ESF S COMMENTS ON CEIOPS CONSULTATION PAPER Nº 13 (CP-01/06)

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1 8th September 2006 Mr. Alberto Corinti Secretary General Committee of European Insurance and Occupational Pensions Supervisors (CEIOPS) Sebastian-Kneipp-Str Frankfurt am Main Mr. Paul Sharma Chair, Pillar I Working Group Financial Services Authority (FSA) 25 The North Colonade Canary Wharf E14 5HS London Dear Sirs: ESF S COMMENTS ON CEIOPS CONSULTATION PAPER Nº 13 (CP-01/06) The European Securitisation Forum ( ESF or Forum ), and in particular the members of its Solvency II Working Group, would like to thank you for the opportunity to submit our comments on CEIOPS Consultation Papers nº 13 (CP-01/06). Given that this Consultation Paper contemplates other forms of risk mitigation for capital relief purposes, such as reinsurance or derivatives (see par. 19), but not insurance securitisation, the ESF wishes to provide CEIOPS with some Lamfalussy Level 1 recommendations as to the guiding principles of how a future Solvency II Directive should be drafted from a securitisation issuance as well as investment standpoint. We note that CEIOPS has already asserted that There should be no inconsistency of treatment [ ] between traditional reinsurance and other risk mitigation techniques simply because of their legal form or accounting treatment (CEIOPS answer to the Commission s Second Wave of Advice October 2005), and the ESF is supportive of such principle, but our members would welcome specific rules for insurance securitisation in the future Solvency framework along the principles outlined in this letter. 1

2 Executive Summary We discuss in this comment letter the following main points: Permitting ceding insurers to obtain capital relief under the Solvency II Directive as a result of entering into securitisation transactions will (i) benefit regulators by encouraging ceding insurers to adopt the more sophisticated risk management mechanisms necessary to qualify for quantification of capital relief, (ii) permit ceding insurers to obtain the many benefits of securitisation as described in the Group of 30 paper in managing and transferring risk, as well as bringing in new risk counterparties to the insurance sector and a large and fresh source of new investment, (iii) encourage a broader distribution of insurance risks within the financial markets and thus reduce the impact of material loss events on any single party. Capital relief obtained as a result of a securitisation should depend on the legal effectiveness of the risk transfer, not the legal form of the transfer. Thus, risk transfers through reinsurance, securitisation, derivatives, contingent loans and other financial instruments should achieve the same capital relief to the extent they transfer the same risks. To attract significant levels of capital market investment to insurance securitisation, as well as to reduce transaction costs and complexity, the ESF supports the elimination or significant reduction in the regulation of certain types of SPVs established as insurance counterparties, to the extent that cash or other collateral is provided by the SPV in support of the risks transferred. The UK FSA s proposed Insurance Special Purpose Vehicles (ISPVs) regime is a welcome step in this direction which the ESF supports, as well as any similar changes proposed by continental European regulators. European Securitisation Forum The ESF is a 160-member association focused on regulatory policy, market standards and member/industry education regarding all types of cash and derivative securitisation, structured products and CDO transactions across Europe. The ESF is a forum affiliated with the Bond Market Association, which will soon be merged with the Securities Industries Association to form SIFMA the Securities and Financial Markets Association. The ESF s membership is comprised of a wide variety of companies that touch all aspects of securitisation insurers who are both issuers and ABS investors; commercial banks who are active issuers of cash securitisations, purchasers of credit 2

3 protection and ABS investors; investment banks that arrange the transactions; rating agencies; law firms; accounting firms; trustees; sellers; servicers; investors; financial guarantors; IT service providers and valuation firms; SPV management companies, and stock exchanges. The European securitisation market is large and growing, with over 320 billion of issuance in 2005 (the US market, excluding agency MBS, was $1.1 trillion 1 and European issuance in 2006 is running at an annualised rate of 350 billion). The insurance-linked component of this market is relatively small, although growing, having been approximately $5 billion of global issuance (public issuance and private placements) annually in recent years with total global issuance since inception of approximately $21 billion for non-life and $13 billion for life insurance-linked securities 2. The insurance-linked securities market could grow significantly and bring considerable benefits to the European insurance industry, if the existing obstacles highlighted in this paper can be removed in a prudent manner. ESF s Basel II Experience Relevant to Insurance Securitisation The ESF has extensive experience in working with European banking regulators. We have been and continue to be actively involved with the BIS Committee and the major European regulators in the development and implementation of the new Basel II Accord and Capital Requirements Directive. Our detailed comment process and engagement with the BIS touched on nearly every aspect of the structure and wording of the Basel II Accord with regard to risk mitigation. Our members provided a wide variety of detailed comments on both high-level policy issues, as well as quantitative analysis on the calibration of various capital weightings on a wide variety of rated and unrated risks. This ranged from technical analyses of the Supervisory Formula Approach, to the review and comment on the conditions for capital recognition for securitisations and other credit mitigation instruments (such as derivatives), to analyses of the required capital levels for both sold and retained exposures, to assisting in the development of a framework for the Internal Assessments Approach ( IAA ) for unrated exposures to asset backed commercial paper conduit programmes. The IAA in particular was adopted relatively late in the process due largely to the active dialogue between the affected banks, the securitisation industry and the BIS, and augmented the Basel II Accord with a critical additional tool for banks to determine capital for securitisation exposures on the basis of internal models. 1 Source: the Bond Market Association 2 Source: Swiss Re 3

4 In our discussions regarding Basel II, the ESF s focus was on developing regulatory policies and calibration that was fair, consistent and transparent regarding securitisation, risk transfer and risk mitigation techniques. The ability of a bank to have flexible tools and clear rules as to the transfer of risk is a fundamental tool in its ability to manage its overall liquidity position, credit risk concentration and volatility, and correlation risk. Through the implementation of the CRD now taking place, banks have an improved capability to collect data, monitor, manage and control various types of risks. Similar types of risk transfer and risk mitigation tools should be made available to the European insurance industry to complement the current use of reinsurance as the major risk mitigation tool. Background Issues for Insurance Securitisation The ESF has identified certain obstacles that currently prevent European insurers from more actively using securitisation and derivatives (both credit and interest rate derivatives) as risk mitigation tools. In particular, the securitisation industry is concerned about the current regulatory treatment of SPVs, which results in significant and unnecessary costs and time delay for those securitisation transactions resulting in different treatment in different Member States. Increased use of securitisation issuance by insurers would provide a number of benefits to the insurance industry, investors, consumers and regulators, as described below. We hope that our dialogue with CEIOPS regarding the securitisation aspects of Solvency II will be highly beneficial for both CEIOPS and securitisation industry participants. Please note that throughout this letter references to insurance include reinsurance unless stated otherwise. Rationale for and Benefits of Insurance Securitisation Securitisation as a financial management tool in Europe started in the 1980s, and has expanded and matured significantly in terms of asset classes, rating agency methodology, standardisation of documentation and investor knowledge. Originally, securitisation of assets was defined as the sale by an asset originator of assets to a special purpose vehicle ( SPV ), which then issued various tranches of securities with various investment grade and non-investment grade ratings. Typically the first loss tranche with the highest risk concentration was retained by the originator, although in recent years there is a significantly larger investor market for these tranches. There are a number of benefits arising from securitisation: (i) to the issuer, from issuing a securitisation as compared to funding those assets through deposits or through whole loan sales a) higher proceeds, b) lower 4

5 issuance costs, c) ability to select which tranches to keep rather than transfer from a risk management/capital standpoint, d) increased liquidity, e) a broader investor base f) better manage the volatility of its results and g) increased detailed knowledge by the originator of its business, since investors and rating agencies require detailed ongoing reporting of the performance of specific pools; (ii) (iii) (iv) (v) (vi) from an investor s standpoint, the benefits of buying an asset backed security as compared to investment in a comparable corporate or government bond of the same rating are a) higher spreads as compared to non-abs securities of comparable credit rating, b) the ability to obtain credit diversification of portfolio by asset class and structure, rather than simply corporate issuer name and c) the ability to lower correlation risk by accumulating portfolios of various levels of correlation. More importantly, the tranching process significantly increases investor appetite by creating a tranche with a specific risk/reward profile and rating otherwise an investor would simply not purchase the underlying pool credit risk at all. This is an important benefit of insurance-linked securitisation, since it will enable the insurance and reinsurance industry to tap new external capital and risk counterparties; from the insurance industry s perspective, it is likely to give rise to alternative sources of capital. The additional capital is likely to give greater insurance capacity within the industry as well as potentially lowering the overall cost of capital. In addition, the discipline the market will impose on pricing risks transferred to it will provide greater transparency and, over time, market validation of modelling assumptions and techniques; from the consumers perspective, additional sources of lower cost capital is likely to lower prices, with the additional sources providing greater security as well as adding capacity for risks not otherwise insured; from the regulators perspective, a more diverse capital base provides greater resistance to systemic shocks. In addition, the greater transparency will benefit the quality of information provided by insurers in regulatory reports; the above will lead to greater efficiency in the insurance markets, enhancing the competitive position of the EU insurance sector. The ratings methodology used by the major rating agencies for the above types of traditional securitisation transactions, as well as by banks in development of their internal ratings under Basel II, is typically based on models, historical experience, or a combination. For a given tranche, the ratings are determined based on the probability of default and loss given default for that specific asset pool and structure. This same type of 5

6 methodology, with industry-specific adjustments, is used for insurance-linked securitisation ratings as well. These same benefits will apply to an insurance company that securitises its liabilities. By slicing a pool of insurance risk into various tranches, an insurer can much better tailor specific profiles of risk that outside buyers and counterparties may want to take, with a relevant reduction in risk capital depending on the profile of that tranche. Use of models Insurers face many risks in their business, not just credit risks but also risks of duration mismatch, longevity, lapse and other actuarial risks. Because of the complexity of these risks, and because insurers do not hold assets against the maximum amount of every risk they underwrite, there are significant advantages to be obtained from insurers using robust internal risk management models in the management of their business. Certain insurers have already adopted risk management models, and certain models are very sophisticated indeed. We support the use of models based on economic capital to derive regulatory capital, as evidenced by the individual capital assessments being applied under the regime in the United Kingdom. Provided that regulators are satisfied as a threshold matter with the robustness and integrity of an insurer s models and other risk management systems, the ESF supports providing incentives to insurers in the form of capital relief under the Solvency II Directive to adopt increasingly sophisticated risk management models and systems. The ESF supports incentives in the Solvency II Directive distinguishing between insurers utilising standard risk management models and systems compared with insurers utilising advanced models and systems (howsoever defined). Following risk transfer transactions, advanced-model insurers could obtain greater capital relief than standardmodel insurers from the same risk transfer. Greater capital relief would be justified because the more sophisticated model would more accurately assess the amount of risk transferred (and thus retained), and such a distinction would motivate insurers to upgrade their models and systems to take advantage of the greater capital relief available. The Basel II Accord is set up in just this way for banks, and could provide some general guidelines useful in the Solvency II Directive s formulation. Key Characteristics of Insurance Securitisations Securitisation involves, essentially, the transfer of one or more liability-side risks to the capital markets and the tranching of such risk or risks. Most often securitisation involves the transfer of a diversified portfolio of risks, but in a significant number of transactions also involve the transfer of a single risk. The Basel II Accord, for example, recognises a 6

7 transaction as a securitisation solely as a result of the tranching of risks, whether one risk or more than one risk is involved. A typical insurance securitisation transaction will have two components, a risk transfer component and a liability component. An SPV will be established to stand in the middle of these two components. As a result of rating agency requirements, an SPV will typically enter into a single transaction and will not conduct a diversified operating business. On the risk transfer side, the SPV will enter into a contract with the party ceding the exposure (the Originator ). The contract (the Risk Transfer Contract ) can take many forms, two of the most typical being (a) a reinsurance contract and (b) a capital markets derivative contract or some similar capital markets document. In either case, the Risk Transfer Contract will transfer all or a specified portion of the risks and rewards of the exposure to the SPV. Although reinsurance contracts and capital markets derivative contracts can be drafted so that they transfer similar risks, they are not the same legally due to the different legal regimes (and available defences) that have arisen around each of them. Derivatives are contracts where a writer of (usually credit) protection will reimburse the buyer of protection up to a defined notional amount if a defined credit event occurs. If the credit event occurs, the writer of protection must pay the buyer. The same technology can be used in the insurance sector. For example it is sometimes used in arrangements involving the issuance of a catastrophe bond by a special purpose vehicle where the special purpose vehicle will, in exchange for receiving a premium, make a payment, for example, dependent on whether an event of a certain severity (such as an earthquake) has occurred within a given distance of a specified location, whether or not the recipient is exposed to or at risk of any loss from such event. In the life insurance sector, derivatives could be used in the context of hedging mortality or longevity risk against indices of such risks. While derivatives may introduce some basis risk, being the difference between the loss the buyer of protection actually suffers from the relevant event (e.g. the earthquake) and the payout under the derivative, the capital benefits of the risk transferred should be recognised. The main differences between a derivative and a reinsurance contract are (a) the requirement in connection with reinsurance, that the holder of the policy have an insurable interest in the risk covered by the contract, and (b) the defences available to a provider of reinsurance that are not available to the provider of protection via a credit derivative. With a reinsurance contract, the holder of the policy only receives payment if the defined event occurs and the holder incurs a loss. With a derivative, the writer of protection must pay if the relevant event occurs, irrespective of who the current holder of the contract is or whether the holder actually incurred any loss. 7

8 It should be noted that in some insurance securitisations not all risks are transferred. For example, the insurance company may retain the risk of administrative cost overruns in administering the policies whilst passing other risks onto the securitisation vehicle. Notwithstanding that some risk is retained, there should be recognition through a reduction in the regulatory capital requirement for the risk transferred reflecting the economic risk transferred. On the liability side, the SPV will typically sell credit-linked or insurance-linked notes or other limited-recourse asset-backed securities (the Bonds ) to investors. The Bonds can be sold to any investor. The cash received from investors via the issuance of the Bonds will, if the insurer is looking for funding as well as protection against particular risks, be transferred to the insurer (e.g. as prepayment of claims under a reinsurance contract). If the insurer does not require immediate funding, the proceeds of issuance would be invested in appropriate assets (the Collateral ), and the Originator would be provided with security over the Collateral by the SPV in respect of the SPV s obligations under the Risk Transfer Contract. There should not be restrictions on the assets in which the SPV can invest, though the credit and market risk of the assets should be taken into account by the Originator in determining the regulatory capital reduction for the Originator (as, broadly, is proposed by the FSA in the UK s regulation of insurance SPVs under its proposed implementation of the Reinsurance Directive). This list includes non-cash assets, which is important for those ceding insurers targeting to minimise overall transactions costs since short-term cash investments will create an additional cost equal to the difference between the short term reinvestment rate and the transaction coupon paid to investors. If a loss occurs, the Collateral will be liquidated and paid to the Originator in satisfaction of the SPV s obligations under the Risk Transfer Contract. The Originator s recourse against the SPV will be limited to, and thus effectively capped at, the amount of the Collateral. To date, many insurance-linked transactions have been structured with the SPV viewed as being a regulated reinsurer, since otherwise the local regulator would not have a framework for providing capital relief. This regulatory process is costly and timeconsuming. The ESF strongly recommends that a distinction be made between an SPV that writes a diversified pool of risks with unlimited liability, as compared to an SPV that provides reinsurance/derivative-style protection on a single policy/isda contract with a capped liability. The former should rightly be subject to standard regulation as a reinsurer, while the latter insurance securitisation SPV should be subject to no or very light regulation since it is not in the general insurance business. 8

9 Summary of Recommended Level I Principles Generally, the ESF recommends that the terms of Solvency II be drafted such that the insurance capital requirements established by the proposed Framework Directive and Level 2 implementing measures facilitate the securitisation of insurance risk on a basis that is consistent with other methods of risk transfer or risk mitigation that can be employed by insurers. We believe that such an approach is necessary to attract additional external sources of capital into European insurance markets at an efficient cost of capital and with reasonable transactions costs. The high-level principles described in this letter are intended to ensure that Solvency II meets this objective. From the viewpoint of the main participants in securitisation transactions, the principles should reflect the following three propositions. Capital requirements should enable a regulated insurance company to obtain capital relief for transfers of insurance risk by way of securitisation on terms that are consistent with other methods of transferring risk, including reinsurance, derivatives and contingent loans. The capital treatment should be determined on the basis of its economic substance and not its legal or structural form. It is not appropriate to regulate all SPVs that assume insurance risks, and capital relief should be permitted following a risk transfer transaction even if involving an unregulated SPV. The regulatory regime should facilitate efficient participation by external investors in insurance securitisation transactions without risk of investors themselves being brought within the scope of regulation. We assume that the Reinsurance Directive (and its SPV rules) will need to be changed as a result of the adoption of Solvency II. Per our comments above, we do not think it appropriate to regulate all SPVs that assume risks (including insurance risks). Securitisation vehicles for assets are not generally subject to regulation since by their charter and by-laws their activities restrict greatly the scope of activities in which they can engage. If CEIOPS and the Commission determine that it is easier for regulatory purposes to have securitisation transactions and derivatives valued on the same basis for regulatory capital relief purposes as reinsurance, and therefore require that a reinsurance contract be used in the form of transaction, then SPVs established for these specific purposes (referred to as single-policy transactions herein for the purpose of simplicity) should be exempt from regulation since in economic substance they are not reinsurance companies, but rather single-event credit risk mitigant counterparties. 9

10 Ceding Insurer Issues From the perspective of an insurance company wishing to transfer all or some of its insurance risk to another party, the following high-level principles should apply: Comparable levels of capital relief should be provided for comparable levels of risk transfer, irrespective of form of the transfer. The amount of capital relief should reflect generally the amount of risk transferred. Because different contractual forms can cover different types of risks and reflect different levels of legal certainty, the amount of risk transferred (and, as a result, the amount of capital relief permitted) should be calculated on a transactionspecific basis using agreed upon internal models. In determining the amount of risk transferred, the ability of the transferee to perform should be taken into account based on economic substance of the transaction Thus, risk transfers to highly creditworthy counterparties, or transfers fully backed by creditworthy collateral, should obtain greater capital relief than transactions with counterparties that are not as creditworthy and do not provide collateral. If these distinctions are not recognised, competitive distortion might result. Collateral should be recognised as a risk mitigant and should give rise to capital relief if provided. SPV Issues From the perspective of the SPV, the following issues should be reflected under Solvency II: To attract significant levels of capital market investment to insurance securitisation products as well as to reduce transaction costs, Solvency II should provide that risk transfer transactions involving unregulated or lightly regulated SPVs (such as with the UK FSA s ISPV approach, which will reduce information requirements and focus on self-certification) can result in capital relief for the insurer if certain conditions are met. In particular, where: 10

11 (a) the obligations of the SPV to the insurer in respect of the insurance risk transferred to it are senior to other creditors of the SPV and secured; (b) the principal repayable to creditors providing funding/financing facilities to the SPV are either subordinate to the obligations in (a) or are subject to limited recourse to the SPV s assets after payment of its obligations in (a); and (c) the SPV provides collateral to the insurer or an agent or trustee acting on its behalf that may be used by the insurer to offset losses suffered by it in respect of the risks it has transferred to the SPV, we see no reason for requiring the SPV itself to meet capital adequacy requirements that apply in the normal course to insurance companies. The effect of such structural arrangements would be more properly reflected in the capital benefit to the insurer than in the need to regulate, or the amount of capital of, the SPV. Investor issues Issues relevant to investors in insurance-linked securities issued by an SPV will vary according to whether they are themselves regulated insurers. The Framework Directive should make it clear that regulated insurers can invest in insurance-linked securities, but should ensure that such an investment is treated appropriately for regulatory capital purposes to eliminate double-counting. However, where such securities benefit from appropriate credit enhancements (e.g. monoline guarantees) the effect of these should be taken into account. For investors who are not otherwise involved in insurance, the Framework Directive should clarify that a person does not fall within the scope of insurance regulation merely because he invests in insurance-linked securities issued by an SPV. Solvency II should allow insurance companies to determine their own portfolio guidelines for all types of structured products (insurance-linked as well as noninsurance-linked) based on discussions with their relevant regulator and development of a prudent person set of principles that will provide greater investment flexibility for each insurer to manage its risk position, rather than being subject to any prescribed national regulations or detailed admissible asset rules. 11

12 Similarly insurance SPVs should have flexibility over the assets in which they invest (including non-cash investments, in order to minimise costs), with that flexibility, to the extent given in the relevant arrangements, being taken into account in the capital reduction available to the Originator from the related securitisation. Investment policies of both general and life insurers should be derived based on a mark to market approach. Comments on SPV references in the Reinsurance Directive The ESF has been asked to comment on certain sections of the Reinsurance Directive that relate to SPVs. Our comments are below: Recital 32 This recital is far too reaching, since it contemplates that every SPV established for the purpose of assuming insurance risks should be regulated (which is then not borne out by the way that the Reinsurance Directive operates). reinsurance is actually engaged in active multi-policy reinsurance business Article 2 In section (p) which defines special purpose vehicle, this definition should be used as the kind of SPV that should not be subject to regulation as a reinsurer, since it is a single-policy transaction. The definition is however not entirely clear for example what does fully funded mean. Article 34 Assets Covering Technical Provisions this definition is far too broad, since an SPV is not an operating company. Investments should be limited to those specified by the rating agencies (if the obligations of the SPV are rated), or otherwise to a high quality investment grade rating. Article 37 Required Solvency Margin this concept is not relevant for singlepolicy SPV transactions that are exempt from regulation. The minimum capital requirement for the SPV should be similar as those required by the rating agencies or investors as appropriate. Article 45 No comment, since finite reinsurance is not a securitisation concept. Article 46 Special Purpose Vehicles. This section will need to be amended so that single-policy transactions are not subject to regulation by any Member State. Article 57 This section will need to be amended to delete references to regulation for single-policy SPV transactions. 12

13 Article 58 This section only needs to state that if an insurer/reinsurer buys an insurance-linked security then it should get a capital deduction (in appropriate circumstances eg where it is using the asset to back technical provisions, but not where it is part of a unit-linked investment product it is offering) We have limited our comments in this letter to the high-level issues that we believe need to be addressed within the Solvency II project. We would of course be happy to discuss any areas in further detail with you and, where appropriate, prepare more detailed written observations that might assist in the formulation of the Framework Directive. * * * The ESF sincerely appreciates the opportunity to present these proposals on behalf of the European securitisation industry on CEIOPS Consultation Paper nº 13 (CP-01/06). We are keen to continue the fruitful dialog we have opened with CEIOPS on these matters and would be pleased to discuss our proposals in greater details if you deem it necessary. Please do not hesitate to contact Rick Watson (Managing Director, Head of the ESF) or Carlos Echave (Director, ESF) at should you have any questions. Yours sincerely, Mark Nicolaides Chair ESF Legal, Regulatory and Capital Committee (Latham & Watkins) Simeon Rudin Chair ESF Solvency II Working Group (Freshfields Bruckhaus Deringer) Rick Watson Managing Director and Head of the ESF 13