Fears of regulatory overreach on LOCs as Vesttoo scandal deepens

As global (re)insurance leaders gather in person for the first time since the Vesttoo scandal emerged in July, fears are growing that heightened scrutiny around letters of credit (LOCs) may see rating agencies and regulators take actions that disrupt a long-established practice.

While perennial industry themes such as market conditions, 1.1 renewals, the use of technology and geopolitical/economic concerns will dominate many of the discussions, the implications of the Vesttoo fallout were not far away from the thoughts of executives at the beginning of the Rendez-Vous – not least following last week's extraordinary revelations.

In the run-up to the event, Howden Tiger vice chairman Elliot Richardson became one of the first prominent market figures to publicly warn of the threat, telling The Insurer’s Pre-Monte Carlo Forum: “There will likely be increasing scrutiny of reinsurance security by rating agencies and regulators, in light of recent issues and fraud allegations surrounding letters of credit posted to collateralise certain reinsurance obligations by a major tech-enabled platform.”

Sources have expressed fears that action could even take the form of applying capital charges to the use of LOCs, which would challenge the viability of using them on transactions where so-called alien reinsurers are required to post collateral to reinsure US insurers.

Amid the fallout from the Vesttoo affair, it was inevitable that the use of LOCs wouldcome under the spotlight as counterparties sought reassurances around collateral quality and security.

AM Best quickly came out with a note confirming that it had opened a review into collateral arrangements at the fronting insurance companies it rates.

It said it was monitoring the situation and reviewing fronting carriers and other insurers with material amounts of reinsurance counterparty credit risk and reliance on various forms of collateral, warning that rating actions would be taken “as warranted”.

Clear Blue – ostensibly the fronting carrier most exposed to Vesttoo after its $1bn strategic capacity partnership announced last year – is among a number of carriers that have significant numbers of collateralised reinsurer relationships on their Schedule F filings.

AM Best put the company under review with negative implications, and Clear Blue has been progressing actions to replace reinsurance and collateral on the programs it fronts for.

In the kind of collateralised reinsurance transactions which MGAs and their fronting carriers are party to, a transformer such as Aon’s White Rock segregated cell platform might be used, with LOCs issued to bridge the gap between premiums held and Schedule F regulatory requirements for collateral.

But the use of LOCs as collateral in reinsurance transactions goes beyond some of the more parochial practices in the programs, MGA and fronting space.

LOCs are widely utilised as collateral in mainstream reinsurance transactions in the US to allow alien reinsurers to reinsure US insurance companies.

The requirement to post collateral applies to all unauthorised reinsurers – including collateralised reinsurers – which have to post 100 percent on transactions, typically in the form of an LOC, single beneficiary trust, or cash.

It also applies to varying degrees to rated non-US reinsurers, depending on whether they have status as a so-called certified reinsurer – where a percentage of cedant liabilities must still be collateralised – or a reciprocal jurisdiction reinsurer (RJR), where they have been approved by a state to be exempt from collateral requirements, subject to meeting various standards.

This is where the concern of some reinsurers lies – that in tightening up controls around fronting carriers’ use of LOCs in a post-Vesttoo world, rating agencies and regulators may also impose restrictions on their wider use, undermining the effectiveness or viability of this form of collateral.

“I think what conceivably comes from ratings agencies is a capital charge, an additional capital charge or different capital treatment from what they receive right now. A more punitive capital treatment,” said a reinsurance executive.

“With regulators it’s probably the same. Maybe regulators start to challenge your internal capital model, to conceivably introduce loads around LOCs. That’s where it would get meaningful for us,” they said.

Multiple sources said that – with the exception of the recent Vesttoo developments – LOCs have performed well as a collateralisation mechanism for decades.

“It would be a shame if one bad actor or a small group of bad actors bring a cloud over a mechanism that has served us all very well for decades. Do we have to now regulate and capital-load potentially to the lowest common denominator? It’s unfortunate because it’s a construct that has served us so well,” a senior source added.

A particular concern is the impact any changes would have on the fronting sector, which proportionately has been a more meaningful user of collateralised reinsurance and other unauthorised reinsurers in transactions.

Changing collateral requirements

As Aon noted in a report earlier this year, historically, US state insurance laws required non-US reinsurers – or alien reinsurers – to post collateral equal to 100 percent of the liabilities they assumed from US ceding insurers. The cedant would otherwise be hit with a US statutory accounting penalty.

But in the last 15 years there have been significant changes in US collateral requirements. In many instances, state legislatures have reduced the percentage of liabilities reinsurers are required to post collateral at.

In 2018 Florida became the first state to allow non-US reinsurers to post reduced amounts of collateral subject to certain requirements being met, a move that was followed by a number of other states.

In 2011, the National Association of Insurance Commissioners formally introduced so-called certified reinsurers, which are permitted to post reduced amounts of collateral for liabilities due to US cedants.

This was followed by the Covered Agreement between the EU and US six years ago, which aimed to eliminate collateral requirements for EU reinsurers that meet certain prerequisites.

In 2019, revisions to this agreement extended its provisions to jurisdictions outside the EU and UK which have strong insurance laws and regulations, share information with US regulators and waive collateral requirements for US reinsurers operating in their domicile. This led to the emergence of the RJR term. As the table shows, certified reinsurers and RJRs are required to meet a series of conditions and to apply for the status at state level.

The key differences between the two classifications are that certified reinsurers must have two commercial ratings, and may still have to post collateral.

Concerns of LOC change downplayed

At least one reinsurance industry senior executive told this publication that the sector may need to coordinate with rating agencies and regulators to ensure that there are no unintended Vesttoo-related reactions impacting the use of LOCs.

Others have sought to downplay the threat, however.

One senior reinsurance broking executive said that while there will be greater scrutiny among counterparties and users of LOCs to ensure that all the collateral posted is legitimate, there is no underlying reason for regulators to change the view that a valid LOC is as good as cash.

“Would the regulator and ratings agencies be wise to ask the question, ‘Have you done these things and can you show it to us?’” they said.

“I think that’s an entirely reasonable response to something that appears to be just a massive fraud. Although there’s always the law of unintended consequences, I’m not anticipating any change in capital charges.”

The executive suggested parties to LOCs are unlikely to object to any request to provide clarification documentation providing evidence that the collateral is valid in order to receive full capital credit.

“I don’t think they would object to providing that to a regulator at all, in fact I’m sure they’d actually be pleased to do so,” they concluded.