Monday, February 26, 2024

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Reviewing credit risk on gross cessions and pure fronting

Emma Sansom is group head of captives at Zurich Insurance Company, based in Zurich, Switzerland.

Following Captive Intelligence’s report on what lessons, if any, there are to learn from Trisura Group’s multi-million dollar write-down, Zurich’s Emma Sansom shares her thoughts on recent changes in fronting trends and the considerations for captive owners.

As we’ve seen a rise in gross cession structures and requests for pure fronting, the issue of credit risk is becoming more of a critical one, and there are some additional considerations for captives looking to benefit from using gross structures to access reinsurance markets.

Reinsurance overriders from these transactions can be seen as ‘risk-free’ income, but it’s not: aside from reputational risk at the front end if there are disputes with the claims handling process, then there’s operational risk, and of course credit risk.

Typically we tend to think of insolvency when we think of credit risk, but it can come from a variety of sources: insolvency of the counter-party, coverage disputes, or potentially even legal reasons (see Side A D&O).

Managing counter-party credit risk

Whilst diversification across a portfolio of risk is generally a good thing, with counter-party credit risk, having a large panel of reinsurers brings with it a host of additional considerations.

Concurrency of reinsurance agreements is key to ensuring there is back-to-back coverage for a captive, but negotiations with a large panel of reinsurers can be time consuming.

Contracts will need to be negotiated with the individual carriers, and potentially, subsequent changes to the underlying policies will also need to be negotiated with the panel, or at least the leading reinsurers. Small changes to claims cooperation clauses for example can have potentially far-reaching impacts. 

Ensuring you understand the financial position of each carrier is important, as is ensuring you are making a provision in your pricing structure to cover counter-party credit risk.

Having highly rated capacity of say A- as a minimum is a good place to start. However, as we have seen, these ratings can change so it is important to be able to monitor the whole panel, and have provisions within the reinsurance contract enabling replacement of carriers where there is significant downgrade.

Other credit risk mitigants such as Letters of Credit (LoCs) are an option, but these also involve operational considerations and risks.

For example, an LoC is often a physical document that needs to be stored in a safe. If it needs to be drawn down on, then this means presenting it at the specified branch, which may mean physically going to the branch with the LoC.

So you need to make sure that firstly, the LoC is on demand and evergreen so that it can’t just be cancelled at renewal by the provider, and you have systems in place to respond at pace when you do receive a notification of cancellation or when you need to drawn down.

And then there’s the credit risk of the LoC provider itself. If you happen to be having an issue with a counter-party and the LoC provider is no longer there to provide the cash, then you may be left with outstanding reinsurance recoveries.

Tail risk

Finally a comment of the tail of risk. Predicting long tail risk is difficult to get right – and claims costs are only rising. Where reinsurance is aggregated, such as with mutli-year-multi line structured reinsurance solutions, this potentially leaves gaps in cover for captives where long-tail claims start making themselves known.

Ensuring reinsurance coverage in your excess layers is dovetailed with these types of insurance is critical – for example, if the SS capacity is completely eroded, do the excess layers drop down or stretch down? A drop down of the excess layers will likely be cheaper, but can potentially leave you exposed in the event this capacity is also eroded.

It can be time consuming so if you are considering switching to a gross cession form a net cession, then counter-party credit risk, concurrency, and a robust, gap-free structure should be the focus of the exercise, but this might not be the cheapest capacity.

There is a balance to be struck and if the risks are minimised, a gross cession can reap many benefits.