Friday, 14 December 2012
International programs fronting and collateral - the insurer's view
Collateral requirements for captive fronting programmes are not popular among captive owners. But they are a necessary part of a programme, and insurers are at pains to explain why the particular forms of collateral are required.
Clive Hassett, Director of Multinational Services, ACE European Group
What does a fronting insurance company take into account when looking at captives? Vinko Markovina, Allianz Global Corporate & Specialty, speaking at a workshop at the recent Luxembourg Captive Forum, provided a list of the key areas that an insurer would examine:
- Financial strength of the captive - capitalisation as per the latest financial statement will be considered for security vetting;
- Exposures - run-off exposures, expected exposures and "worst case exposures will be considered. A combination of run-off exposures and worst case exposures usually gives a good idea of the capitalisation required;
- Tail of the ceded business (short and long tails);
- Rating of captive - most captives are not rated, but if they are, the rating sought is A for short tail or A+ for long tail. Most carriers accept ratings from agencies such as Standard & Poors, Moody's, Fitch and AM Best. However, a rated captive still has collateral requirements;
- Retrocession: Net line cession (captive retains all ceded risk net) and Gross line cession (captive retrocedes part or all of the exposure). Net line cessions are preferred structures by carriers for captive cessions. With gross line, securing security requirements may increase as the fronter has no control over reinsurance purchases by the captive;
- Solvency of the captive's parent is considered and the parent needs to have acceptable security. If the rating of the parent company is BBB- or worse (S&P or equivalent), additional collateral may be required;
- Long-term agreements, typically 12 months in duration with special approvals warranted that exceed 12 month periods.
On the latter point, Mr Markovina said, "We need to be extremely confident that we are going into a long-term relationship, five years plus, but the actual agreement would be for 12 months, sometimes 18 months. We don't like long term agreements because of the market cycles and fluctuations."
Clive Hassett, ACE European Group Ltd, speaking at the same workshop, listed what insurers consider to be qualified collateral. Firstly, Letters of Credit, which need to come from an AA- rated bank, though some exceptions could be made on a case-by-case basis. Secondly, guarantees, which normally come from the parent of the captive and have adequate rating, i.e. have an S&P rating of at least A for short tail and A+ for long tail business. And finally, assets, secured in the favour of the fronting carrier in the form of trust accounts, asset pledges, escrow accounts and deposits.
He explained that there may be competition as to what carriers are prepared to accept as collateral. Some of the softer options include Cut Through Agreements, Simultaneous Payment Clause, Comfort Letters, and Pay as Paid agreement. These would not typically stand alone, but they are can potentially come into play, said Mr Haslett.
Eberhardt Goerke, Managing Director at MIB METRO Group Insurance Broker, who chaired the workshop, said he was a fan of the so-called softer options, "because coming from the German legal environment, guarantees and letters of credit are things that no CFO in a German company likes to see. We are doing whatever we can to reduce guarantees and letters of credit because they are heavily involving our ratings. So finding softer or different solutions, even if they are a little bit more complex in administration, can be very helpful."
Mr Markovina said that fronting captives is not an off the shelf product and every decision is taken on a case-by-case basis. However, he pointed to the following as minimum criteria:
- Captive is sufficiently capitalized to sustain expected losses;
- Parent company seems willing and capable of supporting the captive in case of adverse loss development; and
- Financial strength of captive and mother company seems sustainable for the duration of the tail.
"If these cannot be ascertained, collateral has to be delivered by the captive or other guarantors to mitigate the credit risk, and therefore, additional collateral might be required," he said.
Some insurers believe that the requirement for captives to post collateral is increasingly driven by regulatory and rating requirements, rather than 'just' credit risk.
The issue is that fronting companies may not be able to recognise, in full or even in part, the reinsurance recoverables from their captive reinsurers when calculating their own solvency margins, or when presenting their case to rating agencies - and this can have an implication for both regulatory capital requirements to meet such solvency margins, and rating agencies' view of a fronter's financial strength.
This is the view of Philippe Gouraud, Head of Client Management Group and Global Risk Solutions, Europe, AIG, and he pointed out that the capital requirements for fronting for a captive depend on two variables: where the fronting company (and its ultimate parent) are regulated and where the captive is domiciled.
He said the most obvious issue is, when the fronting company has to post gross loss reserves, how much of the reinsurance recovery can be recognised as an admissible asset? If the answer is 'none', then the fronting company will need to hold capital as if the risk was kept net. He added that the same issue applies to IBNRs, and unearned premium reserves. In some countries, such as Canada, a multiplying factor is also applied.
All of this will affect both the cost to front the programme and the availability of capital for the fronting company, at the subsidiary and group level, said Mr Gouraud. However, there are solutions, he added, pointing out that if the reinsurance cannot be recognised, for example, different forms of collateral can be posted, such as cash with-held, trust accounts or letters of credit. Fronted programmes can also be modified to create a more efficient structure to face these capital and collateral considerations.
"It's just a matter of being able to think outside the box," he explained. "Just as an example, a net line cession, where only the captive net retention is ceded, is more effective than a gross line cession, where the fronter cedes both the captive retention and the captive's market retrocessions. The outcome for such collateral or structural change is that there is no increased cost of capital to be passed through into the overall pricing."
He concluded, "So, the collateral requirements are increasingly being driven by regulatory capital needs and rating considerations, rather than by the counterparty concerns. However, this is not really a 'new' issue; these requirements are commonly included in facultative reinsurance agreements used everyday in the reinsurance world. But pressure on capital across the whole industry means that everybody is now paying more attention to the issue."