Turnabout Is Fair Play—Reinsurers Now Have Credit-Risk Worries

The Credit Risk in the Reinsurance Relationship

The business of insurance is the business of spreading and shifting of risk. For example, a business owner assumes the risk that the product it manufactures may cause injury to a user or that its factory may burn down. By purchasing insurance, the business owner transfers all or part of those risks to its insurance company in exchange for payment of a premium. The insurance company assumes the credit risk that the insured will not be able to pay its premiums, as well as the risks associated with an insured loss. The insured also assumes the credit risk that the insurer will remain solvent so that it will be able to pay any insured losses (although typically an insured will be protected by a state guaranty fund in the event of its insurer's insolvency).

When the insurer reinsures its assumed policyholder risks with a reinsurer, it assumes the credit risk that its reinsurer will have the financial ability to fulfill its obligations under the reinsurance contract and indemnify the reinsured for losses ceded to the reinsurer under the contract. To mitigate this credit risk of the claims-paying ability of a third-party reinsurer, insurance companies will look to the most stable and secure reinsurers they can find. Large reinsureds will have much less trouble securing high quality reinsurance and will be much less concerned with the assumed credit risk.

But when the reinsurance market contracts and reinsurance capacity is tight, reinsureds may find that securing reinsurance protection with the most stable and secure reinsurers is not possible for every reinsurance program. Reinsureds must then weigh the credit risk associated with reinsuring with reinsurers that are less known or less financially secure against the need for reinsurance. Yet, even without a hard reinsurance market, reinsureds always run the risk that their reinsurer may not be able to pay the reinsured losses when ceded.

Credit Risk Provisions in Reinsurance Contracts

Typically, where a reinsured based in the United States contracts with reinsurers not licensed or accredited in the home state of the reinsured, the reinsurance contract will contain a credit for reinsurance clause. Under existing credit for reinsurance rules, a non-admitted, non-accredited reinsurer must post security (cash, letter of credit, trust fund) to enable the reinsured to obtain financial credit for the reinsurance on its balance sheet. Reinsureds may be required to obtain this security for accounting purposes, but invariably they want this security because having a letter of credit (LOC) beats chasing after an offshore reinsurer if that reinsurer fails to pay under the reinsurance contract.

Even where mandatory credit for reinsurance provisions are not required because the reinsurer is licensed or accredited in the home state of the reinsured, reinsureds have been insisting more and more for provisions requiring the reinsurer to post collateral for its payment obligations to the reinsured. Market strength and the flight to quality reinsurance affect whether a reinsured will be successful in insisting on a security clause, but many reinsurance agreements require security regardless of who the reinsurer is or how long the parties have been doing business. Certainly outside the United States, where credit for reinsurance rules are significantly different (or nonexistent), security clauses are used to protect the reinsured from the reinsurer's credit risk.

This relatively recent push for security even when not required by credit for reinsurance rules has been fueled in part by rating agency pressure on reinsureds to demonstrate that their reinsurance program will, in fact, perform as anticipated. By requiring security from all reinsurers regardless of the credit for reinsurance rules, reinsureds seek to avoid the effect on the insurance market caused by the massive reinsurance failures that occurred during the insolvencies of the 1970s and 1980s, and the more recent failures of Legion and Reliance.

More recently, and with increasing usage, reinsureds have been requiring early termination or penalty provisions should the reinsurer's rating be downgraded by the insurance rating agencies. These clauses, of which there are numerous examples, may provide for the posting of an LOC if a reinsurer is downgraded a certain number of levels or may allow the option for the early or immediate termination and/or commutation of the reinsurance contract upon a downgrade. Similarly, some reinsureds insist on provisions requiring termination or security upon a change-of-control event, which includes a sale, partial sale, or creditor action against a reinsurer. These clauses all protect the reinsured from unanticipated changes in the management and solvency condition of the reinsurer by allowing early access to security or a quick termination of the reinsurance relationship.

Certain reinsurance programs also have seen an upswing in reinsurance cut-through clauses, whereby the reinsured retains the right upon the triggering of an event to cut through the reinsurer directly to a more financially secure retrocessionaire. This, of course, works best where the reinsurer has a retrocessionaire with unquestioned financial stability. An example would be where the reinsurer is a captive of a multinational insured, and the cut-through is allowed directly to the captive's parent.

All these downgrade and early termination provisions traditionally have been directed at the perceived credit risk assumed by the reinsured when doing business with reinsurers. Both rating agencies and reinsured's own credit committees concerns caused reinsureds to develop these clauses to address the possibility that a reinsurer would run into financial problems, which might jeopardize its ability to pay under its reinsurance contract.

The Credit Risk Shift

With the global economy in turmoil, led by the severe recession in the United States, some reinsurers—especially those not based in the United States—have become concerned about the credit risk associated with doing business with reinsureds and reinsurance intermediaries struggling with the weakened economy. These reinsurers fear that their reinsureds will not be able to pay the reinsurance premiums due and/or that the reinsurance intermediaries the reinsured uses will not pass through the reinsurance premiums as required.

Essentially, the shoe is now on the other foot as reinsurers are worried about the credit risks associated with doing business with reinsureds that may not be able to perform their end of the reinsurance bargain. This certainly has been exacerbated by the problems seen with large, well-known reinsureds that have run into serious financial problems because of investments in the collapsed credit and mortgaged-backed securities markets.

This concern is real because the insolvency of a reinsured means that a reinsurer will have to pay all ceded losses as they become due, without reduction, because of the insolvency under the typical insolvency clause required in all reinsurance contracts issued in the United States. While premiums due on the reinsurance contract generally may be offset against losses payable depending on the law in the insolvent's jurisdiction, in a typical insolvency, losses will eventually outstrip the premium due.

In response to these new concerns, some reinsurers are insisting on reciprocal clauses in their reinsurance contracts, including early termination based on rating agency downgrades, and interest and penalty clauses for late payments. Other more traditional clauses may be enhanced to reflect the concerns of reinsurers about nonperforming reinsureds.

For example, express offset clauses may be developed that specifically allow reinsurers to offset reinsurance recoverables against overdue premium payments for the specific contract as well as all contracts between the parties. This way, a reinsurer is able to offset reinsurance recoverables due on one contract against overdue premiums on another contract.

Some reinsurers are also considering premium warranty clauses, which require the reinsured to pay premiums on a set schedule. The failure to pay the premium as warranted may result in the early termination of the contract. Additionally, the premium warranty clause may make the payment of premium a condition precedent to the obligation of the reinsurer to pay claims. In that case, even if the losses are significant, the reinsurer need not pay the losses until the overdue premium obligation is paid in full.

Reinsurers in the broker market are also developing concerns about the credit risk associated with the reinsured's intermediary. Some reinsurers are considering provisions that require the reinsured to pay premiums directly to the reinsurer and require that loss payments be paid by the reinsurer directly to the reinsured, bypassing the intermediary and the credit risk shifting provisions in the typical intermediary clause required in most reinsurance contracts in the United States. Whether reinsureds and intermediaries will accept these changes and allow direct premium and loss payments will depend on market leverage, providing alternative compensation to the brokers, and the hardness of the reinsurance market.

Conclusion

Concerns about a counter-party's credit risk has always been an issue in reinsurance contracts, but traditionally had been focused on the reinsurer's risk profile. It appears that the pendulum of concern has now started to swing toward the reinsured's credit risk, especially with non-United States reinsurers worried about the financial stability and the ability of US reinsureds to pay their reinsurance premiums and the risks associated with the default of the reinsurance intermediary.