2011 Vermont Captive Insurance Association Special Section

Collateral: A capital idea

Wells Fargo offers collateral trust as a cost-effective alternative to LOCs

By Michael J. Moody, MBA, ARM

Despite plunging insurance rates for more than 10 years, the alternative risk transfer (ART) market continues to grow. Risk management professionals have noted a number of reasons for this continued growth over the past few years. However, two of the key reasons are the flow of innovative products and the continued acceptance of ART products by the insurance and investment communities.

Development and implementation of new products and acceptance by the industry require a certain commitment from a number of different areas. Acceptance comes only when the industry has faith that these products will perform as advertised. Among the more important components of many ART applications is the reliable supply of funds to be used as collateral. In general terms, collateral is typically described as specific property that is pledged to secure the repayment of a loan. Thus collateral serves as protection for a lender against a chance of the borrower's default. Indeed, the vast majority of ART programs have collateral requirements. As such, said programs are often made available because there are sufficient sources of collateral.

Concerned about capital

Capital (in one form or another) is required in the vast majority of insurance- and risk-related products. However, there are several products that utilize collateral as a major element in the overall risk-financing arena. For several of these products, both reinsurance and captive insurance companies typically require some form of collateral. Collateral is critical for these programs since both have specific regulatory requirements known as "Schedule F Credit for Reinsurance."

In general, according to Robert Quinn, vice president of the Collateral Trust Group at Wells Fargo Bank, as long as the reinsurer or captive has "fully and properly collateralized" its reinsurance recoverable for U.S.-based risks, the cedent will not realize a "charge" against its surplus for this ceded insurance. However, he points out "should the reinsurance not be fully and properly collateralized," the cedent will have to set aside additional capital to meet the regulatory and accounting requirements. So, from the perspective of both the cedent and the reinsurer, collateral is a critical piece of the puzzle.

Another ART market product that has been receiving considerable attention recently is that of insurance-linked securities (ILS). ILSs are broadly defined as a financial instrument whose ultimate value is driven by insurance loss events. The most common ILS is linked to property losses that follow natural catastrophes. These types of transactions are a favorite of investors since the results are not correlated with the general financial markets. While ILSs have been around the insurance industry for a number of years, it was not until 2001 that they started receiving significant attention. Availability of inexpensive collateral has been one of the primary drivers.

While collateral is an accounting and regulatory requirement for both reinsurance and captives, ILSs have no similar "regulatory" requirements.  However, to address the credit risk that typically accompanies such transactions, collateral is usually required. According to Quinn, "Since many of the players in the ILS space are the same as those in the captive/reinsurance transactions (reinsurers and cedents), it is only natural for collateral to be part of the equation.

"Understandably, the collateral in question is usually in the form that they are all familiar with...the same forms as with reinsurance and captive programs." In summary, for reinsurance and captives (which Quinn points out are often fronted reinsurance deals), collateral is required to meet regulatory and accounting requirements. And while ILSs do not have the same regulatory requirements, over time collateral has been required to address credit risk issues associated with ILSs.

More than one way to skin a cat

For those ART products that need collateral for U.S-based risk, there are three basic forms of collateral in use today. By far the most common method has been standby letters of credit (LOC). LOCs are widely accepted by those asking for collateral. They have been successfully used for years, and Quinn states, "Up until three years ago, banks were flush with cash and had a lot of money to lend." However, following the recent financial meltdown, banks' supply of money was severely reduced. Today, he says, "Since banks have less to lend, the cost of borrowing (and therefore LOCs) has increased dramatically."

The second approach to fulfilling the various collateral requirements is a method known as funds withheld. These arrangements were more popular in the past (although not exactly "popular" overall). However, recent financial concerns have cast doubts on this method, notes Quinn. A number of carriers have become uncomfortable with holding a client's cash on their balance sheets. Some financial institutions suffered significant rating downgrades following the financial crisis. As a result, Quinn points out, "Some people just aren't comfortable giving cash to a counterparty who can simply take it the moment there is a problem." Bottom line, while funds withheld is still a possible approach for collateral, concerns about the ownership of the cash have slowed their usage.

The collateral form realizing the most growth recently is the collateral trust. The trust is structured in such a way that the reinsurer, rather than paying for a letter of credit, simply places its cash in a trust pledged to the insurance carrier in question. Or stated another way, those using trusts are using their own balance sheet as collateral rather than that of a bank.

In order to meet all financial and accounting requirements, the assets that are allowed to go in the trust, notes Quinn, "must usually be U.S. debt-based financial assets rated 'A' or better." Acceptance by the industry has grown in recent years. However, even with this growth, he says, "The level of trusts being used compared to LOCs is surprisingly low given the advantages that the trust can provide. To be sure," Quinn adds, "acceptance of the trust is a decision made by the insurance companies on a case-by-case basis based largely on the financial stability of the entity wanting to employ the trust in lieu of LOCs."

Problems with LOCs persist

LOCs continue to provide the security needed.  However, several important shortcomings in the LOC approach have come to light. The most critical of these shortcomings revolve around the affordability and/or availability of the LOCs. Initially, availability issues occurred following the financial meltdown. Although this situation has lessened somewhat, the issue today is much more a function of affordability. As Quinn points out, the issue quite simply is that "banks can only loan money to the extent that they have it." This has driven up the cost of a typical LOC anywhere from 50 basis points to 75 basis points or higher.

Additionally, Quinn notes that another area of concern is the administrative time involved in obtaining and maintaining LOCs. It was a commonly held assumption that LOCs were the quickest of the available options. That is no longer true. "In order to obtain an LOC, the client will have to go through the bank's normal credit review process," Quinn notes, adding, "Today, that is always an arduous task." What many people overlook, Quinn says, is that even after the original approval process, the LOCs (particularly "stand-by" LOCs) must be renewed each subsequent year. And he notes that part of the renewal process is that the client must again go through the time-consuming credit review process.

Another problem that is often overlooked is the fact that the "evergreen" clause of an LOC only means that the client cannot cancel the LOC without the insurance companies' written approval. It does not mean that the bank must always "renew" the LOC. With proper notification, the bank can cancel the LOC at the end of the term. So indeed, the LOC renewal process is "part of the package" when using LOCs as your collateral mechanism. Keep in mind also (and this is a big "also") that for many captive programs, there are multiple LOCs used for the overall program. Therefore, the renewal process (and the credit review process) needs to be done for each LOC in question each year.

Conclusion

The general acceptance of trusts within the insurance industry continues to increase, thanks in part to the efforts of organizations like Wells Fargo's Collateral Trust Group. The advantages to anyone considering the use of a trust are fairly clear. Quinn notes that the reduced frictional costs associated with the trust are meaningful. He says, "Sometimes the amount of savings, when compared to LOC fees, can be as high as 85% to 95%." This is primarily due to the fixed, flat fee arrangement that Wells Fargo uses for their trust accounts. Further, it should be noted that given the credit review process involved in obtaining an LOC, the trust should be no more work to set up initially. Year over year, however, the trust will be much less work.

Quinn and his team have been working with most of the primary fronting carriers (captive programs) and ILS participants and have now established "prearranged" trust agreements that are available for use. Another major benefit of the trust is that once established, the trust continues to move forward with little or no increased administrative workload. When consideration is given to the annual credit review associated with an LOC, the trust comes out quite favorably.

Should a captive or reinsurer or even an ILS owner consider a trust? Quinn puts it this way: "For everyone who has not at least evaluated the benefits from alternatives to the LOC, they are possibly leaving money (frequently a lot of money) on the table." Active consideration of a trust to fulfill your collateral requirement is good business.