The U.S. Commodity Futures Trading Commission has issued a letter providing no-action relief to insurance-linked securities (ILS) and catastrophe bond issuers seeking exemption from being treated as a commodity pool operator.
The U.S. CFTC ’s Division of Swap Dealer and Intermediary Oversight (DSIO) issued the letter on Friday, providing insurance or reinsurance linked securities or catastrophe bond issuing entities with the relief they had been seeking due to an issue that arose from the Dodd-Frank Act’s expansion of the definition of a ‘commodity pool’.
This issue first came up in late 2012 when the expansion of the definition of a ‘commodity pool’ under the Dodd-Frank Act looked set to include any entity which operates to trade in swaps. At the same time the CFTC and the Securities and Exchange Commission (SEC) were expanding the definition of a swap to better fit into Dodd-Frank.
As we wrote in October 2012, the broadening of 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,” made it seem likely that insurance-linked securities (ILS) such as catastrophe bonds could be included.
At the time it seemed very likely that unless ILS and catastrophe bonds were explicitly not considered as swaps, or exempted from the commodity pool operator (CPO) designation, then there was a good chance that they could fall under this broad definition of a swap and thus be considered a CPO.
In December 2012 the CFTC then clarified its position on which securitisations might be exempted from these new Dodd-Frank rules, which made it seem likely that ILS may be exempted but left some doubt as ILS and catastrophe bonds were not explicitly named as such and applications had to be made for exemption to be given.
The letter published on Friday by the CFTC provides the relief that the ILS market had been seeking, allowing ILS issuers such as catastrophe bond vehicles to become exempt from designation as commodity pool operators, as long as they meet certain stipulated conditions.
The CFTC explained:
The operator of an ILS Issuer that meets the conditions outlined in this letter may utilize the no-action relief to be exempt from commodity pool operator (CPO) registration consistent with Commission Regulation 4.13(a)(3), with respect to the issuance of insurance-linked securities.
In addition to meeting the operational and substantive conditions of relief, an operator of an ILS Issuer must file a notice of exemption with the National Futures Association (NFA) pursuant to Commission Regulation 4.13(b) to claim the relief.
The conditions of relief (summarised) include:
- ILS issuers must meet conditions for exemption from CPO registration.
- ILS issuers must file a notice of eligibility for exemption.
- ILS issuers must not engage in active asset management, of assets or liabilities, over the lifetime of the vehicle.
- Collateral must be held in specified highly rated assets, debt or approved collateral. The types listed are as you’d expect for ILS or cat bonds.
- Collateral must mature on or before the end of the risk transfer contract, or be convertible to cash on demand as needed.
- The ILS issuer must meet certain requirements should there be a collateral shortfall, if the value becomes less than the notional risk transfer amount.
- Payment obligations of issuer to protection buyer must be secured by the collateral and such obligations must be met before any collateral proceeds are distributed.
- Collateral has to be maintained to be available at any time it is required for payment.
- Collateral must be protected should the ILS issuer become insolvent for any reason outside of the stipulated payment terms under the risk transfer contract.
So the insurance-linked securities and catastrophe bond market has got the relief it sought and the conditions do not seem particularly onerous, as they simply lay out some of the key considerations with respect to collateral management and solvency that you would expect.
As no-action relief this should not increase the workload to issue an ILS or cat bond, however the one new process that an ILS issuer will need to undertake, in order to be considered exempt from commodity pool operator registration, would seem to be the filing of a notice of exemption. This should not add substantially to time or cost of ILS or cat bond issuance.
The ILS and cat bond market will be relieved that this issue has been solved, as it could have made issuance significantly more challenging or even impossible without some major changes to the issuance process. The full letter from the CFTC detailing how the requirements to take advantage of this relief can be found here.