In today’s challenging economic climate, corporate executives are examining the value of every dollar spent, including those spent on risk and insurance. As a result, risk management departments that effectively control the cost of risk are viewed as invaluable and key strategic partners within their organisations.
Toward this end, collateral requirements and solutions, which are inherent in owning a captive insurance company, are being more closely evaluated by current and prospective captive owners to determine whether the method of collateralisation utilised is the most effective and efficient solution available.
The best solution will vary by an individual captive’s situation, but often, more than one suitable option will work. In these instances, captive owners should assess both the direct cost and the opportunity cost involved. For example, when considering the use of letters of credit, we recommend that the bank, letter of credit, investment management and custody fees be evaluated together with the collateral rates, service and investment returns.
In some situations, an LOC might be the least costly form of collateralisation for a particular captive, but the opportunity cost may diverge as the LOC ties up borrowing ability. Similarly, a higher loan-to-value rate on investments pledged as LOC collateral gives a captive greater unencumbered assets and flexibility and thus may be worth more to a captive than lower fees.
A captive’s collateral obligation
Captive owners rely on collateral to meet the demands of fronting insurers, which are utilised when non-admitted insurers, like captives, are either not recognised in a specific territory or are not permitted to write certain lines of coverage. Fronting companies require the collateral to offset their credit risk resulting from an obligation to pay claims should the captive fail to do so.
Collateral requirements have increasingly become a burden for risk management departments as a result of the financial crisis of 2008. In many situations, collateral solutions have become more difficult to obtain and more costly to the captive.
Before delving into those solutions, here are a few collateral trends found in Marsh’s April 2010 Global Captive Benchmarking Report based on roughly 750 single-parent captive clients located in more than 13 different domiciles around the world:
Nearly 70 per cent of the policies for which captive clients are providing collateral are for casualty policies, with almost 45 per cent of them for Workers’ Compensation/Employers’ Liability (EL) and Auto Liability.
Letters of credit represent 59 per cent of the collateral instruments used by captive clients followed by reinsurance trusts and escrow accounts, used by 19 per cent, respectively.
Captive owners, rather than the captive’s parent company, are responsible for posting collateral directly to the fronting company in 68 per cent of the cases.
Of the insurance programs requiring collateral, 32 per cent require collateral that is equal to the policy limit; 29 per cent require collateral that is less than reserve levels; 23 per cent require collateral equal to reserves and 16 per cent require collateral that is more than reserve levels.
As the report indicates, there is wide variance in the amount of collateral fronting insurers expect from captive owners and the cost of collateral varies depending on the amount and the method of collateralisation used.
A thorough examination and consideration of all collateralisation options available will help risk management departments to manage effectively their captives and their organisation’s cost of risk.
Letters of credit: Letters of credit are by far the most common form of collateral. An LOC is provided by a bank and guarantees the ability of the captive to meet its obligations to the front. It is usually secured with cash and certain allowable investments from the captive. The LOC is typically issued each policy year and automatically rolls over unless cancelled within a certain notice period.
The pricing of an LOC is almost always a percentage of the value of the line of credit. Although the basis point charge is constant, as the credit line value rises, so too does the cost of the LOC.
It should be noted that in a small number of instances LOC fees have run as high as 500 basis points. This usually occurs for unsecured LOCs where the bank bases its pricing on the credit risk it is assuming.
In addition, we also have seen some fronting companies refuse letters of credit from certain banks due to over-exposure to that bank as a result of the financial crisis. In many cases, banks also have lowered the loan-to-value rate for investments used as collateral, causing increased collateral margin concerns for the captive. This situation can require a re-evaluation of the investment portfolio mix as well as ongoing negotiations with the bank to get the loan-to-value rate increased.
Back-to-back letters of credit: These LOC facilities are very common for group captives, where members of the group issue letters of credit to the captive to help support the captive’s outgoing LOC to the fronting company. The issues present in the current financial market are compounded in these instances as they affect both the members and the captive. Group captive banks are facing greater restrictions and may have to refuse letters of credit from members issued by certain banks, even if they have been accepted in the past. In these instances, captive managers should pro-actively manage the situation by seeking pre-approval of new issuing banks from the group captive bank whenever possible.
Reinsurance trusts: These trusts are tripartite agreements between the captive, the fronting insurer and a trustee. In these situations, captives deposit cash and certain restricted assets into a collateral account with the trustee and the fronting insurer has access to the funds to meet obligations under the reinsurance contract.
Trusts can be more flexible and less costly than LOC’s because collateral requirements are reduced as loss payments are made. When compared to LOCs, a larger percentage of reinsurance trusts cost between 0 and 50 basis points. However, there are some cases where trusts have an associated cost that is in excess of this. Some are as high as 350 basis points, most likely a result of a small trust size or more risky investments within the trust.
Indeed, one consideration in utilising reinsurance trusts is that the types of allowable assets are generally limited to very conservative investments, such as US government bonds. Accordingly, sometimes an LOC may be less expensive than a reinsurance trust when all associated costs are taken into account. For example, an LOC may be supported by collateral that, itself, produces an investment return that is sufficiently in excess of the return of US government bonds to offset the higher LOC fee.
In general, most trusts are provided on a flat fee basis so the larger the value of the trust, the more cost efficient the facility becomes.
Escrow accounts: Another common method of security is that of funds withheld, or an escrow account. Under this type of collateral arrangement, a fronting insurer keeps funds from the captive in an account to meet obligations as they arise. While escrow accounts can be an attractive option to some captives as there are no direct costs to the captive, the captive has no control over the investment decisions and, in most cases, earns no investment income on the funds.
Parental guarantees: Although not as popular, parental guarantees can be used in some cases to satisfy collateral obligations. Under this type of arrangement, a captive’s parent company acts as a guarantor should the captive fail to meet its claim payment obligations to the fronting insurer. Here, the front is assuming the credit risk of the parent, not the captive. In some jurisdictions, this form of guarantee may be seen as undermining the independent relationship between the parent and the captive. It also may erode the parent company’s borrowing facility.
In addition to seeking the most appropriate collateralisation, an effective claims resolution strategy also serves as an efficient means to reduce a captive owner’s collateral requirement. Because collateral amounts relate to the amount of reserves a captive sets aside to pay claims, resolving those claims becomes an important cost-reduction strategy.
In some instances, loss portfolio transfers make sense. Under this type of arrangement, a captive pays a premium to a third-party reinsurer to assume a portfolio of incurred losses. Loss portfolio transfers not only can relieve the amount of capital and surplus required to support loss reserves allowing the captive to underwrite more efficiently, they also can reduce the captive’s collateral obligations as its reserves have decreased.
In conclusion, collateral requirements have become top of mind for captive owners as risk management departments strive to find the optimum total cost of risk in today’s challenging economic environment. Evaluating both the direct and opportunity costs associated with various collateral and claims resolution solutions will help ensure that a captive is operating as efficiently as possible. Current and prospective captive owners would be well-served to engage a professional captive management company, like Marsh, that has a wealth of captive and collateral experts to assist current and prospective captive owners in these efforts.