Alirt: Vesttoo scandal calls into question ERM practices of entire fronting ecosystem
Alirt Insurance Research has said that while it believes the fronting model is here to stay, more vigilance is needed after the Vesttoo letter of credit (LOC) scandal “called into serious question” the enterprise risk management practices of the entire fronting ecosystem.
In its latest report on the sector, the research firm said fronting insurers are at a crossroads as they face the headwinds of collateral scandals and restricted reinsurance capacity.
And in relation to the fraudulent LOC scandal, Alirt said the entire ecosystem of wholesale distributors, reinsurance intermediaries, offshore reinsurers/transformers and their collateralized reinsurance platform partners has come under the spotlight after a “major black eye” for the sector.
The firm acknowledged that in an environment where mainstream insurance carriers have pulled back from the MGA and programs space, it had been necessary to find new approaches to find coverage.
This had been a principal reason for the rapid growth that has been seen in the fronting space in recent years, said the report.
“But the rapid growth of newish modes of risk transfer does heighten the risk of serious missteps, as does the fast-follower mentality of our industry.
“In this particular case, an amateurish fraud involving perhaps billions of dollars of forged letters of credit occurred right under the industry’s nose,” said the Alirt update.
It noted that LOCs are required in the segregated account of the transformer or reinsurer to protect any reinsurance recoverable to the fronting company.
“The upshot is that Vesttoo was able to ‘fund’ the segregated account at the fronting insurer with air and purportedly abscond with premium monies that passed through the fronting reinsurer.
“The fallout for the fronting insurers is that they were reporting reinsurance collateral (LOCs) that did not exist and now have to restate their liabilities – or find new sources of collateral – to account for that. Restating liabilities, all things equal, is going to result in surplus deterioration,” it continued.
In its research, Alirt tabulated the total LOCs held by its composite of fronting insurers, as well as those tied to Vesttoo and China Construction Bank – which was purported to have been the issuer on many of the bogus LOCs.
The statutory filings data shows that the composite reported a total of $3.8bn of LOC collateral at the end of 2022, equaling around 50 percent of their surplus position at that point.
LOCs tied to Vesttoo totalled $717mn, or almost 20 percent of the total.
The researchers noted that not all fronting companies were affected to the same degree, but also highlighted that based on the ratio of potentially worthless LOCs to an insurer’s surplus position, Clear Blue subsidiaries were especially exposed – although the report also acknowledged that the carrier has taken action to rectify the situation.
The analysts added: “Criticism of this corner of the P&C market is certainly warranted but this crisis will ultimately be contained and should lead to much improved ERM practices. In short, it has been a very uncomfortable wake-up call to an immature corner of the US P&C industry – but should remain only a growing pain.”
Other headwinds more important
In the report, Alirt suggested that two other phenomena could have greater impacts on the viability and growth of the fronting carrier group: significantly harder reinsurance markets and substantially higher interest rates.
“While demand for specialty coverages remains high as admitted markets retrench in the face of unexpected loss trends, primary insurers – and especially fronts which depend so critically on reinsurance support – face a greater restriction of reinsurance capacity (i.e. supply),” the report detailed.
The firm said this has been especially true for riskier property exposures but is also spreading to casualty capacity as well.
“In short, should the backend of the fronting model dry up, then the fronting insurers themselves will find themselves bereft of capacity to support new business. This may already be occurring to some extent,” it continued.
Meanwhile, the spike in the interest rates over the last two years has made for a higher cost of capital, which has had a dampening effect on private investment of all sorts.
“One may have expected more merger and acquisition activity within the fronting community, much as we saw in the full stack insurtech space a couple of years ago. But that has become less likely in the current interest-rate environment.
“The Vesttoo debacle also seems to have given several possible acquirers pause – at least for the time being,” the report said.
It also commented on the notion of “asset-light platforms representing a new frontier”, coined in a recent report from Conning and Howden Tiger.
These platforms include MGAs, fronting companies and reciprocal exchanges.
“We certainly agree, at least theoretically, that these new mechanisms provide an efficient way for unique or hard-to-place risks to be modeled, underwritten, and brought to market, especially given the rapid expansion of the MGA/PA/fronting model (and new technologies and diaspora of talent, etc.) over the past several years.
“That said, we do sometimes wonder, at least in some instances, whether ‘traveling light’ may be resulting in a ride on the ‘Moral Hazard Express’. After all, risks can easily escalate when one is playing with someone else’s money,” Alirt concluded.
Alirt scores remain “decent” despite missteps
Alirt also updated its scoring of individual composite fronting carriers, and noted that even with the amount of “noise” surrounding the segment, for the most part scores remained “decent”.
The firm said that as of the half-year 2023 reporting cycle, three of the composite insurers performed above a first standard deviation based on the distribution of over 100,000 Alirt Scores produced over the past two decades for US P&C insurers – reflecting a “stronger than average” financial profile.
These included Knightbrook Insurance Company, Palomar Specialty Insurance Company and United Specialty Insurance Company.
A total of 35 of the companies in the composite scored within the normal solvent company range, with nine scoring below one standard deviation of normal.
“Because so many fronting specialists remain in start-up and/or rapid growth mode, they will often operate with sizable operating losses as they seek to scale their business.
“Two principal ways to offset this strain of rapid growth, and preserve long-term financial viability, is by participating in broader inter-group pools and/or by receiving surplus infusions. As analysts, we see both of these trends still very much in evidence,” said the report.
It added that the fronting model lends itself to much higher than normal premium leverage, because so much direct or gross premium is ceded to third-party reinsurers.
“The claims-paying willingness and ability of these reinsurance partners is of critical significance to a fronting insurer’s ongoing financial wellbeing. This is why the Vesttoo situation has caused so much angst within the fronting community,” the Alirt analysts suggested.