Mitigating Reinsurance Risk and Best Practices for Letters of Credit

In the insurance industry, letters of credit play a crucial role in securing reinsurance obligations. National Association of Insurance Commissioners (NAIC) regulations stipulate that certain reinsurance recoverables due from certified or unauthorized reinsurers are more risky and require collateral to secure the recoverable amounts. The collateral requirement is often satisfied through the use of a letter of credit. However, not all letters of credit are created equal. Without robust safeguards around both the reinsurance companies and banks that insurers do business with, ceding insurance companies may be exposed to significant financial risks.

This article outlines the letter of credit requirements established by the NAIC and ways to evaluate collateral when using letters of credit in reinsurance transactions. These strategies are essential for mitigating potential losses and ensuring the stability of your reinsurance program over the long term. 

Letter of Credit Requirements

Stringent rules for letters of credit are established in the NAIC’s Credit For Reinsurance Model Regulation (#786):

• Must be clean, irrevocable, unconditional and issued or confirmed by a qualified U.S. financial institution.
• Contain an issue date and an expiration date and stipulate that the beneficiary (the ceding insurance company) need only draw a sight draft under the letter of credit and present it to obtain funds. No other document needs to be presented.
• Indicate that it is not subject to conditions or qualifications outside of the letter of credit
• Contain no reference to other agreements, documents or entities, with few exceptions.
• Contain a statement to the effect that the obligation of the qualified U.S. financial institution under the letter of credit is in no way continent upon reimbursement.
• The term shall be for at least one year and shall contain an evergreen clause of no less than 30 days notice prior to expiration or nonrenewal of the letter of credit.
• State whether it is subject to and governed by the laws of the adopting state or standards published by the International Chamber of Commerce. All drafts shall be presentable at an office in the U.S. of a qualified U.S. financial institution.

Additional rules apply for financial institutions that are not qualified U.S. financial institutions. These requirements are established to protect the ceding insurer and ultimately the public interest. 

Evaluating Reinsurance Collateral

Insurance companies were created to manage risks and letters of credit are a meaningful tool to manage the specific risk of a reinsurer failing to meet its obligations under a reinsurance contract. Below are guidelines on how to evaluate the parties and contracts involved in a reinsurance agreement.

Due Diligence 

Conduct thorough due diligence on the parties involved in reinsurance transactions with collateral requirements. This includes evaluating the financial stability and reputation of the issuing qualified U.S. financial institution and the assuming reinsurer. 

Verify Terms and Compliance

Establish a process to verify that the terms and conditions of the letter of credit align with the requirements in the reinsurance agreement and with the Credit for Reinsurance Model Regulation.

Monitoring and Surveillance

Continuously monitor the financial health and activities of the parties involved. This includes affirming the financial stability and reputation of the issuing qualified U.S. financial institution and the assuming reinsurer on a regular basis, at least annually.

Legal Support

Consult with legal experts and advisors to draft reinsurance contracts and agreements that provide adequate protection in the event of disputes, fraud, or bankruptcy.

The NAIC Securities Valuation Office publishes a “List of Qualified U.S. Financial Institutions” annually, which can assist with evaluating U.S. financial institutions that are approved by the NAIC for the purpose of issuing letters of credit. 

A.M. Best is most commonly used to evaluate the creditworthiness of reinsurance companies. Brokers can assist management teams with placing reinsurance with carriers that have high A.M. Best credit ratings.

Importance of Actively Monitoring Your Reinsurance Relationships 

An insurance company’s reputation is built on its ability to pay covered claims. The risk of not being able to pay claims due to an assuming reinsurer’s delay in paying or failure to pay its contractual obligations as they become due is first and foremost a financial risk, but it can also significantly impact your company’s reputation. This can have long-term consequences in terms of trust and credibility with customers and within the industry. Collateral requirements for certain reinsurers reduce the financial risk for an insurer, and serve to mitigate the reputational risk.

State insurance regulators monitor insurers, and the level of monitoring depends on an insurance company’s surplus level, and its risk based capital (RBC) calculation. Regulators may become involved if certain ratios or other criteria are met, which can result in additional filing requirements and more monitoring activities from the regulators.

As surplus levels deteriorate, A.M. Best is likely to reassess insurance company ratings and outlooks. Ratings and outlook downgrades can result in loss of policyholders, and loss of revenue, which can exacerbate a downward trend.

Actively monitoring reinsurance partners and collateral requirements is an integral part of risk management for an insurance company.

Customizing Your Reinsurance Risk Assessment

The process of assessing reinsurance and other financial risks is not one-and-done and not one-size-fits-all. You need a solution tailored to the size and complexity of your organization and we are here to help. Contact us with your risk assessment and reinsurance questions.