Captive Collateral Options Martin G. Ellis Senior Vice President November 2008
2 Reasons Captives Must Pledge Collateral to Fronting Carrier Security for Fronting Carrier if Captive Becomes Insolvent or Doesnt 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).
3 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. Advantages:Internationally recognized and accepted. Easy for Front to monitor. More flexible investments. Fixed liability. Can handle back to back LOCs. Better for Front should the Captive go bankrupt. Disadvantages:More expensive than trust. Bank must approve credit. Bank has to allocate capital. Annual renewals.
4 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 Captives Fronting insurance company (the beneficiary) to secure the Captives 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 doesnt 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.
5 SAMPLE STANDBY LETTER OF CREDIT Issuing Bank: ABC BankDate of Issue: November 15, 2008 Beneficiary: Fronting Insurance Co.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).
6 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.
7 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 non- refundable if the LOC is cancelled. LOC fees generally range from 25- 50 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.
8 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 CollateralAdvance Rates Cash98-100% US Government and Agency Securities90-95% Fixed Income Securities (Rated A- or higher)85-90% Equities60-70% Incoming Collateral LOCs from approved banks100%
9 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. Advantages:Less expensive than LOCs. 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.
10 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 Captives Fronting insurance company (the beneficiary) to secure the Captives 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.
11 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
12 TABLE OF CONTENTS SECTIONPAGE Section 1.Deposit of Assets to the Trust Account; Trust Account Structure2 Section 2.Determination of Amount of Assets to Be Deposited in the Trust Account3 Section 3.Withdrawal of Assets from the Trust Account4 Section 4.Application of Assets5 Section 5.Maturing Assets and Redemption of Assets; Investment and Substitution of Assets6 Section 6.Dividends and Interest7 Section 7.Right to Vote Assets7 Section 8.Additional Rights and Duties of the Trustee8 Section 9.The Trustees Compensation, Expenses and Indemnification9 Section 10.Resignation of the Trustee10 Section 11.Termination of the Trust Account11 Section 12.Certain Definitions11 Section 13.Governing Law13 Section 14.Successors and Assigns14 Section 15.Severability14 Section 16.The Entire Agreement14 Section 17.Amendments14 Section 18.Notices14 Section 19.Tax Identification Number16 Section 20.Transaction Confirmation by Call-back16 Section 21.Reliance on Account Information16 Section 22.Headings16 Section 23.Counterparts17 Schedule 1Assets Originally Deposited in the Trust Account Schedule 2Telephone Number for call-backs Schedule 3List of Reinsurance Agreements
13 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.
14 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
15 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. Advantages:No cost to Captive. Disadvantages:Difficult to get money back from Front. No control over investments. Investment returns are minimal.
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