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2013 Captive Insurance Companies Association (CICA) Special Section

Collateral trust provides numerous benefits

Well established among captives, the use of trusts is spreading


Today's commercial insurance market is made up of a wide variety of approaches that are providing corporations with appropriate risk-financing solutions. The reason for this myriad of approaches is that in the alternative risk transfer (ART) market, one size does not fit all. As a result, there are many ART options to select from; however, regardless of which approach is selected, several important elements of the transaction will be similar. One of the common elements of any ART solution is, regardless of the approach used, collateral will be required.

As a concept, collateral is fairly easy to understand. In essence, most insurance transactions require some form of financial guarantee to assure that appropriate funds will be available should they be required to pay a claim. Some form of asset is vital, to be provided as security to ensure satisfaction of any future obligations. While the concept of collateral originally began in the banking sector, it quickly followed suit within the insurance sector. Collateral for insurance or reinsurance programs has typically taken the form of either a letter of credit (LOC) or funds withheld (handing cash to the carrier to hold). However, over the last decade or so, an additional form of collateral has been gaining acceptance.

More viable option

The third form of collateral has a number of advantages, according to Robert G. Quinn, senior vice president in the Collateral Trust department at Wells Fargo Bank. The third option, known by a number of names (Reg. 114 Trust, Insurance Trust, Reinsurance Trust, Collateral Trust, etc.), has been gaining significant interest within the captive sector for years. In fact, one of the first applications for the trust has been with captive insurance companies. Quinn points out that while LOCs continue to make up the majority of the collateral market, there are several critical issues associated with the use of LOCs, not the least of which are the issues of availability and affordability. He states that availability was a major issue during the height of the recent financial crisis. "Availability has improved, but the crisis quickly showed one of the weaknesses of the LOC market. Lower availability means higher costs." He also indicates, "While the costs are easing a bit, they are nowhere near the lower cost of five years ago." The greater issue is that, whether you look at the pricing pre- or post-crisis, the cost of the LOC was and is usually much higher than that of the cost of the trust. Quinn states that the cost of the trust is "typically 80 percent to 90 percent less than that of an LOC."

Operationally, the LOC has a major shortcoming. All LOCs are subject to a detailed credit review prior to issuance, and this is a long process. Further, notes Quinn, LOCs are also subject to an annual credit review and approval to remain in effect. In essence, despite the "evergreen requirement," LOCs are at best a year-to-year proposition, regardless of whether the contract is required to be "irrevocable" or not. He points out that once the trust is put in place, it remains for the life of the collateral transaction, and there is no similar annual renewal feature.

An additional shortcoming of the LOC is the effect it has on the parent's overall credit picture. In order to secure an LOC, a corporation must transfer to the LOC-issuing bank an amount equal to the LOC. If you are going to do this, Quinn states, then you might as well put the same cash or cash equivalents into a trust and forgo the LOC altogether. The idea of collateralizing your collateral, as Quinn calls it, is entirely redundant.

When the LOCs are not collateralized, the corporation's overall available credit is reduced by a similar amount. This is particularly problematic if it should come out of a line of credit the corporation needs for other parts of its business, like operations. The trust is not credit, so it does not have this effect.

Further expansion

To date, the trust concept has been utilized primarily in conjunction with captives. However, Quinn is finding acceptance in other situations as well. One of the most successful areas has been in the reinsurance sector. He points out that growth in this market has been significant and it continues to grow. The cost of credit, Quinn notes, "for reinsurers, especially unrated reinsurers, is likely very high." The Wells Fargo trust approach can provide collateral at much lower rates. "All in all, we believe the reinsurance market represents a significant market for the trust," Quinn says.

Additionally, he points out that the insurance-linked securities (ILS) market is another growing market for Wells Fargo. He notes, "Many investors have realized early on that it is far easier to utilize their funds via an ILS/ILW structure rather than a bricks and mortar reinsurance company." He points out that the Bermuda market, for example, has been very active in these types of arrangements and Quinn's group has begun working with several ILS/ILW reinsurance companies there. The major advantage for these companies is that the trust "helps to reduce the expense side of the ledger and thus makes the ILS/ILWs more attractive."

Wells Fargo is also making inroads in the UK market. Quinn states, "We are currently working with the top four corporate casualty insurers in the UK market." Currently, he indicates that they are seeing success with auto and employers liability coverages via captive and deductible-type arrangements. This has helped to hasten the use of trust for collateral.

Finally, Quinn says that the Vermont captive market is another growth area for trusts. Vermont has historically maintained a position that did not allow a captive to use a trust to meet the minimum capital and surplus requirements and claim the trust funds as assets of the captive. However, in April 2012, Governor Shumlin signed H.512 into law. Among other things, it contained several important changes to Vermont's captive legislation. While much of the law was directed at cell captives, one of the other changes allowed captives to use a trust approved by the commissioner to satisfy minimum capital and surplus requirements. Thus captives can meet the minimum requirements with either cash or LOCs, or now with a trust, thus providing more flexibility for captive owners. Quinn indicates that "Wells Fargo was the first bank to take advantage of the new trust feature" and has been active ever since.

Conclusion

While it now appears that much of the panic in the financial market has dissipated over the past few years, there are still many issues left to be resolved. However, securing appropriate collateral for many of the alternative risk-financing options continues to be problematic. While Wells Fargo's Quinn notes that the major mechanism used to satisfy collateral accounts continues to be LOCs, he points out that there are many reasons to consider a 114 Trust.

To summarize, the trust is easier to get and maintain, and they typically cost at least 80% to 90% less than the LOC. He is quick to note that "trusts are not the answer to all collateral needs; however, it would be irresponsible not to include it in the collateral decision process." As noted earlier, this is a case where he says, "one size does not fit all, but it should at least be afforded some consideration."

 

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