Insurance Risk-Linked Bills: a new milestone in securitization
Latest innovation in Brazil's insurance market allows for new forms of risk transfer and increased underwriting capacity
On March 16, 2022, Brazil’s government enacted a new provisional measure (No. 1,103/2022) creating Insurance Risk-Linked Bills (Letras de Risco de Seguro, or LRSs in Portuguese). Issued by Special Purpose Insurers (SSPEs), these bills enable insurance and reinsurance risks to be transferred to capital markets.
By creating the LRS – a registerable, transferable and freely tradable bill linked to insurance and reinsurance risks – the new provisional measure represents an important innovation for Brazilian markets. This also comes in the wake of the National Private Insurance Council’s (CNSP) Resolution No. 396/2020, which introduced Insurance-Linked Securities (Instrumentos Ligados à Seguros).
Today, securities linked to insurance and reinsurance risks represent a billion-dollar market. LRSs will facilitate the redirection of funds from this market toward Brazil, resulting in greater underwriting capacity for domestic (re)insurance players.
SSPEs are insurance companies whose sole function is to take on insurance, pension, health, reinsurance and retrocession risks from counterparties by issuing LRSs, which fund the transfer of these risks.
The proceeds and insurance premiums SSPEs receive must be equal to or greater than the maximum possible losses arising from the LRS-linked insurance and reinsurance risks, including other SSPE expenses. Moreover, SSPEs must use their proceeds exclusively to cover these risks.
The various companies that may cede risks to SSPEs include insurers, reinsurers, pension companies, pension funds and health insurance operators, whether located in Brazil or abroad.
As per the provisional measure, SSPEs are not directly liable toward insured parties, pension plan participants and beneficiaries when the counterparties in risk transfers are insurers, reinsurers, pension companies, pension funds and health insurance operators. These counterparties remain solely responsible for indemnities and coverage, except in the event of insolvency, bankruptcy or liquidation. In such situations, the SSPEs may make payments directly to the insured parties, pension plan participants or beneficiaries, provided that no prior payment has been made or received by the corresponding counterparty.
As stated above, LRSs are registerable, transferable and freely tradable bonds linked to insurance and reinsurance risks. LRSs are also considered extrajudicial foreclosure instruments, in a similar manner to debentures and promissory notes.
LRSs are risk transfer instruments whose performance is based on the (non)materialization of specific (re)insurance or actuarial risks, which may result from events such as natural catastrophes (cat bonds), death or disability. The obligations the LRSs represent are extinguished if the risks cease to exist, there are no longer proceeds to be paid to their holders, and due and unpaid claims.
Both the LRSs and the risk transfer contracts between the counterparties and the SSPE must guarantee that the risk transfer will be effective in all circumstances. In this context, the rights of LRS holders are subordinate to the obligations arising from the risk transfer contracts.
Asset Segregation through Ring-Fenced Mechanisms
When issued by the same SSPE, the proceeds of an LRS issuance (and the corresponding transfer of (re)insurance risks) are segregated from other LRSs (and corresponding risks) via a ring-fenced mechanism.
As such, the assets derived from each LRS transaction (which include the portion of the premium the counterparty pays that is not used to remunerate the SSPE) must not be used to settle any other liability or obligation related to the SSPE’s other activities. Rather, these assets should be used solely to pay for the LRSs, as well as claims, administrative fees and any related taxes.
Although the provisional measure is already in effect, a few steps remain in order to definitively enable funding and risk transfers via LRSs. New rules still need to be issued by CNSP and the Brazilian Private Insurance Authority (SUSEP), as well as the National Monetary Council (CMN) and the Brazilian Securities and Exchange Commission (CVM).
Provisional Measure No. 1,103/2022 is expected to significantly impact the insurance and reinsurance markets, as LRSs will finally enable insurance, reinsurance, pension and health risks to be offered to capital market investors. Furthermore, it may provide an opportunity to players looking for investments with attractive risk-return based on risks that are not subject to macroeconomic variables.
This new risk transfer instrument is also set to bring Brazil closer to other jurisdictions that offer modern risk transfer alternatives.