Special purpose vehicle (SPV)
A separate legal entity set up for a single, narrowly defined purpose, which ring-fences assets and risks. It is the cornerstone of securitization and cat bonds.
A special purpose vehicle is a separate legal entity set up for a narrowly defined purpose. It isolates the assets and risks attached to that purpose from its originator's balance sheet. This ring-fencing shields the vehicle's operations from the originator's troubles, and vice versa; the market calls this bankruptcy remoteness. The special purpose vehicle is the cornerstone of securitization and of risk transfer to the capital markets. In a catastrophe bond, the vehicle issues the bond to investors, collects their funds and invests them in low-risk collateral. It pays the coupons and, if the trigger event occurs, draws down the principal to indemnify the sponsor. The protection bought by the cedant is thus fully collateralized and independent of the financial health of both the sponsor and the investors. Special purpose vehicles are legitimate financial tools, indispensable to the modern pooling of risk. Their potential opacity has also fed questionable uses in other contexts, which is why regulators keep an eye on them.
Example: to issue a catastrophe bond, a reinsurer sets up a special purpose vehicle. The vehicle raises funds from investors, holds them as collateral and will release them to the reinsurer only if the defined event occurs. The transaction is thus insulated from any default risk.
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