Are insurance linked securities issuers commodity pools under Dodd-Frank?

Once again the changing regulatory environment under Dodd-Frank brings some uncertainty to the insurance-linked securities (ILS) market. The latest stems from the Dodd-Frank Act’s expansion of the definition of a ‘commodity pool’ which can now be read to include any entity which operates to trade in swaps. At the same time the definition of a swap has been expanded by Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to better fit in with Dodd-Frank.

Thankfully, law firm Cadwalader, Wickersham & Taft LLP, has published a detailed memo on the topic explaining the new definitions, how they could impact ILS and what can be done to ensure minimal impact to issuers of catastrophe bonds and other ILS.

It’s a complex topic, as most issues under Dodd-Frank have tended to be. This particular issue, of whether an entity is classed a commodity pool or not, could mean additional responsibilities being placed on ILS and cat bond issuers. Specifically, if ILS and cat bond issuers were designated as commodity pools they would be required to have a CFTC registered Commodity Pool Operator (CPO) and Commodity Trading Advisor (CTA).

This has come about after the definition of a swap was expanded, say Cadwalader. Their memo says that new rules came into effect on the 12th October which broadened the definition of a swap to also include: “any agreement, contract or transaction that provides for any purchase, sale, payment or delivery….. that is dependent on the occurrence of an event or contingency associated with a potential financial, economic, or commercial consequence.” That sounds like a cat bond or ILS deal doesn’t it.

Cadwalader says that unless ILS and cat bonds are specifically not considered as swaps or are exempted, then they will likely come under this new broad definition of a swap. There is a safe harbour provision for insurance and reinsurance contracts, which Cadwalader detail in their memo, but it seems likely that many cat bonds and ILS deals would not satisfy the requirements to qualify as safe (to qualify the cedants must be under U.S. State or Federal supervision and many cedants in cat bonds and ILS are not). The offshore nature of a cat bond or ILS issuer as well may mean that they cannot qualify under this safe harbour provision.

Cadwalader notes that a joint release from the CFTC and SEC specifically called out weather derivatives and catastrophe swaps, as well as other types of reinsurance and retrocession transacted as a swap, security based swap or structured to evade Dodd-Frank, saying that they would be treated as swaps and would not satisfy the insurance safe harbour.

There are certain types of asset backed securities which have received exemption from being classified as a commodity pool, however the exemptions are not particularly clear and Cadwalader advise the ILS and cat bond market to seek clarity on the issue. They say that it may be advisable for the ILS and cat bond market to seek specific exemption for typical cat bond and ILS transactions, to ensure that the issuers are not classed as commodity pools. Cadwalader says that it may be the case that the CFTC are not sufficiently knowledgeable about the ILS and cat bond market and the industry may need to help them to understand why an exemption should be arranged. It may be that this only applies to transactions which have a cedant which is outside of U.S. jurisdictions.

Cadwalader close the memo by saying that if the ILS and cat bond market want to seek an exemption or at least some clarification they advise it is done as soon as possible as the CFTC will be receiving requests from many different parties about these and other rules.

We advise our readers to download and read the full memo here and to speak to their own legal teams to determine whether an approach to the CFTC should be made.

Here are a few of our older articles on Dodd-Frank issues related to the ILS and cat bond market.