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Country Report Bermuda

Country Report

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Following sizeable emigration of highly-paid financial sector employees during the global economic crisis, Bermuda’s undiversified economy has been in contraction mode for four consecutive years, while growth will likely stagnate next year. The associated fall in tax revenues has led to large budget deficits and rising public debt, which should force the newly elected government to embark on meaningful fiscal consolidation in the medium-term if growth does not resume soon. Yet, the problems of the local economy do not affect the island’s (re)insurance sector, since only part of the insurance companies’ management is located on the island, while funds are deposited in major financial centers around the globe. The sector itself proved its resilience once more last year, as fewer natural disasters compared to 2011 led to a marked increase in profits.

National facts of Bermuda
National facts of BermudaSource: EIU, CIA World Factbook, UN, Heritage Foundation, Transparency International, Reporters Without Borders, World Bank.

Economic Structure and growth

Bermuda is a small British Overseas Territory in the Atlantic Ocean, approximately 1,000km off the North Carolina coast. It is Britain’s oldest crown colony and the United Kingdom retains significant powers on the island, primarily in the fields of external and internal security and foreign affairs. It is also responsible for ensuring good governance by the island government. Self-government is modeled after the Westminster-system and the islands’ two-party democracy has ensured considerable political stability. With a total population of about 70,000 and a nominal GDP of USD 6bn, Bermuda’s per capita GDP (USD 85,249 in 2012) ranks among the highest globally. Owing to Bermuda’s benign tax climate, stable institutional settings and sound regulatory environment, the country has become a globally renowned offshore financial center with a particular focus on (re)insurance activities. International financial services generate about 40% of GDP and employ about 4,000 people (12% of total employment) on the island. Luxury tourism, primarily catering to US and Canadian tourists, constitutes the second-most important sector of the local economy. It contributes about 11% to GDP and accounts for about 15% of employment, whereby the majority of jobs in this sector is held by Bermudians. Foreigners constitute about 25% of Bermuda’s total  labor force, which contributes to the marked flexibility of the local economy and labor market. As business-related tourism is gradually gaining in importance, developments in the financial and tourism sector become increasingly intertwined. The small Bermudian economy is highly undiversified and vulnerable to external shocks, ranging from adverse economic developments in the US to financial market turbulences or commodity price fluctuations.

Reflecting Bermuda’s heavy dependence on international financial market developments, its undiversified economy has been in recession since 2009, when the economy contracted by 4.8%. In the three following years, economic growth remained negative at an annual rate of 1% to 2%, while economic growth is expected to stagnate this year. Bermuda’s four-year recession is mainly due to sizeable emigration of highly-paid expatriates during the global financial crisis, which resulted in a considerable fall in domestic demand, both in terms of consumption and construction activity. As payroll taxes constitute about 40% of government revenue, the exodus of foreign financial professionals contributed to sizeable budget deficits and limited the government’s scope for fiscal stimulus.

Figure 1: Income level
Figure 1: Income levelSource: EIU
Figure 2: Economic growth and inflation
Figure 2: Economic growth and inflationSource: EIU, Fitch

The current economic problems of the local economy and the very unlikely event of related rising social tensions in no way affect the smooth functioning of the (re)insurance sector. Even though part of the insurance company’s management is located in Bermuda , most of the insurers’ funds are deposited in the UK, the US, or Switzerland. Owing to the likely timely relocation of personnel in case of tensions on the island, the impact of Bermuda’s country risk on the (re)insurance sector is minimal.

Last year, the sector proved its resilience amid a challenging external environment, but owing to its mature state, its growth potential is limited. Benefitting from a decline in global natural catastrophe-related insured losses from USD 119bn in 2011 to about USD 65bn last year, as well as their own strong risk management capabilities and high capitalization levels,  Bermuda’s 17 (re)insurance companies likely managed to improve their combined ratio [1] from 107% in 2011 to 95% last year. In spite of their particular focus on the US market, losses related to Hurricane Sandy were limited to about 4% of shareholders’ equity, as Sandy-related losses were largely covered by primary insurers due to their increased  risk-taking in recent years. Prior to Hurricane Sandy, sector-wide catastrophe losses declined to USD 900m in the first three quarters, down from USD 8.8bn in the same period of 2011. Meanwhile, net written premium increased by 3.6% through the first three quarters of 2012, while aggregated operating earnings came in at USD 6.9bn, up from USD 400m last year. Although suffering from the current low-yield environment amid only limited (though increasing) investments into higher-yielding (and thus more risky) asset categories, the sector’s net return on average equity came in at a healthy 12.8%. Reflecting the sector’s strong position, none of the 17 Bermudian (re)insurance companies was rated worse than A  by the main rating agencies in 2012. Going forward, Bermuda’s (re)insurance sector is expected to defend its current strong position and benefit from a recently concluded Tax Information Exchange Agreement (TIEA) with Canada. Delays in achieving unqualified Solvency II equivalency, however,  prevent the sector from exploiting related benefits on the European market. (For more on these two issues please refer to the Economic policy section).

Footnotes

[1] ^ The combined ratio compares  the sum of an insurance company’s incurred losses and expenses with its earned premiums. A combined ratio below 100% indicates that the company makes underwriting profits.

Political and social situation

Bermuda’s status as a British crown colony and the ensuing responsibility of the United Kingdom for external affairs and internal security broadly ensures political and social stability. Self-government is conducted on the basis of a Westminster-style system with two main parties, the center-left Progressive Labour Party (PLP) and the centrist One Bermuda Alliance (OBA), which replaced the United Bermuda Party as the island’s main opposition party recently. Besides differences in electorate, whereby the PLP has been particularly popular among African-Bermudans, both parties also differ in their views on the matter of Bermuda’s independence, as the OBA remains a staunch supporter of the current status quo, while the PLP has been a traditional proponent of eventual complete independence. However, according to polls about three-quarters of the population reject independence right now.

Following the December 17th 2012 elections, Bermuda is currently governed by an OBA-cabinet under the leadership of prime minister Craig Cannonier, who has already been sworn in for a five-year term. In spite of major losses of the PLP, the new government only won the election by a narrow margin, which is reflected by its slim 2-seat majority in the island’s 26-seat lower house. While the OBA’s and Mr Cannonier’s limited experience could lead to some internal tensions, general party discipline to implement needed reforms to tackle Bermuda’s fiscal challenges is expected. The new OBA government will focus on the daunting task of reining in last years’ sizeable budget deficits without choking economic growth, improve job opportunities, and increase its efforts at fighting a recent increase in crime levels.

Notwithstanding Bermuda’s four-year recession, there have not been major social tensions on the island, even as income inequality between the financial services sector and other sectors remains considerable. Moreover, owing to the sizeable emigration of expats in recent years, unemployment levels remained at a low 6%, while the concurrent 7% decline in employment levels was mainly borne by foreigners. Provided Bermuda’s tourism sector can stand its ground and necessary fiscal consolidation measures do not result in large lay-offs, we expect ongoing social stability on the island. While a recent rise in crime levels has led to increased policy efforts, we note that Bermuda’s crime levels remain low compared to Caribbean peers.  

Bermuda’s external relations are cordial and mainly focus on Canada, the UK, and the US. Issues regarding financial sector regulation dominate bilateral relations. Owing to its continuous efforts to conclude Tax Information Exchange Agreements, the island does not figure on the OECD’s grey list. Notwithstanding these efforts, legal changes in the US forbidding the use of offshore tax domiciles could impact US-Bermudian bilateral relations. 

Economic policy

Maintaining a highly business-friendly operating environment remains the Bermudian government’s overarching economic policy goal and consequently particular attention is paid to ensuring Bermuda’s reputation as a jurisdiction of choice for financial service providers. The local financial supervisor, the Bermuda Monetary Authority (BMA), therefore intensified its efforts to keep up with the latest trends in supervision and capital adequacy. In recent years, the BMA increased its efforts to implement the European Commission’s Solvency II directive in an attempt to achieve regulatory equivalence [2] by the end of 2012, when Solvency II became effective. Together with Japan and Switzerland, Bermuda belonged to the first non-EU countries where full Solvency II adequacy was assessed. Yet, Bermuda failed to meet all requirements in the initial 2011 report by the European Insurance and Occupational Pensions Authority (EIAPO), as certain principle measures were deemed “equivalent”, while others were not. It remains to be seen, how this mixed result will be interpreted by European regulators. If Bermuda had managed to achieve full equivalence, Bermudian (re)insurance companies operating in the European Union would have faced the same collateral requirements as their EU peers, which would have provided them with a competitive advantage vis-à-vis non-European insurers. We consequently expect ongoing efforts by the BMA to eventually achieve full equivalence as soon as possible.

While earlier hopes for a competitive edge on the EU market have so far failed to completely materialize, the position of Bermuda’s (re)insurance sector on the Canadian market continues to strengthen following the 2011 ratification of a Tax Information Exchange Agreement (TIEA), which earned the island ‘Designated Treaty Country’-status. Under the agreement, Bermuda-based Canadian captive insurers that provide reinsurance services to their parent companies can repatriate profits tax-free, exempting them from a 25% withholding tax. So far, this has led to the relocation of several Canadian captive insurers from Barbados, which enjoys the same status, to Bermuda. 

Figure 3: Public finances
Figure 3: Public financesSource: Fitch
Figure 4: Debt ceiling changes
Figure 4: Debt ceiling changesSource: Fitch, Ministry of Finance

In order to further strengthen Bermuda’s attractiveness for international financial services providers, Bermuda’s government lowered minimum Bermudian ownership requirements for companies, relaxed immigration rules and provided limited stimulus via tax cuts. We note, however, that the government’s room for implementing additional fiscal stimulus remains severely limited by the urgent need to rein in recent years’ sizeable budget deficits. Still, current leniency by the British government regarding Bermuda’s deteriorated public finances should enable the government to still implement limited tax cuts for certain sectors.

Reflecting major losses in payroll tax income due to the emigration of highly-paid expatriates, Bermuda ran budget deficits of about 4.5% of GDP since 2010, which are not expected to decline before 2014. Consequently, its public debt burden increased from a very low 9% of GDP in 2008 to 28% of GDP in 2012. While the current government has pledged to reduce the budget deficit, the previous government’s spending commitments in the fields of healthcare, justice and policing are likely difficult to repeal. Serious budgetary consolidation is therefore rather unlikely in the short-term. Though the overall public debt level is still moderate, the trebling of Bermuda’s public debt level within four years is worrisome, as the limited diversification and size of the local economy and tax base limit the sovereign’s debt capacity. Moreover, we note that the current debt trajectory is unsustainable, unless growth resumes soon. Consequently, we do not exclude the possibility that the British government could force the Bermudan authorities to rein in its budget deficit in the coming years, as has recently happened in the case of the Cayman Islands.

In spite of recurrent increases in the public debt ceiling that threaten to undermine the credibility of the local government’s commitment to fiscal consolidation, Bermuda so far managed to access international capital markets to finance its deficits at acceptable rates. Moreover, owing to Bermuda’s large domestic capital market and its dominant position on the (re)insurance market, we do not expect funding difficulties in the coming years, even as last year’s sovereign downgrade from AA+ to AA by Fitch should have increased investor awareness of the deterioration of the sovereign’s position.

Bermuda does not conduct its own monetary policy, as there is no central bank and the domestic currency, the Bermudian dollar, is pegged to the US dollar at parity. In combination with the country’s open financial account, Bermuda’s monetary policy is consequently determined by the US Federal Reserve. Owing to the absence of a central bank, the local banking sector maintains the currency peg. Given Bermuda’s large structural current account surpluses (about 13% of GDP), its very large external asset position, as well as the dominant position of its (re)insurance sector, the island’s currency peg has remained uncontested and will likely remain so in the coming years, even as foreign exchange reserves are relatively low.

Footnotes

[2] ^ Regulatory equivalence implies that the Solvency II regulations will be adjusted to local circumstances as the Bermudian financial sector is predominantly wholesale-oriented, while the European insurance market caters relatively more to retail clients.

Balance of Payments and External Position

Bermuda’s structural current account surpluses are mainly driven by sizeable income and services balance surpluses that are primarily generated by the financial services sector (and to a limited degree also the tourism sector). Even though the global economic crisis has negatively affected both surpluses, they still amounted to about 23% and 9% of GDP, respectively, last year, and more than compensated a structural trade balance deficit of 15-20% of GDP. While gradually improving domestic demand should contribute to a limited widening of the trade balance deficit, as all consumption goods have to be imported, this year’s current account surplus is still expected to come in at about 13% of GDP.

Figure 5: Current Account balance
Figure 5: Current Account balanceSource: Fitch
Figure 6: External debt
Figure 6: External debtSource: Fitch

Rising oil prices on the back of a stronger than expected global economic recovery could lead to a further increase of the trade balance deficit, but this should be compensated by a concurrent rise in the income balance surplus on the back of improving asset returns.  

Bermuda’s external position is exceptionally strong, as sizeable external asset holdings of the island’s 17 (re)insurance companies far exceed external debt positions. While external debt amounted to USD 158bn in 2011, non-equity external assets reached a level of USD 642bn, resulting in a negative net external debt position of USD 484bn. Still, we note that Bermuda’s favorable external position is purely due to the (re)insurance sector. While the local banking sector’s net external asset holdings are negligible, the public sector is a net external debtor, whereby recurrent large fiscal deficits, if financed externally, could extend this trend. Moreover, the banking sector’s net external position hides sizeable gross external debt levels (about 300% of GDP in 2011), which are mainly composed of short-term deposits of non-residents. This exposes the sector to a possible sudden withdrawal of funds if investor confidence were to deteriorate. Yet, comparable external holdings in highly liquid assets should compensate for the risk of balance-of-payments difficulties amid low foreign exchange reserves levels. Still, owing to the paramount importance of the (re)insurance sector, Bermuda’s external position remains highly exposed to developments on financial markets and the future of the international financial services sector, in particular. 

Economic indicators of Bermuda
Economic indicators of BermudaSource: EIU, Fitch 
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Author(s)
Fabian Briegel
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 21 64053

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