What implications will the Vesttoo incident have on the captive insurance industry? Frances Jones investigates
The allegations concerning fraudulent Letters of Credit (LoC) related to Israeli insurtech Vesttoo programmes have sent shock waves through the insurance industry. Vesttoo provides the insurance industry with access to capital markets through insurance-linked securities (ILS) — an alternative form of reinsurance.
Investors on the Vesttoo platform have been accused of dispensing fraudulent LoCs to insurers for reinsurance transactions. This reportedly occurred after China Construction Bank denied all knowledge of a LoC related to a Vesttoo-facilitated reinsurance transaction.
Rating agency, DBRS Morningstar, estimates that the allegedly fraudulent LoCs issued to insurers will total US$4 billion, according to various media reports, including Israeli newspaper ‘Calcalist’, which translates to ‘Economist’.
Although captive insurance companies are not directly impacted, it has led many in the industry to question the scrutiny of LoCs and ILS-transactions.
It has also shaken captive insurers’ confidence in insurtechs. Subsequently, some industry participants are expressing reluctance to engage in ILS-transactions.
On 7 September, Vesttoo filed its first interim bankruptcy report to the United States Bankruptcy Court for the District of Delaware. In the same statement, Vesttoo said that its investigation identified that “pervasive and systemic misconduct” was carried out by a limited set of Vesttoo executives and other third-parties outside of Vesttoo.
Ami Barlev, Vesttoo’s interim CEO, continued to name and shame former Vesttoo executives, whom he notes “acted with external entities such as employees of China Construction Bank and Standard Chartered.”
Captives and collateral
ILS provides insurers with a ‘fully secure’, collaterised form of funding which can be dedicated to a precise risk requiring coverage.
The collateral is often a highly-rated, highly-liquid investment and provided by capital market investors, for example: a government gilt fund.
Marcus Schmalbach, CEO of RYSKEX, says: “Captive insurers are increasingly attracted to ILS-transactions for several reasons, particularly the ability to diversify risk by offloading it to capital market investors and tapping into alternative, and possibly more cost-effective, capital sources.
“Other reasons include the design of bespoke risk coverage structures, securing immediate financial resources during unexpected significant claims, meeting regulatory and rating benchmarks, and elevating their market profile through advanced risk strategies,” he continues.
“ILS can prove especially useful for captives when they have a desire to diversify the reinsurance tower,” according to a Marsh article entitled ‘Insurance-Linked Securities Provide Another Reinsurance Option for Captives.’
ILS is intrinsically linked to catastrophe bonds, high frequency and low severity events.
The Marsh article provides an example of a captive transaction that used ILS for reinsurance: “Through a Bermuda ILS vehicle, a captive placed US$300 million of US earthquake risks, focused on the west coast. [It also featured] a parametric trigger.”
Nils Ossenbrink, managing partner of products and distribution at Twelve Capital, says: “The predominant risks covered by the ILS market are natural catastrophes, in particular hurricanes and earthquakes. Climate change is increasing the frequency of natural catastrophes, specifically convective storms, floods and wildfires. This means that these risks are becoming more relevant and are increasing the need for protection. This drives the demand for alternative risk capital and ILS-transactions.
“What we see on the horizon is cyber. On the investor side, we are seeing some hesitation toward the adoption of cyber; it’s a question of accurate modelling. Cyber risks and demand for protection are growing fast,” Ossenbrink adds.
The fallout of fraud allegations
Captive industry participants, along with the rest of the insurance industry, are left examining collateral issues in the wake of the scandal.
However, the event’s significance should not be overstated. Ossenbrink says: “Vesttoo is primarily an ILS and insurance industry event. The wider client base at Twelve Capital doesn’t really recognise it, it’s only something brought up by those who are close to ILS markets. It’s something widely discussed at conferences,” such as the recent Monte Carlo Rendez-vous de Septembre — the largest reinsurance gathering in the sector.
It also emerged as a hot topic at the Vermont Captive Insurance Assocation’s annual conference held at the start of August this year, which inspired this reporter to write this article.
Schmalbach notes: “It is a damaging image for all innovative fintechs involved in ILS and captives.”
He adds that the Vesttoo incident followed the collapse of FTX in late 2022 — another company with a unicorn rating (which has since been revoked).
Vermont’s deputy commissioner of captive insurance, Sandy Bigglestone, mirrored this sentiment, commenting that going forward “start-ups and market opportunities will face additional scrutiny.”
“Our priority is to safeguard the stability and continuity of the captives we regulate,” she adds.
Schmalbach says that recent events have shown that “despite all technologies and early warning systems, as well as regulation, those who cheat will find a way.”
Adding his thoughts, Ossenbrink comments: “A general positive for the industry is that Vesttoo is a company-specific event, not a systematic risk. It highlighted again that market participants have to take due diligence procedures seriously.”
A regulator’s perspective
The scandal has increased captive regulators’ responsibility to ensure the security and legitimacy of collateral arrangements within the captive insurance industry.
Vermont’s Bigglestone outlines the measures the domicile already takes. She says: “Our regulatory activities, and the framework, include a review of fronting agreements, collateral arrangements and related credit for reinsurance considerations.”
However, she adds: “There is an expectation for fronting carriers to do their due diligence when considering the credit risk associated with the form of collateral they accept and how the transaction will meet credit for reinsurance requirements. The assessments should include information about the financial backing of the risk taker.”
“Captive insurers can expect the tightening of existing regulatory frameworks to guarantee that they, and related parties, rigorously evaluate counterparties and collateral options to preclude potential fraud.”
A blockchain of events
In the aftermath of Vesttoo, Schmalbach proposes that captive insurers reevaluate the role of blockchain technology to aid collaboration between captive insurance, ILS funds and intermediary platforms.
Blockchain hasn’t necessarily taken a lead within the captive industry, nor has it fulfilled expectations as an industry disruptor. However, the need to fight fraud is changing industry opinions toward technology. It is starting to be seen as an additional layer of protection for captive insurers engaging in ILS-transactions.
Schmalbach says: “It aids collaboration between captive insurance, ILS funds and intermediary platforms through a number of key mechanisms. It offers smart contracts, which are self-executing and can automatically trigger insurance-related actions, based on predefined criteria. The transparent nature of blockchain’s distributed ledger boosts trust and reduces disputes, as all parties can view the same immutable data.”
He adds: “Blockchain also facilitates real-time data sharing, which is beneficial for risk assessment. It offers secure identity verification, reduces costs by minimising intermediaries and provides interoperability so that different systems and platforms can easily communicate. It essentially has the ability to enhance transparency, security and trustworthiness of transactions. The automation of processes can reduce human error and potential manipulation, namely fraud.”
However, on the other side of the coin, Schmalbach does note that challenges such as adoption barriers, interoperability issues, scalability concerns and privacy matters may impede its full-scale adoption in the ILS market.
Lessons learnt
The rating agency KBRA released a report entitled ‘What Could Possibly Go Wrong? Fronting Market Changes Overnight’. It notes that “recent negative events underscore the critical importance of effective enterprise risk management and could be positive catalysts for change.”
It says: “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.”
However, by the same token, the report concludes that “the insurance sector is well positioned to apply lessons learned and potentially emerge as a stronger and more robust participant in the overall insurance market.”
Going forward, Bigglestone says: “Communication and cooperation will be critical.” She adds that “the scandal will not have a significant impact on the regulation of captives.”
Schmalbach says: “Engaging ILS capacity requires a comprehensive understanding, so captive owners should first invest time in education and research. Before diving into ILS, assess your risk appetite to ensure alignment with the securities you’re considering.”
It is perhaps fair to say that Vesttoo’s nature as an isolated incident should not dissuade captive insurers from obtaining ILS capacity. Mirroring this view, Ossenbrink says: “Increasing demand from investors for ILS can encourage captive insurers to participate in capital markets and enhance resilience of their own capital structures through innovative structures.”
Rating agencies, including AM Best, DBRS Morningstar and KBRA, agree that the overarching impact of the event highlighted the importance of insurers’ managing counterparty risk.
“There are different opportunities for captive insurers to seek capital from the capital market, such as catastrophe bonds or ILS, to meet the increasing demand for capital amid the challenges of climate change,” affirms Ossenbrink.
He concludes: “Captives considering ILS transactions should engage with ILS market specialists. The first step is to understand the needs of the capital market, which differs from the needs of the reinsurance market. Education, networking and a long-term perspective is key.”
