February 25th, 2015

CFTC Provides Conditional Relief to Certain ILS/Cat Bond Issuers

Posted at 1:00 AM ET

On December 18, 2014 the U.S. Commodity Futures Trading Commission (CFTC) provided conditional relief to certain insurance-linked securities (ILS)/cat bond issuers from having to register as Commodity Pool Operators (CPOs).

Prior to 2010, ILS issuers that utilized derivative contracts as the form of protection between the sponsor and the cat bond issuer were exempt from registration as CPOs. However, as a result of Congress enacting the Commodity Exchange Act and adoption of the Dodd Frank Act, the definition of commodity interest was expanded to include swaps/derivatives. As a result, certain vehicles participating in ILS transactions were deemed to constitute commodity pools.

After successful lobbying by the Securities Industry and Financial Markets Association, the CFTC declared that the risk transfer contract in the form of a swap/derivative between the sponsor and the issuer of securities “serves merely as a conduit to transmit the insurance-related risks of the protection buyer through the ILS issuer and to the investors purchasing bonds from the ILS issuer.” As a result, catastrophe bonds will gain relief from having to register with the CFTC as CPOs. However, several conditions need to be met for the exemption.

The conditions for exemption include:

  1. The ILS issuer meets the conditions for an exemption from CPO registration.
  2. The ILS issuer files a notice of eligibility.
  3. The ILS issuer is operated in a way whereby there is no active management of assets or liabilities and there are strict collateral rules, as defined by the CFTC.

As a result of the relief, catastrophe bond transactions using swaps/derivatives as the form of insurance risk transfer between the sponsor and the ILS issuer will continue to be flexible, efficient and innovative risk transfer tools.

Also, in December of 2014, President Obama signed into law P.L. 113-295, The Tax Increase Prevention Act of 2014 (”Act”). Section 132(a) of the Act changed the key date in Section 871(k)(1)(C)(v) of the Internal Revenue Code from December 31, 2013 to December 31, 2014. The section provides an exemption from withholding on “interest-related dividends” for U.S. money market funds. The section expired under the prior law, which meant that withholding tax was incurred on dividends on money market funds for taxable years beginning after December 31, 2013. The new law changes the termination date of the exemption to December 31, 2014. Changing the termination date retroactively changed the law with respect to withholding tax on dividends from U.S. money market funds. Now, the 2014 dividends from calendar year money market funds are exempt from such withholding tax. Since many U.S. dollar-denominated cat bonds utilize U.S. money market funds, the withholding tax would have affected the yield received on money market funds that are a component of those cat bonds whose coupon would have been paid at the end of their fiscal year that occurred after December 31, 2013.

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