Managing Collateral Requirements

This article is provided by Strategic Risk Services. Contact details for the company can be found at the end of this article. Background Collateral is usually required in captive programs by the fronting company to ensure that the captive can meet its obligations under the reinsurance contract. Indeed to claim credit for the reinsurance, the fronting company will need to collateralize the reinsurance. Collateral is usually required to the full aggregate of the captive's participation. This creates a risk gap between the funds held in the captive's loss fund and the aggregate to be collateralized. The risk gap will need to be collateralized from funds outside of the premium paid to the captive. With the risk gap typically in the range of 30-50% of the gross premium, this can be a significant additional requirement. Handling the stacking issue Collateral is also required under every policy that the captive underwrites, which can create a stacking problem with the collateral required for the risk gap under the new policy as well as the expiring policy. Assuming that the captive can not avoid the need for collateral, the stacking situation is best handled by negotiating that collateral under the expiring policies is adjusted to projected ultimate net losses at the same level as that used to set reserves in the captive's loss fund. If this can be achieved then the collateral for these old years can be met out of the loss fund held by the captive without the need for additional capital. It may also be possible to negotiate a step-up in the collateral during the current policy year. This can help with initial collateral requirements and help avoid stacking in subsequent years. A quarterly step-up in collateral may be offered by insurers in recognition of the slow claims development process which means that there is a minimal risk of actual losses reaching the risk gap early in a policy year. Letters of Credit The most typical form of collateral is a letter of credit ("LOC"). In this situation, the captive provides a LOC from its bank for the amount of the required capital for the benefit of the fronting company. The LOC is usually issued on an annual basis with an evergreen clause. The captive provides cash and certain allowable securities to the financial institution, which issues the LOC with the fronting company as the beneficiary. The fronting company can draw the LOC at any time and will receive the funds in cash. Typically the size of the LOC will be reviewed annually with the fronting company considering a reduction of the LOC under the expiring policy year based on actual loss experience. For programs that renew with the same fronting company, LOC requirements for the expiring and new policy years are usually combined. LOC's are acceptable forms of collateral for most if not all fronting companies and have long been used for this purpose. However, the costs of LOCs have been increasing and availability tightening. Consolidation in the US banking industry has reduced the number of institutions providing LOCs and the imposition of risk-weighted capital allocations on banks has increased the cost of LOCs. Captives can expect to pay 25 to 100 basis points for LOCs with additional costs payable for drawing down the LOC. Regulation 114 Trusts A less expensive alternative to LOCs may be the use of a Regulation 114 trust. This term refers to Regulation 114 of the Insurance Department of the State of New York which details standards for the use of trust funds for reinsurance. Under this arrangement, a trust agreement is entered into between the captive, the fronting company and a bank, which acts as a trustee for the fund. The captive deposits cash and/or allowable securities into the trust. The fronting company can demand, at any time, assets from the trust to meet the captive's obligations under the reinsurance agreement. The assets are delivered as securities which are converted to cash by the fronting company. A Regulation 114 trust can be used to collateralize both the loss fund and the risk gap, or used in combination with a letter of credit. One advantage of using the trust for the loss fund is that the trust and hence collateral requirement will automatically adjust with loss payments. If a captive can negotiate that collateral under expiring years is adjusted to projected ultimate losses, it may be wise to separate the form of collateral used to support the loss fund and the risk gap. A Regulation 114 trust can be used to manage the loss fund, while the risk gap is handled through a letter of credit, which would be reapplied to each policy year. Conclusion The choice of instrument to use for collateral will depend on each captive's specific location. LOC's and Regulation 114 trusts are the most common, but not the only options available. A funds withheld arrangement may also be used although these are not popular due to the loss of investment flexibility/control and low return on the funds. A key consideration in deciding between a LOC and a trust is the expected market return on investment. In times of low returns, the trust may be more attractive due to its lower costs. However as returns increase, it may be beneficial to incur the extra costs of the LOC and remove the investment restrictions associated with the Regulation 114 trust. About SRS SRS provides underwriting, management and wholesale brokerage services in the alternative insurance market. They design, implement, manage and grow captive and ART programs on behalf of corporations, groups and insurance companies. SRS is an approved manager of captive insurance companies in Arizona, Bermuda, Cayman Islands, South Carolina & Vermont. Through a wholly owned subsidiary SRS is also licensed as an insurance broker in Bermuda. For more information on SRS, visit them at www.strategicrisks.com. Contact: info@strategicrisks.com