Cayman has long been known as one of the premier captive domiciles in the world. With over 750 captives registered, it is certainly one of the largest. The expertise offered captive owners is unparalleled. But more and more, the expertise that Cayman offers the captive industry is working its way into the reinsurance, catastrophe (CAT) bond and insurance liked securities (ILS) space (a space largely reserved for Bermuda and London). With this evolution come both challenges and opportunities.
My area of expertise is in the area of collateral. Since collateral for captives is being addressed in this publication by one of the foremost captive experts in the world, Clayton Price, I would like to focus on one type of collateral, the reinsurance trust (or ILS trust). One reason for focusing on trusts is that, in the reinsurance, CAT bond and ILS space trusts are very common. But there are some details that should be addressed when not only using trusts, but also when choosing a trustee to manage the collateral account.
In the way of introductions, I have been working in the reinsurance trust space for nearly ten years. My team and I have been involved in the establishment and administration of over 1,000 trusts for various insurance related programs, including reinsurance, ILS, CAT bonds, captives, and corporate deductible programmes.
The future of collateralised transactions
It is no secret that for many insurance related transactions, collateral is a common, critical (and much maligned) part of the arrangement. Indeed it does invariably increase the cost of such structures. Recently there has been talk of the relevant regulatory bodies being lobbied to ease collateral requirements. This may well be both ‘true’ and ‘possible’. But the fact remains that while there are regulatory requirements of collateral, there are also (what I call) “business decisions” requiring the same collateral.
Having spoken to a great many ‘beneficiaries’ of collateral, I can say with certainty that the consensus seems to be that, with or without regulatory requirement, the cedents of reinsurance and the sponsors of ILS transactions want to be sure that they are never ‘left holding the bag’. Stated in a different way, the requirement of collateral, even with the regulators breathing down the cedents and sponsors necks, is often more of a credit risk issue than anything. Therefore, collateral seems to be here to stay.
Solvency II and collateral
While there is still some ambiguity with regard to collateral and Solvency II, there is no denying that the entire concept of Solvency II is designed to ensure that the cedents of reinsurance are ‘always able to pay their claims’. Solvency II, in layman’s terms, aims to make uniform the standards by which insurance companies demonstrate, well, their solvency. And it seems an unavoidable conclusion that, while Solvency II does not yet require collateral, collateral seems to makes sense. Until such time as someone comes up with some other way for cedents to ensure that they are protected, collateral seems to be here to stay.
The trust concept
For many years reinsurers and others posting collateral used letters of credit (LOCs). And why not? They were easy to understand, but they were never cheap. And now, more than ever, they are getting very expensive. Just ask anyone that has had to get one lately (or someone that has had to renegotiate their credit facility). Additionally, credit is not infinite. Companies needing to post collateral have limits as to the LOCs they can post. To be clear, the regulations governing collateralised reinsurance are clear. LOCs are not the only way.
The trust is easy to understand. Rather than paying a bank to issue an LOC (and possibly having to cash collateralise said LOC), my clients simply put their cash or “investment grade marketable securities” into an account and pledge the account to the cedent. My clients who use trusts in lieu of LOCs realised specific and substantial benefits. Briefly, they are:
Trusts cost much less than LOCs. Often 90-98 per cent less. Since trusts often have “flat fees” and LOCs are charged a percentage of their size, there is an inherent “point of indifference” between the two. That point is often in the $1million-$2million range. Using a trust for any collateral requirement over that range will generally save the client a lot of money.
The trust is easy to establish. Here at Wells we have worked with most of usual cedents, many of the key Lloyd’s syndicates and many of the Bermuda based reinsurers. Therefore, we have the legal trust document already established and approved with most of the parties involved. This will facilitate a quick and easy trust set-up process without large legal fees (and the time involved in the legal to-and-fro).
The assets in the trust remain on the books of the depositor. In other words, the depositor of the money still owns the money. It is an asset of neither the beneficiary nor the trustee.
The income from trust investments
One key point to remember is that many players in the collateralised reinsurance, CAT bond, and ILS space are not US taxpaying entities. This has implications when it comes time to invest their trust money.
Before I go over the implications of tax status, I will state that most reinsurers or ILS investors, in my experience, have very conservative investment strategies. Many with whom I speak are not interested in taking principal risk with their money. They want their money in trust to stay as safe, liquid and predictable in value as possible. They are not out there investing to maximise yield. They simply don’t want to lose their money because of a market downturn.
Given the choice, many would put their money into a treasury fund. It is certainly safe. The rate of return isn’t very high, but again, that isn’t their primary concern. Now back to the tax status issue.
Income from a fund is (since you are buying shares of the fund) dividend income. Consequently, when you are not a US taxpaying company earning dividend income onshore, that income is taxed at 35 per cent. Therefore, most non-US taxpaying entities don’t use funds. Most will simply purchase short term US treasuries. They don’t pay much either, but at least they don’t have to pay the US withholding tax.
The best alternative
One way my group has been successful is to demonstrate that we are willing to work for the client. And let’s be clear…when we establish a trust we have two clients…the grantor and the beneficiary. We respond to our clients’ needs and we do it in a timely fashion. Another way, one that is much more objective, is the investment vehicle we (alone) offer our clients.
The Wells Fargo Secured Institutional Money Market Account (SIMMA) is an interest bearing deposit on the highest rated bank in the US. Additionally, it is a fully collateralised deposit. Best of all, it pays a rate of return significantly higher than money market funds or short term treasuries. Therefore, our clients that use SIMMA enjoy the most attentive and responsive service in the trust industry, an increased rate of return over their normal options, no additional risk to their investments and a great reduction in fees when SIMMA is used (a great reduction even compared to normal trust fees).
As the Cayman domicile gets more and more involved in reinsurance, ILS, CAT bond (and the need for collateral not only goes up often), the collateral numbers involved will become staggering. Clearly the best collateral option for most is the trust. I strongly encourage all involved in the Cayman insurance markets, in whatever capacity, to be sure that you receive the best trust service, the best trust price and the best possible rate of return on your trust money possible given your very conservative investment guidelines.