In the face of challenging economic conditions, greater regulatory scrutiny and rating agency oversight, captives are increasingly turning to collateral trusts, as Caroline Cruickshank reports.
We have witnessed many challenges over the past year, political, economic and social. Globally, we continue to deal with the effects of a credit crisis that is still putting a squeeze on bank liquidity and lending practices, a recession that is claiming its sovereign victims like dominos, civil unrest and protests spanning diverse regions—and for equally diverse reasons—and an increase in environmental catastrophes with greater global consequences. The changing regulatory landscape affecting many jurisdictions also plays a significant and challenging part in these times, whether it involves the introduction of new international financial reporting standards, sweeping reforms under Dodd-Frank, or new capital adequacy regimes dictated by Solvency II and Basel III, to name but a few.
Change may indeed be challenging to deal with but it can also present an opportunity to be innovative and to find new approaches to everyday demands that may help us to be more efficient. For reinsurance buyers and sellers, the changing financial and regulatory conditions have certainly underpinned a drive towards more innovative approaches to meeting collateral requirements.
Traditionally, the letter of credit (LoC) has been the most common type of collateral sought, especially in years gone by when credit availability seemed plentiful and the creditworthiness of a LoC issuer seemed almost beyond reproach. However, in today’s climate, many institutions are re-evaluating their business strategies and re-balancing the cost of their credit exposures. This has been a direct result of the continuing erosion of balance sheet capital, and further pressures caused by rating downgrades and a lack of market confidence.
Change is inevitable here too. We have seen a significant increase in the cost of credit and a widespread lack of credit availability in the market. A shift in bank appetite from unsecured credit lines also means that LoC applicants are having to cash-collateralise their LoC arrangements, yet still pay a high price for the privilege. Further scrutiny also raises concerns over whether an LoC-issuing bank’s own security can in fact improve an LoC applicant’s creditworthiness to other counterparties. In the case of captives, fronting carriers often impose a security requirement to mitigate risks which may invariably increase the captive’s cost of doing business. In this sensitive financial environment, any additional cost may have an impact upon whether a captive’s contract would even be viable.
An innovative solution that achieves security and reduces costs is available via the reinsurance trust.
A reinsurance trust is not a credit instrument but an account that meets collateral requirements for re/insurance obligations. Methods vary according to the jurisdiction, but under this concept the captive’s obligations are secured by a deposit of eligible financial assets pledged to a designated insurance carrier as beneficiary. A trustee acts with fiduciary and contractual obligations over the account until a default or a claim triggers a call on the assets. A reinsurance trust is often significantly cheaper than a LoC and is easy to set up using standard documentation. Arrangements are typically evergreen, and the collateral amount can be adjusted as more or less business is undertaken. Liabilities can also be aggregated into a single trust per carrier to provide greater efficiencies and any income generated by the portfolio of assets in trust may even be directed back to the captive.
A reinsurance trust can complement a cedant’s risk management by reducing the credit and counterparty risks associated with LoCs. Trusts can also encourage carrier competitiveness among clients looking for flexible options. Finally, consolidated reporting can also help to streamline the back-office LoC tracking functions and enhance data management or increase transparency.
Reinsurance trusts have for many years been used to satisfy US regulatory requirements which impose collateral, such as New York Regulation 114 or National Association of Insurance Commissioners (NAIC) surplus lines requirements. However, due to the globalisation of business and industry, requirements for collateral today often cross borders. This has led to the emergence of reinsurance trusts in the international arena, such as the European reinsurance trust.
In a European context, reinsurance trusts can satisfy a host of client scenarios such as to reduce counterparty risk where the captive has insufficient credit quality, or is outside the scope of the fronting carrier’s national regulator. Operating in a similar manner to the Regulation 114 trusts, the European reinsurance trust is typically governed by documentation recognised in the jurisdiction of the trust provider or trustee. In many ways, a European reinsurance trust can be more flexible than a Regulation 114 trust, and can be customised to individual business needs. Eligible asset criteria or other considerations are, for example, wholly determined by the parties involved rather than dictated by set regulatory expectations.
"An innovative solution that achieves security and reduces costs is available via the reinsurance trust."
Further change and challenges are inevitable in Europe, Solvency II chief among them. Innovative solutions that can help participants overcome—or at the very least to lessen the burden of—these challenges are key. One of the proposed requirements of Solvency II will deal with assets being ring-fenced from counterparty and custodian default. While the requirements have yet to be finalised, reinsurance trusts for the European market are intended to comply with these requirements and help insurers and reinsurers take advantage of the risk mitigation techniques allowed under the directive. A European reinsurance trust designed specifically for use in the European markets will give re/insurers the ability to manage assets according to their investment strategy and the flexibility either to direct the income generated out of the trust, or to keep it within the structure to ‘shore up’ the overall valuation of the collateral held.
In addition, recent interpretations of the directive by industry participants claim that captives may be able to lower their overall capital costs under Solvency II by obtaining a credit rating. It is believed a rating may lower the counterparty risk capital requirements typically levied on the fronting carrier, who in turn would reduce the overall capital requirements imposed on a structure. However, to be eligible for rating consideration, a captive may need to demonstrate robust risk management and governance, perhaps even requiring additional capital injections. It is expected that many captives may be unable, or unwilling, to seek a credit rating and may ultimately look to re-domicile to a non-Solvency II jurisdiction from where they can write EU-based business through a fronting entity. Collateral may therefore continue to be at the forefront of captives’ concerns. Collateral in the form of a reinsurance trust is an efficient means to approach such issues, when compared with the traditional LoC.
Whether replacing a LoC entirely or in part, a reinsurance trust can provide a cheaper and more flexible form of security. In this climate, a company that can demonstrate to its parent that it can significantly reduce and manage its costs may make all the difference. Lower collateral costs may also determine whether an insurance transaction can even close. A reinsurance trust can therefore complement a cedant’s risk management strategy by reducing the credit and counterparty risks associated with LoCs. Where risks have a global dimension and economic areas affect each other, there is a high likelihood that collateral issues will continue to stalk the industry. A trust provider who can provide innovative collateral alternatives to meet multi-jurisdictional requirements, may help the industry not only to manage risks more efficiently but to optimise the potential for opportunities. While change may be challenging, innovative measures will help us to keep ahead. The views expressed herein are those of the author and may not reflect the views of BNY Mellon.
Caroline Cruickshank is a managing director with BNY Mellon. She can be contacted at: firstname.lastname@example.org
EMEA, BNY Mellon, collateral trusts, captive, insurance