Maximising efficiency

What trends are you seeing from the banking side of the captive industry on the Isle of Man?

Colin Freeman: A captive has to justify its existence by being a cost-effective and an efficient risk vehicle, both in terms of its insurance liabilities and in the management of its assets. The parent company could of course find alternative coverage in the market, so a key consideration for the captive must be how to maximise its efficiency, including the return it achieves on cash and investments. We are seeing more parent companies wanting to reduce the funding of their captives, which means captives are searching for more cost effective management of their reserves, surplus cash and of their collateral costs.

Many captives lend funds back to their parent company because they believe that is the best way to assist their group and to make the captive relevant. In a low-interest rate environment, that may be seen as the most effective thing to do, but they also need to be mindful that captives need to meet their regulatory obligations and their cash flow needs to have cash available and liquidity for claims and expenses. Plus, they must ensure sufficient diversification of their investments (including cash) and so many are looking for viable alternatives.

With the progressive reduction in the number of rated banks offshore in recent years, captives are finding fewer options for spreading their liquidity in the Isle of Man. More than ever, captive owners want to prioritise safety and Barclays has seen significant inflows of captive deposits over the last 12 months because of its strong rating and its competitive deposit rates. We have responded by tailoring a wide range of deposit and investment options to meet the needs of all captives, whether depositing for the short, medium or longer term.

In the current low-interest rate environment, achieving investment returns is quite challenging. Money market rates are rising steadily now in the US, but they remain at rock bottom in the UK. In the eurozone, rates are negative and banks therefore lose money accepting euro deposits, a cost they will pass on to their clients.

As such, it is very difficult for EU-domiciled captives to gain meaningful enhancements to their revenues through cash deposits. Many captives are now discussing with us whether investment management could be a better way to go where they have cash, which is unlikely to be required in the medium to longer term.

We are also seeing more captives actively exploring ways to reduce the need to provide collateralised letters of credit (LOCs) to fronting companies, and here they seek either to reduce their LOCs to a minimum or to agree direct guarantees or security trust arrangements whereby the front and captive hold collateral in a trust at lower cost. The benefit here is that there are no credit fees to pay, just a trust fee. Such arrangements have been common in the US for many years, but are only just starting to be used in Europe, which is surprising, given the cost advantages.

Peter Downey: A key objective for both the corporate and the vehicle is that the captive is efficient. Captives need to balance prominent returns with rationale for the vehicle; essentially, risk management. Everyone wants the silver bullet of high-level returns with low levels of risk, but in a captive scenario it is potentially quite inherent.

For example, in Europe, the European Central Bank has introduced negative deposit interest rates, and as financial institutions pass these negative charges to captive clients we are beginning to see conversations and approaches from captives evolve. Yes, banks have solutions, but these have to be the right fit for the client.

It comes down to what the captive wants to achieve and where they are in their lifecycle. New captives, set in the last three years, might be more risk averse, whereas a developed or established captive might be interested in a wider conversation about the alternatives.

What services and insight does Barclays offer SMEs in the Isle of Man looking to set up captive insurers?

Freeman: Captive banking requirements tend to fall under four headings:

  • Transactional banking: Deposit taking and payments, meeting the needs of captives by providing them with a safe (highly rated and global), reliable and responsive banking service they can trust

  • Investment management: When captives that have built up significant surpluses look to put them to more efficient use and review their shorter- and longer-term liquidity needs. Sometimes this is because they have to tie up collateral for letters of credit

  • Letters of credit: A key conversation here is around how we manage that collateral for them in a way that suits their needs and makes the most of the longer-term duration of the liability

  • Insurance trusts: These can be more cost effective than LOCs because the trust is an arrangement between the beneficiary and the captive to which the bank acts as a trustee, and the client pays a fixed fee for those services. Insurance trusts are becoming increasingly mainstream on the European side. They have been dominant over LOCs in the US for many years. But we advise captives considering use of a trust to look at the overall cost/return of the arrangements, as the beneficiary may insist that the assets held are kept in low-yielding short-term deposits, denying the captive the chance to invest those monies more freely, something that may be possible via a bank LOC

  • For all of the above services it is important that the chosen bank offers a relationship manager with experience and expertise in the captive industry.

    By way of example, our captive insurance team has a long-standing relationship with a captive that provided cover for an S&P 500-listed corporation. Initially, the captive insurer required asset diversification, but as the company evolved, an LOC to collateralise their fronting insurance obligations was needed.

    Not only was Barclays able to provide the LOC, but we also gave the option to use either cash or a discretionary managed portfolio comprised of high-quality bonds as collateral. By opting for the discretionary bond portfolio, the client benefited from credit diversification and yield enhancement versus cash, they made no compromise of capital preservation and liquidity and received active management from our team.

    We worked with the client to review and amend their investment guidelines to reflect the evolving nature of their captive business and balance the requirement for prudent collateral management.

    This has subsequently led to the introduction of a bespoke equity component to the portfolio, which reflects the underlying shareholder appetite for growth while protecting on the downside. 

    Our solution of a high-rated, short-duration bond portfolio and conservative equity product provides collateral for LOC in a very efficient and cost-effective way.

    How are their funding and capital challenges different to the traditional Fortune 500s?

    Freeman: Captives are generally not profit centers. Their goal is to be cost-effective and dynamic insurance vehicles that safely protect their parent groups as far as is practical and economic.

    In recent years, captives have responded to economic change and new and emerging insurance risks by expanding the areas they insure, for example, by going into new areas such as cyber risk and making sure they are offering options to protect their owners against other emerging risks.

    Again, the captive must demonstrate its efficiency, value and relevance to the parent company by competing with the alternative routes to insurance.

    Captives are highly regulated and need to demonstrate a strong commitment from the parent company for effective risk management.

    The captive has to make commercial sense to justify its existence, which means delivering on its insurance coverage, claims experience and on managing its costs as well as it possibly can.

    Captive bankers offer a number of banking options and we recommend that captive boards regularly review these to make the very best of their financial planning.
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