A right to recover is not a recovery

Everything so far has assumed the reinsurer pays. The assumption holds most of the time and it does not always hold, and the difference is only measured at the moment it matters. A right to recover is a receivable: it is worth what the debtor is worth, and what the applicable law allows one to extract. Five mechanisms separate the right from the cash, and they are not substitutes for one another: the insolvency clause, cut-through, collateral in its various forms, funds withheld, and the reinsurance credit that ties them all together. Examining them at placement costs a few hours. Discovering them at a carrier's liquidation costs the amount of the receivable.

The insolvency clause provides that the reinsurer's obligation is not conditional on the cedant having actually paid the loss. In liquidation the reinsurer owes the estate its full share, computed on the amount of the loss admitted to proof, and not on the reduced dividend the liquidator will pay policyholders. What it prevents is an argument the reinsurer could otherwise run: its cover would indemnify an outlay the cedant never made, so it should owe only the distribution percentage. That argument would empty reinsurance of its meaning at the precise moment it is most needed, which is why the clause is required by statute or by the regulator in many jurisdictions.

Cut-through goes further and breaks the privity of the reinsurance contract, which normally binds only cedant and reinsurer and creates no right for the insured. It provides that, should the cedant become insolvent, the reinsurer will pay the ultimate insured directly. What it solves is a question of signature quality: an insured placed with a weakly rated carrier, often because a fronting arrangement or a captive requires it, wants the reinsurer's strength to actually benefit it. Without cut-through that strength is of no use, the recovery falling into the estate and being shared among all creditors. Its validity depends on the insolvency law applicable, and some regimes treat it as an unlawful preference between creditors.

Collateral addresses the same problem through assets rather than clauses. A letter of credit is a bank's undertaking to pay the cedant, on simple conforming demand and without being able to raise the defenses of the reinsurance contract, an amount covering a reinsurer's liabilities. It must be irrevocable, unconditional, and issued by an institution approved by the cedant's supervisor. Its advantage is that it ties up only a bank line, where a trust requires real assets to be locked away: the reinsurer keeps the use of its investments and pays only a commission. Its weakness is that it moves credit risk rather than removing it, and banking crises have shown these lines thin out at the very moment cedants need them.

Funds withheld work the other way round and by the simplest of means: the cedant does not remit the premiums or reserves it owes the reinsurer, it keeps them in its own books as security, remunerated at a contractual rate, and releases them as the losses are settled. There is no bank and no trust to put in place, since the security arises from the fact that the money never left the cedant. The mechanism is an old one and remains widely used in life reinsurance and on long-tail treaties. It does, however, invert the risk: the reinsurer becomes a creditor of the cedant for considerable sums, and in turn bears credit and interest rate risk, the contractual remuneration often diverging from the actual yield on the assets.

Reinsurance credit is what ties the rest together, and it is through it that the four preceding mechanisms should be read. It is the cedant's right to carry as an asset, and to deduct from its capital requirements, the share transferred to its reinsurers. It is never automatic: prudential regimes condition it on the reality of the risk transfer, on the reinsurer's authorization or rating, and sometimes on collateral being posted where the reinsurer is not established in the jurisdiction. What it prevents is apparent solidity: a cedant booking as transferred a risk whose carrier is insolvent would show a balance sheet that corresponds to nothing.

From this follows a consequence the outwards underwriter must be able to state, and it is not intuitive. Reinsurance credit turns panel quality into an accounting quantity: the same layer, at the same price, does not produce the same balance sheet effect depending on who carries it. That is what makes it economically rational to pay more for a better rated signature, where a purely technical reading would conclude the opposite. In the United States the absence of an insolvency clause on its own deprives the treaty of all reinsurance credit, which shows the question is not only about recovery on default: it is also about what the treaty is worth on the balance sheet every other day.