Collateral issues for captives
Insurance trusts may offer a viable and cost-effective alternative to LOCs
By Michael J. Moody, MBA, ARM
A host of consequences has resulted from the financial crisis of the past few years. Most are pretty obvious: high rates of bankruptcy, home foreclosures, one of the highest jobless rates since the Great Depression, and general financial turmoil across all business sectors. Certainly the financial service sector has felt its share of pain as well. Investment and commercial banks that have been in business for more than 100 years are now being forced into mergers with long-standing competitors just to survive.
One of the other, less obvious sectors affected has been the captive insurance industry. The captive industry has typically placed a high premium on the security of its capital. Whether it is a well-capitalized start-up or just the maintenance of the proper regulatory surplus, access to capital (in one form or another) has been critical in supporting the captive movement.
In the past, many captives have turned to letters of credit (LOCs) to meet their regulatory capital and collateral requirements. However, for a variety of reasons, LOCs have become harder and harder to obtain. According to Robert G. Quinn, speaking on this topic at the recent Captive Insurance Companies Association annual conference, “LOCs are still out there; it’s just that they are going to the highest bidder.”
He notes that since banks have such limited funds to lend, “the costs of LOCs have continued to increase while their availability has been reduced greatly.” While some insurers, reinsurers, and fronting carriers might rather have LOCs posted to them, for many captive owners or potential captive owners, the affordability and even the availability of LOCs could result in considerable difficulties.
Understanding the difficulties facing captives, most direct and fronting carriers are more readily accepting the trust as an alternative to LOCs.
Quinn, who is a vice president at Wells Fargo Bank, suggests, “The insurance trust concept has always been a viable option to an LOC, but today it is usually the best option.” He says this because now, more than ever, the trust presents itself as a cost-effective, readily available collateral mechanism for the captive industry. He points out that, regardless of the financial environment, the trust has a number of advantages that can compete very effectively with traditional LOCs.
A better mousetrap
While there are several reasons a captive would need an LOC, by far the greatest need (in terms of dollars) is to meet their collateral requirements. Additionally, LOCs can also be used effectively to meet the domicile’s regulatory capital requirements. However, for the past few years (and across industries), it has been harder and harder to obtain LOCs (particularly for captives).
Quinn points out, “One of the primary issues is cost (which directly correlates to credit availability).” He notes that the typical LOC has increased in cost from around 25 to 40 basis points (BPS) just a couple of years ago to over 75 to 100 BPS today. When looked at in real terms, this means on a $10 million LOC, “the cost will be $75,000 to $100,000 annually just for the LOC.” Quinn quickly points out that “the typical cost of the trust is between $5,000 and $10,000.” He says, “This clearly illustrates the pricing advantage that the trust option presents.
“But cost is just the beginning of the benefits available via the trust,” Quinn indicates. He says that there are problems with LOCs that just don’t get much mention. The first of these issues is “stacking,” which is well known to anyone who has ever obtained LOCs for an ongoing casualty insurance program.
The stacking issue revolves around the ever increasing collateral requirement needed not only to cover the current year’s claims, but also the previous years’ unpaid claims (IBNR). Each year, new LOCs are required and, therefore, they tend to “stack” over time. This goes on for as long as collateral requirements grow (often six to eight years).
“Consider the work required to put in place one new LOC,” he says. “Then add to that workload ‘renewing’ each LOC from previous years. The captive must keep track of the LOC issuing banks, the renewal dates, renewal notifications, and they must negotiate the rates each year.”
Quinn re-emphasizes the point that, for the most part, despite “evergreen” language that may indicate something different, “LOC renewal terms and conditions must be negotiated each year.”
Another issue surrounding LOCs is, “What can be used to collateralize them?” In the past, most captive owners could use a variety of investments to collateralize their LOCs. However, Quinn states, “This is no longer the case.” Today, one of two approaches is being taken by banks that are providing LOCs.
The most common method, according to Quinn, is to use cash or cash equivalent investments. “These would include such things as money market funds, Treasuries, or other investments that assure safe, liquid, and predictable value.” But, as Quinn states, “If a captive is going to collateralize an LOC with such assets, why not just put those assets into a trust and save all of the LOC fees?”
He also indicates that other more risky investments can be used. But, Quinn says, “In the case of riskier investments, the banks are simply requesting additional amounts of collateral, maybe 20% more than the face amount of the LOC.”
In either case, he says, “The ultimate cost of LOCs is (often) triple what it used to be and exponentially more than a trust.”
Opponents of the trust concept note that there are several shortcomings to them as well. One of the frequent items noted is the need to negotiate a somewhat longer legal document than a letter of credit. To be certain, the original trust documentation represents a longer document. However, Quinn says, much work has already gone into this aspect of the product. He points out that an LOC is typically about two or three pages, while the trust document is around 14 to 15 pages.
However, Quinn and his team “have already gone to most of the major fronting carriers and pre-established standard wording with each carrier.” Thus, the wording for a given carrier has been worked out in advance and can be implemented in a timely fashion (often in a matter of days). “Additionally (and to be very clear) the actual LOC document might be two pages, but the credit review process required to obtain an LOC is a much more arduous process than establishing a trust.”
Administratively, the trust also offers several advantages. First, once the trust is established, it is done. It remains in effect until the parties sign off on its dissolution. There is no “renegotiating” every year. Quinn also indicates that if the collateral requirement goes up, the captive simply wires more money into the trust. There is no need to redo the entire trust agreement.
With LOCs, as previously described, you must renegotiate them each year, usually multiple LOCs at a time. Use of a trust actually reduces the captive’s workload. Operationally, it is quite simple, he says. “You are taking money that you would normally have to pledge as collateral for the LOC and placing it into the trust at a much lower expense and workload to the captive.” The beauty of this arrangement is that the money that goes into the trust remains on the balance sheet of the captive (marked as a “restricted asset”). Thus, any investment income that results from this arrangement is owned by the captive.
The lack of available credit has taken its toll on the captive industry. As Robert Quinn of Wells Fargo Bank has noted, “Both the affordability and availability of LOCs have been called into question.” Certainly, LOCs have been a mainstay in the captive industry; however, there are viable alternatives to help captives and their owners get around the current difficulties in obtaining affordable LOCs. One the most successful options, according to Quinn, is the insurance trust.
Wells Fargo has been actively marketing a trust approach for several years, and it has been widely accepted by both fronting and primary insurance carriers as well as domicile regulators. And to top it off, Wells Fargo’s trust typically costs around $5,000 compared to $75,000 to $100,000 for a $10 million LOC. It would appear that any captive owner should take a serious look at the advantages that the trust can provide in this difficult financial market.
“For a fully collateralized $10 million LOC, the cost will likely be $75,000 to $100,000 annually, while the typical cost of the trust is around $5,000. But ‘pricing’ isn’t the only benefit of using a trust.”
Wells Fargo Bank