GL33 issued by the Insurance Authority and entitled Guideline on Application for Authorization to Carry on Special Purpose Business” (“Guideline on Special Purpose Insurer Authorization”) provides guidance for insurers looking to establish special purpose vehicles to issue insurance linked securities (“ILS”). In this article, we provide an overview of the requirements in this guideline. In earlier articles, we discussed the statutory framework governing the issuance of ILS and the Hong Kong government’s grant scheme to subsidize the issuance of ILS. If you would like more information about applying for authorization of a special purpose insurer to issue ILS, please contact one of our insurance lawyers.

The Guideline on Special Purpose Insurer Authorization provides guidance on how the Insurance Authority intends to exercise its discretion to authorize special purpose insurers and to assess compliance with statutory requirements under the Insurance Ordinance for special purpose insurers.

Financial Resources

Special purpose insurers are not expected to meet capital and solvency requirements applicable to other insurers. Instead, special purpose insurers are expected to be “fully funded”. This means that a special purpose insurer must hold assets the value of which are sufficient to meet all its liabilities to a cedant, whether actual or potential, under a reinsurance contract at any time and under all reasonably foreseeable circumstances.

In evaluating whether a special purpose insurer is fully funded, the Insurance Authority will have regard, amongst other things, to:

• the aggregate maximum liabilities to the cedant under the contract;

• the expenses the insurer expects to incur; and

• the contractual arrangements or structures that the special purpose insurer has put in place including the type and amount of assets being held, the proposed ILS offering size, the arrangements for holding the assets backing the special purpose insurer’s liabilities, the payment obligations to investors under the ILS and financial projections and investment strategies of the special purpose insurer.

Terms of Reinsurance Contract

The reinsurance contract should contain a clear and unequivocal limited resource clause which ensures that the maximum amount recoverable from the special purpose insurer under the reinsurance contract is limited to the lower of the aggregate limit under the reinsurance contract or the available assets held by or on behalf of the special purpose insurer for the benefit of the cedant.

Special Purpose Insurer Structure

The special purpose insurer should be bankruptcy remote and a legal opinion will be required to confirm this. As a result of this requirement, the special purpose insurer must not be a company within the same corporate group as the cedant. ILS investors should have no recourse against the assets of the cedant in the event the special purpose insurer defaults on its payment obligations under the ILS issued by the special purpose insurer.

Terms of Investment Linked Securities

The terms of any ILS issued must provide that the investors of the ILS are subordinate to the claims of the cedant under the reinsurance contract. A special purpose insurer must ensure that investors in its ILS are aware of the subordination.

Investment Guidelines

A special purpose insurer should provide full disclosure to both the ILS investors and the cedant as to the investment guidelines governing the composition of its assets, including types of assets and issuers and target credit ratings.

Directors and Administrator

Under the Insurance Ordinance, a special purpose insurer must appoint 2 or more directors, all of whom must be fit and proper, and an administrator as a controller who must be fit and proper. In determining fitness and properness, the Insurance Authority will have regard to qualifications, experience, ability to act competently, honestly and fairly, reliability and integrity as well as financial status.

In addition to the factors set out in the GL4 entitled “Guideline on Fit and Proper Criteria”, the Insurance Authority will expect:

• At least one director or the administrator will be resident in Hong Kong;

• The administrator will have sufficient knowledge and experience of special purpose business and the administration of ILS, whether in Hong Kong or elsewhere;

• The special purpose insurer will keep proper accounting records in Hong Kong;

• The special purpose insurer will have in place a sound and effective corporate governance and risk management framework proportionate to its risk profile. The framework should address segregation of duties and management of conflicts of interest.

Reuse of special purpose insurer

The Insurance Authority will permit a special purpose insurer to be used for multiple ILS issuances, each relating to a different reinsurance contract. However, the special purpose insurer must notify the Insurance Authority that it intends to be undertake multiple ILS issuances and must obtain confirmation from the Insurance Authority that there is no objection before each ILS issuance.

As yet, there is no Hong Kong specific vehicle which provides for statutory segregation of assets and liabilities of a special purpose insurer which undertakes multiple ILS issuances. There may be a possibility to explore whether or not an Open Ended Fund Company (“OFC”) may serve as an appropriate vehicle for such a special purpose insurer each ILS issuance could possibly be segregated to its own sub-fund within the OFC.