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Captive collateral concerns Success of a captive formation often hinges on collateral requirements; LOCs and 114 Trusts are leading options By Michael J. Moody, MBA, ARM Interest in nontraditional risk-funding methods (i.e., captive insurance companies) has never been higher. Attendance at several recent captive conferences attests to this interest, with frequently set records, such as the more than 1,300 people who attended this year’s Vermont Captive Insurance Association’s 20th annual conference, titled “Captives: Reaching New Heights in Risk Management.” The conference, which was held in Burlington, Vermont, from August 9 to 11, was another hit. A wide variety of sessions and topics included reinsurance, corporate governance, employee benefits, and taxation. Financial requirements are one of the many roadblocks to the successful implementation of a captive. So it is little wonder that the session on collateral requirements was well attended. Carol Frey, vice president of ACE Captive Solutions, coordinated the sessions and provided some background on the importance of the collateral issue. Background Frey pointed out that the collateral issue is critical to long-term success and is a concern for many captive owners and administrators. “The mere mention of collateral can give pause to even the most experienced of risk managers and chief financial officers,” she said. It is also of concern to many other parties to the captive transaction. “Regulators, rating agencies, and carriers also focus on the suitability of collateral,” Frey noted. “Determining the necessary amount of collateral can sometimes make or break the deal in insurance-related business decisions,” she emphasized. Organizations have a variety of reasons to consider a captive in the first place. These reasons run the gamut, including a need to gain better control of insurance costs, as well as increased control of claims. Other reasons, Frey said, can be, “tailoring coverage that is otherwise either unaffordable or unavailable, and gaining access to the reinsur-ance market.” Reinsurance access can allow the captive owner to realize “underwriting profit and investment income associated with improvements in loss control and loss prevention.” Letters of Credit Many captive owners, particularly group captive participants, have had difficulty in amassing sufficient cash to comply with statutory and domiciliary requirements, and reinsurer and fronting obligations. As a result, many have turned to the Letter of Credit (LOC) option. Today, LOCs have become the choice for most collateral commitments. And, for the most part, they have fared well as security for affected parties. In addition to use by the captive industry, LOCs are frequently used by the traditional insurance industry as collateral when needed. However, several problems can occur with the use of LOCs. By far, the biggest issue surrounding the use of LOCs is that, according to Frey, “over time, captive owners will experience regular increases in collateral and security requirements as the structure is renewed and/or otherwise amended, or losses develop at a level higher than originally projected.” This pyramiding of collateral requirements is known as “stacking.” Each subsequent year adds to the amount needed to continue to maintain the proper ratio for security purposes. While adjustment can be made, the aggregate amount required is typically more than the prior year’s requirements. Recently, LOCs have also proven to be more difficult and/or costly to obtain than in the past. While this has not been felt as much for single-parent captives whose owners have existing banking relationships with financial institutions, it has affected group captives and risk retention groups. The U.S. banking sector has gone through some significant consolidation over the past few years; even some large money market banks have been subject to acquisition. As a result, the number of banks that are actively looking for LOC business has been reduced. Additionally, continued increases in interest rates have resulted in affordability and even availability issues for some group captives. Regulation 114 Trusts One option that more and more captives are beginning to look at is the Regulation 114 Collateral Trust (114 Trust). The 114 Trust gets its name from Regulation 114 of the New York State Insurance Department code that spells out the standards for trust funds for reinsurance. As with LOCs before them, 114 Trusts were originally used by the traditional insurance/reinsurance market and now have been adopted by the captive movement. In effect, the 114 Trust is structured to have eligible assets of the captive placed into a trust, which would be held by a trustee, usually a bank, to guarantee payment of an obligation to either a fronter or reinsurer. The captive owner then makes periodic payments of required assets, usually in the form of permitted securities or cash, into the trust account. The 114 Trust must meet a number of requirements under the New York Insurance code and more recently NAIC requirements as well. However, use of the 114 Trust can provide a valid alternative to the LOC. Among the advantages noted by proponents of 114 Trusts is, first and foremost, the cost. Today, depending on a number of variables, group captives are paying between 25 and 100 basis points for an LOC. Additionally, they may be subject to transaction and drawdown charges. Typical 114 Trust flat fees range between $10,000 and $20,000. Favorable pay-ins are also available in the case of the 114 Trust. Typically, the 114 Trust amounts can be paid in over time as opposed to the LOC, which must be established at full value. And since the 114 Trust can be funded with a mix of guaranteed fixed assets and allowable securities, which are held in the name of the captive owner, there is income potential which can offset some expenses. In addition, a key advantage of the 114 Trust is that it has an unlimited duration, whereas the LOC has annual renewal requirements. Availability is also an advantage to the 114 Trust since the trusts are readily available, compared to the LOC, which is suffering from the recent consolidation issues in the banking industry. And while LOCs continue to be the standard in the industry with regard to funding collateral commitments, acceptance of the 114 Trust by fronters/reinsurers continues to grow. A potential captive owner(s) must face any number of obstacles when considering the feasibility of a captive insurance company. Historically, it has been disruptions in the traditional insurance market that have led to the growth in captives. However, more and more organizations are starting to see the value of controlling their own destiny via captive ownership. But despite the importance of both of these items, Frey pointed out, “Some cases will not be dictated by pricing or services, but rather by collateral. It is the amount of collateral and the years of collateralization,” that will be the determining factor, she said. Make no mistake; LOCs remain the collateral of choice for most captive situations. However, it is important to be aware that other options are available. Certainly, the 114 Trust is one of the obvious alternatives that should be explored during the feasibility stage of the captive formation. In addition, a number of insurers, reinsurers and financial institutions are starting to introduce innovative products that can assist in meeting the collateral obligations. * |
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