that could be changed reflecting other jurisdictions’ experience with different structures. The UK government recognises this is necessary for the UK to be attractive as an ISPV jurisdiction. The government proposes that ISPVs must be private limited companies (not PLCs), as it does not wish to permit public offerings of investments in ISPVs. Unfortunately the current plan is to introduce UK protected cell companies for ISPVs only and not more generally, and an application to incorporate a UK protected cell company will need to be made to the PRA at the same time as applying for authorisation of a UK ISPV. The proposals that an ISPV should meet the requirements of Solvency II and be fully funded is commensurate with the trend for fully collateralised ILS reinsurance but it is interesting that the PRA regards limited recourse clauses as unpersuasive as a prudential basis for the ISPVs. However the proposals surrounding the senior insurance managers regime and the directors duties may be unnecessarily cumbersome for these single transaction vehicles, and applying Solvency II may simply be overkill.
Unlike in some of the leading offshore jurisdictions, the proposed transformer vehicles are not living up to their billing - whereas it is possible for a transformer vehicle to undertake a single ILS transaction, without needing to be a PCC, there is no proposal in the legislation as currently drafted which might enable that original transformer vehicle to be itself “transformed” into a PCC. This would certainly encourage early adoption of the proposals and enable successful initial vehicles to become PCCs and make multiple issuances of insurance linked securities.
In the past, the UK Government has flirted with the idea of cell companies for investment funds only - so permitting UK cell ISPVs may eventually pave the way for the UK to allow cell companies for a wider range of regulated entities such as funds and insurers, as a number of offshore jurisdictions already do. The Autumn Statement recognises market interest in use of UK protected cell companies for wider purposes, and indicates the Government will keep this under review, even though it will not extend protected cell companies beyond ISPVs at this stage.
The new HM Treasury consultation is open for responses until 18 January 2017, and indicates that it is intended to finalise and implement the regulations in spring 2017.
Simmons & Simmons will be submitting a response to the consultation in due course. Please contact Mark Sheiham (Tax), Pollyanna Deane or Michael Dodson (Capital Markets) if you have any comments or concerns on the consultation document proposals for UK ISPVs - we would be happy to include these in our response to the consultation.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.