Financial risk is an inherent part of the insurance market, an industry well-versed in managing such risks. However, the emerging facts surrounding the InsurTech disruptor, Vesttoo, remind us that vigilance towards risk exposure within our businesses is paramount. This vigilance extends beyond mere risk transfer accepted from clients but also encompasses the way carriers identify and mitigate risks more generally.
The capacity provided by the Insurance-Linked Securities (ILS) market, through collateralized reinsurance, is estimated to be around $55bn. This vehicle for managing catastrophe losses is increasingly utilized across the insurance market.
Collateralized reinsurance provides several key benefits. It reduces counterparty risk without restricting balance sheet optimization mechanisms of reinsurance cover. Additionally, it can offer protection for the ultimate net loss sustained by a reinsured. Furthermore, it offers flexibility and customization for both a cedant and the protection provider. This mechanism opens up channels for accessing and providing lines of credit through traditional and non-traditional sources.
Vesttoo, an InsurTech company founded in 2018, provides such products. They offer collateralized reinsurance products through a model that meshes the capital needs of the insurance industry with the low-volatility investment objectives of capital markets. As a marketplace for non-catastrophe insurance-based risk transfer and investments, Vesttoo was valued at $1.5 – 2 bn in May 2023.
However, in July 2023, Vesttoo became embroiled in a fraud scandal. It was discovered that fake letters of credit had been provided by an affiliated bank to the company, representing around £4bn in collateral. The extent of the fraud’s impact on insurance market players remains unclear.
Fronting specialist Clear Blue Insurance Group revealed it had paid at least $23 million in commissions to Vesttoo entities that provided collateral for reinsurance deals. Clear Blue and other similar specialists faced the risk that required reinsurance capacity to support transactions would not be there, or that the collateral security would not be valid to support their client programs. This led to Clear Blue joining a legal case involving Vesttoo as a creditor to the Chapter 11 action, alongside Aon’s segregated accounts and reinsurance transformer company White Rock Insurance (SAC) Ltd.
While Clear Blue has publicly stated its intention to seek more reinsurance to protect its surplus and capital, this has not stopped them from being put under review by AM Best. Prompted by concerns about its ability to rely on certain letters of credit, Clear Blue’s A-rating has been qualified with a negative outlook, while the effectiveness of mitigation strategies to address this issue are assessed.
This scandal poses numerous questions for those using collateralizing instruments for their reinsurance arrangements. The implications of such scandals should be considered through the lenses of solvency and financial security, supply chain management, and reputational risk.
Whether you’re a carrier or an MGA, if you use collateralized reinsurance to retain a portion of a risk on your own balance sheet, you need to understand the potential financial implications, including:
- Loss of Collateral: In the event of a default by the reinsurer, the cedant may lose access to the collateral.
- Operational Risk: The process of collateralization is complex and can lead to operational risks, such as errors in documentation or mismanagement of collateral.
- Legal Risk: If the validity of the collateral is disputed, it can lead to lengthy and costly legal disputes.
- Reputational Risk: Any association with fraudulent activities can lead to significant damage to the reputation of the involved parties.
The insurance industry must remain vigilant and proactive in identifying, understanding, and mitigating these risks. By doing so, we can continue to harness the benefits of collateralized reinsurance while protecting our businesses from potential pitfalls.