Captive collateral… are you leaving money on the table?

Due in large part to the financial crisis that has plagued the global banking system, letters of credit (LOCs) continue to be more expensive and harder to find. For those that are wondering “When are LOC fees going to go down?” I say, with a high level of confidence, that they are not coming down any time in the foreseeable future. Having recently spoken at both the IMAC Forum as well as CICA, some information came to my attention that should be interesting to captive owners and captive managers.

At the CICA 2010 conference in Orlando in March, Peter Rapciewicz of Chartis and I were on a panel discussing alternative forms of collateral for captives. He put up a chart that listed the different forms of collateral posted to Chartis for the insurance programmes they write (captive, deductible etc). The chart stated that, even today, 70 per cent of the collateral posted to them is in the form of LOCs. Given the state of the credit markets that number is surprising. Assuming the numbers from Chartis are somewhat representative of the overall industry (recent studies say they are), there is potentially a lot of money being ‘left on the table’ by captives posting collateral. This money is in the form of fees paid for LOCs when there is, in fact, a less expensive way.
This article is meant to discuss the alternative forms of collateral, as well as the features, benefits and limitations of each.
Why collateral?
I won’t spend much time explaining why collateral is required. I will just say that collateral is required by insurance carriers to cover the insurance carrier’s potential loss in the event that the captive cannot or will not cover their obligations.
The good thing about LOCs is that they are universally understood and accepted by both the captive and the carrier. There isn’t much confusion with LOCs. That not withstanding, the benefits of LOCs are fairly limited.
One concern related to LOCs for captives is that they tend to be expensive. These days they are even more so. How expensive? They generally cost anywhere from 25 (for the best credit risks) -100 BPS or more. My experience is that they average about 75 BPS. Think of that…75 BPS for a fully collateralised LOC. It is no wonder that captives are looking for alternatives.
Another concern with LOCs is that they have a tendency to ‘stack’ over time. That is to say that each year, due to IBNR and other reasons new LOCs must be obtained. And over time, finding a bank to issue the LOC, renewing previous LOCs, negotiating the price and collateral requirement for each and establishing custody accounts for each collateral base becomes an administrative nightmare.
Additionally, and particularly in the Cayman domicile, we see a lot of ‘confirming LOC’ arrangements. This is to say that the captive begins by establishing a fully collateralised LOC at a non-NAIC approved bank. The problem is that, since that LOC issuer is not ‘NAIC approved’, that LOC is not acceptable to the carrier. The original LOC is posted to a bank that is NAIC approved. It is the NAIC approved bank that posts the final LOC to the carrier. Sounds confusing? Convoluted? Yes and yes. To make matters worse, the captive is paying for both LOCs, effectively doubling their costs of collateral. This does not seem to be an ideal arrangement.
Funds withheld
Simply stated, some captives give their captive’s cash to the insurance carrier to ‘hold’ as collateral for their programme. While the fees for this arrangement are often very low (often zero), it creates a problem in that the rate of return on the cash handed over is generally very low. Again, this is not an ideal situation. But it is certainly more simple than an LOC, and especially the confirming LOC, arrangement.
Insurance trusts
This option, of the three, seems to offer the most benefits while posing the fewest limitations. Captives using the insurance trust in lieu of LOCs and funds withheld simply establish a tri-party arrangement where the captive (the ‘grantor’) puts their money into an account with the trustee to hold for the benefit of the carrier (the ‘beneficiary’). By doing this they enjoy the best of both worlds. By this I mean that they pay much lower fees than LOCs would allow for, but they get an increased investment income that is not generally possible in the funds withheld environment.
We previously mentioned that LOCs might be assigned a fee of 75 BPS of the LOC value. On a $10m LOC, that is $75,000 per year. A client that is considering a trust should expect to pay $7,500 per year (or less). That is a 90 per cent savings. If the LOC is $20m, then the fees would be $150,000. The trust would still be, generally speaking, less than $10,000. Clearly the trust makes sense from a fee perspective.
One thing that the trust does not require (and LOCs do) is the ‘renewal’ process. Once a trust is in place it does not need to be renewed, renegotiated or even addressed each year. If the collateral requirement goes up, simply put more money in. Think of all the work that one would save over having to go through the aforementioned LOC process!
Investment income
The next logical question is this: “How does each alternative affect my captive’s ability to earn income from the investments?” This is a great question that warrants an explanation.
Generally speaking, captives and corporations have conservative investment guidelines. While we would all like to maximise our investment income, the fact that this money is in a captive, and therefore meant to eventually pay claims, means that the primary objective is to be sure that the money is there to pay claims. Therefore, risking the captive’s money by ‘playing the markets’ is simply not a possibility.
Funds withheld situations don’t generally allow for anything other than cash. The carrier holding the money pays a rate of return on the cash. That rate is often excessively low, but there is no real ‘principal risk’.
With LOCs and trusts the opportunity to earn a reasonable income is much more realistic.
For LOCs: LOC providers have rules that govern what the captive’s money can be invested in. That is to say that under certain conditions, the carrier might let the investments be somewhat liberal. But be warned, the more ‘liberal’ the investments, the less credit that investment is given towards the collateral requirement. Stated another way, you are going to have to put up more than 100 per cent collateral (often much more) for an LOC if the collateral is more liberally invested.
For trusts: The investment guidelines are a combination of the regulatory requirements (NY Reg. 114 section 1404a) and carrier acceptance. While the regulations set forth minimum requirements, the carriers might ‘manage up’ the minimums. That is done on a carrier-by-carrier basis. To be sure, similar haircuts are applied to both LOC and trust assets.
They key to remember here is that, by and large, neither the LOC collateral investment options nor the trust investment options are the real issue. The real issue is this: In what types of securities is your captive currently investing? I will bet that nearly all captives have internal investment guidelines that will fit perfectly into either the trust or the LOC option. So in the end, there should be ZERO difference in ‘investment income’ by using a trust or an LOC.
The set-up process
For an LOC, the client must go through a credit review process. That is a lot of work. While the trust is governed by a legal agreement that is often 20 pages long compared to the short LOC document, the real issue is the amount of time required to get that LOC, not just the document itself. The trust agreement has been substantially pre-established between Wells Fargo and most carriers. So in most situations, you will spend more time establishing LOCs than trusts.
In the end, one collateral alternative is not perfect for everyone. But ignoring the fact that there are alternatives to LOCs could actually be creating more work than need be. And you could certainly be leaving money on the table.


Previous articleAdvertisers – Issue 19 Second Quarter 2010
Next articleGrey matters
Robert Quinn

Robert Quinn is a Vice President at Wells Fargo Bank in New York.  Robert has conducted educational seminars on insurance and reinsurance collateral needs to thousands of insurance industry professionals as well as delivered collateral alternative sessions at various industry conferences such as CICA (2010, 2006), IMAC (2009, 2007), SIIA 2009, 2006, Les Rendez-Vous de Septembre 2008, the Bermuda Captive Conference 2008 and RIMS 2006.

Robert G. Quinn
Vice President
Wells Fargo Bank
45 Broadway, 14th Floor
New York, NY 10006

T. +1 (203) 293 4394
[email protected]