Vesttoo: Collateral damage

The insurance and reinsurance industry faces a potential crisis of confidence over some forms of collateral, as the fall-out from the Vesttoo fraudulent, or forged, letter of credit (LOC) claims spread, which might elevate the profile of the fully-collateralised model of reinsurance adopted by the insurance-linked securities (ILS) market.

Vesttoo, the insurtech that aims to connect diverse sources of insurance risk with investors, has come under fire after allegations that potentially billions of dollars of collateral were fraudulent.

Recall that, initial claims suggested a reasonably large amount of collateral may be affected, either being fraudulent or having faked signatures, with letters of credit (LOCs) seen as the most likely structure behind it, given Vesttoo used LOCs for some of its transactions.

Then, fresh claims emerged yesterday stating that the audit undertaken by Vesttoo has turned up an issue with letters of credit (LOCs) that total a significant sum in collateral, with around $4 billion mooted, which were held for transactions facilitated by the company.

Numerous senior executives have left the insurtech, while concerns are spreading fast over the integrity of collateral for deals the firm had transacted and how far the fall-out might reach.

Details are still lacking as to the cause of collateral problems, or precisely where any claims of fraud may lie (they remain allegations until some facts come to light), with no statement from the under-fire company yesterday or this morning.

In addition, there has been no statement or comment on the matter by any other parties involved in the risk transfer and collateral chain, while some firms have told staff to refrain from discussing the issue in public, we understand.

So, the industry remains largely in the dark over the facts, as a result of which there is still a lot of conjecture. Although the general feeling is that something has gone very wrong, or a bad actor is involved, for the industry’s collateral management and quality control processes to have gone so awry here.

Fronting specialists involved, such as Clear Blue which has a significant relationship with Vesttoo, face a particularly challenging time, as collateral behind deals they’d done for the insurtech and its clients now face questions over the quality of the collateral, whether it exists at all or has any true value.

That could expose the fronters to concerns over their own credit quality, as if the collateral was found to be worthless there could be questions asked of fronting companies by their rating agencies, unless collateral can be replaced and other resources such as premium float be used to assist in providing integrity to the deals already done.

We’ve heard from numerous concerned parties on the integrity of the fronts that are exposed to Vesttoo deals, while another area of concern comes from ceding companies that Vesttoo deals provided reinsurance to.

One concerned party said that it now feels like it has a significant hole in its reinsurance tower, because of which other reinsurer participants in the same tower are having concerns as they feel the program has lost its integrity.

Resulting in a scramble for facts and information about whether the collateral exists, Vesttoo did say it is working with clients and other parties to try and resolve such issues, but we’re also told there has been a scramble to find alternative cover as well, by some of the cedents exposed.

Questions are being asked about who knew, or should have known, and what has happened to the process of checking and assessing counterparty security and collateral integrity or quality.

We’re told those processes often came down to a cursory check that a counterparty credit rating remained in place and had not been degraded. So, in the case of the bank named in the concerns related to Vesttoo-linked collateral, China Construction Bank having been highlighted, as long as its rating was intact we’re told the market may not have gone much deeper to check on the integrity of any specific letters of credit (LOCs) it provided.

Which has led people to ask, who is looking after the interest of the ceding parties, to reinsurance and risk transfer deals, to make sure their counterparties and collateral providers are good to act on the promises made?

Quality of collateral may now have an elevated importance in discussions going forwards, thanks to the potential for a crisis of confidence to emerge.

We’re already hearing from market participants wanting greater certainty on the integrity of collateral, such as letters of credit (LOCs), no matter the providers.

Today, we’re also hearing some concerns for more thinly capitalised cedents that have reinsurance that is backed by Vesttoo deals.

Any loss of collateral value, or even just concerns over the integrity of collateral, could damage some cedents own capital adequacy in the eyes of rating agencies, ability to secure alternative cover if it’s needed. Here, we’re thinking regions like Florida in particular, where we’re told by sources that Vesttoo facilitated some reinsurance deals.

All of  this should speak to the fully-collateralized nature of catastrophe bonds and other insurance-linked securities (ILS), which are typically backed by cash or equivalent as collateral, then invested in highly-liquid assets such as US treasury money market funds.

What really matters is that the collateral for any insurance, reinsurance or risk transfer deal is securely held, in trust or similar, as well as readily accessible, and can be turned into cash at the point it is needed under the terms of the risk transfer or re/insurance contract, at the point of recovery by a cedent or investor, or at maturity so capital can be returned.

It’s also important to remember that fraudulent actors could affect any type of collateral and issues can also emerge where a balance-sheet promise-to-pay turns out to be unable to make good on that.

Vesttoo was always said to be working with multiple types of collateral, and was known to be using banks that were not typically seen in the market.

Many questions still remain, some of which should be resolved once the results of the ongoing audit become available, which we understand that Kroll is undertaking for the firm’s Board.

As we said yesterday, leaked information appears to be coming from Board or very senior level within Vesttoo, as one publisher yesterday claimed some results from the audit already showed a wider issue.

However, the “around $4 billion” figure cited seems far too high, given the stage of development Vesttoo was operating at. But how high the true figure is remains unknown.

We’ve learned some more details as to what kicked off this whole episode as well, as a cedent had apparently gone to the New York branch of a Chinese bank that provided an LOC and sought to cash it in, but was told by the bank that they had no idea what the cedent was referring to.

That kicked off an enquiry and Vesttoo was informed, after which the Board started their own audit and hired Kroll to assist with that.

This specific cedent is related to a single intellectual property transaction that Vesttoo had been part of and there was just one letter of credit involved. But the ramifications of that have turned into a full audit of all LOC’s that Vesttoo’s transactions had been party to.

There is no solid evidence of fraudulent behaviour by any party as yet, we understand, but the audit is ongoing and obviously the Israeli publisher Calcalist had said its sources believed a wider problem and that forged signatures were likely part of that.

As a result, the real facts are still very murky here and the scale of the problem unknown. But it has triggered a wider concern in the market over collateral, its integrity and the sources used for letters of credit, all of which will likely create waves for some time to come.

The whole episode is not good for the market’s perception of collateral and the chains of trust involved, as well as the process of ensuring counterparty security is maintained.

Again, the fully-collateralised model of catastrophe bonds and that is used in the vast majority of insurance-linked securities (ILS) arrangements, looks a very solid option here.

Typical cat bond and ILS market practices are extremely robust, well-documented and governed in law, while the quality of the collateral used, being largely cash, is second to none when it comes to counterparty creditworthiness and security.

Sadly, it’s important to remember that bad actors can happen anywhere and no collateral, cash, balance-sheet, LOC, or whatever it might be, can be considered 100% secure if a sophisticated fraud attempt occurs. In this case, the jury remains out as to precisely what has happened, although suspicions remain high.

The collateral chain of trust is an absolutely critical component of the insurance, reinsurance and ILS market process. Here, it has been brought into question, but we suspect the market will respond with a healthy increase in scrutiny and oversight, as well as counterparty security controls.

Whether there will be any wider collateral damage from this episode, remains to be seen.

Also read:

July 19th – Vesttoo: New report claims significant amount of forged LOCs. The question is how?

July 18th – Vesttoo faces fraudulent collateral claim. Confirms investigation, exit of some leaders.