The Economic Bailout and Its Unintended Consequences
April 2009
Events are moving quickly in the insurance
world and our little slice of it. It behooves one to keep up to the extent
that you are able to do so.
by Michael
R. Mead
M.R. Mead &
Company, LLC
It is no longer conjecture that the federal government will be involved
in the regulation of insurance; the only question now is how and when. Bills
to regulate some or all insurers to varying degrees have been introduced.
Whether or not they will pass this time around with all of the other issues
confronting the Administration is problematic, but the probability is
certainly greater than in years past. This is an issue which bears a close
watch to determine the effect, if any, on captives, but it is not the
subject of this article.
Beyond regulation, the "Law of Unintended Consequences" is now arriving
on the captive scene in the form of fallout from bank failures and bank
problems being addressed by the Troubled Asset Relief Program (TARP).
The "economic crisis" affecting much of the world is showing itself in
surprising ways to captive owners and managers. If you have not yet
encountered the issue, then this discussion may help you prepare.
Reinsurance and Collateral
Two strong influencers of captive success, reinsurance and collateral,
are both being affected negatively, and the pain is spreading. Late last
year, many captives began to find that the cost of letters of credit and
other forms of collateral were getting more dear as the banking industry
struggled with its problems, well discussed elsewhere [see
Captives and Collateral (August 2007)].
Banks began to restrict the lines of credit, and/or negatively adjust the
terms of letters of credit supporting the captive's collateral.
Collateral Alternatives
At the same time, many fronting companies were beginning to increase
their collateral requirements, causing the captive owners and managers to
consider alternatives. One of the alternatives was the purchase of
reinsurance at lower attachment points. By reducing the limits written by
their captives, they were able to obtain reinsurance at lower levels, thus
reducing the amount of collateral needed to support their letters of credit,
and reducing the letters of credit themselves.
This strategy is definitely a short-term solution based largely on then
reasonable reinsurance terms. It made sense to take advantage of the market
in the fourth quarter of 2008. In the first half of 2009, that position must
be reconsidered.
Rising Reinsurance Rates
Coming into play now is the predicted rising rates for reinsurance. Some
have observed that this may be in the category of a self-fulfilling
prophecy, but the facts show that reinsurers had a tough year in 2008 not
only from natural catastrophes but also investment losses, along with the
rest of the world. These losses must be recouped, and there is only one way
to do that—raise rates. The midyear renewals should see the first effects of
this strategy and may well carry forward for quite some time.
Bank Problems
Intersecting the rising rates are the credit crunch and the troubles of
banks. As captive owners evaluate their existing and proposed letters of
credit, bank lines of credit, and the size of their deposits in the banks,
fronting companies and reinsurers are considering their exposures to
troubled banks. This is a very delicate situation that must be navigated
with care and skill. Who is to judge the maximum amount of money to be
deposited in major banks whose share prices have plunged and who may be
hanging on to solvency by a federal thread? At what point are directors and
officers of a captive exposed to the consequences of choosing a bank which
defaults and ties up or destroys assets needed for claims and capital? What
is the role of regulators in this process? Will they be state regulators or
federal?
Some fronts and reinsurers have preempted the captive owners' analysis by
restricting the overall exposure of the front/reinsurer to the banking
exposure. In some cases, captives have been advised to find another bank to
hold their deposits or to issue their collateral support. The
fronts/reinsurers are seeing a genuine credit risk from some of the leading
banks.
To the front/reinsurer now comes the same question being asked of the
directors and officers of the captive posed above: When is the company at
risk for using a "threatened financial institution"? The quite natural
response is to limit exposure. Banks are being rejected as acceptable
issuers of letters of credit or as acceptable depositories, even while the
banks in question continue to be licensed and to operate.
What is now the process to select the financial institution for your
captive if it is licensed, operating, but may have appeared on a fronting
company/reinsurer's "do not use further" list? How do you renegotiate your
attachment point as reinsurance rates rise and collateral becomes more
sticky? How will you renegotiate collateral with a federal regulator,
whether that regulator is an insurance authority or the overseer of a failed
financial institution, be it bank or insurer?
Conclusion
I suggest for your consideration that, if you have not yet encountered
these issues, you will before the year is done. In keeping with the purpose
of captives as vehicles of control, it behooves the prudent owner/manager to
be in early discussions with the fronts, reinsurers, and banks to be in
agreement and to quickly put terms in place that will provide the captive
the best opportunity to succeed.
There are no quick, easy answers for this unintended consequence, just as
there none for the other parts of the current economic crisis. But early
airing of the challenge, and prompt and frank discussion of alternatives,
will serve us well going forward.
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