Introduction

In the Chief Executive’s Policy Address in 2018 and the 2019-2020 Budget Speech by the Financial Secretary, the government announced that, as part of its initiative to promote the development of the insurance industry in Hong Kong, it would make legislative amendments to allow for the introduction of an insurance-linked securities (ILS) regime in Hong Kong. Asia is considered as the next frontier for ILS growth; Hong Kong has been behind Singapore in establishing an ILS regime (Singapore launched its regime in February 2018 and the first catastrophe bond (cat bond) was issued there in early 2019). That said, Hong Kong is poised to capitalise on its developed capital markets, sound and independent legal system and its proximity to Mainland China and become an ILS hub in Asia.

The draft legislation for the ILS regime in Hong Kong was formulated quickly. On 20 March 2020, the Insurance (Amendment) Bill 2020 (the Bill) was gazetted. The Bill provides for a bespoke, streamlined regulatory framework for the issuance of ILS in Hong Kong through a special purpose vehicle (SPV). It also provides insurers and reinsurers with a strategic initiative to transfer risk to the capital markets, as well as extend their capacity. 

‘ILS 101’

The insurance industry typically raises capital by charging premiums from its insureds, with the insured risks of individuals being pooled and redistributed across the insurer’s portfolio. Insurers also usually insure against their risks with another insurer through reinsurance to reduce the potential exposure. For an even broader spread of risk, insurers reinsure their risks in the capital markets, where the potential amount of capital they can raise is a lot higher, instead of being confined to the reinsurance market, where there are only a limited number of carriers. One means of doing this is if insurers issue ILS, with the transaction being essentially one of insurance securitisation.

The usual manner in which an insurer (or cedant) goes about issuing ILS can be summarised as follows: 

  • The cedant sponsors a bespoke entity – an SPV – that is designed to protect investors against the insolvency of the cedant. 
  • Through a reinsurance contract, the cedant will transfer its risks to the SPV, which can then can issue ILS, for example, cat bonds (being the most prevalent type of ILS) to investors in the capital markets to raise capital to finance the risk assumed under such an reinsurance contract. 
  • The proceeds from the sale of bonds will be placed into a collateral account to be used for no other purpose than payment of claims on the reinsurance contract in the event it is triggered. The SPV in effect operates as a fully collateralised reinsurer. 
  • The investors are compensated for the risks assumed under the cat bonds by receiving a coupon payment, which is funded by the reinsurance premiums the cedant pays and the proceeds of investing the bond’s principal. 
  • When the ILS reach maturity, the investors would receive the proceeds of the ILS minus any claims made by the insurer (if any). 

Historically, Asia (other than Japan) has not been considered as a developing market for ILS because of its low insurance penetration. Further, existing reinsurance coverage in the region has been able to meet the demands of insurers. However, the frequency and severity of natural catastrophes in Asia are on the rise. Strong economic growth (especially in Mainland China) and increased urbanisation have led to increases in the value of assets at risk. The impact of climate change further compounds the problem. As such, the natural catastrophe risks posed by typhoons and flooding (and Typhoon Mangkhut in 2018 is a stark reminder) in places like Hong Kong and the Greater Bay Area could bring about unprecedented payouts for insurers and reinsurers. As such, considerable business opportunities exist for ILS (in particular cat bonds) in Asia.

As the world navigates through the COVID-19 crisis, it is interesting to note that the World Bank’s Pandemic Emergency Financing Fund (PEF), a facility created by the World Bank to channel surge funding to developing countries facing the risk of a pandemic, was backed by cat bonds (CAR Series 111 and 112) issued in July 2017 as well as pandemic risk-linked swaps. The COVID-19 outbreak has triggered the bonds and as the World Bank reported on 27 April 2020 the bonds and swaps are expected to contribute about US$195 million to the PEF.

Proposed ILS Regime in Hong Kong

The Bill proposes to add a new class of insurance business, namely special purpose business (SPB), under the Insurance Ordinance (Cap. 41) (IO). Under the Hong Kong regime, an insurer authorised to carry on SPB only is referred to as a special purpose insurer (SPI), which will be a new type of authorised insurer under the IO and will carry out the function of an SPV as mentioned above. 

For an SPI to be authorised as a company carrying on SPB, the Bill also lists some requirements that must be met:

The liabilities of the SPI to the insurer must be fully funded;

(a)  The liabilities of the SPI to the insurer must be fully funded;
(b) The SPI must appoint an administrator as a controller to manage the business; the administrator must meet the fit and proper requirement under the IO; 
(c) The SPI must appoint at least two directors to ensure accountability and responsibility; 
(d)  The SPI can only carry on SPB; 
(e)  The SPI must comply with the relevant financial, solvency, and other requirements prescribed by the IA; and  
(f)  The SPI has to pay fees to the IA. 

  
As mentioned above, a fundamental feature of ILS business is that it is fully funded or fully collateralised. The fully collateralised aspect of ILS is a principal reason why it is attractive to cedants as the counterparty credit risk is minimal. Also, because the SPV or SPI issues the bond, the cedant’s credit rating does not affect it, nor is it considered as debt of the cedant. 

In drafting the Bill the Government must be lauded for the approach it has taken to implement a simplified regulatory regime under the IO. Applying existing stringent regulatory requirements under the IO to ILS business will not facilitate the development of ILS in Hong Kong and put it at a competitive disadvantage to jurisdictions like Bermuda and Singapore. Bermuda, in particular, is known as having a very efficient ILS regime enabling to be the leading ILS jurisdiction for many years.

Requirements on the Sale of ILS

The Legislative Council (LegCo) does not consider ILS to be suitable financial products for ordinary retail investors, rightly so, as they are risky products. Hence, their sale will be confined to qualified institutional investors (like dedicated ILS funds and hedge funds) by private placement. To better protect the public, funds targeted at the public (e.g. MPF funds, ORSO schemes) are also excluded from being regarded as qualified investors.

Having regard to the proposed legislative architecture of the Bill, the detailed requirements for the sale of ILS that the IA is empowered to make will be important. Specifically, the IA may make rules under the proposed section 129A of the IA to:

(a)  prescribe the types of investors to which ILS may be sold or offered to be sold (i.e. qualified investors); 
(b)  prohibit the sale of, or making of an offer to sell, ILS to any person other than a qualified investor; 
(c)  prohibit the sale of, or the making of any offer to sell, ILS to a qualified investor at an amount lower than a prescribed amount; and 
(d)  prescribed criminal offences for contravention of the rules in (b) and (c) above. 

 
With the convergence of the insurance and capital markets that ILS brings about, one of the issues going forward that needs to be resolved is regulation of ILS sales. As they will only be made available to qualified investors in the capital markets, it would appear that the Securities and Futures Commission will regulate these securities but we expect this is something to be decided. 

Opportunity Knocks

Since the issuance of the first cat bond in Singapore in early 2019, the city issued three more in the same year. The single-regulator regime in Singapore coupled with its fast-track regime, which allows for issuance within eight weeks of application, will likely attract more cat bond issuers. Hong Kong has some catching up to do but this Bill is the first step in positioning it as a hub for ILS business in Asia. It is well placed to do so given it has a sophisticated and well-developed capital market as well as a legal sector that is familiar with Rule 144A offerings under the US Securities Act. Its proximity to Mainland China and the growth in the reinsurance market there, coupled with the Greater Bay Area Initiative, means Hong Kong has significant opportunities in this space. 

LegCo was set to give the Bill its first reading on 25 March 2020, but it has been closed because of COVID-19. It is hoped this Bill will be passed at its next sitting to facilitate the development of Hong Kong’s ILS regime. 

For the gazetted bill, see here.


1 https://www.worldbank.org/en/topic/pandemics/brief/fact-sheet-pandemic-emergency-financing-facility