HAMILTON, Bermuda—Bermuda has introduced a new regulatory framework for catastrophe bonds and other specialized insurance instruments in an effort to attract more business to the island.

The Bermuda Monetary Authority's guidance—which became effective last week—applies to cat bonds, reinsurance sidecars, industry loss warranties and other special-purpose vehicles offered by insurers seeking to be licensed in the domicile.

“We have set a very high standard for disclosure and transparency and we believe the framework will create a clear picture of the risks these instruments contain,” said Matthew Elderfield, chief executive officer of the Bermuda Monetary Authority, the island's main regulatory body.

In addition, Mr. Elderfield said the regulations will position Bermuda to win more business as capital markets seek to enter the insurance sector.

Special-purpose insurers were introduced as a new class of insurer under Bermuda's Insurance Amendment Act of 2008. The legislation reorganized Bermuda's insurers and reinsurers in an effort to categorize them more appropriately based on their risk profiles.

Prior to last year, sidecars, which usually operate as separately capitalized affiliates of existing insurers and reinsurers that cede business to the sidecars, were regulated as Class 3 insurers within Bermuda's four-class regulatory framework. As Class 3 insurers, they were subject to the same regulations as small insurance companies—a designation some observers said was “too severe” given the instruments are fully collateralized with a remote chance of bankruptcy. Meanwhile, cat bonds and other insurance-linked structures were not subject to regulation at all.

Under the new regulations, all special-purpose insurers will be vetted in line with the BMA's risk-based approach to supervision. In order to be approved, the vehicles must pass a collateralization test on the basis of the structure and the risks that are being underwritten. In addition, to prevent credit risk, the regulations call for detailed reporting on the types of assets invested in the structures, as well an obligation to report any declines in asset valuations. The rules apply to any special-purpose insurer established in Bermuda.

Bermuda previously has enjoyed a strong sidecar market, approving some 26 sidecars in the wake of hurricanes Katrina, Wilma and Rita, with $6.4 billion in total capital, according to the BMA. While sidecar formations have declined as a result of credit market conditions, observers say they expect sidecar formations to increase as additional capital becomes available.

“Should there be a market-changing event, such as a significant catastrophe, we anticipate there will be more sidecars launched as opposed to new company startups,” said Andre Perez, CEO of Bermuda-based Horseshoe Group, an insurance management and consulting firm and member of the BMA's advisory group on special-purpose insurer supervision.

The cat bond market, however, is dominated by the Cayman Islands, and Bermuda has never been chosen as domicile for the incorporation of a cat bond, even though many cat bond sponsors have been Bermuda-based firms. That is something observers said they hope the new regulations will change. “We think it will encourage cat bonds to come to Bermuda,” said Mr. Perez.

Incorporating cat bonds in the Cayman Islands generally is viewed as inexpensive, and the domicile offers ample legal and other services to facilitate the transactions quickly, observers say. Bermuda “really couldn't compete on legal costs alone,” said Chi Hum, global head of distribution at GC Securities Ltd. in New York, a unit of the MMC Securities Corp. division of Marsh & McLennan Cos. Inc.

However, Mr. Hum said, Bermuda's regulations are a “positive step that should streamline the process and, in turn, reduce costs.”

Previously, potential cat bond sponsors had no clear path for setting up a transaction. The new designation “will prove to be a lot more attractive,” he said.

However, observers say its unclear exactly how much cat bond business Bermuda will win from the Cayman Islands.

“I don't see there being a rush to set up cat bond transactions in Bermuda in the short term, but I do believe it's more of a long-term investment,” said David Cash, chief underwriting officer at Endurance Specialty Holdings Ltd. in Hamilton, Bermuda.