Letters of Credit in Reinsurance — In the Wake of Fraud Allegations, Focusing on the Fundamentals

Widely reported allegations of fraud at an offshore company this past summer have drawn attention to the use of letters of credit (LOCs) to secure reinsurance obligations. The company, now in bankruptcy, specialized in matching reinsurance capacity in the capital markets with insurance cedents and structuring the resulting reinsurance transactions through special-purpose entities. During the summer of 2023, allegations appeared in media reports, and later in court pleadings, that corporate officers generated forged LOCs to support the company’s reinsurance transactions, resulting in billions of dollars in “illusory” collateral (which may have been intended for regulatory or purely commercial purposes). (At least one of the officers involved has denied the allegations in a public statement.)

In this alert, we review the model rules issued by the National Association of Insurance Commissioners (NAIC) for the use of LOCs as collateral for purposes of allowing a ceding company to claim balance sheet credit for (that is, to claim as an asset or contra-liability) a reinsurance recoverable.

The rules on when an LOC held as security will entitle the ceding company to balance sheet credit are set forth in the NAIC’s Credit for Reinsurance Model Regulation (MO-786). The applicable version of the model as adopted in a given state (rather than the model itself) should be consulted to ascertain the law of that particular state. Under the model, the requirements are generally as follows: 

• An LOC must:
  • Be clean, irrevocable, unconditional, and issued or confirmed by a “qualified U.S. financial institution” (generally, a U.S. federally or state-chartered bank determined by the Securities Valuation Office of the NAIC to meet standards of financial soundness (QUSFI));
  • Contain an issue and expiration date and stipulate that the beneficiary (i.e., the domestic insurer for whose benefit the LOC has been established) need only draw a sight draft under the LOC and present it to obtain funds and that no other document need be presented;
  • Indicate that it is not subject to any condition or qualifications outside of the LOC and not contain reference to any other agreements, documents or entities, except as described in the next-to-last bullet and set of sub-bullets below;
  • Contain a statement to the effect that the obligation of the QUSFI under the LOC is in no way contingent upon reimbursement with respect thereto;
  • Be for a term of at least one year and contain an “evergreen clause” that prevents the expiration of the LOC without due notice from the issuer of at least thirty (30) days prior to its expiration or nonrenewal;
  • State whether it is subject to and governed by the laws of the adopting state or specified standards published by the International Chamber of Commerce applicable to financial institutions that issue LOCs (the ICC Standards); all drafts must be presentable at an office in the United States of a QUSFI; and
  • If the LOC is subject to the ICC Standards, then the LOC shall specifically address and provide for an extension of time to draw against the LOC in the event that one or more of the force majeure occurrences specified therein occur.
    
    
•  Notwithstanding the above, an LOC may:
  • Include a boxed section in its heading that contains the name of the applicant and other appropriate notations to provide a reference for the LOC, which shall be clearly marked to indicate that such information is for internal identification purposes only. 

• If an LOC is issued by a financial institution authorized to issue LOCs other than a QUSFI, then:
  • The issuing financial institution must formally designate the confirming QUSFI as its agent for the receipt and payment of the drafts; and
  • The “evergreen clause” must provide for thirty (30) days’ notice prior to expiration date for nonrenewal.
    
    
• The reinsurance agreement in conjunction with which an LOC is obtained may contain provisions that:
  • Require the assuming insurer to provide LOCs to the ceding insurer and specify what they are to cover; and
  • Stipulate that the LOC is provided pursuant to certain provisions of an existing reinsurance agreement and may be drawn upon at any time and shall be utilized only for certain permissible purposes described therein (e.g., losses and return of unearned premium). 

• Nothing contained in the sub-bullets immediately above precludes the ceding insurer and assuming insurer from providing for (a) an interest payment, at a rate not to exceed the prime rate, on the amounts held pursuant to the second such sub-bullet or (b) the return of any amounts drawn down in excess of actual amounts required.