“LOCs tend to come from large institutions that are highly rated. We do
quite a bit of LOC work with Credit Suisse and also some local Zurich banks. On the LOC side, it is crucial that we have very good service, because our business is very time-sensitive. There is a very short window during which the trade has to be done and collateral needs to be in place.”
Other businesses use these kinds of mechanisms to fulfil regulatory demands. “We only usually place collateral to meet regulatory requirements, such
as in the US,” says Gerhard Lubitz, head of collateral management and corporate finance at Hannover Re. “For all life and health business, along with most of the business from pre-licensing times, we still use letters of credit to cover our liabilities.”
“Banks offer a broad number of reporting functions that can be accessed online, along with fast-track account opening and the provision of trust wordings, which comply with the regulations of the individual states—or if that is not necessary—comply with the requirements of the underlying reinsurance contract.
Although there have been moves to reduce the amount of collateral
reinsurers need to post in some states in the US, this has not detracted from the need for collateral being posted.
“As long as the US requires reinsurers to collateralise US liabilities, they
are absolutely essential,” says Lubitz. “In Florida and New York, we now have status as an eligible reinsurer,
which means that we can benefit from reduced collateral requirements. However, we still have to place collateral and therefore we use these services.”
But outside the US, LOCs and trusts are becoming more important as
regulators demand more of insurers and reinsurers. “Generally in the US, posting collateral has been part of reinsurance
for years. In Europe, collateral has not (historically) been as common. For years, the ‘hand shake’ agreement often worked, without any collateral being posted,” says Robert Quinn, vice president of collateral trust services at Wells Fargo.
“Now, European businesses are recognising the credit risks associated
with reinsurance, and collateral is becoming more common. Insurers around the world realise that they could face problems if they don’t ask for collateral.
“As Solvency II is about gaining uniformity in the EU and about insurers
demonstrating their solvency and ability to pay claims, collateral will probably become part of the programme.
“For example, if an insurer in London underwrites $100 million worth
of German windstorm policies and buys reinsurance, the insurer is going to have to demonstrate an ability to pay those claims even if its reinsurer goes bankrupt.
“Regulators will want to know that the insurer is good for it. One way
to do this is to make the reinsurer post collateral that can be drawn on in the event of a claim, regardless of what has happened to the reinsurer.”
“ As Solvency II is about gaining uniformity in the EU and about insurers demonstrating their solvency and ability to pay claims, collateral will probably become part of the programme.”
Others agree with this forecast that the use of collateral will become
more commonplace in Europe. “Our clients and their regulators always require formal assurance that
reinsurers will be solvent to pay claims. So letters of credit and trust facilities, to me, are some of the most critical services banks provide us with as they are an efficient way for reinsurers to provide that formal assurance to clients,” says Patrick Boisvert, chief financial officer of Flagstone Re.
The issue of collateralisation is set to be a big topic given the new
regulatory regime the industry faces. “With the onset of Solvency II, where an insurer is the beneficiary,
collateralised structures will take more prominence,” says Mick Murphy, managing director of UK asset management and insurance at BNY Mellon.
“For example, an insurer with an LOC will assess its exposure using
the counterparty risk model, which takes account of factors such as credit ratings. This allows risk mitigation techniques under Solvency II to be included so that since the collateralised custody is ring-fenced from counterparty default, it provides additional benefits to beneficiaries.”
While regulatory regimes such as Solvency II focus on ensuring the
solvency of insurers, insurers must also monitor the solvency of the banks they use for LOCs, argues Julian van Kan, head of the financial institutions group at BNP Paribas.
“We are now living in an environment where from one day to another,
we don’t know which banks are considered creditworthy or not. That should be insurers’ primary concern,” he says.
“For a long time, insurers have accommodated that risk through fronting banks, but today there are fewer banks considered fronting banks, for all sorts of reasons.
“This is not only because of the cost of funding but also changes under
Basel III and how a fronting bank is defined in a large letter of credit, for instance. It has actually become very costly for a single bank to be a fronting provider.”
To overcome some of these challenges, better communication is required
between the insurance and banking industries, argues van Kan. “I believe the banking industry and insurance industry must discuss what
is practical and what isn’t, what works and what doesn’t work,” he says. September 2011 | INTELLIGENT INSURER | 29
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