Vesttoo issue shows importance of sound counterparty risk practices: DBRS

Rating agency DBRS Morningstar says that the credit implications of the Vesttoo linked collateral issues should remain manageable for most insurance and reinsurance firms, but that “a number of fronting specialist insurers could have more significant exposure.”

Overall, DBRS Morningstar says that the Vesttoo episode highlights “the importance of sound counterparty risk practices for the insurance industry.”

But the rating agency estimates the potential industry exposure to Vesttoo related collateral as between $5 billion and $10 billion, higher than any previous estimates we’ve seen.

Of course, for the true implications to be that significant, it would require every collateral provided to back a Vesttoo facilitated deal to be invalid, or lacking in value, something that has not been alleged so far.

Recall, that an incident where a cedent tried to cash in a letter of credit (LOC) linked to a transaction facilitated by Vesttoo kicked off an investigation, as we reported before, an ongoing audit is said to have found that multiple letters of credit (LOCs) are involved, all of which were issued by the same bank.

As we said at the time, this appears to be a significant failure of collateral security controls and even KYC.

DBRS Morningstar commented, “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.

“A weakening of confidence in collateralized reinsurance deals could have unexpected consequences for the industry, including the overall reduction of reinsurance capital available.”

It’s important to note here that, while these are collateralized reinsurance deals, backed by LOCs, they are a long-way from the typical insurance-linked securities (ILS) market practice of cash collateralized deals, with assets held in trusts and invested in liquid assets such as treasuries.

LOC use is much less typical in ILS than it is in traditional re/insurance, including wide use in the Lloyd’s market to support Funds at Lloyd’s.

Echoing our thinking from when the news first broke about Vesttoo, DBRS Morningstar rightly notes that “The integrity of collateral is critical” for the market.

“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. 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,” DBRS Morningstar continued.

The rating agency said that, “We need additional visibility on the aggregate value of transactions cleared using the platform.

“However, we estimate the total size of outstanding transactions to be between $5 billion and $10 billion based on the Company’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.”

But mitigating the potential size of the problem, “Nevertheless, cedents can only use the reinsurance capacity issued through the Vesttoo platform following the occurrence of a valid claim. More importantly, the reinsurance capacity placed through the Company is mostly for non-catastrophic risks, reducing the industry’s systemic risk.”

“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,” Marcos Alvarez, Global Head of Insurance at DBRS Morningstar said.

“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.”

We 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.

Also read:

July 27th – Beazley CEO on Vesttoo: We would look to replace cover & recover premium.

July 26th – Clear Blue rating under review with negative implications on Vesttoo issues.

July 25th – Vesttoo: Updated statement says appears “procedures were circumvented”.

July 25th – AM Best to review fronting collateral in light of Vesttoo news.

July 25th – Fronting company Obsidian says Vesttoo exposure “de minimus”.

July 24th – Clear Blue: No material rating impact from Vesttoo issue. Reinsurance may be required.

July 21st – Vesttoo: Multiple LOCs from one bank in focus. Failure of security controls or KYC?

July 20th – MS Transverse: Any exposure to Vesttoo LOC collateral issues “immaterial”.

July 20th – Vesttoo: Collateral damage.

July 19th – Vesttoo: New report claims significant amount of forged LOCs. The question is how?

July 18th – Vesttoo faces fraudulent collateral claim. Confirms investigation, exit of some leaders.