Law of Insurance risk securitization by Tamar Frankel and Joseph LaPlume
A commentary by Vinod Kothari

Securitization of insurance risk and other types of risks (notably weather, credit risks, etc.) is increasing engaging the interest of both those who carry such risks as also those who are interested to buy such risks. The process of securitisation of risks into a tradeable commodity highlights the most significant trend of our times: supremacy of the markets. The process of securitisation converts a relation into a commodity: insurance contracts are relations: when securitised, they become a commodity that can be bought and sold in the marketplace.

There is a general agreement among various commentators that in time to come, we will see greater application of the securitisation process to convert and market risks. Last year, Peter Drucker wrote an article in The Economist, and he saw, in his own foresightful wisdom, the possibility of pooling and transfer of exchange rate risks by securitising them. Al Hageman, Citibank's global securitisation head, very recently wrote of his experience with securitisation over last 20 years and he say increasing trend towards much purer forms of risk transfer in securitisation. Thus, securitisation as it is emerging would have more elements of risk transfer than financing.

Risk securitisation is essentially a product of mid-1990s, while securitisation itself is about 30 years old. In most countries, the law of securitisation itself is far from clear: let alone the law of risk securitisation. In this scenario, the article titled Secuitizing Insurance Risks by Tamar Frankel and Joseph LaPlume published in the Annual Review of Banking Law 2000 is a very important resource. This commentary tries to capture the substance of the authors' views, but is interspersed with my own comments as well. Besides, references to specific US laws have been taken in more general context from the viewpoint of global applicability of the authors' views.

The authors have focused on the legal issues in insurance securitisation, but have taken the opportunity to build a general platform of introduction to the concept and motivations. Talking about the investors' motivation, the authors rightly point out that investors view insurance securitisation products as a tool of diversification, as the underlying risks behind such products, say a catastrophe event, would not be correlated with the risks inherent in other investments held by the investor. Besides, the higher yield offered by these instruments is also a definitive motivation.

Insurance securitisation has its own economic rationale: as a process of integration and differentiation of risks.

The authors contend that there are legal issues surrounding insurance securitisation at each step: primarily issues relating to the classification of the contract between the insurer and the SPV, and the bonds issued by the SPV. Arguably, the bonds issued by the SPV can be treated as either securities, or insurance contract, or futures contracts. Their regulatory treatment will depend on this classification. It is due to the lack of definitiveness in the law that has caused several insurance risk securitisation transactions to fly offshore to tax haven jurisdictions.

Will the SPV be regarded as insurance entity:

On the question of whether the SPV will be regarded as an "insurance entity", the authors refer to the US Supreme Court ruling in Union Labor Life Ins. Co. v. Pireno 458 US 129 in which the Court laid down 3 criteria to decide whether a particular practice is a business of insurance, viz., whether the practice has the effect of transferring or spreading a policyholder's risk; whether the practice is an integral part of the policy relationship between the insurer and the insured; and whether the practice is limited to entities within the insurance industry.

The authors contend that though US states have carved out their own definition of "insurance business", the above criteria should generally be followed to distinguish insurance business from non-insurance business. In my view, the above ruling of the US Supreme Court should also be internationally relevant, subject to local definitions of insurance business.

Bankruptcy of the ceding insurance company and impact of the SPV

The authors have discussed in detail the implications of the principal insurance company's bankruptcy. While in traditional asset-based securitizations, the key issue is to ensure that the assets transferred by the originator to the SPV are protected against the insolvency of the originator, that issue is not relevant in insurance securitisation. Reason: there is no transfer of assets as such by the originator to the SPV. All that the SPV receives from the originator is the reinsurance premium for the contract of reinsurance. The reinsurance premium is in the nature of a continuing payment, a kind of a future receivable, and there is no non-cancellable obligation on the part of the insurance company to pay this premium to the SPV. On the other hand, if the premium is not paid, the SPV can terminate the contract of reinsurance.

The other issue is the impact of the bankruptcy of the principal insurance company on the assets of the SPV created by the bonds issued by it. The authors do not think this is a serious issue at all, since the investments made out of the bond issue proceeds would be held as a security for the bondholders. The authors have not considered the issue of substantive consolidation of the SPV with the ceding insurance company: in that event, though the assets created out of the bondholders' money will remain charged to the specific interest of the bondhoders, but the claims may certainly be affected by the prior claims of preferential creditors of the insurance company.

The authors have generally argued that since the SPV will most likely be regarded as an insurance company, it would not be subject to the normal bankruptcy codes applicable to corporations in general. In most countries, bankruptcy laws dealing with general bankruptcy are not applicable to insurance and banking companies. However, the principles remain by and large the same.

Are investors insurers?

The most interesting question probed by the authors is whether the nature of the bonds issued by the SPV has elements of an insurance contract such that the investor can be regarded as an insurer? The answer to this question will lead to several implications: each investor may then be treated as an insurer and be subjected to insurance regulation. The agencies that market such bonds may be treated as insurance brokers. The SPVs may be regarded as an insured, rather than an insurance, since it buys an insurance cover from the investors, etc.

In answer to this critical question, the authors contend that "the bondholders do not underwrite the risks and do not undertake to pay policyholders directly. They do so through the SPV, and most likely through the insurance and reinsurance companies. In that respect the bonds are similar to financiers of the insurer or, better still, its partners. Presumably, investors have no control over the SPVs investment decisions and business practices. Therefore, even though the bonds are linked to the underwriting of insurance, their holders are not engaged in the insurance business".

The argument advanced by the authors seems to be quite sound. The investors have acquired a bond which carries a general obligation on the part of the SPV to repay the investors on fixed dates fixed sums of money. The obligation, however, is not unconditional: the investors agree to suffer a loss of interest, or loss of principal, or both, or deferment of one or the other or both, in the event of any loss suffered by the SPV. Such a conditional payment obligation cannot be regarded as a contract of indemnity or insurance. If the bonds were in the nature of pass-throughs, that is, fractional interest in the policies of insurance ceded to the SPV, there could possibly have been a case to treat the investors as insurers, but not if the investors are passive investors. The authors contend that the key issue is "control".

NAIC's model law excludes the issuance of bonds from the purview of an insurance contract, to avoid any such controversy.

Are cat bonds securities?

The issue as to whether the bonds issued by the SPV are securities under the securities law needs to be answered with reference to the definition of "security" under the relevant law. Talking about the US law, the authors contend that the definition sec. 2 (a) (1) of the Securities Act 1933 is wide enough to include such instruments; besides, the instruments seem to satisfy the tests laid down in W J Howey and Co 328 US 293.

According to the authors, the bonds are "securities with insurance features".

The authors have also elaborated at length the protected cell legislation and the NAIC model law for insurance securitization. We have, on our news page, covered reports about NAIC model law. We have also covered the concept of protected cell legislation.