Choosing carefully: who is right for you?
Selecting an entity to act as custodian, trustee or letter of credit issuer is often left as the last step when setting up a captive insurance company.
Selecting an entity to act as custodian, trustee or letter of credit issuer is often left as the last step when setting up a captive insurance company. After months of feasibility studies, negotiations with captive managers, fronting companies, actuaries and investment managers, you are finally ready to fund your captive and start writing policies, but there is no custody account to fund.
While it may be tempting to make a quick selection, finding the right custodian can significantly affect ease of operation and profitability and should not be made without proper due diligence. The following has been compiled to help you become familiar with key details that may help you save precious time, money, and energy.
What is a custodian?
A custodian is a financial institution that performs the following tasks:
Most custodians also have established electronic links with reconcilement services and regulatory reporting services. Such links facilitate the creation of quarterly Schedule D reports (also known as the Yellow Book) required by the National Association of Insurance Commissioners (NAIC) and most state insurance regulatory departments. Without such an electronic interface, creation of the report requires manual data entry (I’m assuming a captive with a US parent or beneficial owners and the use of a bank as custodian—in some circumstances, a stock brokerage firm may fill this role).
Custody accounts versus trust accounts
Custody accounts and trust accounts utilise all of the services noted above. In a trust account, the bank takes on an additional level of fiduciary responsibility. This is usually in the form of a trustee for a reinsurance trust where the trustee is the gatekeeper on behalf of the beneficiary limiting the grantor’s access to the account. Only US banks may act as trustee for a New York State (NYS) Regulation 114 trust.
Impact of FATCA
Much has been written about this new regulatory hurdle, the Foreign Account Tax Compliance Act (FATCA), and the industry in general is in learning mode. In summary, if a captive holds US securities of any kind, regardless of which custodian is used, new W-8 forms are required. Many other countries have passed similar regulations and have reciprocal agreements with the US.
Depositories
The Federal Reserve Bank and the Depository Trust Company are the largest US depositories. The Depository Trust Company was formed in the late 1960s in an effort to streamline settlement and reduce the number of failing trades. It has worked very well, reducing the standard settlement time from T+5 to T+3. There are continuing efforts to reduce the time even further.
The Depository Trust Company holds master certificates of the securities traded on US exchanges in its vault. US banks and stock brokerage firms are either direct participants or access the system through a correspondent relationship with a clearing firm.
Either way, as trades settle, the Depository Trust Company debits and credits the appropriate participant accounts for shares and dollars. No certificates move.
Shares and cash are allocated electronically with each participant responsible for one net cash settlement with the Depository Trust Company each day. The US Federal Reserve system works in much the same way.
Armed with some knowledge of the role and responsibilities of a custodian, the next step is to compare and evaluate custodians to make the best choice for your captive insurance programme.
What should go into your choice of custodian?
Onshore versus offshore
When selecting a custodian, you may first want to determine where the custodian is based, onshore or offshore. Offshore captives usually use offshore banks or offshore branches of US banks. Keep in mind that no matter where the custodian is based or how many layers there are, US assets are held in the US on the books of US depositories. Time zones are also an important consideration.
Experience and commitment
You may want to consider a bank’s experience in working with captives as well as their commitment to the captive industry. It can be a long and costly exercise to establish reinsurance trusts if the bank’s attorney is learning about NYS Insurance Regulation 114 by reviewing your agreement.
A bank with a staff dedicated to working with captive insurance accounts will speak your language and understand why accounts are established the way they are. Find out if the bank’s staff attends captive conferences for the opportunity to learn and better service captive accounts.
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Reporting needs
Insurance companies have particular reporting needs. Before you can determine if a custodian is able to meet your reporting requirements, you need to understand what those requirements are. Here are some things to consider:
Target market relative to your size
A bank/custodian’s target market has a definite correlation to service and products, and therefore, it is important to know where you fit with a potential provider’s client base. For example, a bank with a minimum account size of $50 million or more will likely not provide a captive in that range with special attention.
The captive service providers may have to contact a call centre when there are questions or problems, rather than have access to a specific team with captive expertise. In this case, you may want to consider selecting a bank with a middle-market target market, where a $50 million account is worthy of an experienced account officer who knows your name.
On the other end of the spectrum, a smaller bank with limited technology capabilities may not be the best custody provider for a large, complex programme with extensive reporting needs.
Investment management
Custody has become a low priced commodity, and investment management is very profitable. Be sure that you know the custody providers’ stance on third party investment managers. Will the bank provide the services your programme needs and also accept a third party investment manager? Or does the bank insist on being hired as investment manager before other services such as letters of credit are provided?
This arrangement may be beneficial as long as the investment management results are satisfactory. When they are not, the search for a custodian may begin anew.
Global custody
If there is any chance of the captive investing in foreign securities, it is vital that the custodian have access to global settlement. This can be done via a proprietary in-house network of foreign banks or through a contracted global custodian.
Expect to pay additional fees for this service. Be sure you understand the custodian’s reporting capabilities. Not all have multi-currency accounting systems and may therefore do all reporting in its local currency.
Fees
Once the field of custody providers is somewhat narrowed, it is time to evaluate fees. Banks are usually paid on a market value-based fee schedule, which may also include transaction fees and an overall minimum. Their fees are in addition to those paid to other service providers.
It is worth the time to run the numbers comparing fee schedules, as they vary widely and directly affect the profitability of the programme, especially if transaction fees apply. Pay attention to minimums, what is included in the base fees and what is considered to be additional services for additional fees. That being said, the least costly is not always the best value.
Selecting a custodian
An effective relationship with your custodian is critical to the operations of your captive. The field of custody banks has consolidated in the recent past and banks continue to exit the captive space.
This adds to the challenge of finding the right custodian for your programme. Custodians come in many shapes and sizes, and you want to find one which works for your programme, now and as it grows.
