DUAE market growth places higher demands on due diligence

Given the increasingly diverse ways that capital is flowing into the growing delegated underwriting authority enterprise space, market participants’ focus on due diligence should rise in tandem.

The DUAE market, which includes MGAs, MGUs, program managers and similar entities, has seen capacity balloon as it has attracted interest from providers such as the capital markets, the ILS market, fronting/collateral markets and private equity. As a result, managers now have several ways to access capacity. The sheer amount of available capacity in the market demands a correlated amount of due diligence in accessing and monitoring this capital.

Due diligence helps the carrier verify the program’s profitability and helps to determine whether the program’s objectives, experience, market knowledge and technological abilities represent a good match for the carrier. The recent Vesttoo scandal was a wake-up call to market participants that comprehensive due diligence is necessary to protect all parties and sustain the market’s growth.

With the ingenuity and creativity in the sector, the outstanding growth in the MGA space is no surprise. AM Best estimates US direct written premiums of $68bn for 2022, based on Note 19 data, and this likely does not represent the entire universe of MGAs since many MGAs generate annual premiums for insurers that fall below the 5 percent surplus threshold. (NAIC reporting regulations for Note 19 require that companies disclose individual MGA premium data only for those MGAs whose premium constitutes more than 5 percent of the risk-bearing entity’s policyholders’ surplus.) Direct premium written estimates vary across the market as well; for example, Conning estimated US MGA premium in 2022 at closer to $90bn.

Although the number of deals and deal volumes have not outpaced that of prior years, the capital markets are still averaging strong multiples in the mid-teens. Furthermore, the supply of ILS capital grew in 2023 as a result of the heightened demand for reinsurance capital. AM best, in conjunction with Guy Carpenter, estimated total ILS market capacity at about $100bn at year-end 2023, up about $4bn from a year earlier. Fronting carriers’ capacity is supporting approximately 15 percent of total US MGA premium, representing approximately $13.5bn and an increase of 38 percent from 2022.

The full impact of the Vesttoo letter of credit fraud has yet to be determined but it appears that the overall sector has emerged relatively unscathed. That said, due diligence is an underlying risk amid ever-increasing investments in the DUAE market, and if the Vesttoo case highlighted anything, it was the importance of managing counterparty risk. AM Best’s approach to a company’s due diligence in this area is aimed at identifying the possibility of volatility seeping through the cracks and causing major disruptions – an expectation of continuous evolution of best practices in such a burgeoning market is critical.

Following the published news reports on Vesttoo, AM Best reviewed rated fronting carriers and other insurers with material amounts of reinsurance counterparty credit risk and reliance on various forms of collateral and shortly thereafter made warranted rating actions. AM Best’s interactive rating process allows for a continual dialogue on key rating factors and so AM Best is regularly monitoring the risk landscape for new developments.

AM Best’s performance assessment methodology for DUAEs gives an overview of the assessment process. From a due diligence perspective, the process is designed to complement and serve as an independent, objective, non-credit opinion geared toward greater transparency in the DUAE sector.

The approach is anchored around AM Best’s analysis of historical trends and expected future performance stemming from the DUAE’s underwriting capabilities. There is an emphasis on the impact that volatility will have on the long-term sustainability and success of the DUAE’s business.

Other reviews of competitive advantages also can reveal nuances of a well-diversified and profitable DUAE. This analysis includes a study of the DUAE’s proprietary data and analytics. Moreover, the process seeks to understand how technology is used in the underwriting process; how data is applied to pricing, loss reserve development and IBNR; and how this affects the overall business and a DUAE’s ability to perform services on behalf of its insurance partners.

Oftentimes we find failed measures of due diligence when analysing a DUAE’s risk appetite in comparison with agreed-upon risk parameters. DUAEs that are not strict in adhering to the limitations of their underwriting authority find that they expose the operations to unwanted risks. AM Best will look to understand how a DUAE’s governance and internal controls would mitigate these unexpected risks.

Often this means asking skilled questions around contractual obligations that tie an entity to potential risks. An analytical review of systems is undertaken: We look at the real-time integration of data capture and reporting processes and whether it includes audits and other management reports. The analysis hones in on integration as it stresses the importance of alignment of interests.

Part of a sound due diligence plan is to know the triggers of policies and procedures and to verify that they are consistent and standardised. AM Best is interested in the various business continuity measures are undertaken, this includes key person risk, disaster recovery, E&O and cyber policies.

AM Best is not focused on buy-side due diligence, however we do take an analytical approach in reviewing the financial metrics of the operations. Stability and sources of income are assessed along with cash-flow evaluation. Our due diligence process looks to uncover any areas of potential financial stress that can affect the overall efficiency of operations.

In the end, DUAEs are seeking to make a profit for their capacity partners and themselves, and in today’s operational risk climate, one catastrophic loss can have a chain reaction and cause major disruptions in the industry. Having a comprehensive due diligence process in place supports the evolution of the DUAE market.