Conning: Diligence, reinsurance costs, ratings scrutiny among Vesttoo fallout

Conning has highlighted a greater focus on diligence and risk management, reinsurance costs and diversification, regulatory and rating agency scrutiny, and fronting sector growth impacts as among the key ramifications of the ongoing Vesttoo scandal.

In a commentary outlining key market issues that the Vesttoo controversy has brought into the spotlight, Conning said it was “almost unfathomable” that a fraud thought to total in the billions of dollars of fake letters of credit (LOCs) could have occurred “under the eyes” of so many in the market.

“Yet here we are, six-plus weeks into this abyss without a clear answer,” Conning said in the commentary.

Within its report Conning examined why collateralised reinsurance capacity has become such a significant component of security for the fronting world, as opposed to purchasing reinsurance from traditional markets.

“The most obvious answer is it was probably cheaper, at worst because it was the only reinsurance available,” Conning wrote.

“Many news articles have been tracking the fate of the Vesttoo fallout, including ones suggesting some of the fronted programs had been turned down by the traditional reinsurers,” Conning noted.

The report noted that the impact of the scandal has mostly been felt “in a few niche corners of the market”, as it said the episode represented “a clear black eye” for both the “rapidly growing fronting market” and what it described as the “opaque” collateralised reinsurance market.

As this publication analysed earlier this week, fears are growing as the Vesttoo scandal deepens that heightened scrutiny around LOCs may see rating agencies and regulators take actions that disrupt a long-established practice.

Effects from niche part of the market could be broad-based

Despite the scandal emanating from a niche market segment, Conning said that the repercussions will be “far reaching” for the broader industry.

“We expect the fallout from Vesttoo will continue to evolve and expect the ramifications will be significant,” Conning said.

The asset manager’s report grouped the implications of the scandal into four broad categories: diligence and risk management, reinsurance costs and diversification, regulatory and rating agency scrutiny, and prospective growth for the sector.

“We expect the fronting companies are revisiting their procedures around the procurement of reinsurance,” the commentary said, saying that the diligence process around counterparty risk “appears to have been lacking”, with many fronts effectively outsourcing LOC procurement.

Conning noted that as fronting companies have been scrambling to replace reinsurance and LOCs, they are turning to other markets and banks for this capacity, where in some cases a solution may be as simple as finding replacement LOCs.

“Replacing LOCs can address the immediate problem,” Conning commented.

“However, longer-term concerns about counterparty risk with weakly capitalised reinsurers remain,” it continued.

“Fronts may take the view that exposure to collateralised markets should be reduced, perhaps for a variety of reasons. If this is the case, it certainly implies an advantage to traditional reinsurance markets. The big question is, will this be at a higher cost than what is being replaced?”

Scandal likely to spark greater regulatory, rating agency scrutiny

Conning also noted that despite the scandal breaking in mid-July, after the second quarter, the event is a reportable one for the Q2 statutory statement filings for companies with exposure.

“If replacement LOCs were not obtained by 15 August (the statement filing date), an insurer may be required to post a provision for reinsurance charge,” it noted.

The Insurer reported over the weekend that Clear Blue filed delayed Q2 statutory financial statements which include a $15.8mn charge for the writedown of collateral on run-off business in relation to Vesttoo and Corinthian Group.

Conning also noted that rating agencies, specifically AM Best, as well as state regulators have a large vested interest in fully understanding insurer exposures.

The rating agency said the week after the scandal broke in July that it is “monitoring the rapidly evolving situation” regarding Vesttoo and concerns over fraudulent collateral, and warned fronting carriers and other insurers that they may face rating actions.

On the same day, AM Best put Clear Blue’s A- financial strength rating under review with negative implications as it acknowledged that the fronting carrier was “aggressively” working to address the “uncertainty” tied to letters of credit associated with Vesttoo-related reinsurance it has placed.

“We can assume that the rating agency will be taking a conservative approach to rating affirmations. It remains to be seen if all this leads to more significant changes in capital models or rating requirements,” Conning said this week.

Fallout could add to fronting market’s pressure for growth

Conning had already said in its July report on the fronting market that it already expected growth in the sector to be under pressure, even before news of the fraudulent LOCs at the troubled insurtech emerged.

“Now Vesttoo is yet another factor that will slow the growth in the fronting market,” Conning commented.

“Both reinsurance capacity and equity capital are likely to be in higher demand, and it is unclear if either of those elements of support will be readily available,” it continued. “While insurers cannot fully insulate themselves from fraud, especially a potentially highly sophisticated fraud, they can act to minimise concentration risks.”

Conning added: “If the surprise write-down of a reinsurance recoverable by Trisura at year-end 2022 was a wake-up call of the perils of rapid growth, we are not sure how to describe this most recent development.

“Given the rapid growth of Vesttoo and fronting market premiums, more scepticism should have been warranted.”