The Hong Kong Insurance Authority (IA) has recently published the "Guideline on Application for Authorization to Carry on Special Purpose Business" (the Guideline) which came into force on 30 June 2021. The Guideline represents the culmination of the IA’s quest to implement an insurance-linked securities (ILS) regime in Hong Kong since the Government’s announcement of this initiative in the Chief Executive’s Policy Address in 2018. The Guideline expands on the key provisions in the Insurance Ordinance (Cap. 41) (IO) in relation to the regulation of special purpose insurers (SPI) and sets out requirements to be complied by an applicant seeking authorization to carry on special purpose business (SPB) in or from Hong Kong and the authorization process.
Following the announcement of the Pilot Insurance-linked Securities Grant Scheme (Grant Scheme) in May this year (please refer to our previous Legal Update regarding the Grant Scheme), the Guideline is the finishing touch to the Government’s efforts to promote and develop the insurance industry in Hong Kong since 2018. In the current publication, the IA elaborates on relevant regulations and principles governing the application for authorization to carry on SPB. The requirements are summarized as follows:
1. Requirements for Authorization of SPI
Application to the IA in writing is necessary prior to becoming an authorized SPI under one (but not any other) class of insurance business listed in Schedule 1 to the IO.
The Guideline breaks down the requirements into further conditions when considering an SPI application, respectively:
- Administrator and director requirements: The applicant must appoint at least two directors and one administrator as controller who are fit and proper to hold such positions. This is judged against the criteria listed in sections 3, 4 and 5 of the IO. All relevant factors will be considered including but not limited to competency, integrity and financial status.
- Financial and solvency requirements: As provided in section 2(8) of the IO, the SPI must be fully funded. In evaluating whether this criteria is met, the IA will consider all relevant factors and evaluate the financial position of the SPI holistically, including:
- Aggregate maximum liabilities of the SPI under the reinsurance or risk transfer contract;
- Expenses that the SPI expects to incur;
- Contractual arrangements or structures that the SPI has put in place for its aggregate maximum liabilities including the type and amount of assets being held for the cedant(s);
- The proposed offering size of ILS and net proceeds receivable;
- Arrangements for holding assets that back the SPI’s liabilities and the respective legal ownership;
- Payment obligations to investors in respect of the ILS;
- Financial projections and investment strategies including the types of invested assets, future premium or other payments to be received, the composition of assets to its cadent(s) and investor(s); and
- Other matters which the IA considers relevant.
The SPI must be “bankruptcy remote”. Thus, the reinsurance or risk transfer contract must contain a clear, unequivocal limited recourse clause to ensure the maximum amount recoverable from the SPI under the reinsurance or risk transfer contract is limited to the lower of either the aggregate limit or available assets held under the contract terms for the benefits of the cedant(s). Further, the SPI must not be a company within the same group of companies to which the cedant belongs to, and the IA expects that the applicant obtain a legal opinion confirming the bankruptcy remoteness of the SPI in this respect.
An auditor must also be appointed within one month from the date of authorization. The authorized SPI shall serve a written notice to IA informing the appointment, including the appointment date, name and qualifications of the person.
- Sophistication of investors: ILS issued by an SPI can only be offered, sold and purchased by permitted institutional investors. The relevant rules under Insurance (Special Purpose Business) Rules (Cap. 41P) (SPB Rules) must be strictly complied with.
- Other criteria: Miscellaneous requirements are set out as follows:
- An administrator or at least one director being resident in Hong Kong;
- Knowledge and experience requirements showing the administrator’s capability in managing and overseeing the SPI’s activities effectively;
- Continued maintenance of proper accounting and other records of any office (or offices of its accountant) in Hong Kong prior to and after authorization; and
- Sound and effective corporate governance and risk management frameworks in place upon authorization which facilitate efficient operations and address the organizational structure of the SPI, including segregation of duties and management of conflicts of interest.
2. Requirements for Authorization to Carry on SPB
Prospective SPI applicants are encouraged to approach the IA with all relevant documents to discuss their proposals prior to completing the application form which is obtainable via firstname.lastname@example.org.
3. Information and Documents
The IA intends to understand the nature of risks to be securitized, the proposed structure of ILS and targeted investors and administrators. Each applicant should submit an application form and provide all relevant documents and information, including:
- Particulars of the applicant;
- Form A/Form B of Schedule 2 to the IO and directors of the SPI;
- Written and binding undertaking from the SPI and/or written representation from the placement agent(s)/arranger(s) of such proposed ILS transaction, committing to comply with the SPB Rules;
- Types of perils to be covered and respective triggering events;
- Investment strategies and types of potential investments;
- Financial projections of the SPI for a period of three years or up to the maturity date of the ILS, whichever is longer;
- Copies of the financial statements of the cedant(s), where appropriate;
- Draft term sheet and draft offering document(s) for the ILS;
- Draft indenture;
- Draft reinsurance/risk transfer contract to be entered into by the SPI and cedant(s), and in which the aggregate maximum amount of liabilities shall be specified;
- Draft contractual documentation for the ILS showing the fulfilment of all requirements; and
- A detailed written explanation of how, upon authorization, the applicant will satisfy the “fully-funded” requirement.
4. Reuse of SPI and Roll Forward of Reinsurance or Risk Transfer Contract
When making the application, the applicant or its cedant(s) shall make a declaration as to whether the SPI would be reused for other ILS transactions in the future. Confirmation of no objection from the IA must be obtained before the SPI enters into any reinsurance or risk transfer contract which is to be backed by the new ILS issuance. Disclosure of asset allocation to different contracts is also required if all or part of the assets used to fully fund the original liabilities are rolled forward.
5. Restrictions of the Sale of ILS
The SPI shall fully disclose certain restrictions in its contractual and offering documents for any issued ILS, namely that the SPI and other parties involved in an ILS transaction must not contravene the SPB Rules, specifically those that govern the offering or selling of ILS in both primary and secondary markets.
Such restrictions include rule 3 of the SPB Rules which limits the scope of persons to whom ILS may be offered and sold to, as well as the range of eligible ILS investors (rule 3(4)). Under rule 3, prohibitions against offering or selling ILS or any financial products backed by ILS (i.e., repackaged products) or which derive their value from ILS as underlying assets (i.e., derivatives) to certain classes of persons also apply. Other rules include imposing a minimum investment size for ILS transactions.
It is compulsory for an SPI to implement adequate procedures and for involved intermediaries to observe the SPB Rules to ensure that the above-mentioned restrictions have been complied with. Any contravention of the SPB Rules constitutes a criminal offence.
6. Filing Requirements
Upon authorization, the SPI shall comply with filing requirements under the IO. The submission of accounts, statements and other information required by Schedule 3 to the IO shall be submitted to the IA accordingly. SPIs are also subject to simplified reporting requirements, the details of which will be communicated and formalized at the time of authorization, subject to further modifications and variations as the IA considers appropriate.
The IA must be lauded for its efforts in setting up an ILS regime in such a short period since the Government’s announcement in 2018. Although the ILS market in Asia is in its early stages as cedants still have access to reinsurance, this region is considered as the next frontier for ILS growth especially with increased urbanisation in Mainland China (read: the Greater Bay Area) and the natural catastrophe risks of typhoon and flooding (not to mention exacerbation of such events brought about by climate change). Encouragingly, there is support for the ILS regime in Hong Kong from Mainland China and there are Mainland sponsors interested in issuing catastrophe bonds out of Hong Kong so it is expected there will be some ILS deals in Hong Kong this year.
Timing is a crucial factor when it comes to ILS deals as it is after all an alternative to reinsurance. In this regard, we are encouraged that the Guideline is not complex and sets out with clarity the application requirements and procedural arrangements for interested SPI applicants. With the level of commitment demonstrated by the IA thus far, we expect that they will hit the ground running and endeavour to make the approval process efficient in order to be competitive with the existing regimes in Bermuda and Singapore. The Guideline may be accessed here.