Volcker Rule passes with no exemption for insurance-linked securities

Yesterday saw the issuance of the final ruling developed by five U.S. government agencies to implement the Volcker Rule, which is section 619 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Back in March 2012 we wrote that SIFMA, the Securities Industry and Financial Markets Association, had highlighted some concerns regarding how the current implementation of the Volcker Rule could potentially impact the issuance of insurance-linked securities and catastrophe bonds.

The Volcker Rule, as part of the Dodd Frank Act, seeks to prohibit certain proprietary trading activities of banking institutions (short-term proprietary trading of certain securities, derivatives, commodity futures and options on these instruments) for their own account and to limit their investments in, and other relationships with, hedge funds or private equity funds.

SIFMA’s concern was about part of the rule, formally known as Section 13 of the Bank Holding Company Act of 1956 (the Volcker Rule), which sought to change the way covered fund transactions and activities are regulated and SIFMA said that this could potentially impact ILS and cat bond issuers.

The key concern was that the Volcker Rule seeks to restrict the activities of covered funds and that insurance-linked securities issuers may fit within the wording of the definition for a covered fund. SIFMA said that if a prospective ILS or cat bond sponsor or issuer was characterized in this way, once the Volcker Rule was passed it could mean that they were prevented from either sponsoring or owning insurance-linked securities. SIFMA say that it did not believe this was intended by Congress when it passed the Volcker Rule.

So SIFMA, among others, had submitted comments on the proposed Volcker Rule and suggested explicitly excluding insurance-linked securities and asset-backed securities issuers from the covered fund definition in this case.

Now the five government agencies have passed the Volcker Rule, meaning it is destined to become law in its current form. A 900+ page document was published containing all of the feedback to comments made and details of the final rules and it looks like insurance-linked securities (ILS) have not received the exclusion that SIFMA, as well as others, had been seeking.

The final ruling document published yesterday contains the following statement regarding the covered funds issue:

The Agencies are not adopting specific exclusions for other securitization vehicles identified by commenters, including insurance-linked securities, collateralized loan obligations, and corporate debt re-packagings. The Agencies believe that providing such exclusions would not be consistent with the rule of construction in section 13(g)(2)of the BHC Act, which specifically refers to the “sale and securitization of loans.”

We expect that SIFMA will provide an update at some point on this, once it has had a chance to fully digest the lengthy document that the agencies published yesterday.

In a statement, SIFMA president Kenneth E. Bentsen, Jr., said;

“SIFMA remains concerned that an overly restrictive Volcker Rule will inflict serious harm on our nation’s economy and American savers. It is imperative that the final Volcker Rule does not unnecessarily restrict market making or a firm’s ability to hedge risks in the effort to clearly define prohibited proprietary trading activities.

“As the rule is contained in a 900 page document, SIFMA will review the final document in detail with our members and provide further comments. It is important to remember that SIFMA member firms have already taken steps to prepare for implementation of the Volcker Rule. Many firms have been working to meet the spirit and purpose of the Rule by curtailing activities that would be clearly prohibited proprietary trading. Additionally, firms have begun the process of reducing positions in entities that are clearly a private equity fund or hedge fund. “

So at the moment it appears that the concern that SIFMA and others had, that ILS or cat bond issuers may risk coming under the covered fund definition, will become reality.

However, the question is how much of a concern this really is. Specifically on the covered fund issue, banks involved in ILS or catastrophe bond issuance are not typically investing in the asset class. If there is any investment management going on at the banks it is typically in their asset management divisions, normally covered by different rules.

On the proprietary trading issue covered by the Volcker Rule, the ILS market is not one which sees banks involved in trading in the securities. In fact, trading is typically a straight purchase of the ILS notes at issuance, or a secondary trade from a seller to a buyer via an over-the-counter brokerage desk, not a case of a bank investing to profit for its own account.

So at first glance it appears that Volcker may not negatively impact the ILS market at all, however it is advisable to seek legal advice if there is any concern about participants in an ILS transaction coming under the Volcker Rule.

Artemis reached out to law firm Mayer Brown LLP, an active legal service provider in many ILS and cat bond issues, seeking some clarification on the potential impact, or otherwise, to the ILS market. J. Paul Forrester, a corporate finance and securities focused Partner at Mayer Brown spoke with Artemis regarding the Volcker Rule and said:

The recently final Volcker rule has two primary parts: one a prohibition on proprietary trading and the other a prohibition on ownership of and certain other relationships with, so-called covered funds.

Unfortunately, the rule defines “covered funds” to include entities that would be “investment companies” under the US Investment Company Act except for their reliance on the exceptions thereunder contained in section 3(c)(1) or 3(c)(7) thereof. Most ILS issuers rely on the 3(c)(7) exception and are covered funds as a result.

While the adopting agencies declined to provide the relief that had been requested for ILS, the potential consequences of the Volcker rule for the ILS market is probably not that significant on first impression.

Unless banks are investing in ILS or are engaged in other impermissible transactions with ILS issuers or are trading in ILS as a principal (or other non-market making activities), the rule is unlikely to have a materially adverse effect.

In addition, the rule generally will not apply to foreign banks in respect of their non-US activities.

So it does seem unlikely that the Volcker Rule will have a negative effect on the ILS or catastrophe bond market. However, the 900+ page document is extremely lengthy and contains many nuances which are sure to take time for legal experts to fully digest. It also depends on the activities of the banks who have an involvement in the ILS market, which is very difficult for anyone to fully comprehend without spending significant time unpicking them.

We will update you should an update be released by SIFMA with relevance to the ILS market.