Exploring the collateral alternatives


Robert Quinn

Robert Quinn examines the various collateral alternatives in the light of a recent industry panel discussion mulling over the options.

A collateral discussion

I was fortunate to have recently sat on a panel discussion at Captive Live UK 2011. On the panel with me were Barry Beard, credit risk manager for ACE in London, and Clive James, director of Kane, also out of London. Both were amazing contributors to the conversation.

Normally, when delivering sessions at industry conferences, I, understandably, make the case for the use of a Wells Fargo insurance trust in lieu of letters of credit (LOCs) or funds withheld used as collateral for captive, corporate, ILS, reinsurance or other insurance programmes. In fact, more often than not, I take the position that the trust will save clients money and, in the end, greatly reduce the clients’ workload. For this session, however, I decided to take the role of moderator and simply let other experts in the industry voice their opinions and their experience with each type of collateral.

The options

We discussed the options at length. What I was really going for was to get someone in the position of the carrier and the other the captive manager, and for them to tell the audience what they saw as the benefits and limitations of the different alternatives.

With audience participation, we came to some interesting conclusions.

Funds withheld

The first collateral option discussed was the funds withheld arrangement. This is the option where the captive would hand the designated amount of collateral—in cash—over to its insurance carrier to hold in the event of a problem.

Both Beard from Ace and Salil Bhalla, then vice president at Chartis in London—who were in the audience—chimed in on this one. They both seemed to agree that this was an option that their respective companies would possibly allow. They said that indeed, from the carriers’ perspective, this is likely the easiest of the options to have posted to them. I mentioned that, since the carriers don’t charge a fee to hold cash for their clients, this is also often the least expensive option.

The rub with the funds withheld concept is that—as I pointed out— the captive using the funds withheld arrangement must hand over their cash to the very counterparty asking for the collateral in the first place. A great legal mind once said that, in legal terms, it is far easier to “keep” something than it is to “get it back”. To be honest, it was Judge Judy who I quoted here, but it nevertheless seemed to resonate with the audience.

One last comment on the funds withheld. Opinions vary on this point, but I should point out that by giving your cash to the carrier, you may be setting up an arrangement where the cash—and yes, it must be cash—you turn over comes off your books and appears on the books of the carrier. Maybe your firm won’t have the benefit of these assets on its books. Furthermore, the cash handed to the carrier in the funds withheld environment may be subject to the solvency of the carrier. In short, my problem with funds withheld is that these are three really big maybes.

Letters of credit

An LOC is simply where the captive or corporation in the deductible programme environment goes to a bank and asks that—for a fee— it writes a financial guarantee to the insurance carrier. More and more—particularly for captives—the LOC must be fully collateralised.Ultimately, this guarantee states that, if the captive cannot or will not reimburse the carrier for claims paid, the bank will. Then the bank sorts it out with the captive.

"The trust offers more than low fees: the income that is generated by putting money into a trust belongs to the depositor of said money, remains on the books of the captive and does not negatively impact the finanials of the captive."

With LOCs, the conclusion seemed to be that they are the most widely recognised form of collateral and therefore the path of least resistance. The common understanding around the room seemed to be that LOC pricing has increased substantially—often between 65 and 100 basis points (bps)—but has seemingly levelled off. In fact, one audience member working for a bank commented that LOCs from his bank out of Guernsey were around 15 bps—on a fully collateralised basis, of course.

At the prompting of a different audience member, the discussion soon turned to the following point: why should a captive (or anyone posting insurance-related collateral) put their cash with a bank to collateralise a letter of credit, even at 15 bps? I sort of smiled, wondering if anyone out there thought that I had paid that person to ask that question. Of course, I hadn’t. But maybe I should have.

The reason I smiled is that the person who made the comment was spot on for most circumstances. I outline below why I say this. In the end, the LOC was however acknowledged as an alternative that made sense for some captives.

The Wells Fargo collateral trust

The trust concept is fairly simple. My clients using the trust in lieu of LOCs or funds withheld simply place their cash—the same cash that they would have given to the carrier for funds withheld or the same cash that would collateralise the bank LOC—into a trust account where the insurance carrier is listed as the beneficiary of this money. In short, they are using their money to directly collateralise the programme, circumventing the LOC costs and process, while not exposing themselves to the potential problems inherent in handing the cash directly to the carrier as is the case in the funds withheld alternative.

When we got around to my favourite subject, the collateral trust, I did my best to remain impartial. Those with whom I spoke later said I did a great job of staying neutral. Of course, it was Todd Winchel and Mike Ramsey—both on my team—who told me this, but hey, I will take my compliments where I can get them.

More seriously, it was Clive James at Kane Group who kicked off the trust part of the conversation by stating that there is no perfect solution for every captive. I agree. But Clive also recognised that, given theright fit, the trust represents an opportunity to save much of the LOC fees that people seem so unhappy with these days. At the same time, Clive also pointed out that the key was in finding out what a captive’s objectives are and to work on the collateral aspect of the programme as part of the overall solution for the captive. Very well stated.

Beard confirmed once again that, for Ace, the trust is an acceptable form of collateral (based on a brief review of the situation). He also stated that during his career, he saw a lot of Bermuda captives using trusts in lieu of LOCs. Bhalla likewise confirmed that Chartis would generally allow for a trust as well.

Beard pointed out that as long as the carrier understands the trust concept and has a pre-negotiated trust agreement with a qualified trustee, then the trust is actually not difficult to establish. This is a huge point that hopefully didn’t go unnoticed. While the trust is an extensive legal document, most carriers have already pre-negotiated the required language with Wells Fargo. So 98 percent of the work in establishing a trust—at least with Wells Fargo—is already done. Not using Wells Fargo might mean reconstructing the trust agreement altogether. The long reviews, the legal toing and froing, and getting everyone to agree on something that is already agreed upon with Wells Fargo might be more work than you want. This is not meant to be an endorsement of Wells by any carrier. Rather, it is just to point out that a trust can be easy or difficult. Key to this is the trustee selection.

The trust and its benefits

Let’s use, for example, a captive with a $10 million collateral requirement. The trust might cost around $5,000 per year. With Wells, it might be much less than that. Compared to an LOC at the above quoted example rates, that LOC might cost between $60,000 and $100,000 per year. The difference is stark, right? Even considering the aforementioned bank in Guernsey offering a 15 bps LOC, that LOC would cost $15,000—three times the cost of a trust.

The trust offers more than low fees: the income that is generated by putting money into a trust belongs to the depositor of said money. Furthermore, the money in the trust remains on the books of the captive. Therefore, use of the trust does not negatively impact the financials of the captive.

Of course, the funds withheld arrangement mentioned above does not have a fee. That is a good thing. But for reasons mentioned in the funds withheld section, it is not the ideal arrangement for most captives.

I need to be very clear

Barry and Clive, whom I mentioned in this article, were very knowledgeable and extremely gracious for sitting in on the panel. They were great. I want to be clear here that neither of them—nor Bhalla at Chartis—expressed a preference or endorsed any one collateral type. Further, this article should not be considered a Wells Fargo endorsement by any of the three. I do enough endorsing of Wells Fargo for everyone these days.

In summary, the debate was a great success. Our discussion about collateral options was a fair, honest evaluation of the alternatives and the benefits and limitations of each. I look forward to further fruitful discussions of such matters going forward.

Here’s to a great year for you all!

Robert Quinn is vice president of the collateral trust division at Wells Fargo Insurance Trust. He can be contacted at: robert.g.quinn@ wellsfargo.com

Captive International