scary
One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don’t know is that often times when insurers would write reinsurance contracts with one another, they would enter into “side letters” whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract.
Let’s say that an insurer needs to enhance its capital surplus by $100 million in order to meet regulatory capital requirements. They can enter into what appears to be a completely legitimate form of reinsurance contract, an agreement that appears to transfer the liability to the reinsurer. By doing so, the “ceding company” - an insurance company that transfers a risk to a reinsurance company - gets to drop that $100 million in liability and its regulatory surplus increases by $100 million.
The reinsurer assuming the risk does actually put up the $100 million in liability, but with the knowledge that they will never have to actually pay out on the contract. This is good for the reinsurer because they are paid a fee for this transaction, but it is bad for the ceding company, the insurer with the capital shortfall, because the transaction is actually a sham, a fraud meant to deceive regulators, counterparties and investors into thinking that the insurer has adequate capital. Typically the fee is 6% per year or what is called a “loan fee” in the insurance industry.
When it operates in this fashion, the whole reinsurance industry could be described as a “surplus rental” proposition, whereby an insurer literally loans another insurer capital in the form of risk cover, but with a secret understanding in the form of a side letter that the loan will be reversed without any recourse to the seller of protection. You give me $6 million in cash today, and I will give you a promise that we both know I will never honor.
Does this sound familiar? What our contacts in the insurance industry describe is almost a precise description of the CDS market, albeit one that evolved in the reinsurance industry literally decades ago and has been the cause of numerous insurance insolvencies and losses to insured parties. Or to put it another way, maybe the inspiration for the CDS market - at least within AIG and other insurers — evolved from the reinsurance market over the past two decades
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One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don’t know is that often times when insurers would write reinsurance contracts with one another, they would enter into “side letters” whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract.
Let’s say that an insurer needs to enhance its capital surplus by $100 million in order to meet regulatory capital requirements. They can enter into what appears to be a completely legitimate form of reinsurance contract, an agreement that appears to transfer the liability to the reinsurer. By doing so, the “ceding company” - an insurance company that transfers a risk to a reinsurance company - gets to drop that $100 million in liability and its regulatory surplus increases by $100 million.
The reinsurer assuming the risk does actually put up the $100 million in liability, but with the knowledge that they will never have to actually pay out on the contract. This is good for the reinsurer because they are paid a fee for this transaction, but it is bad for the ceding company, the insurer with the capital shortfall, because the transaction is actually a sham, a fraud meant to deceive regulators, counterparties and investors into thinking that the insurer has adequate capital. Typically the fee is 6% per year or what is called a “loan fee” in the insurance industry.
When it operates in this fashion, the whole reinsurance industry could be described as a “surplus rental” proposition, whereby an insurer literally loans another insurer capital in the form of risk cover, but with a secret understanding in the form of a side letter that the loan will be reversed without any recourse to the seller of protection. You give me $6 million in cash today, and I will give you a promise that we both know I will never honor.
Does this sound familiar? What our contacts in the insurance industry describe is almost a precise description of the CDS market, albeit one that evolved in the reinsurance industry literally decades ago and has been the cause of numerous insurance insolvencies and losses to insured parties. Or to put it another way, maybe the inspiration for the CDS market - at least within AIG and other insurers — evolved from the reinsurance market over the past two decades
- Skinny 4-02-2009 5:22 pm