Special Purpose Vehicles (SPVs) Defined
October 25, 2017
If you are like many captive insurance company owners or board members, you have come across the term "special purpose vehicle" or "SPV" at some point. While some of you may be intimately familiar with these types of entities, others will have only a nodding acquaintance. In the following article, we provide a working definition of "special purpose vehicle" and look at some key attributes.
SPVs—A Brief History
Special purpose vehicles, also referred to as special purpose entities (SPEs) or variable interest entities, began outside of the insurance industry and have a less-than-savory pedigree. It may be this history that colors individuals' feelings on these corporate structures. As detailed in "The Accounting Trick Behind Thirty Years of Scandal," an article written by Christopher Matthews and published on business.time.com August 15, 2012, the genesis of SPVs or SPEs occurred in the late 1980s with "junk-bond king" Michael Milken and his firm Drexel Burnham Lambert. As the demand for high-yield debt waned, Mr. Milken went in search of a new way to package this debt to make it more palatable to investors. Thus, the SPE was born. The SPE allowed Drexel to deposit the high-yield debt into the SPE and then, said the business.time.com article, "slice and dice them in such a way that the ratings agencies would give them an investment-grade rating—allowing insurance companies and pension funds, which [had] rules against putting money into high-yield debt, to invest. These special vehicles were ... 'entwined in the failure of one of the nation's largest life insurers—and the world's largest investor in junk bonds—First Executive Corporation.'" SPEs were also implicated in the collapse of Enron Corporation and the more recent mortgage market collapse of 2006–2008—not the most auspicious start.
SPVs—A Working Definition
So, what are SPVs exactly? The following definition is found in Wikipedia.
A special-purpose entity (SPE; or, in Europe and India, special-purpose vehicle/SPV, or, in some cases in each EU jurisdiction—FVC, financial vehicle corporation) is a legal entity (usually a limited company of some type or, sometimes, a limited partnership) created to fulfill narrow, specific or temporary objectives. SPEs are typically used by companies to isolate the firm from financial risk.
In a narrower context, for insurance, International Risk Management Institute, Inc. (IRMI), defines SPV as follows.
A company created by (but not owned by) an insurer or reinsurer for the sole purpose of issuing debt (usually in the form of a catastrophe bond). The use of SPVs is restricted to off-shore domiciles to be able to maintain the issuer's (the U.S.-based insurer or reinsurer) U.S. tax and accounting treatments with regard to such transactions.
For this article, the focus is on the narrower definition offered by IRMI.
Not surprisingly, the National Association of Insurance Commissioners (NAIC) has become involved with insurance-related SPVs with the 2013 publication of a white paper titled Captives and Special Purpose Vehicles. The paper explains as follows.
An SPV, where defined under state law, is a captive licensed and designated as an SPV insurance company by the insurance commissioner. SPVs can take several forms. Special purpose financial captives are limited to issuing only special purpose financial captive insurer contracts to provide reinsurance protection to the cedant/parent. Special purpose reinsurance vehicles facilitate the securitization of one or more ceding insurers' risks as a means of accessing alternative sources of capital and achieving the benefits of securitization. Limited purpose subsidiaries can also be created for similar purposes.
The Executive Summary of the NAIC white paper states as follows.
The Captive and Special Purpose Vehicle (SPV) Use (E) Subgroup studied the use of captives and SPVs formed by commercial insurers. The Subgroup concluded that commercial insurers cede business to captives for a variety of business purposes. The Subgroup determined that the main use of captives and SPVs by commercial insurers was related to the financing of XXX and AXXX perceived redundancies.
Traditional property-casualty captive insurers are most likely to encounter an SPV as part of the reinsurance structure being offered by a number of the Bermuda- or Cayman-based reinsurers. The use of an SPV entity provides the following benefits to the reinsurer.
- An SPV is authorized to write reinsurance.
- It offers the traditional reinsurer some regulatory capital relief.
- The SPV allows capital markets investors exposure to reinsurance risk without having to take on the solvency and credit risk of the main reinsurer.
Basically, an SPV allows the reinsurer to raise funds in the capital markets for specific risks (i.e., catastrophe risk) at a cost to the reinsurer that is cheaper than purchasing traditional reinsurance or through raising equity. An additional benefit of using an SPV is that it allows the issuing entity to reinsure the risk offer for a longer-term period than a normal 1-year reinsurance policy.
Like any potential reinsurance structure, captive owners and board members will need to do their due diligence, especially with the use of an SPV. They will need to understand the underlying contractual language between the SPV and the investors and whether the SPV structure provides as good or better protection to the captive than a normal reinsurance contract.
Although SPVs have a storied past, that is no reason to discount their use within the insurance markets as a way to address certain risks on a comprehensive and cost-effective basis.
October 25, 2017