Why are LOCs still popular?
I’ve been writing banking articles for many years and, according to various industry surveys, the most popular collateral type used by captives continues to be letters of credit (LOCs). The less popular options include reinsurance trusts, followed by funds withheld by the fronting carrier.
Collateral required on fronted programmes
Captives are generally required to provide collateral on fronted programmes. In a fronted programme, the fronting insurance carrier, who is usually highly rated and licensed in the applicable US state to issue insurance, issues the insurance policy such as workers’ compensation directly to the owners of the captive, and then reinsures some of the liability such as the first $150,000 on all claims with the captive. Since the fronting carrier issued the policy, they are legally responsible for paying claims to the insured, whether or not they can collect from the captive. As a result, the carrier requires collateral to mitigate this risk. Also, the collateral allows the fronting insurance carrier to exclude these reserves for losses from its balance sheet for regulatory purposes and avoid the Schedule F penalty on statutory statements, which is triggered when premium is ceded to an unauthorised reinsurer.
The captive is generally considered unauthorised, since it is not licensed in most states in the US. Finally, to avoid this Schedule F penalty, banks issuing the collateral must be approved by the National Association of Insurance Commissioners (NAIC).
Why fronting carriers prefer LOCs
Some of the reasons LOCs are still the most popular collateral option, according to fronting carriers, are their simplicity and ease of use, evergreen or automatic renewal feature, and irrevocable nature.
Also, most fronting carriers prefer to use LOCs should the captive go bankrupt, because the LOCs are irrevocable, from a third party—the bank—and becuase the issuing bank’s obligations under the LOC are independent from those of the captive.
Attorneys generally agree that trust assets could very likely be pulled into a bankruptcy by the captive and possibly split among all creditors to the detriment of the fronting carrier.
Why captives prefer LOCs
Although LOCs are more expensive than reinsurance trusts in most cases, captives prefer LOCs because of their investment flexibility. Banks issuing LOCs will generally allow some high-yield bonds and equities to secure their LOCs, which should result in more investment income offsetting any added costs. Many argue that the investment flexibility offered by LOCs far outweighs the difference in cost. A portfolio of 70 percent bonds and 30 percent stocks actually has less volatility than a portfolio of 100 percent bonds over the long term, and returns an extra 3 percent annually, according to industry statistics.
Also, captives like the fixed-dollar amount on LOCs, which caps their liability with the front. Finally, LOCs are usually better for group captives where participants get LOCs from their banks and pledge them as collateral for the LOC the captive has issued to the carrier. These are called back-to-back letters of credit and are common under the LOC option, but not the trust option.
A reinsurance trust, also known in the captive industry as a Regulation 114 Trust, is an alternative to an LOC. It is adopted from the New York Department of Insurance regulations and is a three-party agreement between a captive, a fronting insurance company, and a bank.
Reinsurance trusts are cheaper, but have investment restrictions not only imposed by regulation, but also from fronting carriers. For example, some fronting carriers will only allow cash in the trust. Also, trusts generally do not allow equities or other risky assets.
Some carriers have begun to limit the amount of collateral they will accept in trust form, because of the extra work required to monitor the trusts. In addition, some carriers have begun to charge trust administration fees of up to 125 percent and are requiring that captives pay for expensive portfolio monitoring software to make sure the assets in the trust are in the required form.
A common complaint with reinsurance trusts is that the captive often times has trouble removing excess assets from the trust. The front will claim that their liability has increased and is reluctant to release assets until an actuarial calculation can be performed. Also, some leading industry experts characterise trusts as complex legal agreements with vague provisions that often do not surface until many years later when the captive and its owner are most in need.
The LOCs issued by the bank on behalf of the captive are almost always secured by collateral in the form of marketable securities (for example, cash equivalents, US government and agency securities, corporate fixed income securities, equities, and so on). The reason for this is that there is generally no recourse back to the parent company, since the captive should be a standalone entity with its own financing to support the premium deductibility by the parent.
Also, pricing for secured LOCs is generally much cheaper than pricing for unsecured LOCs. Pricing for secured LOCs varies, depending on the type of collateral pledged by the captive. In the event of a draw on an LOC, the bank can liquidate the collateral to reimburse itself for funding the LOC obligation. Similarly, with a reinsurance trust, the captive must fund the trust account with marketable securities although somewhat more conservative.
For LOCs, banks apply different advance rates or collateral margins on the collateral to provide some cushion against market fluctuations. Cash usually has a 100 percent advance rate, whereas a bank will generally only advance up to 70 percent on equities. Similarly, reinsurance trusts usually require over-collateralisation of up to 110 percent of the amount of the obligation.
The process of making a change to an LOC is fairly simple. It is done via an amendment request submitted by the applicant to the issuing bank. The issuing bank would then issue the amendment, which must be approved by the beneficiary.
The most common changes to an LOC are the amount and the expiration date. The fees to amend an LOC are usually nominal. Reinsurance trusts are complex legal agreements, so amendments are much more expensive.
The least popular collateral option for captives is funds withheld, which are cash and/or premiums that are due to the captive, but held by the fronting company as security. Although this is the cheapest option, it is also the least popular, since investment returns (if any) are minimal, the captive has no control over its investments, and it is often difficult for the captive to get this cash back from the carrier.
LOCs are still the most popular collateral choice for captives. Fronting insurance carriers prefer LOCs for their simplicity and ease of use, as well as the evergreen feature and the irrevocable nature.
Captives prefer LOCs because of the investment flexibility, which generally offsets any added costs, and the fixed-dollar amount caps their liability with the front.
Reinsurance trusts appear to be cheaper, but all costs, including administration charges by the fronting insurance carrier to monitor trust assets, lower investment income, and extra legal costs need to be considered.