The Cayman Islands is the world's fifth most important financial centre after London, New York, Tokyo and Hong Kong. It has just under 300 active banks, more than 750 insurance companies, primarily captives underwriting the risks of their owners and associates, and more than 8,000 active mutual funds.

As a domicile for captive insurance companies, it is second only to Bermuda. It is also a leading jurisdiction for specialised financing methods and in recent years has become the jurisdiction of choice for the establishment of capital markets vehicles that are used to under-write reinsurance risk. To date it has licensed 27 insurance-related companies described as alternative financing vehicles, which is a large proportion of the total number created worldwide.

The Cayman Islands Government has indicated that it would like the jurisdiction to build on its existing strengths as a financial centre to develop an open market reinsurance market and is exploring what steps it should take to make the jurisdiction more attractive for this type of business.

This article will explore the reasons for the increased usage of alternative financing vehicles by reinsurance companies, the reasons why the Cayman Islands has developed as the jurisdiction of choice in which to establish such vehicles and the plans the Government has to develop the jurisdiction as a centre for open market reinsurance companies.

Hurricane Andrew in September 1992 marks the beginning of the modern history of catastrophe underwriting; the hurricane's effects bankrupted 11 insurance companies and forced others to recapitalise. The industry was not fully aware of its exposures, which resulted in a sharp contraction in capacity and rise in prices for catastrophe reinsurance, exacerbated by an earthquake in North-ridge, California, in January 1994.

The 1999 European windstorms, the 9/11 losses and Hurricane Katrina in 2005 also drained large amounts of capital out of the reinsurance market. In particular, Hurricane Katrina demonstrated what a large catastrophe can do. Increasing awareness that even larger and more frequent events are possible has increased demand from industry and the insurance market for balance sheet protection. Climate change has been another catalyst. At the same time, there has been a demand for new asset classes with the potential to provide enhanced returns.

As prices rise, new investment comes into the reinsurance market. However, the process can be volatile, leaving large businesses and insurance companies concerned about the continuity of cover for their peak risks. These gaps in availability of reinsurance in terms of limits or territory have created opportunities for non-traditional participants in the market, which gaps have been filled to a large extent through the use of catastrophe bonds and reinsurance sidecars.

Securitisation of insurance risks typically employs an arm's length or 'orphan' company, the special purpose vehicle (SPV). It removes the income and the asset being securitised from the balance sheet of the insurer or reinsurer that is sponsoring the structure and protects investors from its possible insolvency.

For the sponsor, it is effectively collateralised reinsurance; the counter party risk is minimised.

The coupon is defined upfront. The SPV/issuer must post the notional amount of the bond in an account, or trust, which invests in high-grade securities – thus eliminating credit risk -and earns London Interbank Offered Rates (LIBOR). Cat bonds are issued at spreads over LIBOR.

Among the sponsors of these structures, colloquially known as cat bonds, are leading insurance and reinsurance companies. A lack of correlation between natural catastrophes and other financial risks and an enhanced return make the securities issued by such SPVs attractive to a variety of investors, including diversified mutual funds, specialist hedge funds and private equity funds.

Although most published securitisations have involved catastrophe risks, the technique is clearly suitable as a means of raising extra capital for other types of insured risk.

The reinsurance sidecar, has also been used to add capacity to the reinsurance market. The sidecar is a reinsurance company that has been established by a primary reinsurance company to offer reinsurance to parties other than the sponsor. Such a structure allows the sponsor to provide additional catastrophe capacity without the need to restructure the capital base of the sponsor. This structure enables parties to invest in the catastrophe element of the portfolio of an established reinsurance company without exposure to the whole business of that company.

The ownership structure of each sidecar is specific to the transaction.

The sponsor may retain an interest in the new entity as an associate company or an equity investment or put the vehicle at a greater distance, but gain income from underwriting fees.

The Cayman Islands was immediately seen as a hospitable jurisdiction for cat bond SPV companies because it has a regime that, while conforming to international standards, allows such structures to be established relatively quickly and cost effectively.

In addition, it has no direct taxes or exchange controls, has a ready supply of high-quality professional service providers – including attorneys, auditors and insurance managers – and a well-established and reliable legal system. This remains the case today, with more new cat bond SPVs registered in Cayman than any other jurisdiction.

A cat bond SPV that is established in the Cayman Islands is generally incorporated as a Cayman exempted company and is also licensed as a class B insurance company (or possibly as a reinsurance company depending on the results of the current legislative review). Typically, it is possible to have an SPV established and licensed within two to three weeks after providing the Cayman Islands Monetary Authority with a complete application.

Having established itself as a leading jurisdiction for cat bond SPV companies and captive insurance companies, the Cayman Government is also keen to establish the islands as a preferred jurisdiction for the establishment of open market reinsurance companies following the formation of Greenlight Re in August 2004.

Towards the end of 2006 or the beginning of 2007, Cayman is likely to create a new category of licence for reinsurers as part of proposed amendments to the existing insurance law, which new category was proposed by a working group that was formed to review the insurance law. The aim is to differentiate commercial, open market reinsurers from captives that underwrite reinsurance.

Morag Nicol is deputy head of the insurance supervision division of the Monetary Authority and will become head of that division on 1 January, 2007. She says: "There is no reason why Greenlight Re should be seen, or prove to be, a one-off event.

"Since Cayman has the infrastructure, professional expertise, regulatory environment and physical space requirements to facilitate the development of a reinsurance market, those looking for a supportive, proactive domicile for their reinsurance company will consider Cayman."

Bryan Hunter is a partner in the corporate and commercial group in the Cayman office and Warren Cabral is managing partner of the London office at Appleby Hunter Bailhache.