An advocate of the insurance trust as an alternative to the letter of credit, Robert Quinn reflects on his long association with Bermuda’s captive insurance market.
The Bermuda Captive Conference 2010 will be a very special event for me. Of course, the domicile always throws a great event. But the reason why this will be special for me is that it marks my 10th year calling on Bermuda captives. But before I go into why I have been calling on this industry for so long, allow me briefly to reminisce.
I remember my first meeting in Bermuda—with Peter Strong from (what was then) IMG. Ring a bell? On that same trip, I remember meeting Mark Pougnet at Marsh. He has since moved on to a different company on the Island (and doing quite well, indeed). I remember Mark sitting me down at Little Venice and saying: “Let me explain to you how this ‘fronting’ thing works.” A few beers, at least six attempts to draw me a picture of the business and two dozen ‘ehs’ later (Mark is, of course, Canadian), I thought I had it. And to the extent that no one has asked me to explain a fronting arrangement myself, I did. I still have one of the pictures he drew.
So many names—Oliver Heyliger, Paul Pereech, Kate Robinson, Tom McMahon, Nick Dove, Jill Husbands, Phil Barnes, Mike Hardy, Mike Tait, Nicole Rozon, Ellen Charnley, Mick Larkin, Francis Carter, Tony Bibbings—I could go on for days. Even Tony at Little Venice and that doorman at the Hamilton Princess (the one with the deep voice who could have been a DJ somewhere) were there during my grand introduction to the Island. It is so nice to have spent 10 years in the company of such quality people!
I have also spent the better part of the past 10 years talking to various captive industry professionals about what concerns them. The subject of collateral invariably comes up often. Indeed, collateral is of great concern to captive owners and captive managers alike. Or maybe the subject comes up often because I never stop talking about it myself? I tend to think it is a combination of the two. But to be clear: now more than ever, collateral is one of the two hottest topics out there.
Why is collateral such a big deal now?
I like to tell my friends that the reason my phone rings as much as it does is that I am the one that is getting more popular. For some reason, I suspect that this is not entirely the case. Fortunately, there is a much more logical reason for all of the calls I am getting. With regard to insurancerelated collateral (the subject I have been discussing this entire time), letters of credit (LOCs) are often the worst option out there now.
The best way to explain the problem with LOCs is to look at the LOC markets both before and after the recent financial crisis. The analysis is not sophisticated. It is not complicated. But it does need to be done.
I vividly remember discussing collateral options with captive professionals just before the financial crisis of 2008. There was a certain amount of frustration on my part that was really a function of the credit markets themselves. That is to say that, back then, I was competing with LOCs that were costing 25 to 45 basis points (BPS) annually. My position then was that $10 million LOCs were costing $25,000 to $45,000 per year, while a trust might cost $5,000.
The response I would get from people was that LOCs were quick, clean and easy to understand. There were also the colossal misconceptions that LOCs were easy to obtain and trusts were difficult to establish. I will address these concerns in a moment. But from a simple ‘cost’ perspective, it was somewhat difficult to get people’s attention. To be sure, I stand by my position that even in 2007 (when the savings were $20,000 to $40,000), use of the trust in lieu of an LOC made great financial sense.
I am not sure if I really need to say much more than just the heading June 2010. When considering the date with regard to credit, it says a lot. But just in case that isn’t enough, I will continue.
During a recent conference, I was on a panel with a representative from an LOC-issuing bank. The representative was the first to concede that 75 to 100 BPS is not unusual for a letter of credit today. In fact, he said that it was fairly common. However, if one were to think about this objectively, then the recent LOC rate increases are likely the biggest reason why my phone is ringing as much as it is.
I have recently seen two articles written in captive industry magazines similar to this one that discuss collateral options. They both say that trusts are gaining in popularity. I am sure that this recent interest and popularity in ‘alternatives to LOCs’ is due largely to LOCs not being the best option in the first instance. Now they make less sense than ever.
Simply stated, a $10 million LOC at the above listed pricing would cost $75,000 to $100,000 per year. It is certainly worth noting that the trust pricing, at least with my firm, has actually gone down. In many situations, the trust might cost $3,500 per year or less.
Misconception: Investment income is lower with a trust
This part of the discussion gets easier every time I have it, especially in this investment environment.
Let me start by pointing out that the ever-increasing LOC rates mentioned above are contingent on the client fully collateralising said LOCs with the captive’s cash.
LOC issuers will tell you that the issuing bank will allow you to put your ‘collateral’ money into more liberal investments than would a trust. By doing so, they say, they are enabling you to earn more income on the investments and therefore offset the cost of the LOC versus the trust. I will be the first to tell you that this might be possible. However (and this is a big however), the letter of credit (and therefore the collateral you post for it), and/or the trust money you might post, are there specifically to pay claims in the event of a problem. The last thing anyone wants is to suffer principal losses in your trust. Investing captive collateral money for yield is a dangerous game.
The key here is that you can do one of two things:
1. Use a trust with relatively safe investments and pay $3,500 per year, or
2. Use a collateralised LOC, pay 75 BPS for it, invest the collateral such that you hope the rate of return will offset the cost so that the LOC costs as little as the trust, and really hope that nothing happens to the investments themselves.
I ask you this: Isn’t your captive taking enough risk in the first place? Do you really want to start taking investment risk too?
The current investment environment is very unpredictable. It is also risky. Therefore, most captives keep their money in more conservative investments. So my position is that while you could invest in riskier investments and increase your rate of return, most captives today aren’t doing this. They are remaining conservative in their outlook. And if you are conservative with your investments, then those investments would be eligible to use in a trust. For most, the trust would eliminate the LOC fees and not affect their current investment return at all.
Misconception: The trust set-up process is more difficult
I have heard it a number of times: “I was running out of time so I just went with the LOC.” “I was advised that the trust was too much work to set up.” “The trust is a 20-page document and the LOC is only two, so I went with the LOC.”
The response to such statements is this:
All things considered, the trust is no more work than an LOC. It is often less work.
I say this for a few reasons. Yes, the trust is often 20 pages and the LOC is often two pages. However, the amount of work involved in obtaining that two-page LOC is substantial. You must go through the bank in question’s credit review process. Anyone who has ever bought a home knows how difficult that can be (and the home loan is also fully collateralised by the home itself). But when the credit request is from a captive, then the review process only gets worse. This is not to say that the banks are wrong for doing such due diligence, but it is to say that collecting your company info, submitting it in the proper format, filling out the forms and generally going through a credit review process will be a lot more work than establishing a trust.
Here is why: while the trust agreement is indeed a comprehensive legal document, it has already been pre-negotiated between Wells Fargo, the relevant regulators and just about all of the primary fronting carriers out there (for both captive programmes and deductible programmes). Our ‘information requests’ are simple and are sent to you in an email.
The best evidence I have that trusts are actually easier than LOCs is that we have established trusts in less than 24 hours for clients that had no previous relationship with Wells Fargo. While that isn’t always the case, I challenge any LOC issuer that claims LOCs are easier to establish than trusts to demonstrate that they can set up LOCs this quickly.
Wrapping up the first 10 years
Clearly, and in almost every situation where the LOC is above $1 million, the trust is less expensive than LOCs (often 95 percent less). There should be no foregone investment income by using a trust in lieu of an LOC. And to be sure, the trust is actually less work than an LOC to establish.
So much to say and so little time. Let me just finish by saying that this whole ‘Bermuda gig’ has been great. Great people, great weather and great business opportunities. But above all, I am most proud of the friends I have made in Bermuda. Thanks to those who have been so helpful to me in the past, and I am really looking forward to contributing to the domicile in the future.
Robert Quinn is the vice president of the collateral trust division at Wells Fargo Bank. He can be contacted at: firstname.lastname@example.org.