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6 December 2021
 

The regulatory framework for the issuance of insurance-linked securities in Hong Kong is now in place with the amendments to the Insurance Ordinance having commenced operation on 29 March 2021.

The amendments to the Insurance Ordinance (Cap. 41, Laws of Hong Kong)1 facilitate the development by insurers of an insurance-linked securities (“ILS”) business in Hong Kong by providing for a streamlined regulatory framework for the authorisation of ‘special purpose insurers’ to carry on ‘special purpose business’. On the same date that the legislative amendments took effect, the subsidiary legislation governing the sale of ILS (the Insurance (Special Purpose Business) Rules (Cap. 41P, Laws of Hong Kong)) also came into operation. 

The legislative amendments are part of the Hong Kong government’s initiative to promote Hong Kong as a preferred domicile for the issuance of ILS and to strengthen Hong Kong’s position as a global risk management centre and regional insurance hub. 

What are ILS? 

ILS are securities which securitise insurance risks and transfer such risks to investors in the capital markets, with catastrophe – or “cat” – bonds being the most significant form of ILS issued to date. Cat bonds package up the risk of having to pay out on insurance policies which cover, typically, large-scale natural disasters such as extreme weather conditions. They can also relate to the risk of other, non-natural catastrophes happening – for example, FIFA issued catastrophe bonds worth US$260 million to provide protection against the possibility of the 2002 FIFA World Cup being cancelled. Once packaged up as securities, those risks are then transferred to capital market investors, instead of the risks being ceded in a more conventional way to reinsurance companies. 

Focussing on the simple structure which is used in a typical cat bond issuance, three key players are usually involved: 

1. The insurance company (the ‘sponsor’) which is sponsoring the deal and is ceding risk. 

2. A special purpose vehicle (established by the sponsor) which issues ILS. As with most securitisations, an SPV is used to issue the ILS so that it is immune to any potential financial distress of the sponsor, i.e. it is bankruptcy remote. Under the Hong Kong regime, this role would be performed by the ‘special purpose insurer’.
 

3. Capital markets investors, who are ultimately taking on that risk. 

 The sponsor and the SPV would enter into a risk transfer contract under which the sponsor pays a reinsurance premium to the SPV in order to reinsure its risk. The risk transfer contract is a contract similar in nature to a standard reinsurance contract, providing for terms such as the premiums to be paid, the duration of the deal, the risks that are to be ceded, the circumstances in which claims can be made and so on. The risk transfer contract does not have to be a reinsurance contract and can also be structured as a derivative.
 

 Capital markets investors would subscribe for their investment in the form of ILS issued by the SPV. Subscription proceeds paid to the SPV are usually invested in high quality securities and are held in a collateral trust.
 
 Once established, the returns generated by the collateral investments plus the premium paid to the SPV by the sponsor together make up the coupon payment made under the ILS to the capital markets investors.
 

 If no predefined event occurs during the lifetime of the ILS, then the investors receive the principal payment in full at maturity. If, however, a covered event happens, then the SPV pays out to the sponsor in accordance with the terms of the risk transfer contract and uses the amounts available from the collateral account to do so. The balance is paid to investors, meaning that investors lose all or part of their principal under these circumstances.
 
Benefits of ILS
 

 From the sponsor’s point of view, ILS are attractive because the capital markets have a much larger risk-bearing capacity than the reinsurance industry to absorb the often substantial losses caused by catastrophic events. ILS also typically provide multi-year protection at a fixed price, whereas reinsurance policies are generally renewed every year. Interest rate and credit risks are also minimised because the collateral for an ILS deal is typically highly-rated short-term notes.
 
 From the investors’ point of view, ILS have historically offered better investment returns than many traditional assets and they also hold a key advantage of having low correlations with traditional assets – for example, there is unlikely to be much of a link between a catastrophic tsunami and the performance of the equity markets.
 
 The ILS regime in Hong Kong
 
 Special purpose business 
 
Given the differences between the nature of ILS business and conventional insurance and reinsurance businesses, a new class of insurance business – special purpose business (SPB) – has been added under the legislative amendments to the Insurance Ordinance. SPB means the insurance business of effecting and carrying out contracts of insurance that are fully funded through insurance securitisation; i.e. the business of entering into risk transfer contracts by the SPV with the sponsor as described above with such contracts being fully funded through the issuance of ILS. To be “fully funded” for the purpose of the Insurance Ordinance, the value of the assets held under the terms of the insurance contract for the benefit of the insured (i.e. the cedant sponsor) must not be less than the amount of the insurer’s (i.e. the SPV’s) liabilities under the contract at any time under all reasonably foreseeable circumstances, taking into account the obligations of the insurer toward the insured under the contract and the expenses the insurer expects to incur. The “fully funded” feature makes ILS attractive for cedant sponsors as it minimises their counterparty credit risk.
An SPV in an ILS issuance which carries on SPB in or from Hong Kong has to be authorised as a special purpose insurer (SPI) under the Insurance Ordinance. The SPV can be a Hong Kong-incorporated company or an overseasincorporated company registered under Part 16 of the Companies Ordinance. For it to be so authorised, it must carry on SPB only and not any other class of insurance business. Given the difference between the business of a SPI and that of a traditional insurer carrying on long term business or general business, the regulatory regime does not impose the same capital or solvency requirements on SPIs as are applied to other insurers. Instead, SPIs are required to be “fully funded”.
 
 Authorisation requirements 
 
The IA has issued its Guideline on the Application for Authorisation to Carry on Special Purpose Business (GL 33), which sets out the supervisory principles and requirements adopted by the IA in authorising SPIs under the Insurance Ordinance.
 
 The IA has supplemented the legislative provisions with the requirements it expects to see for the SPI and the risk transfer contract.
 
  The IA expects the risk transfer contract between the SPI and the cedant sponsor to include a contractual limited recourse clause such that the maximum amount recoverable by the cedant sponsor is limited to the lower of
 
 the aggregate limit under the risk transfer contract; and
 
 the available assets held under the terms of the risk transfer contract by, or behalf of, the SPI for the benefit of the cedant sponsor. 
 
 An SPI has to be “bankruptcy remote” in that it must not be a company within the same group of companies as the cedant sponsor. ILS investors must have no recourse to the assets of the cedant sponsor. The IA expects to see written legal advice to confirm the bankruptcy remoteness of the SPI.  Under the terms of the ILS, the rights of noteholders must be fully subordinated to the claims of the cedant sponsor under the risk transfer contract.  The SPI’s investment guidelines with respect to the collateral assets must be disclosed.
 
 Multi-issuance SPVs? 

Interestingly, the IA has opened up the possibility for an SPI to be re-used for more than one ILS transaction. This must be declared in the initial application to the IA for authorisation. If so, the SPI must obtain confirmation from the IA that it has no objection before it enters into any risk transfer contract to be backed by a new ILS issuance. The IA expects the SPI to provide updated information and documents relating to the proposed new ILS transaction to ensure that requirements including the “fully-funded” condition will be complied with.
 

Sale of ILS in Hong Kong 
 
Given the potential for the loss of principal in an ILS investment if the predefined trigger events occur, ILS are generally viewed as being unsuitable for retail investors. The Insurance Ordinance empowers the IA to make rules restricting the sale of ILS to certain types of investors and subject to prescribed amounts. Under the Insurance (Special Purpose Business) Rules made by the IA, the sale of ILS is restricted to “eligible ILS investors”, these being certain qualified institutional investors such as banks, insurers and hedge funds. To protect the retail public, funds targeting the public (e.g. SFC-authorised retail funds, Hong Kong mandatory provident funds (MPFs) and occupational retirement (ORSO) schemes) are prohibited from investing in ILS. The investment size for ILS must be no less than US$250,000 (or equivalent in other currencies). These restrictions must be disclosed in the contractual and offering documentation for the ILS.
 
Intermediaries distributing ILS and related products (these include structured notes or derivatives whose returns are linked to the performance of ILS, and collective investment schemes whose investment objective or principal investment strategy is investing in ILS) are subject to the supervision of the Securities and Futures Commission and the Hong Kong Monetary Authority, who have jointly issued a circular in October 2021 reminding intermediaries of their obligations to observe the requirements governing selling practices such as requirements on suitability and those relating to complex products under the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.
 
 Looking ahead at the opportunities in the Guangdong-Hong Kong-Macau Greater Bay Area (GBA) 
 
In November 2019, the State Council of the People’s Republic of China announced at the meeting of the Leading Group for the Development of the GBA that the Chinese government would support the issuance by mainland insurers of catastrophe bonds in Hong Kong and Macau by relaxing the requirements for establishing special purpose insurers. This was one of the 16 policy initiatives announced at that time. The Chinese government has for years encouraged mainland insurance companies to diversify and manage their risks by issuing cat bonds in Hong Kong, as a way to access the capital markets for risk transfer and reinsurance purposes. In September 2021, the China Banking and Insurance Regulatory Commission (CBIRC) issued a notice signifying its support for mainland insurers to issue cat bonds in Hong Kong under Hong Kong’s new regulatory regime for ILS, at the same time clarifying some of the CBIRC’s regulatory expectations on SPIs and the sponsors. 
 
The new regulatory framework for SPIs is part of the Hong Kong government’s response to the Chinese government’s efforts to promote Hong Kong as the hub for mainland insurers to issue cat bonds. To encourage market development, a two-year Pilot ILS Grant Scheme was announced by the Financial Secretary in February 2021 to attract insurance companies and other organisations to issue ILS in Hong Kong. Details of this scheme were finalised by the IA in May 2021. Onshore and offshore ILS issuers and sponsors (including supranational and multinational organisations) are eligible to apply for the grant, which covers the upfront costs of an eligible ILS issuance. An eligible ILS issuance is one which takes place in Hong Kong, has an issue size of at least HK$250 million (or equivalent in foreign currency), with at least 20% of upfront issuance costs going to service providers based locally in Hong Kong. Priority will be given to first-time issuers and sponsors as well as issuances lodged with and cleared by the Central Moneymarkets Unit operated by the Hong Kong Monetary Authority. For an eligible ILS issuance with a maturity of three or more years, the amount which can be granted is the lesser of (i) HK$12 million or (ii) 100% of  total upfront costs incurred. For an eligible ILS issuance with a maturity of up to three years, the grant is the lesser of (i) HK$6 million or (ii) 50% of total upfront costs incurred.
 
The ILS market supplements the traditional reinsurance industry with a much larger risk-bearing capacity from the capital markets. Given the rising trend of climate-related catastrophes, potential business opportunities are expected to arise in Asia especially with mainland insurance companies. It is hoped that Hong Kong’s developed capital markets, depth of specialist experience and mature regulatory environment, coupled with the sizeable insurance/reinsurance industry in the mainland, will once again demonstrate Hong Kong’s pivotal role in connecting global capital with the mainland market. 
 

 

For further information, please contact:

 

Chin-Chong Liew, Partner, Linklaters

chin-chong.liew@linklaters.com

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