However, Andrew Silver, an AIG representative, said, “AIG is asking for collateral and getting it.”

The issue driving AIG, say some market observers, is that AIG expects long-term reinsurance coverage from companies that are not as highly rated as is AIG itself.

But what if all U.S. ceding companies make collateral a requirement? What if regulators make collateral and a license a requirement for U.S. reinsurers?

Of course, not every ceding company has the market leverage to require collateral, said sources.

Given that reinsurance recoverability is a growing concern, S&P, in a recent report called “Collateralization: Curse or Cure,” questioned how best to safeguard insurers: “Is it by an arbitrary collateralization rule that applies only to overseas reinsurers? Is it by allowing the market to seek its own security by favoring reinsurers with higher ratings? Or is it by applying the same arbitrary rule to all reinsurers, irrespective of either location or creditworthiness, so that U.S. players are held to the same standard?”

S&P noted that each approach has its supporters.

S&P said if the AIG requirement was implemented across the market, financial markets could not “absorb such widespread demand for security.”

It would be “absolutely crazy” to codify the AIG approach in a regulation, or require a U.S. reinsurer with a license to also post collateral,” said Brad Kading, senior vice president and director of state relations for the Reinsurance Association of America in Washington.

In the United States, “you either have a license or you provide collateralits a licensed or a collateral approach,” said Mr. Kading.

If U.S. reinsurers are required by regulators to maintain a license and post collateral, everybody would move offshore completely, he said. “There would be absolutely no reason for any U.S. reinsurer to have a U.S. license; it would be the end of the U.S. reinsurance marketabsolutely the end.”

U.S. reinsurers are subjecting themselves to an extensive amount of regulation and much higher capital requirements than competitors outside the United States, he said. “There is a huge cost associated with being a U.S. reinsurer and having a U.S. license.”

Mr. Kading quoted testimony given by David Robb, executive vice president with The Hartford Financial Services Group, who at the June meeting of the National Association of Insurance Commissioners said that no reinsurer in its right mind would create a U.S. reinsurance company because of the high regulatory requirements, the high cost of capital and the high burden of taxation.

Mr. Kading noted that all the new reinsurance capital has gone offshore due to onshore regulatory requirements.

Discussing the collateralization requirement and the potential for its more widespread use, S&P said there are important issues of market efficiency to consider in this debate. When collateralization is applied indiscriminately, “the underlying financial strength of a reinsurer makes no difference to the balance sheet credit a primary company receives from it,” said S&P in its report. Therefore, ceding companies have no incentive to select the stronger reinsurers, S&P added.

On the other hand, in an open market where financial strength is valued, “the least reliable reinsurers would be shunned by security-minded ceding companies and eventually driven out of business,” S&P said.

“Market efficiency is also affected by the costs of collateralization,” S&P said. “About half of the collateralization provided by reinsurers comes from letters of credit issued by banks or through various kinds of trust arrangements,” the report continued. “Both mechanisms entail fees, and although reinsurers can reduce these fees by providing security, this means dedicating liquid assets more or less permanently to claims that may or may not materialize, while giving up income on those assets in the meantime.”

While LOCs are popular with cedents because banks “far outshine insurers in their reputation for timely payment,” S&P questioned the wisdom of relying on banks to provide collateral. “An LOC is only as good as the bank behind it, and many of the institutions providing them are rated lower than the reinsurers they are backing.”

Discussing the U.S. rules, S&P indicated that state regulators currently require alien reinsurers to collateralize 100 percent of their gross liabilities. While Canada and France are the only other countries with similar requirements, France also applies the same rule to domestic companies, S&P noted.

Although alien reinsurers are pushing for a relaxation of the requirements, U.S. regulators have little incentive to change the current rules, S&P said, noting it would probably take a drastic reduction in reinsurance capacity to bring about change.

Mr. Kading said even U.S. reinsurers pay collateral. “The U.S. collateral systema point which the Europeans never seem to comprehendalready applies to U.S. reinsurers if they dont have a license in the cedents state of domicile,” said Mr. Kading, noting that the collateral requirement is triggered by the lack of a license.

Mr. Kading said that over $7 billion in collateral was provided by U.S. reinsurers to U.S. cedents in 2002, according to RAA estimates.

Bermuda carriers, which dont have to pay corporate income tax and can discount loss reserves, have said to U.S. regulators that collateral is not a problem for them, Mr. Kading said. “They understand that, if as a condition of doing business in the United States they have to provide collateral, then so be it. Its still an efficient way of doing business.”

“Whatever the distortions caused by mandatory collateralization, the overseas contingent [has] not suffered in terms of market share, with premium volume growing at a compound annual rate of 15 percent in the past six years, compared with 12 percent for U.S. reinsurers,” according to the S&P report.

“This may in part reflect an unanticipated boon to non-U.S. players, because a primary company that takes up fully collateralized reinsurance is arguably getting a more secure credit risk than if it bought from even a highly-rated domestic reinsurer,” S&P said. “By 2002, 39 percent of recoverables among U.S. insurers was secured by collateral, compared with 29 percent in 1997.”

Although S&P would not take sides in this debate, it noted a relaxation of the current system would benefit overseas reinsurers by increasing profits. However, if this enabled reinsurers to compete more aggressively on pricing, there would be an adverse effect on ratings, S&P continued.

“Somewhat more certain would be a negative short-term ratings impact on U.S. insurers that use overseas reinsurance exclusively,” S&P said. “In the long term, however, the outcome could be better risk-based reinsurance placement, a stronger global reinsurance market and reduced insolvency risk.”

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, September 1, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.