With LOC prices still going up, it is time to do something about it, says Robert Quinn.
As I sit in my hotel room after an outstanding CICA (Captive Insurance Companies Association) conference, I am reflecting on some of the more interesting conversations that I had here. The booth traffic was great, and the speakers at the conference were not only informative but also (for me, at least) very entertaining. In fact, I moderated a panel discussion on collateral alternatives that seemed to have been very well received. Peter Rapciewicz from Chartis and Mike Ramsey from my team at Wells Fargo participated and did their respective firms proud. Other than my usual attempts at silly humour, I won’t comment much on my participation…but I would like to comment on what I observed.
Attendance at the conference and the ‘collateral alternatives’ session was very strong (stronger than most other sessions I have delivered). That was a clear indication to me that collateral, in all of its forms, is of great concern for captive owners and corporate treasury groups. Unfortunately, for those that follow my articles and have seen some of my presentations, there were no ‘smack-downs’ at this one.
I have always believed that evaluating how well a session is going is best measured by audience participation. I have attended sessions where you could hear crickets singing after the speakers asked: “Are there any questions?” This one was different.
While the panelists did, in fact, discuss all of the alternatives (and did so fairly), the questions were nearly all centred on the one alternative that seems to be gathering so much attention—the insurance trust. I suspect that since nearly everyone currently uses letters of credit (LOCs), there aren’t many mysteries out there about them (except for maybe why they cost so much!). But the number of questions about trusts, how they work and the benefits of using them has compelled me to repeat them here, together with the answers that we gave.
First, what is an insurance trust?
Rather than post LOCs to their insurance carrier to cover their collateral requirements, insurance trust users simply place theircaptive’s cash or cash equivalents into a trust account at Wells Fargo and pledge the trust to their carrier. When they do this, the trust is the collateral and the need for the LOC is eliminated—and so are the fees for said LOCs.
What is the least expensive collateral alternative?
Without going too far into it, I will say that using a trust in lieu of an LOC will likely save you most, if not all, of your LOC costs. When the audience was asked how much they generally pay for their LOCs, most said around 75 to 100 basis points (BPS). But some actually admitted to 200 and 300 BPS for their LOCs (special note: those LOCs that are in the lower range are usually cash-collateralised). How an LOC-issuing bank issues LOCs on a fully collateralised basis for that kind of money is beyond me. But hopefully the readers of this article, and the attendees at the CICA session, have come to realise that there is a better, less expensive and more efficient way to do this.
If you use a trust in lieu of an LOC, then the costs are often 90 percent less than that of an LOC. In some situations, the savings are more; though in some, they are not as much. But in nearly all situations, the savings are enormous. And in this day and age, every bit helps.
How is my ability to earn a rate of return affected by the alternatives?
This subject comes up, without fail, at every session I either deliver or attend. LOC-issuing banks will tell you that while LOCs do cost more than insurance trusts, the LOC collateral account will allow for more aggressive investments, therefore negating the extra cost of the LOC.
Well, there is more to it than that. The real issue isn’t what the captive could invest its money in (whether a trust or LOC collateral account). The real question is what is the captive investing in. My assertion is this: a captive might earn more money investing in subinvestment grade bonds, dot-com stocks and the like (assuming they aren’t taking losses, which are often big on such investments). Butto be sure, most captives and their parent corporations generally have conservative investment criteria. They don’t want to lose their money ‘playing the markets’. They know that, in the final analysis, the captive’s money must be there to pay claims. Risking their own ability to pay claims is not, for most, what this is all about.
"Given the losses, banks have sustained, they simply have less to lend-- 'Economics 101'-- and the supply and demand laws tell us that when banks have less less to lend, they are going to lend to the highest bidder."
That said, captives generally keep their money safe, liquid and predictable in value. They don’t try to ‘chase yield’ (at least not with the trust assets). They usually invest their money in a way that is in perfect alignment with the requirements of a trust. So to be clear, there should be zero ‘forgone investment income’ for those that use a trust. Is this a perfect solution? As Peter Rapciewicz from Chartis stated during the CICA session: “No, not for everyone. But each alternative should be evaluated. No option should be ignored.”
Why are bank LOCs so expensive?
The current lending environment is really simple to understand. However, understanding the situation does not make the current LOC rates any easier to swallow. Both Mike Ramsey (Wells Fargo) and Peter Rapciewicz (Chartis) mentioned in various parts of their respective presentations that banks were under a lot of pressure. It was Mike Ramsey who offered the clear and simple explanation: banks are taking losses, due to both bad loans and bad investments (among other things). And clearly a bank’s ability to lend is contingent on how much money it actually has. Given the losses banks have sustained, they simply have less to lend—‘ Economics 101’—and the supply and demand laws tell us that when banks have less to lend, they are going to lend ‘to the highest bidder’. As much as I would like to pick on LOCissuing banks, it would be unfair to single out any one or two. LOCs for captives are a systemic problem (for those needing to post collateral). Make no mistake about this: the lending crisis is still in full swing. And no bank is immune to the current lending problems. In the absence of an alternative, LOC-issuing banks have captives ‘over a barrel’.
But there are alternatives as our CICA session (and this article) tried to explain.
What is the set-up process for a trust versus an LOC?
This question was driven by a misconception in the market (as I found out later from the person asking the question).
At a recent conference, an LOC issuer made the comment that one ‘benefit’ of using LOCs over trusts is that LOCs are a simple two-page document—the trust could be 15 to 20 pages long). The representative of the LOC-issuing bank stated that the LOC proposition is therefore ‘less work’.
That assertion is more than misleading. We all know that LOCs are not just ‘a simple two-page document’.
When you last approached a bank for a letter of credit, was the documentation process a simple two-page form? Is that all you had to supply to the bank? Of course it wasn’t. You had to supply the bank with tons of information for it to make a lending decision.
I would normally ask the reader to think back to what an LOC (in millions of dollars) would require (work-load wise), but I don’t have to. According to recent reports, around 75 percent of ‘captive collateral’ posted today is in the form of an LOC. Additionally, nearly everyone needing collateral has used LOCs at one time or another. So you already know that it is a lot.
Yes, the trust agreement is a 15 to 20-page legal document. However, Wells Fargo has already pre-negotiated the required language of the agreement to include the carrier, regulator and trustee requirements. Therefore, the work required to establish a trust is 98 percent complete. The client just needs to review the trust language (language that all other trust users have agreed to in the past), then simply supply Wells Fargo with some supporting documentation and it is finished. But to be clear, this is not a credit review process and is nowhere near the work of an LOC.
Why would anyone do anything else?
That sounds like something I would say, right? In fact, I have probably said this 1,000 times before. But during our CICA session, a prominent person in our industry asked that very same question.
It was such a perfect validation of what I have been saying for years that I even made a joke from the podium, asking: “To whom should I make out my cheque as payment for such a ringing endorsement?” This person said, in front of everyone, that they have established a number of these in lieu of LOCs and the savings have been tremendous. Further, the LOC process, and the efforts required to put such LOCs in place each year, put a considerable strain on the company’s risk management group. Converting its collateral into trusts has made the entire LOC process unnecessary (annual negotiations, renewals, etc.). And it has made the collateral process simpler. So I will ask the same question for the 1,001st time: why would anyone do anything else?
So, congratulations to CICA for a great conference and thanks to Mike and Peter for a session well done. You set out to explain the alternative forms of collateral available to captive clients and you did so, fairly, impartially, with tremendous expertise and without any ‘smack-downs’. ]
Robert Quinn is vice president of the collateral trust division at Wells Fargo Insurance Trust. He can be contacted at: firstname.lastname@example.org