Vesttoo issues highlight need for strong counterparty risk practices – DRBS Morningstar

Insurance technology company Vesttoo recently revealed the discovery of inconsistencies between an investor and a reinsured party in transactions it modeled the risk for. As a result, the company is now undergoing a comprehensive third-party audit of its due-diligence process.

Vesttoo, headquartered in Israel with offices in New York, London, Seoul, and Hong Kong, developed a digital platform for evaluating risk in insurance investments, allowing insurance firms to acquire reinsurance coverage from investors through the capital markets, according to a commentary by DBRS Morningstar.

Reports in the media indicate that potentially fraudulent letters of credit (LOCs) provided to insurers by investors for reinsurance transactions within the Vesttoo platform could amount to $4 billion. The majority of the contested LOCs utilized the name of one of China’s largest banks, which seems to have been unaware of the situation, DRBS Morningstar reported.

The widespread issue of questionable LOCs within the Vesttoo platform could have significant repercussions for the broader insurance and reinsurance market, particularly for fronting specialist companies and insurance brokers involved in these deals. This situation may involve more than one reinsured party, and it could potentially weaken confidence in collateralized reinsurance deals, leading to a reduction of available reinsurance capital.

The importance of collateral

Collateral is commonly used in various reinsurance transactions to safeguard reinsured parties in case of a reinsurer default. While highly rated reinsurance companies use collateralized arrangements less frequently due to their strong credit quality, lower-rated entities or structures often rely on collateral as their only option to conduct business with reinsured parties, according to DRBS Morningstar.

Standby letters of credit (standby LOCs), issued by reputable banks, are a common form of collateral. These LOCs act as guarantees that ensure payment will be made even if the applicant (the client of the bank requesting the LOC) cannot fulfill its obligation. However, the recent situation with Vesttoo highlights the importance of banking institutions ensuring the credit strength of clients to repay the LOCs in case they are required, DRBS Morningstar said.

Catastrophe bonds and insurance-linked securities (ILS) also depend on collateral, usually in the form of cash invested in highly liquid and rated securities. Members of the Lloyd’s of London market also use standby LOCs as a form of Tier 2 capital to meet their Economic Capital Assessment requirements.

Given the widespread use of collateral, cedents (reinsured parties) must properly manage the counterparty risk arising from these transactions. Insurance and reinsurance companies typically rely on financial strength ratings to assess credit risk, but they should also implement validation procedures and robust know-your-client controls whenever collateral is utilized as a credit mitigant.

While the exposure of insurance companies to the Vesttoo platform varies, many have already suspended further transactions on the platform until investigations are completed. Fortunately, most of the reinsurance capacity placed through the platform covers non-catastrophic risks, reducing the systemic risk to the industry, DRBS Morningstar reported.

Cedents involved with the platform are currently verifying the validity of standby LOCs received from investors and exploring alternatives, such as requesting replacements from different banks. If needed, they may seek coverage from better-rated traditional reinsurers, albeit at a potentially higher cost.

For cedents where Vesttoo constitutes only a small portion of their reinsurance strategies, any fallout from collateral failure is expected to be manageable, DRBS Morningstar said. However, fronting insurance companies with significant exposure to Vesttoo could see a weakening of their credit profiles in the short to medium term.

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