The Insurance Bill 2020: Update on Hong Kong’s new Insurance-Linked Securities (ILS) regime

The Insurance (Amendment) Bill 2020 (IO Bill) passed on 17 July 2020 provides for a new regime under the Insurance Ordinance (Cap. 41) enabling the issuance of insurance-linked securities (ILS) by special purpose insurers (SPI).¹ Subsequently on 4 September 2020, the Insurance Authority (IA) published a consultation paper on the draft Insurance (Special Purpose Business) Rules (Consultation Paper), which has proposed some draft rules for the ILS scheme, such as the scope of eligible investors, the minimum investment size and relevant offences and penalties (Draft Rules).²

The IO Bill and the Draft Rules are part of the initial tranche of authoritative documents published in Hong Kong or the PRC in recent months which promote the development of ILS, particularly within the GBA. Beginning with the latest statutory developments in both Hong Kong and the PRC, this article will address recently launched policy initiatives, business opportunities that we have identified in relation to ILS, the interaction of the new scheme with the Securities and Futures Ordinance (Cap. 571) (SFO) and other elements we find crucial for forming a commercially viable and attractive ILS regime.

Typical ILS arrangements

An ILS arrangement typically involves an insurer/ reinsurer (a Cedant) setting up a special purpose vehicle (known as an SPI under the IO Bill), which acquires insurance risk from the Cedant. The SPI then issues financial instruments (e.g. catastrophe bonds) to investors, through which it can raise capital for fully covering the risks that it has accepted from the Cedant. The simplified structure chart below summarises such typical ILS structure:

Opportunities in the Guangdong-Hong Kong-Macau Greater Bay Area (GBA)

There had been clear interest in promoting reinsurance businesses from both the Hong Kong and PRC authorities even before the ILS initiative was formally introduced. As early as July 2018, the IA and the China Banking and Insurance Regulatory Commission (CBIRC) announced that they had reached a consensus that under the China Risk Oriented Solvency System, when a Mainland insurer cedes business to a qualified Hong Kong professional reinsurer, the capital requirement of the Mainland insurer will be reduced. The purpose of such preferential treatment is to facilitate the cooperation between the Mainland and Hong Kong in cross-border reinsurance business, enabling the Hong Kong reinsurance industry to assist Mainland insurers in diversifying and managing their risks more effectively.³ This has been complemented by local regulatory and commercial initiatives – for example, in October 2019 a leading PRC reinsurer signed a strategic cooperation agreement with the Zhuhai government aimed at encouraging the development of innovative reinsurance products across the GBA.⁴

The introduction of ILS and in particular catastrophe bonds in the Chinese market must be viewed against the country's history with catastrophic events. While in recent decades sizeable economic losses have resulted from significant natural disasters, only a very limited portion of such losses were insured or indemnified – Chinese government figures reported that insurance claims in China have historically accounted for less than 1 percent of direct economic losses in major large-scale disasters. For instance, direct economic losses from the 2008 snowstorm and ice storm disaster, the 2008 Wenchuan Earthquake, and the 2010 Yushu Earthquake were RMB 151.7 billion, RMB 845.1 billion and RMB 64 billion respectively; but the insurance recovery for these the three disasters were only RMB 5 billion, RMB 1.66 billion and RMB 0.08 billion, respectively.⁵ This means going forward there is a significant amount of loss that can be absorbed by the ILS sector.

It was first publicly indicated in early November 2019 at the meeting of the Leading Group for the Development of the GBA (the Leading Group Meeting) that ILS would be a key area of development for the GBA. Since then, different PRC authorities, at both state and local levels, have published various official papers echoing the same while also introducing other policies that will not only complement ILS transactions but promote cross-border insurance businesses.

Key policy initiatives relevant to ILS are summarised in the table below:

While the policies above seem to have been drafted primarily from the perspectives of PRC insurers and financial entities, their unified goal is to promote cross-border collaboration of insurance and reinsurance businesses across the entire GBA. This is reflected in the Draft Rules, which state that there will be business opportunities arising from the GBA development with support from the PRC government for Mainland insurers to issue catastrophe bonds in Hong Kong.¹¹

We expect further implementation rules and explanatory notes to be published by PRC authorities, the IA and probably also the Securities and Futures Commission (SFC), which will clarify the regulatory elements of the cross-border initiatives and policy advantages to be enjoyed by Hong Kong insurers and financial entities.

Interaction with the SFO

As ILS contain features typical of both insurance products and securities products, it would be prudent to expect that the SFO would apply to ILS, especially given the wide scope of financial products covered by the definition of 'securities' and 'structured products' under the SFO.

On the basis that ILS would be construed as securities, a principal dealing in them will generally have to be licensed or registered for Type 1 regulated activity of the SFO (dealing in securities), otherwise the principal commits an offence under the SFO. However, if the principal deals with professional investors only, it may be exempted from the said licensing requirement (Professional Investors Exemption).

As stated in the Draft Rules, the sale of ILS should be confined to qualified institutional investors by private placement, such that ordinary retail investors would be sufficiently protected. Accordingly, the eligible ILS investors proposed therein are all institutional investors already captured by the definition of 'professional investor' under the SFO. Hence, the Professional Investors Exemption will likely be directly applicable in relation to the SPIs and they would not have to obtain Type 1 licenses. That said, depending on how the business of each SPI is structured, it could also be engaging in Type 4 (advising on securities), Type 9 (asset management) and Type 11 (dealing in OTC derivatives products or advising on OTC derivatives products – currently not in force) regulated activities, for which the Professional Investors Exemption does not apply and the corresponding licenses would still be necessary.

Given ILS arrangements will be subject to vetting and authorisation by the IA, and ILS products are extremely insurance industry-specific, any additional licensing requirements under the SFO would arguably not be necessary and would be discouraging to potential market players, especially when in the same circumstances there are no equivalent requirements under the Singapore and Bermuda counterpart regimes. Take Singapore for example, the Monetary Authority of Singapore (MAS) made the country's ILS framework deliberately easy to manage, having avoided putting in place complicated hurdles such as multiple licensing obligations, so that it could encourage international businesses to go to Singapore for their ILS projects. It would be key to the success of the ILS regime in Hong Kong for the SFC to confirm that ILS will not be caught by the SFO or otherwise benefit from a specific exemption from the SFO licensing regime. Otherwise, the overall attraction and competitiveness of the proposed ILS scheme in Hong Kong would be substantially reduced.

Notwithstanding the above, the SPIs could generally be held liable for offences under the SFO and should in any event act in accordance with the SFC Code of Conduct.

Additionally, it is unclear from the IO Bill and Draft Rules how other usual participants in ILS arrangements would be regulated. These may include the manager/ administrator of the SPI, who is responsible for managing the SPI, and the placement agent, who is in charge of promoting and distributing the ILS products to the investors. The administrator should not need a SFO licence so long as its role is only administrative in nature (e.g. processing payments and handling ILS investors' subscriptions and redemptions). The position gets more complicated with the placement agent, whose distributing activity is likely an act of inducing others to invest in securities and/or structured products, which falls under the definition of 'dealing' under the SFO and therefore would potentially constitute a regulated activity.

Further, based on international examples of more mature ILS regimes, the SPIs would, apart from entering into a reinsurance/ risk transfer agreement with the Cedants, invest the issuance proceeds into other investment products (e.g. money market funds), which would generate part of the interest payment to the investors. It remains to be seen how the IA and the SFC may regulate such investment activities conducted by the SPIs.

Tax incentives for ILS

Apart from a competitive and sound regulatory regime, there should also be financial incentives for market participants to make the Hong Kong ILS market attractive to international businesses. As noted by the Financial Services Development Council¹², the government may consider referring to the experience of overseas competitors in introducing favourable policies to help promote the ILS market. For example, Singapore has a cost subsidy scheme for eligible ILS schemes which has just been extended until the end of 2022¹³, and tax exemption in respect of income generated from special purpose vehicles set up for issuing ILS which will lapse on 31 December 2023.¹⁴

While we note that there is currently a 50% concession in the profits tax rate for the reinsurance business of onshore and offshore risks underwritten by professional reinsurers authorised in Hong Kong¹⁵, and such benefit will soon be extended to cover general reinsurers¹⁶, we are not aware of the proposal of any similar concession/ incentive for the SPIs. However, given that the ILS regime is meant to be an alternative reinsurance arrangement (and SPIs are akin to professional reinsurers (which carry on reinsurance business only) as they also only carry on ILS business only), such concession should theoretically and ideally be extended to cover SPIs as well.

Conclusion

Despite stunted economic growth and unprecedented low interest rates in recent years, the ILS market has demonstrated resiliency and investor appetite for ILS has remained strong, with the amount of catastrophe bonds issued in the first quarter of 2020 exceeding two-thirds of the total volume issued in 2019.¹⁷ With over USD 4 billion of ILS having matured by the second quarter of 2020¹⁸, it is expected that issuance will continue to be robust, which would be reassuring news amid the continuing COVID-19 pandemic for not only the insurance industry but also fund managers and administrators that operate the ILS structures. With the issuance of catastrophe bonds being a key initiative of the PRC government and the opening up of the PRC insurance industry in favour of Hong Kong insurers and financial entities, we expect that the Hong Kong ILS regime will be much welcomed and hopefully soon be used by PRC as well as international/ Asian insurers and reinsurers.

About us

DLA Piper is one of the world's leading law firms in ILS and alternative risk transfer, having advised on all Singapore ILS issuances so far (together with our US team which is led by our industry expert David Luce). We are often called upon for the most complex and first-in-kind transactions, including the first flood, wildfire, and Singapore-domiciled catastrophe bonds. We offer in-depth, world-class corporate, securities law, tax, insurance regulatory, ERISA, and other expertise in these transactions.

¹ The Insurance (Amendment) Bill 2020 as passed
² The Consultation Paper on Draft Insurance (Special Purpose Business) Rules published by the IA
³ Press release by the IA issued on 17 July 2019
⁴ Page 32 of “粤港澳大湾区保险业调查报告” published by KPMG in June 2020
⁵ 'Learning from Experience – Insights from China's Progress in Disaster Risk Management' published by The World Bank and the Global Facility for Disaster Reduction and Recovery (GFDRR) in August 2020
⁶ The 16 policy measures introduced by the PRC government after the meeting of the Leading Group for the Development of the Guangdong-Hong Kong-Macao Greater Bay Area
⁷ See item 19 of the 'Opinions on financial support for the development of the GBA' (《关于金融支持粤港澳大湾区建设的意见》)
⁸ See item 25 of the 'Opinions on vigorously supporting social forces in participating in the construction of the GBA and pilot demonstration zones of socialism with Chinese characteristics' (《关于大力支持社会力量参与粤港澳大湾区和中国特色社会主义先行示范区建设的意见》)
⁹ Unofficial translations of the 'Agreement Concerning Amendment on Trade in Services of the Mainland and Hong Kong Closer Economic Partnership Arrangement' and the annex thereto known as 'The Mainland's Specific Commitments on Liberalisation of Trade in Services for Hong Kong'
¹⁰ Item 15 (paragraphs 32 to 39 thereunder) of the 'Implementation Plan for the opinions on financial support for the development of the GBA' (《关于贯彻落实金融支持粤港澳大湾区建设意见的实施方案》)
¹¹ Paragraph 6 at p. 5 of the Consultation Paper
¹² See Financial Services Development Council's Paper No. 42 'Enhancing Hong Kong's Status as Offshore RMB Business Hub through the Development of the RMB Asset Market'
¹³ Paragraph 14 of the relevant MAS publication
¹⁴ Section 43N of the Singapore Income Tax Act (Chapter 134)
¹⁵ Section 14B of the Inland Revenue Ordinance (Cap. 112) (IRO).
¹⁶ See amendments to section 14B of the IRO under the Inland Revenue (Amendment) (Profits Tax Concessions for Insurance-related Businesses) Bill 2019, which was passed by the Legislative Council on 15 July 2020 and will hopefully come into effect in early 2021.
¹⁷ 'Insurance-Linked Securities Q1 2020 Update' published by Aon Securities LLC and Aon Securities Limited
¹⁸ Ibid.