Bermuda: still dancing, but to a different BEAT

Bermuda’s niche position in the reinsurance sector has been challenged recently by a number of factors: US tax reform, enacted in December 2017; a shrinking pool of reinsurance companies due to an active mergers and acquisitions (M&A) environment; competition from other jurisdictions; and, to a lesser extent, the uncertainty caused by the UK’s departure from the EU next March.

Bermuda’s association with the reinsurance industry can be traced back to 1947, when AIG established American International Company in Bermuda. Captives, established by pioneer Fred Reiss, became an increasingly popular and innovative risk financing solution and Bermuda became a particularly attractive domicile for captives.

ACE (now Chubb) and XL Group led the way in Bermuda in enhancing liability coverage. In the aftermath of Hurricane Andrew in 1992, reinsurers such as PartnerRe and RenaissanceRe established their presence in Bermuda. In the last 25 years, Bermuda has not only become a reinsurance hub, but also an underwriting center of excellence for reinsurance and insurance-linked securities (ILS) markets.

Transparent environment conducive to reinsurance

AM Best views Bermuda’s legal environment and business infrastructure as predictable and transparent with sufficient financial system regulation and a mature insurance industry framework. Our country risk evaluation places countries in one of five tiers, ranging from CRT-1 (for countries with a stable environment and the least amount of risk) to CRT-5 (for countries that pose the greatest challenge to an insurer’s financial stability, strength, and performance).

Bermuda is assessed as a CRT-2 country, with a moderate level of economic risk, a low level of financial system risk, and a very low level of political risk. Bermuda’s economy contracted in 2016, but returned to growth in 2017 and is projected to expand further in 2018. Inflation rose moderately in 2017 to 2 percent and is likely to rise slightly in 2018.

Tourism and international financial services are Bermuda’s dominant sectors. The Island is traditionally known for luxury tourism, but it is slowly losing its competitiveness owing to neighboring states’ investments in their own tourism industries. The economy remains vulnerable to natural disasters and external shocks that would adversely affect tourism.

Bermuda’s current government follows a prudent fiscal policy and supports a pro-business agenda, encouraging increased foreign direct investment through policies such as zero corporate income taxes. It plans to tap into more revenue streams following the implementation of new and revised taxes. These efforts will be countered somewhat by political pressures and measures taken to maintain the business environment’s competitiveness.

The Insurance Department at the Bermuda Monetary Authority (BMA) is responsible for all supervision, regulation, and inspection of Bermuda’s insurance companies and licensing of brokers, agents, and managers. Most of the foreign currency is denominated in US dollars, to which the Bermuda dollar is pegged one to one. Bermuda recently joined the effort to tackle base erosion and profit shifting (BEPS), demonstrating its commitment to international tax treaties. Bermuda’s banks maintain historically strong levels of capital and liquidity, providing an important buffer against unexpected shocks.

Strategies after US tax reform

The US Tax Cuts and Jobs Act (TCJA) was signed into law on December 22, 2017, with its provisions generally effective for tax years starting after 2017. The TCJA contained fundamental changes that apply to the taxation of multinational entities. Changes include a 100 percent deduction for dividends received from an owned foreign corporation; a minimum tax on “global intangible low-taxed income”; a 15.5 percent tax rate for earnings attributable to a foreign cash position; and the Base Erosion Anti-Abuse Tax (BEAT), which is a minimum tax on deductible payments to foreign affiliates.

The BEAT is intended to mitigate erosion of the US tax base by corporations that make deductible payments to related non-US parties, as well as impose a minimum corporate tax. The BEAT is applied at 5 percent for 2018, increasing to 12.5 percent for taxable years beginning after December 31, 2025.

AM Best considered how BEAT and the decreased tax rates in the US presented challenges to the strategies of reinsurers domiciled in Bermuda, especially as related to inter-company reinsurance agreements. The stock markets reacted in a similar manner and the average daily returns for a subset of Bermudian reinsurers underperformed the S&P 500 and firms with significant US-based reinsurance operations, including Alleghany and Berkshire Hathaway.

Many reinsurers have reacted to the changes in the tax laws by decreasing the size of the inter-company reinsurance arrangements or eliminating them altogether. We have also seen, and continue to see, the movement of some capital to on-shore balance sheets. Some reinsurers have formed new Bermuda entities that elect to be US taxpayers and have restructured their treaties from a quota share to excess of loss or stop-loss policies.

M&A shrink the number of reinsurers

Prolonged soft pricing in the catastrophe markets, low interest rates and a steady influx of alternative capital resulted in anaemic returns for reinsurers. In the absence of profitable avenues for organic growth, M&A became the preferred tactic for reinsurers to diversify, increase their relevance, and compete in the market.

At the same time, Asian investors with lower opportunity cost of capital in domestic markets found Bermudian firms an attractive acquisition opportunity. Japanese insurers struggling in a very low interest rate domestic market looked outside for growth. Chinese investors were looking for profitable diversification opportunities because of challenges in domestic markets.

The US tax law provides yet another impetus for M&A activity, resulting in a shrinking pool of reinsurers to regulate. However, these pressures are partially offset by the larger balance sheets of the reinsurers.

ILS: catching up is hard to do

Bermuda remains the leading jurisdiction for issuing catastrophe bonds. According to the Bermuda ILS Market Report, issuance in 2017 was approximately $12.6 billion, with $8.1 billion maturing. The total amount of outstanding ILS coverage was approximately $31.2 billion, which was over $4 billion higher than the total outstanding ILS coverage at the end of 2016.

Bermuda has emerged as a leader in the global ILS market after implementing a regulatory framework to facilitate the formation of ILS through a new licence class for insurers. In 2009, the BMA introduced the concept of a special purpose insurer (SPI), following passage of the Insurance Amendment Act 2008. Bermuda’s regulatory and supervisory framework also provides for the creation of sidecars, industry loss warranties (ILWs), and collateralised reinsurance vehicles.

Although competition from other jurisdictions is emerging, it is our opinion that it will take some time for other jurisdictions to catch up. The Cayman Islands and Ireland have significant ILS presence as well. The UK parliament approved Risk Transformation Regulations to enable ILS funds to be incorporated in the UK. Singapore has been developing regulations related to ILS transactions by the Monetary Authority of Singapore, Singapore’s Central Bank and insurance regulatory authority.

A proactive approach to challenges

The response to Brexit by insurers and by the Prudential Regulatory Authority may affect Bermuda, but to a lesser extent than other challenges. Bermuda’s status as a British overseas territory and its Solvency II equivalence, combined with ongoing dialogue with British regulators, will help continue its proactive approach to emerging risks.

In a period of increasing regulatory uncertainty, the BMA’s experience and ability to deal with different jurisdictions may even make it a more attractive jurisdiction for re/insurers. Bermudian re/insurers have played a critical role in fulfilling their promises and have aided in the recovery of the local economies that they insure.

This article is an excerpt from Best’s Market Segment Report Global
Reinsurance: Optimism Fizzles, It’s Back to the ‘New Normal’, published September 4, 2018.

Sridhar Manyem is a director, Industry Research & Analytics, at AM Best. He can be contacted at sridhar.manyem@ambest.com