BNP Paribas
CIT catches up with Laurent Dignat of BNP Paribas to find out how the firm is assisting its captive clients through post-financial crisis problems
How does your role at BNP Paribas help the captive market?
At BNP Paribas’s risk and capital management solutions, we focus on insurance and reinsurance and that also includes the captive market. The way we tend to operate is to adopt a solution driven approach—meaning that we don’t actually sell investment products but we try to develop the appropriate solution to address an existing issue. ‘Ask a better question, get a better answer, develop a better solution’, this is our credo. This can apply to investment topics as well as risk management or capital management issues in the insurance world.
I joined BNP Paribas a couple of weeks before the Lehman Brothers crisis, with a reinsurance background. In the reinsurance world, the business model is very much of the opinion, ‘I take risks on the liability side because my core business is underwriting risks and this is where I make my money, but as far as the asset side of the balance sheet is concerned I simply do not take risk, so therefore I have an extremely conservative investment strategy’. This approach is absolutely fine as long as you can get a yield of 4 percent out of your portfolio of non-risky investment. Things have changed since the Lehman Brothers crisis. Five years ago short term cash was yielding at 5 percent and nowadays it is only yielding around 50 basis points, or 10 times less. This is a major issue especially if a significant if not the majority of your investment portfolio is trapped either in trust funds or pledged as collateral for letter of credit (LoC) which is the case for the reinsurance captive markets.
Addressing the issue of reinsurance captives squeezed between extremely poor yield on their cash and higher cost of guarantees such as LoC is the way we approached this specific market, which has become a new market for us that complements the ‘traditional’ reinsurance market. Our solution works in both worlds.
What is the issue with posting collateral?
In the aftermath of the credit crisis, maintaining financial strength remains a critical concern for the insurance industry. The pressure on reinsurance recoverable credit risk in fronting insurers balance sheets is extremely strong, but unlike traditional reinsurers, most captives do not have a specific financial rating.
So for reinsurance captives it is of utmost importance to be able to credit enhance their liability. Otherwise they may not be able to deal (as posting collateral is imposed by regulators) and may have to pay a much higher fronting fee to compensate for a higher capital charge in the fronting insurer balance sheet.
The issue with all those credit enhancement solutions is that they require assets to be posted as collateral. The constraints in terms of eligibility of those assets are such that as a company, unless you opt for low-risk assets with limited returns like short term cash, then a punitive haircut will be applied, making the operation inefficient. These can be 60 percent for equities. For instance, posting $1 of equity as collateral will only give you 40 cents of guarantee.
We also know the reinsurance business and the cash flows associated with it. One very important point to understand is that generally when captives do post collateral to a fronting insurer (LoC or trust), it is very rarely to effectively pay claims. The role of collateral for captives is simply to credit enhance the reinsurance recoverable credit risk that sits in a fronting insurer’s balance sheet sometimes for several years. The fronting insurer will require collateral to be posted in order to minimise the capital charge on its reinsurance recoverable.
How can BNP Paribas help companies to see the types of returns they witnessed before the financial crisis?
By nature, the reinsurance business is a long-term business where contracts are renewed from one year to another. This means that whatever asset is trapped and used as collateral it will very likely serve as collateral for a longer (than one year) period of time. One may have some LoC that will be in place for more than five or 10 years. Today, you have no other choice than collateralising such a LoC with a three-month cash deposit, which poses a considerable challenge.
We have therefore developed a series of new assets that are eligible as collateral and that can provide exposure to yielding assets with an investment horizon of three to five or seven years. The most important point is those assets provide capital protection at maturity and they also provide additional protection against the downside risk associated with the yielding assets at any point of time. The level of protection—generally 95 percent or 90 percent—can be used to support the LoC as if the collateral was cash. Our solutions are developed around strong risk management at the asset level without impeding the liquidity.
If the investment performs as anticipated, you get the upside as if you were 100 percent invested in the yielding asset, but as the downside risk is protected up to a certain level, you enjoy a much lower haircut.
With these solutions we are able to provide either a much lower haircut for a given target yield (in other words for a given expected yield you get more capital for $1 of collateral), or for a given level of haircut, you get a much higher expected yield out of your collateral.
You have at one end of the spectrum cash, which offers almost no return but has no haircut. At the other end you have equity, for instance, where you may have a targeted 6 percent return (YTD is 10 percent) but with a 60 percent haircut applied.
Our goal is not to generate the highest possible yield but to optimise the haircut/return of the portfolio. We target a 4 percent to 5 percent yield for a 5 percent to 10 percent haircut. Our solution is about enhancing yield and/or getting more capital for one dollar of collateral.
The BNP Paribas Solvency II Capital Requirement solution launched late last year. How has it progressed?
Assuming that Solvency II will be implemented in due course, I think there are two main positive factors about this. The first factor is that it is a risk-based capital model, which means that when you manage risk you manage capital and vice versa. It means you have to look at ways to manage risk on both side of the balance sheet including the asset sides in order to reduce the capital charge apply on investments. The second factor is probably the counterparty credit risk, which will have some direct consequences for the captives business.
At the moment a number of captives return the reinsurance premium they received back to their parent company. The cash is therefore pooled with the rest of the company’s cash and managed as one. Going forward, this cash pooling mechanism will raise an important counterparty credit risk issue for captives. With only one counterparty, no diversification, and a credit rating of the parent company probably in the BBB or below range, captives may have to hold more capital to cope with their Solvency II requirements.
As a consequence, the situation for parent companies will be for them to accept an increase in the capital of their captive, which can reveal costly, or to establish ways to diversify the credit risk and look at developing a specific investment strategy for their captives. This second alternative is what BNP Paribas tends to do in a risk controlled framework. It is very binary for companies—if they want to keep the cash they will have to increase the capital within the captive and if they don’t want to bear this additional cost they will have to define their own investment strategy. Through the BNP Paribas Collateral Enhancer platform we can certainly provide them with a competitive advantage.
