Captive Collateral Options
Martin G. Ellis
Senior Vice President
November 2008
Reasons Captives Must Pledge Collateral to Fronting Carrier
•
Security for Fronting Carrier if Captive Becomes Insolvent or Doesn’t
Honor its Obligation
Front is licensed to do business in a particular state, whereas Captive
generally is not. Front issues insurance policy and cedes some or all
liability to Captive. Front wants to limit its risk, so requests collateral to
cover deductible, actual losses, unearned premiums, etc. in case
Captive cannot or does not pay.
•
Avoid Regulatory Schedule F Penalty
Since Front is regulated and issuing the underlying insurance policy, it
must report the liability (i.e. take a surplus penalty) on the balance
sheet of the annual statement it prepares for the insurance regulator
unless it has qualified reinsurance or acceptable and sufficient
collateral (e.g. cash, letter of credit or trust).
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Types of Acceptable Collateral
I.
Standby Letters of Credit
According to recent industry surveys, this is still the most popular
option preferred by Fronting carriers.
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Advantages:
Internationally recognized and accepted.
Easy for Front to monitor.
More flexible investments.
Fixed liability.
Can handle “back to back” LOC’s.
Better for Front should the Captive go bankrupt.
Disadvantages:
More expensive than trust.
Bank must approve credit.
Bank has to allocate capital.
Annual renewals.
STANDBY LETTERS OF CREDIT
•
Definition – Document issued by a Bank that “assures” payment of an
obligation.
•
Purpose – Standby letters of credit are issued by a Bank in favor of the
Captive’s “Fronting” insurance company (the beneficiary) to secure the
Captive’s obligation under a reinsurance contract.
•
Reason – The letter of credit assures the Fronting insurance company that
the Captive will pay its share of losses (e.g. deductible) on any and all claims
and enables the Fronting insurance company to exclude these reserves for
losses from its balance sheet for regulatory purposes. Also, since the
Captive is not a publicly held company which regularly publishes its financial
results, the Fronting insurance company cannot or doesn’t want to monitor
the financial condition of the Captive. Therefore, the Bank which issues the
LOC substitutes its creditworthiness for that of the Captive to assure prompt
and full payment of any valid drawing on the letter of credit.
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SAMPLE STANDBY LETTER OF CREDIT
Issuing Bank: ABC Bank
Beneficiary: Fronting Insurance Co.
Date of Issue: November 15, 2008
Applicant: Captive Insurance Co.
We (ABC Bank) have established this clean, irrevocable and unconditional standby letter of credit in your favor
as beneficiary for drawings up to U. S. $10,000,000 (ten million U.S. dollars) effective November 15, 2008.
This letter of credit is issued, presentable and payable at our office and expires on November 15, 2009.
Except when the amount of this credit is increased, this credit cannot be modified or revoked without your
consent.
We hereby undertake to promptly honor your sight draft drawn on us for all or any part of this letter of credit
upon presentation at our office on or before the expiration date hereof or any automatically extended expiry
date.
This letter of credit is deemed to be automatically extended without amendment for one year from the
expiration date or any future expiration date, unless at least 30 days prior to such expiration date, we shall
notify you by registered mail or overnight mail that this letter of credit will not be renewed for any such
additional period.
This letter of credit is subject to and governed by the laws of the State of New York, including Article V of the
Uniform Commercial Code, and the International Standby Practices ISP98 of the International Chamber of
Commerce (Publication No. 590).
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CHARACTERISTICS OF STANDBY LETTERS OF CREDIT
•
Letter of Credit is “clean, irrevocable, and unconditional.”
•
Letter of Credit may only be decreased, modified, or cancelled with the
approval of BOTH the applicant (Captive) and the beneficiary (Fronting
insurance company).
•
Annually renewable with non-renewal or “evergreen” clause of 30, 60,
90 days (i.e. unless you hear otherwise from Bank within 30-90 days
before expiration, the letter of credit automatically renews for an
additional year).
•
Partial drawings are permitted by the beneficiary.
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CHARACTERISTICS OF STANDBY LETTERS OF CREDIT
(CONT.)
•
The Bank which issues the letter of credit must review the
creditworthiness of the Captive in order to approve the credit exposure,
even though the letter of credit is fully collateralized.
•
The fees are generally paid annually in advance and are nonrefundable if the LOC is cancelled. LOC fees generally range from 2550 bps depending on the collateral and the financial condition of the
Captive.
•
Banks issuing standby letters of credit must be NAIC (National
Association of Insurance Commissioners) approved.
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COLLATERAL FOR LETTERS OF CREDIT
What – Banks require Captives to pledge marketable securities (collateral) to secure
outstanding letters of credit. In the event of a draw on a letter of credit, the bank
can liquidate the collateral to reimburse itself for funding the letter of credit
obligation.
Benefits of Collateral – There is generally no recourse (liability) to the owner of the
Captive. Since the letters of credit are secured, the Captive should pay lower letter
of credit fees. The Captive gets to keep investment income from the marketable
securities the bank holds as collateral.
Eligible Collateral
Cash
US Government and Agency Securities
Fixed Income Securities (Rated A- or higher)
Equities
Incoming Collateral LOC’s from approved banks
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Advance Rates
98-100%
90-95%
85-90%
60-70%
100%
TYPES OF ACCEPTABLE COLLATERAL
II.
Regulation 114 Trust
Trust agreement governed by New York Department of Insurance
regulations that have been adopted by most states. This is often times
cheaper than a letter of credit, but collateral is often times more
restrictive. Some Fronts charge administration fees and require
expensive portfolio monitoring software.
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Advantages:
Less expensive than LOC’s.
No bank credit approval required.
Disadvantages:
Harder for Front to monitor.
Investments are generally more restrictive (e.g.
no equities or offshore mutual funds allowed).
Must get Front approval to remove excess assets.
REGULATION 114 COLLATERAL TRUSTS
•
Definition – Eligible assets are placed by a Captive into a trust held by
a trustee (usually a Bank) to guarantee payment of an obligation.
•
Purpose – As with standby letters of credit, the trusted assets are
placed with a Bank trustee in favor of the Captive’s “Fronting” insurance
company (the beneficiary) to secure the Captive’s obligation under a
reinsurance contract.
•
Reason – As with standby letters of credit, the Reg 114 collateral trust
assures the Fronting insurance company that the Captive will pay its
share of losses (e.g. deductible) on any and all claims and enables the
Fronting insurance company to exclude these reserves for losses from
its balance sheet for regulatory purposes.
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SAMPLE REINSURANCE TRUST AGREEMENT – TABLE OF CONTENTS
REINSURANCE TRUST AGREEMENT
dated as of September 30, 2008
Among
ABC CAPTIVE
as Grantor,
XYZ INSURANCE COMPANY
as Beneficiary,
And
COMERICA BANK & TRUST, NATIONAL ASSOCIATION,
A NATIONAL BANKING ASSOCIATION
as Trustee
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TABLE OF CONTENTS
SECTION
Section 1.
Section 2.
Section 3.
Section 4.
Section 5.
Section 6.
Section 7.
Section 8.
Section 9.
Section 10.
Section 11.
Section 12.
Section 13.
Section 14.
Section 15.
Section 16.
Section 17.
Section 18.
Section 19.
Section 20.
Section 21.
Section 22.
Section 23.
Schedule 1
Schedule 2
Schedule 3
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PAGE
Deposit of Assets to the Trust Account; Trust Account Structure
Determination of Amount of Assets to Be Deposited in the Trust Account
Withdrawal of Assets from the Trust Account
Application of Assets
Maturing Assets and Redemption of Assets; Investment and Substitution of Assets
Dividends and Interest
Right to Vote Assets
Additional Rights and Duties of the Trustee
The Trustee’s Compensation, Expenses and Indemnification
Resignation of the Trustee
Termination of the Trust Account
Certain Definitions
Governing Law
Successors and Assigns
Severability
The Entire Agreement
Amendments
Notices
Tax Identification Number
Transaction Confirmation by Call-back
Reliance on Account Information
Headings
Counterparts
Assets Originally Deposited in the Trust Account
Telephone Number for call-backs
List of Reinsurance Agreements
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REG 114 TRUST AGREEMENT MAJOR PROVISIONS
•
3-party agreement between Captive, Front and Bank.
•
Amount and type of investments (e.g. minimum rating) allowed in trust
and pledged to Front.
•
How withdrawals are made by the Captive or Front to reimburse for
losses and expenses paid or unearned premiums.
•
How much over collateralization (e.g. 102 – 110%) is required.
•
Statement reporting responsibilities and timing (e.g. 15 days after
month end).
•
How dividend and interest income are handled.
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PERMITTED TRUST INVESTMENTS
•
Cash
•
Deposits in NAIC approved domestic money market funds
•
US Government, State or Agency Obligations
•
US Corporate Bonds Rated “A” or higher
•
Equities generally are not allowed by Fronting carriers
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TYPES OF ACCEPTABLE COLLATERAL
III.
Funds Held
Captive deposits cash or excess premiums with Front who may or
may not pay the Captive interest. This is the least popular collateral
option.
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Advantages:
No cost to Captive.
Disadvantages:
Difficult to get money back from Front.
No control over investments.
Investment returns are minimal.