Bermuda SPI guidance update clarifies collateral rollover, release & clawback positions

An update to the Bermuda Monetary Authority’s (BMA) guidance notes on special purpose insurers (SPI’s), the most commonly used structure for transacting insurance-linked securities (ILS) and collateralised reinsurance, lays out the regulators position on key issues related to collateral rollover, release of collateral and also the subject of clawback.

The 2020 update to the BMA’s guidance on its Special Purpose Insurer (SPI) class vehicle revises the original set of documentation published back in 2009, when Bermuda first launched the SPI class of vehicle and its rapid rise in playing host to catastrophe bonds, other ILS and collateralised reinsurance deals began.

Use of the SPI itself has changed over the years and with the ILS market now a much larger segment of global re/insurance as a whole.

At first the SPI was seen as a vehicle for issues under catastrophe bond programs, but it has also been used for multiple collateralised reinsurance reasons, as sidecar vehicles and to support other ILS transactions as well.

The BMA has clarified its guidance so market participants are clear as to how the SPI structure should be used and what is allowable.

The full and updated guidance is available to download from the BMA website in PDF format here, but a few points worth summarising are below.

A main focus of the document and a key reason for updating the guidance notes for the first time since 2009 is to more clearly explain the BMA’s approach to the licensing and ongoing supervision of SPI’s, to ensure there is clarity in the way Bermuda’s Insurance Act of 2008 is implemented with respect to SPI’s.

Much of the clarity being provided in the update is related to collateral and what is expected in respect of key areas related to the collateral held by an SPI, around contract inception, completion and rollover.

A few areas of the guidance that hold particular importance and clarify specific features of the SPI include the following.

The guidance note confirms an up to 30 day grace period for the funding of collateral to support reinsurance contract needs. But it’s important to be aware that:

Where the grace period is relied upon, the (re)insurance contract must clearly define, using explicit contractual language, how the SPI will settle any claim occurring during the grace period. For example, including clear contractual provisions in a funding agreement, which is legally binding on its investors, stating that the funding agreement will be automatically drawn down or enforced by the SPI to settle any claim occurring during the grace period.

Limited recourse clauses must be in place, to specify the maximum reinsurance recoverable under the SPI, which will be limited to the collateral amount or aggregate limit.

Where multiple reinsurance agreements are entered into within an SPI, structuring must be done with full collateralisation of each kept in mind and the SPI must always meet this for every contract.

On collateral rollover or rollforwards, typically at the end of contract terms and at renewal, the guidance states:

Where all or part of the collateral supporting a (re)insurance contract is used to support a subsequent collateralized (re)insurance contract, for example in the case of renewing a (re)insurance contract, the contractual documentation must clearly state to what extent the collateral supports each (re)insurance contract and the corresponding effect on the aggregate limit of each of the (re)insurance contracts.

The Authority expects the aggregate limit(s) of the contract(s) from which the collateral is transferred to be simultaneously and commensurately reduced with the associated release of collateral.

Similarly, the aggregate limit of the contract to which the collateral is transferred shall not contractually come in-force until after the associated collateral is fully paid-in to the collateral account.

The guidance also clarifies the clawback issue, stating that:

On full release of collateral by the cedant, the cedant shall discharge the SPI of all past, present and future liabilities arising from the (re)insurance contract.

This is an important one, as there have been some cases where cedents have allowed collateral to return to investors, then found their ultimate losses have risen and so tried to claw it back again.

The BMA further explains:

The collateral release arrangement should be governed by clear contractual provisions, for example, a commutation clause in the (re)insurance contract.

On clawback the BMA also clarifies:

Given the requirement that an SPI must fully collateralize all of its obligations under a (re)insurance contract and that the liability of an SPI under a (re)insurance contract must ultimately be limited to the assets provided as collateral supporting the (re)insurance contract, an SPI may not as part of a (re)insurance contract (or contract ancillary thereto) include an obligation to return collateral released by the cedant as that would potentially leave the SPI with an unfunded liability.

The BMA also clarifies that while topping up of collateral assets is allowable, to manage the risk of a loss of value to the collateral assets, this cannot be utilised as a way to secure clawback.

These clawback related issues are particularly important for both fund managers or investors and cedents to understand, given this can be a key point of disagreement especially when reinsurance arrangements are subject to influences such as adverse loss development and creep.

These guidance notes have been out in the market for some time, with feedback elicited from anyone wanting to comment on them.

They’ve also been developed around the same time as Bermuda’s new collateralised insurer class vehicle, which is designed for more flexible use as a collateralised reinsurer than the SPI.

You can download the updated SPI guidance document here.