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In some cases Vesttoo was transacting directly with buyers, but in the most extended version of deals where it utilised the MGA/fronting segment, the chain of transfer would include a long line of providers.

This runs from the broker to the original MGA via its fronting company connecting to reinsurers via reinsurance brokers and on to a capital markets investor base of which little is known.

The multiple steps in the process are not only going to load costs and commissions into the chain, but also damage the ability to establish the goodwill that is necessary to grease the wheels of the system.

The distance between end-client and capital makes it hard to manage difficult discussions and grey-area claims. Also, the lack of transparency and number of links in the chain creates risk around poor underwriting and weak oversight.

This holds regardless of whether this case was a sophisticated fraud that was inherently difficult to detect or a case of multiple intended defences failing.

A value chain this long and convoluted was an accident waiting to happen.

“A value chain this long and convoluted was an accident waiting to happen”

There is a case for some deconstruction of the value chain and ensuring that companies are specialising in their area of expertise and transferring on risk to the lowest-cost sources of capital.

However, this model appears to be far from an ideal solution as it exposes several key risks: 1) issues with partial collateralisation, 2) the vulnerability implicit in the fronting segment’s high levels of leverage and 3) the challenges of assigning responsibility in a fragmented value chain.

Partial collateralisations

Firstly, it is worth coming back to the inherent risk of using collateralised or unrated capacity in the primary markets, rather than traditional rated (re)insurers using their paper. Unlike the more established cat ILS market where collateral means cash collateral by and large, there are higher degrees of credit risk built into the system.

That is because cedants are required to hold collateral (which may be cash or letters of credit) against current loss reserves – not the ultimate maximum liabilities.

Fronting companies would ask for a collateral buffer above current loss reserves, typically somewhere between 120% and 150% of the reserved loss (although regulations allow it to be lower). But the front’s outwards protection may cap out at a 130%-200% loss ratio, which means – assuming the original reserved loss predictions are around a 60% loss ratio – the ultimate liability could be a multiple of 2x the current collateral levels. (Of course, the fronting company also takes back the loss above these caps – leaving them running high levels of risk for tail events.)

The letters of credit are designed to cover the risk that the ultimate investors behind the deals renege on their commitments, and the bank credit rating is merely viewed as a safeguard on that capital, rather than the ultimate bearer of the risk.

This is an industry-wide practice that is not peculiar in any way to Vesttoo or one of its partners, Corinthian Re. Other examples of carriers in this space include Topsail Re, Fergus Re and Longtail Re.

Market participants have said letters of credit have been used for many decades and if correctly verified from strong providers, should be a stable system. But the point remains that the system has vulnerabilities built into it that need to be managed.

Leverage

Similarly, the leverage of the fronting carriers works like all leverage to multiply returns in the good times, and to exaggerate losses in the bad times.

If fronting companies or hybrid fronts operate with counterparties that are poorly vetted, or where there is a lack of willingness to pay on loss-making deals, they would be left with losses that are outsized for their balance sheets.

Fronting carriers can be writing close to $10 of premium for every $1 of their own capital – 10:1 leverage is incredibly high. And it only works because 80%-90% of non-tail risk is being ceded.

Should any of these companies suddenly find they are unreinsured on a specific program, they could find themselves either over-levered and so without sufficient capital to support their rating, or impaired if the portfolio turns out to be heavily loss-making.

With that said, fronting market carriers have pointed to the cushioning impact of retaining premiums that they were ceding to unrated carriers – meaning that loss experience would have to deteriorate before they needed to call up letters of credit.

But this will clearly be a public relations headwind for the sector, with the onus on players to show how they are delivering on credit checks.

Sister title Inside P&C argued in a piece last year that the use of collateralised reinsurance was a fault-line in the MGA market that could be exposed over time, and also called attention to the risks inherent in the fronting model.