Vesttoo’s issues with allegedly fraudulent letters of credit (LOC) highlight the importance of sound counterparty risk practices for insurers, suggests DBRS Morningstar.
Citing various media reports, DBRS Morningstar has said that the allegedly fraudulent LOCs provided to insurers by investors for reinsurance transactions within the Vesttoo platform could total $4 billion.
“Most of the disputed LOCs used the name of one of the largest Chinese banks, which appears to have been unaware of the situation,” DBRS Morningstar said.
The rating agency continued, “The widespread issue with LOCs in the Vesttoo platform could have ramifications for the broader insurance and reinsurance market, particularly for fronting specialist companies, as well as for insurance brokers involved in the arrangement of these deals, with likely more than one cedent being involved.”
DBRS Morningstar noted that a weakening of confidence in collateralised reinsurance deals could have unexpected consequences for the industry, including the “overall reduction of reinsurance capital available.”
“Given the ample use of collateral, including LOCs, in the insurance and reinsurance market, cedents must adequately manage the counterparty risk arising from these transactions,” the rating agency added.
DBRS Morningstar suggested that thus far, insurance companies have reported varying materiality levels in their overall exposure to the Vesttoo platform.
The rating agency went on to explain that there is a need for additional visibility on the aggregate value of transactions cleared using the platform.
DBRS Morningstar continued, “We estimate the total size of outstanding transactions to be between $5 billion and $10 billion based on the Company’s (Vesttoo’s) total revenue of approximately $200 million in 2022.
“Several insurance companies have already suspended further transactions in the Vesttoo platform until their investigations are complete.
“Nevertheless, cedents can only use the reinsurance capacity issued through the Vesttoo platform following the occurrence of a valid claim.”
The rating agency noted that the reinsurance capacity placed through Vesttoo is mostly for non-catastrophic risks, reducing the industry’s systemic risk.
According to DBRS Morningstar, the cedents involved with the platform are verifying the validity of the standby LOCs received from investors.
“Cedents can request a replacement in collateral, including standby LOCs from different banks. If this is not possible, cedents could place existing transactions with better-rated traditional reinsurers but likely at a higher cost,” the firm said.
Marcos Alvarez, Global Head of Insurance, DBRS Morningstar, commented, “Although insurance and reinsurance companies rely mainly on financial strength ratings to assess their counterparties’ credit risk, proper validation procedures and strong know-your-client controls should be in place whenever collateral is used as a credit mitigant.
“For cedents where Vesttoo accounts for only a small fraction of their reinsurance strategies, we expect any fallout from collateral failure to remain manageable.
“However, some fronting insurance companies have more significant exposure to Vesttoo and could see a weakening of their credit profiles in the short to medium term.”
Our sister publication Artemis reported earlier today on one possible cedent, Beazley, whose CEO implied its exposure is not significant and that it could easily replace any reinsurance affected by the collateral issues at Vesttoo.
In related news, AM Best recently placed the credit ratings of fronting and program specialist, Clear Blue Insurance Group, under review with negative implications, citing uncertainty around the firm’s ability to rely on certain LOC posted to back reinsurance.
