In June 2011 I spent a few days at the Bermuda captive
conference. It was a very well done affair. Great speakers, very nice venue,
and very well organised. As much as any conference I have attended, I saw the
conference organisers and the conference committee personnel front and centre,
ready and willing to help with exhibitors, sponsors and attendees with whatever
One thing I noticed during the conference was a
consistent series of “side-discussions” about Insurance Linked Securities (ILS)
and their relationship to the captive insurance industry. Interestingly, (from
what I could tell) only about half of the people that I heard engaging in these
conversations were actually Bermuda based. I guess that makes sense as quite a
large percentage of CAT bond and other types of securitisations are being done
in other domiciles. Cayman comes to mind.
One of the insurance
managers with whom we work often on ILS transactions is Horseshoe Group out of
Bermuda and Grand Cayman. They run a great shop and have tons of expertise. I
had to call and ask my friend Steve Britton at Horseshoe Group in Cayman if he
had any sense of why Cayman is so popular for certain types of risk transfer.
He stated (fairly simply) that the deals often follow the expertise. He noted
that while each domicile seems to have one or more niches, these types of risk
transfer transactions have a nice home in Cayman.
notwithstanding, it seems that there is a clear need for these ILS
sponsor/transformer arrangements to consider “collateral” as part of the
To be clear, it isn’t just a regulatory
requirement or an accounting process that compels parties involved in ILS
transactions to post collateral. In fact, regulations and accounting issues
have little to do with it. Having discussed this issue with multiple sponsors
and transformers, I am clear that it is all about “credit risk”. No one wants
to, nor should they want to, be left holding the bag.
So what exactly are the collateral
options? And what are the considerations one must keep in mind as they move
forward with their transaction?
Letters of credit
(LOCs) offer little in the way of efficiencies. But they are, in fact, one of
the two primary ways that ILS transactions are secured. And without question
the most prevalent.
The “pros” of using
LOCs are few, but they are worth considering. First, they are universally
understood and accepted. Since LOCs have been used for years in the reinsurance
and captive space, it makes sense that the parties to ILS transactions accept
LOCs as collateral.
Further, if you are
“carving out” part of a larger existing credit revolver that your company
already has in place, then LOCs can be somewhat simple to secure. But
beware…using LOCs from your overall corporate credit lines is expensive and it
encumbers your credit.
to the complexities of these transactions, most parties needing to post
collateral for ILS transactions don’t have access to their larger credit
relationships for this purpose. Most need to secure LOCs on an individual
basis. This is where the concept of LOCs falls apart.
For starters, most
captive and ILS related LOCs need to be cash collateralised. And even when they
are cash collateralised they cost anywhere from 50 to 100 bps or more. Lastly,
when LOCs are obtained on a case by case basis, the “purchaser” of the LOC must
go through the LOC issuing bank’s arduous credit review process. Anyone that
has had to do this knows that a bank credit review process is no simple task.
So in the end, the
use of LOCs for ILS and other captive collateral is often a lot of work and
very expensive, even for “cheap” LOC (more on that in a bit). Further, the fact
that one must usually “cash collateralise” their LOCs makes the ILS and captive
LOC proposition entirely redundant.
Trusts are often a
much more efficient way to collateralise captive and ILS programmes. The
concept is simple. Rather than giving cash to a bank so that they will issue an
LOC, my clients simply place the same cash or cash equivalents into a trust
account that designates their counterparty, to whom they would otherwise post
the LOC, as the beneficiary. From a regulatory and beneficiary perspective,
this satisfies the requirement of collateral. Use of the trust in lieu of LOCs,
particularly with Wells Fargo, offers a number of advantages.
Price – Compared to LOCs, the price of a
trust is often the biggest reason people use trusts. As previously stated, LOCs
in today’s environment, in normal terms, usually cost between 50 and 100 bps.
Splitting the difference and assuming 75 bps, let’s look at this in real terms.
Figure 1 is fairly clear in the pricing of LOCs compared to an equal sized
trust. See Figure 1.
The first thing that
jumps out on in Figure 1 might be the $5,000 flat fee. This assumes simple cash
deposits in MM funds or deposit accounts. If it isn’t a simple deposit, then
the most a $10 million trust cost would cost is $10,000, a far cry from the
A couple of other
things might jump out when reviewing Figure 1. First, you can see that there
are cost savings at nearly every level of the “trust vs. LOC” discussion. It is
also clear that as the collateral requirement
goes up, the savings do as well, both as a dollar amount and as a percentage of
the LOC fees.
next chart I find particularly useful in describing to people “for what
collateral amount the trust makes financial sense”. The way I answer this is to
show them Figure 2. I give sample basis point charges and tell them that, based
on Wells Fargo’s average fee of $5,000, the “collateral size where the trust
makes sense” is really dependant on how much the client pays for their LOC (in
the following chart reads as follows: “If I pay 15 bps for my LOC, then my
collateral amount needs to be over $3.33 million before the trust actually
costs less than the LOC” and so on. But please be clear, this is the
“break-even point”. Even at 15 bps, your collateral requirement won’t have to
be huge to save money using the trust. This is the “cheap LOC” that I mentioned
earlier. Not so cheap after all, is it? See Figure 2.
from the cost – As stated before, most captive and ILS LOCs are actually cash
collateralised. Therefore, the previous pricing analysis assumed that the LOCs
in question were exactly that…cash collateralised. If they weren’t, then the
price for the LOCs (if available at all) would have been much higher. The point
of this is that collateralising an LOC to post to a carrier creates a terrible
redundancy. You are posting collateral to get collateral.
the trust, your cash IS the collateral. It eliminates the redundancy and saves
you most of the fees you are currently paying.
investments and their income – We have now established that whether you use a collateralised LOC or a
trust, you will usually need to post your captives cash into one account or
another. The question now is “what comes of that cash?”
of whether it is an LOC or a trust, the money posted will more than likely be
invested the same way. Here is what I mean: Most, if not all, captive insurance
companies have internal investment guidelines. They have limitations as to what
sort of “investment risk” they are willing to take. Indeed there are
restrictions on what a captive can invest in within the confines of both trusts
and LOC collateral accounts. The difference is that, for trusts, there are regulatory
“minimum investment guidelines”. For LOC collateral accounts, the rules are set
by the LOC issuing bank. To be fair, LOC issuing banks might be more liberal
than the trust regulations, but the real issue isn’t “what can I invest in”.
The real question is “what do I invest in.”
me not convolute the issue. The real issue isn’t what the regulators or the
banks “allow for”. The real issue is this: what are captives generally
investing in? I don’t know many, if any, captives that seek out the “riskiest
investments allowable” (especially in this investment environment). Most are
looking for safe, liquid and predictable in value.
net result is this: Whether you use a trust or an LOC, the investment income
from the cash posted should be the same.
income and set-up – Assets placed into a trust with Wells Fargo remain on the books of the
depositor. This means that the capital ratios of the captive will not be
interfered with if the trust is employed. Further, any income generated by the
trust assets remains an asset of the depositor. And since Wells Fargo has
pre-negotiated the required legal document with most of the beneficiaries of
these transactions, establishing a trust with Wells Fargo will be quick, easy,
In the end…
The growing popularity of ILS transactions in the market, along with the
continued popularity of corporate captives mandates that the principals to
these transactions seek out the most efficient and cost-effective ways to do
business. When it comes to collateral, LOCs have been used for years. But
clearly there is a more efficient, cost effective way. Use of the Wells Fargo
Captive or Wells Fargo ILS trust will save you most of the fees and most of the
work involved with LOCs.