Understanding the reduction in US collateral requirements

The potential to reduce – or perhaps even eliminate – current US collateral requirements for non-admitted reinsurers is taking a prominent role in international discussions about global standards for the insurance industry.

This article will briefly describe the current situation, the reason for the call for collateral reduction and resistance to that call, the possible benefits of lower collateral requirements to reinsurers and what reduced collateral will not provide.

Under the National Association of Insurance Commissioners (NAIC) credit for reinsurance model law – a version of which has been adopted in every state – credit for reinsurance is allowed for a domestic ceding insurer as an asset or a reduction from liability on account of reinsurance ceded when a reinsurer meets certain requirements.

Credit for reinsurance is an accounting rule applicable to the cedant, not a direct regulation of the reinsurer. Historically, if the reinsurer was not licensed or accredited in the US, and therefore outside US regulatory jurisdiction, a US cedant could not take credit for the asset or reduce its liability for the reinsurance.

There was an exception if the non-admitted reinsurer deposited in trust (in a US bank) or provided a letter of credit issued by a US bank an amount equal to 100% of the amount of reserves ceded.

Large European reinsurers for years complained that the requirement was unfair because a reinsurer domiciled in any US jurisdiction had no collateral requirement. Many US ceding companies, however, supported the 100% collateral requirement for non-admitted reinsurers as necessary for ensuring that reinsurance claims were paid promptly and fully.

Other US cedants were indifferent, believing that the rating and reputation of the reinsurer was more important than the amount of collateral. The upshot was that two years ago, after more than a decade of debate, the NAIC modified its model regulations. It now allows states to grant credit to their domestic ceding companies for reinsurance purchased from highly rated non-admitted reinsurers that meet certain standards and are regulated by qualified non-US jurisdictions, as determined by the NAIC, at less than 100% collateral.

The amount of collateral reduction is flexible. Each state can set its own standards based on the NAIC findings. So far, 23 states have adopted the new model into law or regulation, but only two – New York and Florida – have approved any significant number of non-admitted reinsurers for lower collateral. While many major European and Bermudian reinsurers have sought lower collateral, others have not. Why? It has to do with what collateral reduction can and cannot do for the reinsurer.

Calculation method

Cedants and reinsurers calculate their liability for loss, loss adjustment expense, claims for losses incurred but not reported (IBNR) and unearned premium reserves under the law and the accounting rules of their state or country of domicile, and using their own actuarial judgement.

In every US state, domestic insurers can reduce those reserve liabilities by the amount for which the non-admitted reinsurer will be responsible if collateral in the amount of the reduction is provided.

The reduction increases the cedant’s surplus and thus gives it additional solvency. So that the cedant can obtain this benefit, the cedant and reinsurer agree – in the reinsurance agreement – that the reinsurer will do what is necessary under the laws and rules of the cedant’s state of domicile. The cedant may take this balance sheet credit for reinsurance ceded.

An unauthorised reinsurer that fails to provide sufficient collateral for the benefit of the cedant is in breach of contract, but providing collateral does not satisfy any regulatory requirement to which the reinsurer is subject.

If a state lowers the collateral requirement, it does not have an impact on the reinsurer’s reserving practices. Collateral reduction simply determines whether assets owned by the reinsurer are placed in trust for the benefit of the cedant or mingled with the reinsurer’s general funds (or collateral reduction reduces the amount of the letter of credit provided by the reinsurer).

Collateral reduction has no balance sheet impact for the reinsurer – it does not increase or decrease its surplus and does not enable a reinsurer to take on more or larger risk.  What lower collateral can provide for non-admitted reinsurers is, in the case of reinsurers using trust funds for their US cedants, the ability to treat a greater portion of their surplus as unencumbered, rather than pledged (encumbered), assets.

This will allow a wider range of investment possibilities. It also simplifies regulatory reporting obligations, an advantage that will be more significant if US jurisdictions achieve a uniform system, either through the NAIC or by way of a covered agreement negotiated by the US with non-US regulators.

With respect to reinsurers using letters of credit, the reduction in face amount of the letter of credit can reduce bank fees for providing the credit facility.

Qualification problems

The downside? The process of qualifying for collateral reduction is cumbersome. It may involve an International Financial Reporting Standards conversion to generally accepted accounting principles and currently varies state by state.

The Federal Insurance Office has announced that it intends to use its authority under the Dodd-Frank Act to seek a “covered agreement” with European regulators, based on the NAIC model law. This could allow for the pre-emption of state laws, thus enforcing a uniform collateral rule in all US jurisdictions.

Qualifying for lower collateral requirements can be of marginal, but significant, benefit to certain reinsurers, but it is not for everyone. It depends on the nature and location of a reinsurer’s business in the US and its appetite for jumping through all the regulatory hoops that are required under the present polyglot system.

Lawrence Mirel is partner and Elisabeth Curzan is of counsel at Nelson Brown & Co