Vesttoo matter shines spotlight on fronting sector ERM: KBRA

The fall-out from the Vesttoo matter shines a spotlight on enterprise risk management (ERM) for the fronting sector, while there is a potential for some in the insurance value-chain to suffer short-term reputational damage after this issue, rating agency KBRA has said.

Explaining that the fronting sector has now faced two major challenges this year, the Vesttoo issue over allegedly fraudulent letters-of-credit (LOCs) backing collateralized reinsurance deals behind fronts, and a Trisura issue where that firm revealed an $81.5 million pretax write-down of a reinsurance recoverable related to a program in its U.S. fronting business, KBRA notes that these are not insurmountable challenges, but could hinder the sectors’ growth due to reputational damage and time taken to resolve any issues.

“The reputation of those in the insurance value chain is likely to suffer short-term damage as various fronting insurers, reinsurers, cedants, brokers, and MGAs assess the full financial and operational impacts of recent events,” KBRA explained.

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

Before also saying, “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.”

Stating, “KBRA believes it is increasingly important for fronts to maintain robust risk management processes and for management teams to be focused on continuous ERM improvement.

“KBRA believes the sector is well positioned to apply the lessons learned and potentially emerge as a stronger and more robust participant in the overall insurance market.”

The rating agency highlights some areas for potential improvement in the fronting sector, in light of recent events.

“Changes could include a variety of enhancements ranging from: (i) more stringent diversification requirements for collateral providers; (ii) not binding policies until after LOCs have been verified; (iii) reducing the relative amount of exposure to LOCs and increasing the amount of collateral held in trust; and (iv) reducing the portion of unrated and captive entities on reinsurance panels. These and other enhancements to risk management could leave fronting insurers in a better protected and stronger position to manage credit risk. Notably, some actions could have broader impacts on pricing and other drivers of the business.”

Looking ahead, KBRA has a positive outlook for fronting specialists though, “M&A could lead to acquired companies becoming larger, of scale, and more diversified and could also potentially give them access to greater amounts of capital to pursue their business strategies―all of which could leave them with stronger business profiles and an improved position to grow their business.”

Fronting specialists have been working hard to replace any affected, or potentially affected, collateral, while distancing themselves from the issues that have emerged.