In simple terms, a letter of credit (LOC) is a document issued by a bank that assures payment of an obligation.
In simple terms, a letter of credit (LOC) is a document issued by a bank that assures payment of an obligation. In the captive world, the obligation is usually the reinsurance obligation between the captive called the applicant and the fronting insurance company called the beneficiary who is actually issuing the insurance policy and then reinsuring some portion of this liability with the captive.
According to industry surveys, standby LOCs are still by far the most common type of security used by captives and preferred by fronting companies because of their ease of use.
The other types of security are reinsurance trusts and ‘funds withheld’, which in simple terms is basically cash and/or premiums that are due to the captive, but held by the fronting company as security.
The LOC is security that assures the fronting insurance company that the captive will pay its share of losses on any and all claims and enables the fronting insurance company to exclude these reserves for losses from its balance sheet for regulatory purposes.
This regulation is also called 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 LOCs must be National Association of Insurance Commissioners (NAIC)-approved.
For captive insurance purposes, a standby LOC is usually a relatively simple document involving three parties—the issuing bank, the beneficiary and the applicant. The fronting insurance company is the beneficiary of the LOC, so it will generally impose certain requirements regarding the LOC.
First, the LOC is issued for a fixed dollar amount and usually expires one year from the issuance date, but often has an evergreen clause, which means it automatically renews for an additional year unless the issuing bank notifies the beneficiary otherwise.
Next, the fronting insurance company wants the LOC to be clean, irrevocable and unconditional. Clean and unconditional means there are no conditions to the issuing bank’s obligation to pay under the LOC, other than the presentation of documents that comply with the terms of the LOC. Irrevocable means the LOC cannot be cancelled by the applicant or the issuing bank prior to its expiry date without beneficiary approval.
The issuing bank must honour and pay any drawing or demand for payment under the LOC when presented, so long as the drawing and the documents comply with the terms of the LOC. Essentially, under a LOC, the issuing bank substitutes its credit for the captive, and the issuing bank is required to pay a complying drawing, even if the applicant objects.
The beneficiary holds on to the original LOC and enjoys its ease of use. It simply files this piece of paper away, and since there is generally an evergreen clause, the LOC automatically renews every year unless the beneficiary receives notice from the issuing bank within a specified period prior to the expiration date that the LOC will not be renewed.
This gives the beneficiary time to either get a replacement LOC or simply draw on the LOC.
A final important characteristic is that the LOC generally cannot be decreased, modified or cancelled without the approval of the beneficiary. This assures the beneficiary that the LOC issued in its favour, which is its collateral, will not change without its consent, for example, the applicant couldn’t decrease the amount unilaterally.
The obligations of the applicant to the issuing bank with regard to captive LOCs 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, and equities.
The reason for this is that there is generally no recourse on the part of the issuing bank 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.
Pricing for the issuance of LOCs varies depending, in part, on the type of collateral pledged by the captive. LOCs secured by collateral with less market risk, such as cash, warrant better pricing than those secured by equities. Note that pricing on secured LOCs should be cheaper than if the parent were to get unsecured LOCs.
In the event of a draw on a LOC, the issuing bank can liquidate the collateral to reimburse itself for funding the LOC obligation. Banks apply different advance rates on the collateral. Cash usually has a 100 percent advance rate, whereas a bank may only advance 70 percent on equities.
The process of making a change to a 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 LOC changes are the amount and the expiration date. The fees to amend LOCs are usually nominal.
In order for the beneficiary to draw on a LOC, they will generally be required return the original LOC, along with any amendments, to the issuing bank, together with any other documents required under the terms of the LOC. In order for the issuing bank to honour and pay the drawing, the drawing and the documents presented must strictly comply with the LOC.
Frequently, partial drawings and multiple drawings are permitted. This means that the beneficiary is not required to draw or request to be paid the full amount of the LOC. For example, if the LOC is issued for $10 million, and the beneficiary only requested $1 million at this time, they would be paid the $1 million, assuming the drawing complies with the LOC, and the available amount of the LOC would be reduced to $9 million. The $1 million drawing would be noted or endorsed on the LOC, and the original LOC would be returned to the beneficiary.
Standby LOCs issued by banks on behalf of captives are used to assure the fronting insurance company that the captive honours its reinsurance obligation and allows the fronting company to exclude this liability from its statutory balance sheet.
The main characteristics are that they are irrevocable and unconditional with evergreen clauses. Their ease of use makes them the preferred and most common type of security. CIT
