Hidden Risk in Reinsurance: Investment Fraud and Bank Failures

Owners and managers of affiliated reinsurance companies are generally very good risk managers. They pay close attention to key factors that drive the ARC’s profitability and regularly adjust reserves, product mix and other factors while closely monitoring the frequency and severity of claims.

They are usually very good at managing investment risk as well. Working within their providers’ investment guidelines, they monitor markets and adjust invested assets to maximize return and minimize downside risk.

However, even the most sophisticated ARC owners and managers might overlook two very real risks inherent in their program: (1) investment manager misconduct and (2) failure of the bank holding the ARC’s assets. These risks seem more remote and esoteric than others, but recent history has proven otherwise. ARC owners and managers should be aware of these risks and how to mitigate them.

Investment Manager Risk

Investment fraud is much more common than one might think. The Federal Trade Commission reported over $3.8 billion in losses due to investment scams in 2022. Financial fraudsters tend to go after people who are college-educated, optimistic, self-reliant and high-income earners. Most ARC owners fit that description and are ripe targets for an investment fraudster.

Investment managers are not banks and generally there is no insurance or other surety that will make up for the bad actions of an investment manager. If an investment manager steals from or mishandles the assets of an ARC, they may be ordered to pay restitution over a number of years. In many cases, the victims of a fraudster recoup very little.

ARC owners can mitigate this risk by doing some diligence on the people who are entrusted with investing the ARC’s assets. The Financial Industry Regulatory Authority is dedicated to protecting investors and fair financial markets. FINRA maintains a database called BrokerCheck, which is a free tool to research financial brokers, advisors and firms. Simply search the name of an investment manager and BrokerCheck will provide a variety of information regarding experience, licensure, complaints and regulatory actions. Using this information, an ARC owner can make informed decisions when choosing an investment manager.

Bank Failure Risk

For many years, the banking industry has enjoyed a very stable market and there has been little talk of banks becoming insolvent. That suddenly changed last year when Silicon Valley Bank, Signature Bank and First Republic Bank collapsed virtually overnight. When a bank is in trouble, uninsured depositors may start pulling their deposits causing the bank to fail.

Banks can also become fundamentally insolvent when liabilities exceed assets, and there is currently a systemic risk in the banking industry due to potential charge-offs in the commercial real estate sector. The risk of bank failure is very real.

ARC owners and managers should understand what would happen if the bank holding the ARC’s assets were to collapse. To do so, it’s important to understand the difference between deposit and non-deposit assets.

“Deposit assets” are cash and cash-like assets, including money market funds and certificates of deposit. Most ARC accounts hold these types of assets for liquidity purposes and while funds are waiting to be deployed into a long-term investment. Anything other than a deposit asset is a “non-deposit asset,” including securities, mutual funds, stock, bonds and annuities. In most cases, the majority of an ARC’s assets are non-deposit assets. When a bank fails, these deposit and non-deposit assets are treated differently.

Deposit assets create a debtor-creditor relationship between the ARC and the bank, where the bank is obligated to repay the amount on deposit plus interest, if applicable. When a bank fails, the ARC’s deposit assets are protected by the FDIC, up to $250,000 per ARC per bank. Deposit assets over that threshold are likely to be pulled into the bank’s insolvency proceedings and the ARC can expect to receive pennies on the dollar, if anything.

Non-deposit assets held in a trust or custodial account are segregated from deposit assets and remain the ARC’s property even if the bank fails. According to the Office of the Comptroller of the Currency, “[a]ssets held by banks in a custodial capacity do not become assets or liabilities owned by the bank. If a bank is bought or fails, custody assets remain the property of the account owner. They are not subject to the claims of the bank’s creditors.” This means an ARC’s non-deposit assets are safe in the event of a bank failure.

ARC owners can mitigate the risk of a bank failure by managing the balance of deposit and non-deposit assets. Most ARCS are going to have deposit assets as new funds come in and cash is generated from investment assets. ARC owners and managers should regularly review the assets in their trust and custodial accounts to ensure that the amount of deposit assets is less than the FDIC insured amount. Ensuring that all assets over that amount are non-deposit assets will protect them in the event of a bank failure.

In addition to managing the day-to-day risks associated with an ARC, owners and managers need to be aware of these latent risks. Putting a little thought into these issues today will pay off if the ARC is the victim of fraud or a bank failure.

Andy Seger is an attorney and the COO of Portfolio, a leading provider of reinsurance and F&I programs and products. This article is for informational purposes only and should not be construed as legal advice.