Collateral Trend : Crippling For Global Reinsurance Industry

The apparent desire by some insurers to impose similar burdens on all reinsurers might at least illustrate graphically to the American reinsurance industry the problems faced by their foreign counterparts. Unfortunately, it is also likely to have a crippling effect on the efficient and cost-effective provision of global reinsurance.

Imposing a collateral requirement as a matter of course would be an extraordinary burden and contravenes the very principles on which the reinsurance industry has developed.

The collection of premiums from the many to reimburse the losses of the few has always operated with companies planning and managing their net, not gross liabilities.

In some circumstances where there is a real and significant credit risk, it can be justified, just as in other areas of commerce where letters of credit, for example, are used to manage credit risks.

But where there is a financially strong counterparty or reinsurer, excessive collateral requirements are problematic and unnecessary.

First, such a move artificially restricts capacity.

Eventual profitability is, of course, the primary concern when deciding how much business to write with a certain client or in a particular region. An unwarranted collateral requirement clearly reduces potential returns, because for every $1 of liability incurred, a reinsurer must not only ensure it has available cash to pay net losses, but also that it has sufficient assets to provide acceptable collateral for its gross liabilities.

Inevitably, therefore, widespread collateral demands would lead to a significant reduction in the range of reinsurance capacity available to insurers.

As well as exerting a direct constraint on capacity, collateral requirements can also prove very expensive indeed. One obvious cost is a reduced level of investment income due to the exceptionally limited range of investment options for assets posted as collateral. Generally these must be very liquid and easily accessible, even though, in practice, it may take the insurer years to settle any original claim.

Then there are direct bank charges for letters of credit or other security used as collateral. The burden here was neatly summed up by Lawrence Mirel, Commissioner of Insurance for the District of Columbia, when he addressed a recent IUA briefing in London. "It does not help anyone except New York bankers," he said, commentating on the United States existing 100 percent collateral requirement for alien reinsurers.

Last, but not least, are the sizeable overhead costs, including dedicated personnel, accounting systems and other resources, that must be met in order to post and reduce collateral as claims come in and are paid.

The IUA has conservatively estimated that collateral requirements bring losses on investment yields of around 15 to 20 basis points, bank charges of a further 75 basis points and overheads of another 10 to 25 basis points. Thus, in total, collateral requirements are comfortably responsible for imposing a total additional cost of 100 to 125 basis points or one to 1.25 percent on reinsurers. With current interest rates and investment returns so low, such margins cannot be ignored.

Applying this cost factor only to the aggregate gross liabilities due from non-U.S. reinsurers (approximately $45 billion), the annual cost of 100 percent collateral currently imposed on alien reinsurers operating in the U.S. is at least $450 million to $560 million. The true figure is probably much higher since real overhead expenses are most certainly greater than the estimate here.

But it is clear that demands for collateral requirements, if made as a matter of course to all reinsurers, would be hugely expensive for the industry. Ultimately that cost must be borne by consumers who will face rising direct premiums to pay for an unnecessary business-to-business expense.

Even if such requirements were to become generally accepted as a useful instrument, it is difficult to see how they could be effectively administered and implemented on a wide-scale basis. Given the potentially huge sums involved, it must be highly questionable whether there is sufficient letters of credit capacity readily available from approved banks.

In 1992, a proposal was presented to the National Conference of Insurance Legislators to establish a "Safe-T Account" that would have required U.S. insurers to place into custodial accounts for the benefit of policyholders an amount equal to their liabilities to these policyholders.

This plan generated a storm of opposition and was roundly condemned by the industry as a needlessly excessive knee-jerk reaction to solvency problems experienced during the late 80s and early 90s. It would drive up the cost of insurance and reduce capacity, opponents complained.

Meanwhile, the International Association of Insurance Supervisors is due to approve a new set of core principles for reinsurance regulation in October that advises against any use of collateral requirements.

Indeed, such requirements are currently only supported by three jurisdictions across the globe: the United States, Canada and France.

The danger of individual companies asking for collateral guarantees from reinsurers, however, is that it could lead to a creeping imposition of this burden on the industry. If a company agrees to the measure for one particular client, how then could it reasonably refuse to do the same for another?

And if such a service is provided by some reinsurers, it suddenly puts pressure on others to operate in the same way.

So without any regulatory interference at all, the industry could suddenly find itself voluntarily hamstrung by the kind of restrictions many have been fighting against for years.

The message to regulators, commercial buyers and ultimately the public would be clear: that the industry itself cannot decide between good and bad security. It would damage buyers confidence in our ability to meet liabilities and cause lasting harm to the industrys reputation.

Stephen Cane is chairman of the International Underwriting Association in London and chief executive officer of Alea London Ltd.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 1, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.