Avoiding the Reinsurance Credit Risk

September 2005

One of the most important aspects to consider when developing a reinsurance program for a book of business is the credit risk associated with the reinsurance selected for the program. Like all financial transactions, there is always a risk that a counterparty will develop solvency issues or will become a slow payer or nonperforming. It is crucial to maintaining a viable book of business that the reinsurance associated with the business remains available to respond to losses as they become due.

by Larry P. Schiffer
LeBoeuf, Lamb, Greene & MacRae LLP

The ramifications of the loss of reinsurance support for a book of business are many and can cause serious financial losses for the reinsured and sometimes the underlying insured. Selecting a reinsurer that responds to payment requests promptly and is willing to remain with the program for the long haul is the goal of every reinsured.

Selecting the Reinsurer

All insurance and reinsurance companies are rated by numerous rating organizations for financial stability. Those reinsurers that are public companies or are owned by public companies are subject to even more financial scrutiny. It is more than obvious that the ratings of potential reinsurers should be examined before entering into a reinsurance program.

Today, there are a wide variety of rating organizations ranging from the traditional insurance specialists like A.M. Best to financially oriented rating organizations like Standard & Poor's. Each rating organization obtains financial information from every U.S. reinsurer (and often from non-U.S. reinsurers) and often meets with the management of those reinsurers before issuing a rating decision.

That a reinsurer is given a top rating by the rating organizations is not, however, a guaranty that the reinsurer will not suffer a financial downfall in the future. We know from the experience during the last 30 years that many an "A" rated carrier has become insolvent with an alarming degree of speed. Rating organizations were subject to extensive criticism for failing to predict the insolvencies of a number of well-known carriers. In response to those criticisms, the rating agencies have been much more conservative in their ratings in the last several years, which is why there are many fewer top-rated carriers, including reinsurers, today.

What this means is that the recent "flight to quality" by reinsureds has its limits. The highest quality reinsurers have the luxury of turning down deals on programs that are not clearly profitable because they are in such demand. This is problematic for a program in turnaround mode or for a new program with no real loss history. The highest quality reinsurers have no reason to take unnecessary risks on a questionable or start-up program. Programs with potential problems will find it difficult to land a reinsurer with the highest ratings unless there is a strong preexisting relationship or past history between the parties.

Besides ratings, a reinsurer's reputation in the industry for paying losses must be considered. The ultimate responsibility of an insurance company is to pay claims. That is true of reinsurance companies as well. If the reinsurer you are considering for your program has a poor reputation for responding to loss notices and has a poor track record of timely payments, then you need to consider alternatives.

Reinsurance brokers also maintain lists of reinsurers in the brokers' market that are considered by the broker's security committee to be creditworthy. Reinsurance brokers have an obligation to place business with reinsurers that are not solvency or credit risks and under some state's regulations have a duty to inquire into the financial condition of the reinsurer and report those findings to the reinsured. Reinsurance brokers are excellent sources for intelligence about the ability or willingness of a reinsurer to pay losses when due.

Obtaining Security

Of course, the best way to avoid a credit risk or a solvency problem with a reinsurer is to obtain security for the reinsurance recoverables that ultimately will be paid by the reinsurer. Obtaining security, however, is easier said than done. Under traditional reinsurance contracts, unless the reinsurer is not admitted or accredited in the reinsured's state of domicile, it is rare to see a reinsurance contract requiring security. The theory here is that a licensed or accredited reinsurer is under the regulatory control of the relevant insurance department and will be vulnerable to legal process in the state to enforce the reinsurance contract.

A reinsurer that is not licensed or accredited in the reinsured's state, however, must post security in order for the reinsured to take credit on its financial statement for the reinsurance. Because taking credit for the reinsurance on the financial statement of the reinsured is a major purpose of obtaining reinsurance in the first place, nearly all reinsurance contracts have a clause that provides for the posting of security by a non-admitted or non-accredited reinsurer for credit for reinsurance purposes.

In the last few years, however, there has been a movement toward obtaining security from licensed reinsurers to avoid the ramifications of a rating downgrade. These provisions are obviously subject to negotiation and a highly rated admitted reinsurer is unlikely to agree to post security unless there is a strong business reason to do so. If, however, the program is very profitable, the reinsurer may be willing post some level of security to remain a part of the program.

Another clause in reinsurance agreements that has gained popularity in the last few years is the downgrade clause. This clause may allow the reinsured to cancel the reinsurance contract (and then seek a new reinsurer) if the reinsurer is downgraded by the rating organizations. Other similar clauses require the reinsurer to post security in the event of a rating downgrade. The triggers for these clauses vary from a single step downgrade to a specific downgrade level (e.g. "B+").

Types of Security

Where a requirement for security exists in a reinsurance contract there often is a choice of the type of security. Broadly speaking, security may take the form of cash (often funds withheld), trust funds, and letters of credit. Each of these forms of security has different ramifications and different requirements.

Some reinsurance contracts require that a portion of the reinsurance premium be held by the reinsured in a special account to pay claims. Often these "funds-withheld" accounts are beneficially in the name of the reinsurer, which receives an interest rate credit for these funds reported to it for its annual statement purposes. The purpose of the account is to allow the reinsured (or the managing general agent) to have a fund to pay claims without having to approach the reinsurer for payment requests for smaller claims. This structure is typical of a program controlled by a managing general agent where the reinsured is really just a front. Usually a funds-withheld account is limited to a specific dollar amount, which gets topped off on a quarterly or other periodic basis. Large claims, however, may not be covered by a funds-withheld account and cash calls to the reinsurer, which are unsecured, may be required depending on the loss emergence patterns.

Trust funds are often used as security devices in reinsurance agreements where the reinsurer is not admitted in the reinsured's state. Most states have regulatory requirements for valid trust funds. The trust agreement must have certain terms required by regulation or statute to allow for the reinsured to take credit for the reinsurance on its financial statement. Trust funds also require that a third-party trustee be involved, usually a bank, to hold the funds subject to the trust agreement and the reinsurance contract.

Letters of credit are the cleanest form of reinsurance security. There are regulatory requirements for letters of credit, which generally must be unconditional and evergreen (meaning that they automatically renew for as long as the reinsurance remains in existence). Letters of credit are issued by a bank in favor of the reinsured. The reinsurer has no interest in and maintains no control over the letter of credit. The reinsured merely submits a draft to the bank and the bank must draw down on the letter of credit. Of course, if the reinsured draws down on the letter of credit without a valid basis, the reinsurer may have a cause of action for breach of the reinsurance contract. Letters of credit are favored by reinsureds because in the event of the reinsurer's insolvency the letter of credit is not part of the insolvent estate (that does not mean the liquidator will not try to prevent a draw down).

Basis for Security

In particular lines of business it is easy for the reinsured to become undersecured. Most often, security requirements are established based upon the reinsured's reporting of unearned premium and incurred losses. Incurred losses often only includes paid losses and reserves, not incurred but not reported (IBNR) losses. With a book of long-tail exposures, it is often the IBNR losses that make up the largest component of the reinsurer's ultimate obligations. If the security is not set based on incurred losses including IBNR, and the reinsurer becomes recalcitrant or unable to pay, the reinsured may find itself woefully undersecured. Modern regulatory requirements for unlicensed or unaccredited reinsurers require that security be posted for the gross liabilities of the reinsurer, which includes IBNR. Of course, if the reinsured's IBNR calculations are deficient the provision for security will be deficient as well.

Conclusion

Creating a reinsurance program for a book of insurance business requires careful consideration of potential reinsurers. The best-case scenario for a reinsured is to have its reinsurance recoverables secured to avoid any unnecessary credit risk associated with obtaining reinsurance.

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