Insurance linked securities and the Bermuda fund structure

They may be used in addition or as an alternative to the purchase of reinsurance. More specifically, ILS structures represent alternative risk transfer instruments. They enable insurance risk to be sold in capital markets, raising funds that can be used by issuers to pay claims arising from catastrophes and other loss events. The most prominent type of ILS are catastrophe bonds which are fully collateralised debt instruments that pay off on the occurrence of defined catastrophic events. Although the ILS market is small relative to the overall (re)insurance market, it is significant when compared to the property and casualty sector of the traditional (re)insurance market.

Pension funds and retirement schemes have been leading the charge in pumping capital into ILS products in a bid to diversify their equity and stock market exposures into less volatile and non‐ correlating risks and higher yields (between 5‐7% on average), spurring demand in the ILS space. Pension funds have amassed huge capital work with a longer investment time horizon and have traditionally been active in alternative investments with increasing allocations to alternative assets. Sluggishness in exchange traded securities is increasingly driving them to seek greater returns in the face of their rapidly aging baby‐boomer beneficiaries.

The typical ILS investment fund structure centres around the following corporate limited liability vehicles, frequently in combination:

a mutual fund company authorised or exempted (Fund) under the Investment Funds Act 2006, as amended (IFA); and

an insurance company (usually a special purpose insurer (SPI)) registered under the Insurance Act 1978, as amended.

Closed‐ended funds are funds where investors hold non‐redeemable securities and funds that are (i) private (i.e. not promoting itself to the public) and (ii) have less than 20 investors. Closed‐ended funds are excluded from regulation under the IFA.

In a typical ILS transaction, the Fund would be an excluded fund, a Class A Exempt Fund or a Class B Exempt Fund. ILS structures commonly use a stand alone Fund (being an Excluded of Class A Exempt Fund) or a master/feeder structure with a combination of a Excluded master and a Class A Exempt or Class B Exempt feeder.

To qualify as a Class A Exempt Fund, a fund must:

only be open to qualified participants (which includes Institutional investors); have an investment manager who:

is licensed under the Investment Business Act 2003; or

is authorised or licensed by a foreign regulator recognised by the BMA (e.g. the Securities Exchange Commission in the United States); or

is carrying on business in or from Bermuda or a jurisdiction recognised by the BMA and who has gross assets under management in excess of $100 m or is a member of an investment management group that has consolidated gross assets under management of not less than $100 m;

have an officer, trustee, or representative that is resident in Bermuda and has access to the books and records of the fund;

appoint an auditor, investment manager, fund administrator, registrar and a custodian or prime broker who are fit and proper to perform the respective functions of their office; and

prepare financial statements in accordance with IFRS or GAAP.

To qualify as a Class B Exempt Fund, a fund must:

only be open to qualified participants (which includes institutional investors);

have an officer, trustee, or representative that is resident in Bermuda and has access to the books and records of the fund;

appoint an auditor, investment manager, fund administrator, registrar and a custodian or prime broker who are fit and proper to perform the respective functions of their office; and

prepare financial statements in accordance with IFRS or GAAP.

Excluded Funds, Class A Exempt Funds and Class B Exempt Funds must registered as non‐licensed persons under the Bermuda’s anti‐money laundering and anti‐terrorist financing laws and regulations.

Where an open‐ended investment fund company issuing participating shares to investors incorporated in Bermuda does not qualify as an Excluded or Exempted Fund, it is required to be authorised under the IFA as:

an institutional fund if the shares are essentially offered to ‘qualified participants’ (i.e. sophisticated high ‐ net worth investors) or if the fund required a minimum investment of $100,000 per participant and has an officer, trustee or representative present in Bermuda with access to its books and records;

an administered fund if its administrator is licensed under the Investment Funds Act 2006 and requires a minimum participation of $50,000 or is listed on a recognised stock exchange; or

a standard fund if it does not qualify as under (a) or (b) above, unless exempted by the Bermuda Monetary Authority (BMA).

Regulated funds typically require the appointment of auditors in connection with the filing of financial statements, a fund administrator and an independent custodian to safeguard the fund’s assets, unless exempted by the BMA.

ILS Funds typically invest in cat bonds, industry loss warranties (ILWs) and a variety of opportunistic reinsurance products ranging from mortality bonds, property and catastrophe reinsurance through the SPI. SPI insurance contracts must be fully‐funded and the parties to the transactions must be sophisticated. As a result, the SPIs enjoy an expedited application process, overall lighter regulation and only nominal capital requirements.

The SPI may be owned and operated in tandem with the Fund with the fund allocating capital to the SPI to fund specific ILS participations underwritten by the SPI. The SPI distributes earned premium and investment profits to the Fund.

In addition to the structuring above, the Fund and the SPI have the power and ability to legally segregate and profile investor classes, or strategies and transactions by registering the entities as segregated accounts companies (SAC) under the Segregated Accounts Companies Act 2000, as amended. This would enable an SAC Fund to issue multi‐class securities to investors linked to individual risk profiles and investment appetites, mandates and strategies. Registering the SPI as a SAC also has the advantage of isolating and ring‐fencing the legal and financial risks in respect of each cat bond or reinsurance programmewithin separate cell structures achieving limited or non‐recourse to the other assets of the SPI, ensuring the continuity and integrity of the overall structure against adverse results, claims or liabilities.

As the Bermuda insurance market continues to grow and the product offerings continue to expand, the ILS industry is likely to continue to expand. The BMA has reported an increased number of insurance and reinsurance company registrations on the island in the first two months of 2018, which was helped by an increase in the number of special purpose insurers being registered for ILS transactions and there is no sign of this trend slowing anytime soon.