Vesttoo scandal has changed fronting sector 'overnight’

The once stable and predictable insurance fronting sector has changed overnight in the wake of the Vesttoo scandal and a major write down by fronting company Trisura, a ratings agency has said.

KBRA, in a paper entitled “What Could Possibly Go Wrong? Fronting Market Changes Overnight”, said the two events will cause short term damage to “those in the insurance value chain” as various fronting insurers, reinsurers, cedants, brokers, and MGAs assess the full financial and operational impacts of recent events.

It noted that the effects of the Vesttoo scandal, in which the company discovered fraudulent letters of credit (LOC) collateral from China Construction Bank had been used in reinsurance transactions, were still unfolding.

Vesttoo has said the problems were caused by external banks and financial institutions and has vowed to take legal action against them (see related story).

Trisura announced on February 28 that its Q4 2022 results included an $81.5 million pretax write-down of a reinsurance recoverable related to a programme in its US fronting business.

The paper added: “KBRA notes that recent negative events underscore the critical importance of effective enterprise risk management (ERM) and could be positive catalysts for change.”

It said the two events could lead to possible mergers and acquisitions, adding the sector was well positioned to apply the lessons learned and potentially emerge as a stronger and more robust participant in the overall insurance market.

It added:  “As the Vesttoo matter continues to play out, the spotlight shines brightly on ERM. The situation is evolving, and it may be some time before all the facts are known.

“KBRA understands that its rated universe and others are actively reassessing ERM policies that could help manage risks related to counterparty and collateral security concerns.

“Given the extensive level of checks and balances across the sector, including legal and regulatory requirements as well as counterparty and collateral risk management procedures, the reports are causing many market participants to question how this happened.

“KBRA notes that even for a widespread and relatively mundane operational element such as collateral verification, companies may employ vastly different processes to manage LOC exposure.

“Companies may independently verify some or all LOCs directly with the issuing bank, while others also follow diversification guidelines to mitigate concentration risk for LOC providers.”

It added: “Trisura announced earlier this year a Q4 2022 write-down of a reinsurance recoverable of $81.5 million related to a programme in its US fronting business, contributing to Trisura Group’s net loss of $40.3 million in Q4.

“Trisura stated that the programme structure was unique, including captive participation and catastrophe exposure.

“Trisura further reported that the write-down led to internal policy and organisational changes in the US KBRA believes that an effective ERM framework and system of internal controls should provide for appropriate policies, organizational structures, and reporting lines designed to mitigate these types of risks.”

The Changing and Challenging Reinsurance Environment

KBRA also noted that it has been increasingly difficult for fronts to obtain the amount of reinsurance in the form and at the cost desired.

“While productive relationships with reinsurers remain a critical success factor for the industry, the fronting industry has seen a distinct shift in their reinsurance panels toward more captives and unrated paper,” KBRA said. “With relatively more exposure to captives and unrated reinsurers, counterparty credit and collateral risk management becomes increasingly important to fronting carriers.

“There has also been a shift over the years to reinsurers increasingly requiring fronting carriers to retain exposure, which has spawned various risk-sharing strategies. One potential outcome of the Vesttoo matter could be that management teams reassess the type and extent of their usage of unrated and captive carriers.”

KBRA said there are approximately 25 fronting carriers in the market, but the top four account for the majority of the market.

“Given this growth and the current market structure, the space may experience a rise in M&A activity among fronting companies if newer entrants cannot achieve sufficient scale.”

It concluded: “As a consequence of adversity, changes could occur that leave fronting companies in a stronger position through enhanced risk management. Further, as M&A continues and perhaps increases, new owners and/or industry consolidation could also improve company positioning.

“In the wake of processes and procedures that did not serve the industry well, fronting insurers are attuned to risk management enhancements that could leave them better protected against counterparty credit and collateral management risks.”