Reinsurance transactions are financial transactions whereby insurance liabilities assumed by direct writing insurance companies are transferred (ceded) to reinsurers in exchange for a share of premium and a promise by reinsurers to pay their share of the claims on those ceded insurance policies as they become due. That promise is essentially an asset transfer from the reinsurer to the balance sheet of the ceding insurer. In other words, the liabilities owed by the ceding insurer are offset by the asset provided by the reinsurance arrangement.
There are all sorts of accounting, actuarial, and regulatory rules that govern reinsurance accounting affecting security. A detailed discussion of those is far beyond the scope of this commentary. Instead, this commentary addresses why and how a ceding insurer secures the asset provided by the reinsurance arrangement, which is the reinsurer's obligation to pay under the reinsurance contract.
What Is Security?
Reinsurance security is not that different from security in other commercial contexts. Assets (collateral) are set aside solely to secure the reinsurer's obligation to pay. The typical forms of security that one sees in reinsurance transactions are funds withheld, letters of credit, and trust accounts. There are other forms of security, both regulatory and nonregulatory, but those three are the major forms of security seen in a majority of the reinsurance contracts.
Funds withheld is exactly what it sounds like. Instead of the ceding insurer paying the reinsurance premium to the reinsurer through the reinsurance intermediary or directly, the ceding insurer instead retains the reinsurance premium in a segregated account as security for the reinsurer's obligation to pay. The ceding insurer may use those funds to pay claims or to secure the payment of claims billed to the reinsurer depending on the terms of the funds withheld provision of the reinsurance contract.
A letter of credit is a financial instrument issued by a bank, which requires the bank to pay the amounts stated in the letter of credit if a draw request is received by the issuing bank, with no questions asked. Typically, the reinsurer establishes the letter of credit in favor of the ceding insurer and posts collateral with the bank to secure the letter of credit. There are various banking and accounting requirements that go alongside a letter of credit, and there is an obvious cost to using a letter of credit (banks do not do this for free).
Letters of credit are typically "evergreen," meaning they continue to renew automatically through the life of the reinsurance obligation. The amount of the letter of credit may adjust annually (or periodically) based on the total insured losses, often including incurred but not reported (IBNR) losses reported by the ceding insurer. If the total incurred losses decrease, the amount of the letter of credit may decrease, and collateral is released back to the reinsurer. However, if the total incurred losses increase in value, the reinsurer will have to increase the amount of the letter of credit.
A trust account also involves a bank or investment company, but the reinsurer funds the trust account with assets based on the requirements of the separate but related reinsurance trust agreement. Trust agreements can be far ranging and usually have provisions concerning the management and replacement of the collateral used to fund the trust account. Typically, a trust account is somewhat similar to a letter of credit in that it is generally not used to pay claims but to secure the reinsurance obligation. Trustees are usually absolved for all liability concerning the value of the collateral funding the trust fund. Assets in the trust account may be used and invested based on the trust agreement and will decrease or increase based on the reported incurred losses.
Is Security Required?
The answer is that it depends. Each reinsurance arrangement is unique, and some require security as part of the transaction. Others require security for the reinsurance contract to count as an admitted asset on the ceding insurer's financial statement. And some reinsurance arrangements do not require security at all.
Under credit for reinsurance laws, regulations, and accounting rules, certain reinsurance contracts require the posting of security for the reinsurance agreement to count as an admitted asset on the ceding insurer's financial statement. But, with the modernization of credit for reinsurance rules, the number of reinsurance contracts requiring security for accounting purposes is far fewer than it was 10 or 20 years ago.
Decades ago, parochial state regulations and laws required a ceding insurer to obtain security from a reinsurer if that reinsurer was not licensed in the state that regulates a ceding insurer. If a reinsurer was not licensed or accredited by the ceding insurer's domiciliary regulator, the reinsurer would have to post security greater or equal to the ultimate liability owed by the reinsurer or the reinsurance transaction would not be considered "reinsurance" and would not be listed as an admitted asset on the ceding insurer's balance sheet.
As time went on, the security requirement for reinsurers was challenged by non-US reinsurers, especially by Lloyd's of London, which ended up creating US Trust Funds to qualify as security. Ultimately, based on what are called "Covered Agreements," the United States entered into agreements with the major non-US jurisdictions to forego security for admitted asset purposes if the non-US reinsurers were regulated by jurisdictions considered to have equivalent solvency regulations to the United States. US states were required to amend their credit for reinsurance laws and regulations to conform to the covered agreements to maintain their accreditation.
Today, most major reinsurers do not need to post security for regulatory/accounting purposes when reinsuring US domestic ceding insurers. Nevertheless, many reinsurance contracts require security contractually because of the nature of the reinsurance transaction, the parties involved, or the nature of the business being reinsured. So, if the reinsurance contract is negotiated to require security, then the reinsurer must post that security.
What Are Some of the Reasons for Security?
Besides regulatory and accounting requirements, security for reinsurance obligations exists for several reasons. First, rating agencies and regulators may see certain reinsurance transactions as material to the solvency of the ceding insurer and may require that the reinsurance transaction include security. Requiring reinsurers to provide security for the main reinsurance program of a ceding insurer may qualify that ceding insurer for a higher financial rating, thereby allowing the ceding insurer to write more and better business.
Another reason to require security is where the reinsurer is relatively new and/or backed by new players in the reinsurance market. A reinsurer may agree to a security requirement to get its foot in the door with the ceding insurer and the reinsurance broker. This will benefit both the ceding insurer with security for the current transaction and the reinsurer with the ability to show a track record for future transactions.
Security may be warranted because of the nature and/or size of the reinsurance transaction. This is especially true of fronting and captive deals, where security protects the fronting insurer or the captive from a loss of reinsurance coverage. Coinsurance deals on the life and health side often require security, for example.
In an economic downturn, security for reinsurance obligations is especially important to avoid the loss of reinsurance protection should a reinsurer go into insolvency.
Obtaining security in a reinsurance transaction for nonregulatory purposes will be driven by the status of the reinsurance market. It is subject to the parties' negotiation of the reinsurance contract based on market availability, capacity, and the relationship between the parties.
What Can Go Wrong with Posting Security?
In a majority of cases, the reinsurer posts security using one of the methods discussed above, and the parties adjust the security over the lifetime of the reinsurance contract or its runoff without incident. But like all commercial transactions, things can go wrong.
Disputes have arisen when the party responsible for positing security fails to do so. For example, in AmTrust North Am., Inc. v. Signify Ins. Ltd., No. 18 Civ. 3779 (ER), 2020 U.S. Dist. LEXIS 129476 (S.D.N.Y. Jul. 22, 2020), the ceding insurer sued the reinsurer for breach of contract for failing to post required collateral arising from a form of captive fronting arrangement for workers compensation policies. On summary judgment, the court held that the failure to post collateral was an indisputable material breach of the program agreement and the reinsurance agreement.
Where a funds withheld or trust account is the security method, issues may arise concerning the management of the account by the ceding insurer. There are several cases where collateral management has resulted in the loss of security and lawsuits over allegations of mismanagement and fraud.
For example, in Great Western Ins. Co. v. Graham, No. 18-cv-6249-LTS-SN (S.D.N.Y. June 25, 2024), a ceding insurer and a reinsurer entered into a coinsurance agreement, which required that the trust account be established for collateral. Along the way, a novation took place replacing the original reinsurer with an offshore company, and the trust account was moved to a new trustee. The allegations were that the collateral was used by several individuals and their intertwined companies to defraud the cedent of the collateral. Who manages the collateral and how the collateral is used is critical to the collateral being available should the security be needed to pay the reinsurance obligations.
Conclusion
Security is a major component of many reinsurance transactions. While less a regulatory/accounting issue than in the past, prudent ceding insurers continue to negotiate for security to protect against a loss of reinsurance because of financial failures or recalcitrance.
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