Have You Secured Your Unauthorized Reinsurance Obligations?
Credit for reinsurance has been making the news lately, particularly in light of the “Notice of Proposed Action” issued by the California Department of Insurance with respect to reinsurance and insurance company accounting practices.1 With all of the “cat” activity in 2005 making its way through the reinsurance and retrocessional marketplace, and with ongoing issues regarding solvency, both reinsurers and ceding companies can expect enhanced scrutiny by regulators in 2006. Moreover, as everyone is painfully aware, Sarbanes Oxley (”SOX”) imposes greater reporting requirements upon chief financial officers, including certification of corporate financial statements. As a result, the importance of accurately reporting the credit for reinsurance has never been greater. Outlined below is a basic overview of the credit for reinsurance issue. Also provided is a tabular summary regarding the credit for reinsurance under the National Association of Insurance Commissioners Credit for Reinsurance Model Act.
The credit for reinsurance operates similar to an accounts receivable for a manufacturing enterprise. Reinsurance recoverables are reported as an admitted asset on the cedent’s balance sheet.3 This amount is ultimately reflected in the cedent’s underwriting income as a credit to losses or loss adjustment expenses. Reinsurance recoverables on unpaid, incurred but not reported losses (”IBNR”) and loss adjustment expenses (”LAE”) are netted against the liability for gross losses and LAE.4 Only cedents with authorized5 or accredited6 reinsurance can use this favorable accounting treatment. This accounting treatment is favorable because reinsurance recoverables directly improve the cedent’s underwriting results. The reinsurance recoverables also appear as an asset on the financial statements, thereby enhancing the cedent’s surplus as well.
Cedents with unauthorized, unsecured reinsurance cannot take advantage of the foregoing favorable accounting treatment because although they may report their reinsurance recoverables as an asset, they must separately record a liability to the extent it is unsecured.7 Excessive unauthorized reinsurance can attract regulatory scrutiny or rating agency attention, since regulators view unauthorized reinsurers as having higher financial risk.8 Accordingly, cedents using unauthorized, unsecured reinsurance must reflect this higher risk (of potential default) by recording a liability on their financial statements. In turn, the cedent’s underwriting results and surplus do not benefit as much from unauthorized reinsurance as compared to authorized reinsurance.9
But cedents can have their cake and eat it too! Cedents can obtain the more favorable accounting treatment, if the unauthorized reinsurer fully secures its reinsurance obligations. This requires the reinsurer to establish one or all of the following: (a) a funds on deposit account;10 (b) a security trust account (”Trust”); or (c) a letter of credit (”LOC”). Both the Trust and the LOC must comply with state insurance regulations. Therefore, we recommend that every cedent perform a review, even a cursory one, of its unauthorized reinsurance portfolio. At a minimum, every cedent should ascertain that its Trusts and LOCs are regulator compliant and fully secured.
THE REGULATORY FRAMEWORK
Every state has adopted the Model Act or a version of it. Under the Model Act, a cedent may claim the credit for reinsurance if any of the following apply:
A. The reinsurer and cedent are from the same domiciliary state and the reinsurer is a licensed reinsurer;
B. The reinsurer is accredited by the domiciliary state of the cedent;
C. The reinsurer’s domiciliary state has a substantially similar credit for reinsurance law as the cedent’s domiciliary state, and the reinsurer has at least $20 million in policyholder surplus;
D. The reinsurer maintains a Trust of not less than $20 million in a qualified U.S. financial institution;
E. The cedent withholds funds on deposit from the reinsurer; or
F. The cedent holds security such as a Trust or a LOC.
The following table” summarizes this information in tabular form:
Thus, in addition to placing funds on deposit under the Model Act, an unauthorized reinsurer may post a Trust or LOC, securing its reinsurance debt. When employing such methodology, the reinsurer’s collateral must equal one hundred percent (100%) of the loss;12 otherwise the cedent receives a penalty for the unauthorized reinsurance. In contrast, domestic reinsurers who are authorized or accredited in the cedent’s domiciliary state do not need to collateralize their obligations to the cedent.