Insurers and reinsurers are faced with uncertainties relating to the timing and scale of future losses and the risk that the premiums charged and reserves held will be insufficient to cover such losses.

One way that the Bermuda Monetary Authority, as the island’s financial regulator, addresses these uncertainties is by requiring insurers and reinsurers to have sufficient capital of appropriate quality to allow them to meet their obligations to policyholders should such losses occur.

The BMA has a three-tiered capital system, the purpose of which is to assess the quality of capital resources that an insurer or reinsurer has available to meet its regulatory capital requirements.

This is applicable to every such organisation that is subject to enhanced capital requirements. The ECR is the amount of economic capital and surplus that an insurer or reinsurer is required to maintain and is calculated using either the appropriate Bermuda Solvency Capital Requirement model or a BMA-approved internal model.

The ECR is important to the BMA as it serves as an early warning tool. The BMA expects insurers and reinsurers to operate at or above a target capital level, which exceeds its ECR.

While not specifically prescribed in legislation, the BMA requires insurers and reinsurers to have a TCL of 120 per cent of its ECR; however, in practice this percentage is usually much higher – for example, 150 per cent.

Failure by an insurer or reinsurer to maintain the available statutory capital of at least equal to its TCL will result in increased regulatory oversight.

The insurer or reinsurer discloses the make-up of its capital and the BMA assesses the quality of such capital resources via a three-tiered capital system.

Capital instruments are classified into tiers based on their loss absorbency characteristics and within each tier, capital can be either “basic” or “ancillary”. The highest quality capital is classified as tier one capital and lesser quality capital will be tier two or tier three capital.

Tier one is capital that is available when required and can fully absorb all losses at all times, including on a going-concern, run-off, winding-up and insolvency. Examples include all forms of cash such as fully-paid common shares, contributed surplus or share premiums.

Characteristics of tier one capital include:

• Having the highest level of subordination on a winding-up

• Being paid up

• Being undated or having a maturity of not less than 10 years from the date of issuance

• Being non-redeemable or settled only with the issuance of an instrument of equal or higher quality

• Being free of incentives to redeem

• Having a coupon payment on the instrument which, upon breach (or if it would cause a breach) in the ECR, is cancellable or deferrable indefinitely

• Being unencumbered

• Not containing terms or conditions designed to accelerate or induce an insurer or reinsurer’s insolvency

• Not giving rise to a right of set off against an insurer or reinsurer’s claims and obligations to an investor or creditor

Tier two capital includes capital instruments that fall short of the quality in tier one but still provide protection to policyholders. Examples may include qualifying hybrid capital instruments such as preference shares, unpaid and callable common shares and subordinated liabilities.

Tier two capital has almost the same characteristics of tier one except that it is subordinated to policyholder obligations on a winding-up, and is undated or has a maturity of not less than five years from the date of issuance.

Tier three capital has some of the characteristics of tiers one and two. Examples may include short-term approved letters of credit and short-term approved parental guarantees.

Key characteristics of tier three that differ from tier two are that the capital instrument will have full subordination on a winding-up and that the instrument will be undated or have a maturity of not less than three years from the date of issuance.

The BMA will only allow up to certain specified percentages of tier one, tier two and tier three capital to be used to support an insurer or reinsurer’s solvency margins and ECR.

Insurers and reinsurers intending to treat any capital instruments as eligible capital should have the instruments formally vetted and approved by the BMA.

• Cathryn Minors is counsel in the corporate department of Appleby. A copy of this column can be obtained on the Appleby website atwww.applebyglobal.com. This column should not be used as a substitute for professional legal advice. Before proceeding with any matters discussed here, persons are advised to consult with a lawyer