The Murky World of Off-Balance-Sheet Items (Part 3)

See part 1 and part 2.

This is the third and final article regarding Off-Balance-Sheet Items (OBSIs). As mentioned in part 2, the National Association of Insurance Commissioners (NAIC) is currently considering a proposal that would empower individual states to decided whether or not reinsurers not-authorized or accredited to do business in their state, will need to post collateral in respect of their share of reported claims and reserves. I believe the proposed changes raise some interesting questions.

For one, how will each state assess the financial position of these insurance companies? We know what a wonderful job the ratings agencies have done recently in terms of assessing financial stability of various companies such as Lehman (LEHMQ.PK) and AIG, so I would have guessed that this option would not be high on the list. Yet Florida’s eligibility requirement per Richard Fidei’s blog states that

a reinsurer would still be required to post 100 percent collateral for its obligations unless it has and maintains certain minimum ratings from at least two nationally recognized credit rating agencies, such as A.M. Best Company, Standard and Poor’s, Moody’s Investors Service or Fitch Ratings.

That’s wonderful news given the credit rating agencies’ track records recently!

And secondly, what is the likelihood of enforcing judgments against foreign reinsurers in the event that they default on their obligations? Once again Florida seems to be on top of this per Richard who states that

a reinsurance contract also must contain certain required provisions relating to solvency, including service of process and the reinsurer’s submission to Florida jurisdiction.

Working in the reinsurance industry, I personally know how difficult it is to go after foreign reinsurers. And I’m not the only one concerned by these proposed changes. Per the Property Casualty Insurers Association of America,

the proposal exposes U.S. ceding companies to a lower level of security than under the existing collateral requirements, it contains too many provisions that appear not to be clearly defined and it should not be adopted.

Right now, there are many collateral obligations per reinsurance treaties that are OBSIs. These obligations can be triggered immediately upon ratings downgrades. Yet by the time ratings agencies respond and reduce their ratings, it’s probably too late. For example, Standard & Poor’s had Lehman rated as an “A” the week before it filed for bankruptcy protection and stated that “We continue to view Lehman's near-term liquidity as satisfactory”.

And when Steve Eisman, the hedge fund investor who was one of the first to see the mess behind subprime mortgages and shorted the companies engaged in them,

called Standard & Poor’s and asked what would happen to default rates if real estate prices fell, the man at S.& P. couldn’t say; its model for home prices had no ability to accept a negative number. ‘They were just assuming home prices would keep going up.'

(See here).

To top it off, a PBS investigation uncovered what was really going on behind closed doors at the credit rating agencies the public relies on to evaluate the safety of their investments. "During this period, profit was primary; analytics were secondary."

Given all of this, I think the proposed change by the NAIC is a crisis in the making. Without collateral posted as is currently mandated, and without a bailout by the government as happened with AIG, one can only imagine how quickly liquidity can become an issue for companies whose insurer/reinsurer defaults on its obligations and have no recourse to recover on these defaults because of the proposed change.

We know what a great job the SEC did as a watchdog for the public. Who’s to say individual states are going to be in a better position to do the same watchdog role for the public when the proposed change is enacted?

Disclosure: No positions in any stock mentioned.