Collateral reform for reinsurers

In November 2011, the National Association of Insurance Commissioners (NAIC) revised its Credit for Reinsurance Model Law and Regulation, which governed, among other things, the collateral requirements for reinsurers.

“It’s been a while since any new major reinsurers appeared in the United States,” said Michael McClane, managing director and head of market analysis for Aon Benfield, in explaining the rationale for the significant industry move. “We need regulations to see that insurance claims get paid. About 250 reinsurers hold the vast majority of U.S. property and casualty premiums, but many are offshore.”

While the end result is relaxed collateral requirements – previously, a100 percent rule was applied to all non-U.S. reinsurers that were not authorized (e.g., licensed, accredited, or equivalent) in the ceding company’s state of domicile – reform measures have impacted reinsurance reporting for U.S. ceding companies as well as the potential credit risk associated with some of the off-shore reinsurers.

McClane and his team continually evaluate the implications of the law and regulation as they review collateralized reinsurance transactions, and it is from that vantage point that he offered a view of the current status of U.S. collateral reform as well as an outlook for where the industry is headed.

Update on U.S. Collateral Reform

Originally passed in 1984, the Credit for Reinsurance Model Law provided a balance sheet credit for cessions made to reinsurers that were licensed or accredited (or equivalent), known as authorized reinsurers. It also provided credit for unauthorized reinsurers that provided sufficient collateral (and in the case of many non-U.S. reinsurers, this meant posting 100 percent collateral). For the ceding company, if the unauthorized reinsurer did not post collateral, a penalty offsetting the value of the reinsurance recoverable asset would be assessed.

Common forms of collateral include: cash, letters of credit (LOCs), single beneficiary trusts (a trust established for the sole benefit of a single beneficiary or ceding insurer), and multi-beneficiary trusts (MBT — a trust established for the benefit of multiple beneficiaries or ceding insurers). MBTs require state approval. However, they reduce the administrative burden (compared to some other forms of collateral) on both ceding insurers and reinsurers. Furthermore, they are much more cost efficient for reinsurers. “How much can you save?” McClane asked rhetorically. “One customer put its figure at three million a year."

While a line of credit allows for prompt payment from the bank providing the collateral, McClane said, “You need a court order in order to get money from an MBT. The time and expense is therefore shifted to the ceding insurer, which is a clear disadvantage from other forms of collateral.” Many believe that the disadvantages are moot, as the reinsurers using MBTs have a strong history of paying claims on a timely basis.

Historically, non-U.S. reinsurers faced costly burdens in meeting the100 percent collateral requirement and approached U.S. regulators and the NAIC to relax the collateral requirements. The 2011 changes were designed to assist those reinsurers that were financially capable and domiciled in jurisdictions that are considered well-regulated.

In order to post reduced collateral, the key elements of the new rules require reinsurers to:

• Apply to become a certified reinsurer within each state in which they intend to offer reinsurance,
• Maintain capital and surplus of at least $250 million (this is the minimum amount recommended),
• Be licensed and domiciled in a qualified jurisdiction,
• Maintain a secure rating from at least two rating agencies (A.M. Best, Fitch, Moody’s, S&P), and
• Submit audited financial statements and reports on assumed and ceded reinsurance balances, keeping insurance commissioners abreast of ratings and licensing changes.

Each state’s insurance department will assess the reinsurer’s rating in arriving at a reduced collateral amount, classifying the reinsurer by a secure-level rating. For instance, those reinsurers who rate A++ (A.M. Best) and AAA (Fitch/S&P) are deemed “Secure-1” and may have their collateral requirement reduced to zero, while those who rate B++ (A.M. Best) and BBB+ (Fitch/S&P) are classified as “Secure-5” and required to post 75 percent collateral.

A certified reinsurer whose rating is downgraded is granted a three-month grace period for obtaining additional collateral, if required. For catastrophe losses (i.e., hurricanes), certified reinsurers may be eligible for a deferral in posting collateral. The grace period applies to certified reinsurers at all rating levels.

Seven jurisdictions have been approved as “qualified jurisdictions” effective January 1, 2015. Reinsurers domiciled in the following jurisdictions are eligible to become certified reinsurers: Bermuda, France, Germany, Ireland, Japan Switzerland, and the United Kingdom.

Since the Act was passed in 2011, 23 states have enacted a reduced collateral law while 13 states have approved reinsurers for posting reduced collateral.

Complexities in Reinsurance Reporting

The Credit for Reinsurance Model Law and Regulation was well intentioned. Unfortunately the debate and compromise over some of the issues resulted in increased reporting complexity for U.S. ceding insurers. Some of the reporting issues that will complicate the reporting of recoverables from certified reinsurers include rating upgrades, downgrades, and tracking recoverables from catastrophes that may be eligible for a one-year deferral of collateral. Combined with the increased use of MBTs and the lack of adequate information on reinsurers at the state level, accurate reinsurance reporting may be a very labor-intensive exercise.

Collateral Management

As a result of the reform, “some of the larger ceding insurers are swimming against the tide,” McClane said, “trying to maintain existing collateral levels to avoid any potential increase in credit risk.While the reduced collateral is a regulatory minimum, ceding insurers may choose to negotiate for higher levels of collateral at the time of the reinsurance placement, incorporating amount, type, and deferral into the reinsurance contract.

Looking Ahead

While 23 states have passed legislation, representing over 60 percent of the direct written premium across all lines, reduced collateral has yet to significantly impact the U.S. market. Florida, New York, and Pennsylvania are the only states to have certified more than four reinsurers. As such, the collective industry impact has been modest.

McClane stated that “most of the reinsurers who have been approved for reduced level of collateral are highly rated entities and pay their claims on a timely basis. However, some of the larger and more sophisticated ceding insurers are beginning to proactively manage their collateral requirements. As a result, a few reinsurers have elected to let their certifications lapse.”

Additionally, reinsurers and ceding insurers are increasingly trying to leverage control, often at the expense of the other. For instance, reinsurers that have realized relaxed collateral requirements have not discounted their rates to ceding insurers. And as ceding insurers look to negotiate a higher level of collateral, some reinsurers are allowing their certification to lapse.

“More states will adopt the collateral reforms.” In addition, recent developments such as NAIC led efforts to qualify jurisdictions and analyze and approve reinsurers will facilitate the implementation of these reforms. “Over time, it will be more beneficial and cost effective for reinsurers to provide reduced collateral.”