Letters of credit are used increasingly in the insurance market as collateral, but could the latest incident lead to more rigour being applied to ensure validity?

In Spielberg’s 2002 film Catch Me If You Can, con artist Frank Abagnale – played by Leonardo DiCaprio – is pursued by FBI agent Carl Hanratty –over scams that swindle people out of millions.

Clare Ruel

Clare Ruel

While the recent case of Israeli insurtech Vesttoo facilitating allegedly fraudulent letters of credit (LOC) for reinsurance transaction has less box office potential, the incident has attracted the attention of the FBI and shaken confidence in the insurtech sector.

In mid-July this year (2023), Vesttoo became embroiled in an investigation after China Construction Bank denied all knowledge of a LOC related to a Vesttoo-facilitated reinsurance transaction.

An LOC acts as a financial backstop between business and customer to ensure that payments will be met and can be cashed in at a bank if payments are not made.

The revelation of multiple potentially fraudulent LOCs on the Vesttoo platform during an audit has prompted some of the insurtech’s leadership team to depart, with a statement from the firm noting ”at a minimum, it appears that Vesttoo’s procedures were circumvented”.

Further to this, yesterday (1 August) the insurtech revealed it was laying off around 75% of its 200 strong staff after closing several of its offices across London, New York, Tel Aviv, Dubai and Bermuda.

A Vesttoo statement to Reuters explained: “In order to solidify the foundation of the company and reassure the industry, leadership must return its focus to core services while reducing overall costs, including parting ways with some of our employees.” 

The insurtech was also in the process of raising $200m in a late-stage funding round that, if achieved, would have cemented the firm’s overall value at around $2bn.

Earlier in May this year, Vesttoo was dehorned from its unicorn status after SureTech sold its holdings in the startup.

With the FBI now reportedly conducting an investigation of its own into the international financial manipulation, according to a statement from reinsurance firm Corinthian, how might this fallout impact the UK insurtech sector?

‘Potential weakening’ of market confidence

I recently spoke to Marcos Alvarez, global head of insurance credit ratings at Morningstar, who told me that this fallout could temporarily cause a “potential weakening” in insurance market confidence over LOCs.

He added: “This could make insurance companies revamp their practices around the management of LOCs. There also might be an increase in using cash collateral.”

When cash cannot be paid upfront, guarantees such as LOCs are used. However, an initial relationship must be established with the bank, which often takes the form of a credit relationship.

“The LOC is a guarantee issued by a third party – in this case a bank,” Alvarez explained. 

In a situation where cash is not stumped up, a bank with an LOC agreement is on the hook should the party that promised the capital not be able to pay.

Alvarez added: “I assume that the regulator might also be taking a deeper look – especially in traditional insurance jurisdictions like the UK, US and Bermuda.”

However, he explained that there are control mechanisms already in place around LOCs. For example, the beneficiary of the LOC could contact the issuer of the letter to determine its validity.

Alvarez believes the incident could prompt “people to rethink the process of LOCs” in more detail. Those considering their internal processes include regulators, banks, insurance firms and clients.

But for Alvarez, the issue is also reputational.

He explained: “It’s in the interest of banks that these beneficiaries have a way to confer the integrity of an LOC.” 

Alvarez predicted that more stringent checks and balances could now be put in place for LOCs in terms of the verification of validity. Technology could be of use here.

Likewise for Matt Carter, insurance specialty markets director at Altus, the concept of risk transfer “plays right into the heart of technology as it brings together buyers and sellers” and it can be completed via platforms.

Carter added: “There’s nothing wrong with the mechanism of risk transfer, but there does seem to be a challenge with not enough rigour being placed over the due diligence that [is] expected to be applied.”

For me, happenings in other insurtech territories around the world have often had a “ripple effect” on the UK, such as in the case of the collapse of Silicon Valley Bank in March 2023, which saw HSBC swoop in and buy the bank’s UK arm to avert a funding crisis for many UK insurtechs.

This situation is no different – but more stringent controls can’t be a bad thing where major capital is involved between parties.

If anything, this is the very concept of insurance, ensuring that neither party is left unfairly out of pocket and that transparency remains.