Insurance transformer transactions are structured to transform a potential liability under a credit-default swap into an insurable loss falling within the scope of an insurer's permitted activities. As such, they are amongst a number of products used to transfer risk from the banking sector to the insurance markets (and to a lesser extent vice versa), which have been the subject of a discussion paper, Cross sector risk transfers, published this month by the U.K. Financial Services Authority. This article briefly considers some of the legal issues associated with this type of transaction.
Under a typical transformer transaction, a dealer in the default swap market will purchase mezzanine or senior protection under a cash-settled portfolio credit-default swap from a transformer company, which will in turn insure itself with an insurer against the risk of payout following the occurrence of a credit event. The dealer will then sell protection on a single-name basis in the market. The function of the transformer company is broadly to channel payments of premium from the dealer to the insurer, and claims payments in the opposite direction, it may be a bankruptcy-remote special purpose vehicle, or a protected cell company consisting of a number of ring-fenced pools or cells of assets and liabilities.
Benefits And Pitfalls
There are a variety of factors which may make the transaction attractive. As between the dealer and the ultimate protection buyers, differences in the way in which credit-default swaps are treated in calculating their respective capital adequacy requirements provide the opportunity for regulatory arbitrage. As between the dealer and the insurer, the latter may be prepared to accept credit risk at a lower price than that demanded by other participants in the market, either because of pressure on premiums in other sectors of the insurance industry, as a result of different modelling approaches, or because differences in the applicable regulatory framework mean that the insurer is required to maintain a relatively lower level of capital to meet provisioning and solvency requirements. Provided that the dealer is able to effectively hedge its position by selling protection on the portfolio names, it can benefit from this price differential and reduce its own capital requirements by offsetting risk in the reference assets. The FSA has considered whether this differential is the result of inadequate analysis, and hence underpricing of risk, by insurers and concluded that, at least in today's market, it is not.
There do not appear to have been substantial settlement issues unique to these transactions arising out of recent credit events. However, the FSA points to difficulties which have been experienced in other instances where banks have sought to rely on insurance products to transfer credit risk. An additional current example is the litigation in the New York courts in which J.P. Morgan Chase is seeking to recover payment under surety bonds written by various U.S. insurers in relation to Enron subsidiaries. This illustrates the potential pitfalls implicit in the transformer transaction, which brings together two contracts that may be intended to have similar economic effect, but which are quite different in their legal context.
Waiver Of Insurer Defences
A dealer purchasing credit protection through a transformer transaction may view the transaction as economically equivalent to concluding a direct default swap with the insurer. However, absent provision to the contrary, an insurer under a credit risk insurance policy will have a range of extra-contractual defences to payment which would not be available to a default swap counterparty.
A particular area of sensitivity is the duty on an insured party under a policy governed by English law (and the laws of other jurisdictions, such as Bermuda, which have evolved on this basis) to disclose all material facts to its insurer. This stems from the characterisation of an insurance policy as a contract of the utmost good faith. Where the insurer has undertaken its own evaluation of each of the reference entities comprised in the portfolio, as well as of any correlation risk, it is not appropriate that, for instance, a failure by the dealer to disclose relevant credit information should entitle the insurer to refuse payment. This issue should also be borne in mind when documenting any ongoing reporting requirements which the insurer seeks to impose on the dealer.
The International Swaps and Derivatives Association has recently published a draft waiver of defences to be included in insurance policies written to cover swap liabilities and acceptance of this language, or a variant of it, may simplify negotiations on this issue.
Valuation
Another area of concern is likely to be the involvement of the insurer in the valuation of the selected reference asset. The insurer may also seek to mitigate any loss by taking physical delivery of the reference asset--on a delivery-versus-payment basis--where it feels that it might be advantageous to do so, either because it feels that the valuation does not reflect the true price at which the asset is trading, or where it anticipates making a higher recovery by holding the asset for a period of time. This requires careful framing to ensure consistency with bid procedure, and that physical settlement rights do not impinge on the insurer's cash-settlement obligations.
Other Legal And Documentation Issues
There may be a range of issues relating to allocation of the risk of default by the transformer company, of withholding or insurance premium tax risk, and to the legal status of the transformer company itself. The transaction documents will need to be reviewed together to make sure that the proposed structure is operationally feasible as to, for instance, timing of cashflows, in particular given any management arrangements in relation to the transformer company. All of the above will require amendments to the standard form of credit-default swap confirmation and/or schedule to the ISDA master agreement.
Finally, the dealer should ensure that recharacterization risk-- that is, the risk that a liquidator of an insolvent insurer may argue that the transaction in reality constitutes a direct default swap transaction between the insurer and dealer in contravention of applicable regulation--is acceptably remote under the laws of relevant jurisdictions. So far as U.K. insurers are concerned, the FSA has indicated that it proposes to issue guidance as to the scope of insurers' permitted activities in this context.
Looking Ahead
The FSA paper emphasises the need to ensure, first, that the underwriting and insurance activities of insurance companies in this context are subject to effective oversight by senior management and, second, that insurers' counterparties are confident, based on appropriate legal due diligence, that the relevant risk has been effectively transferred. However, it recognizes that any significant regulatory initiative should be global rather than national in scope. Regardless of eventual changes in the international regulatory environment, the prospects for cross-sector transfers of credit risk, whether through transformer structures or by other means, appears bright given the increasing volumes in the credit-default swap market and the actual and potential significance of the role played by insurers and reinsurers.
This week's Learning Curve was written by James Coiley, an associate at Ashurst Morris Crisp in London.
