Collateral trusts are a competitive alternative to letters of credit, but carrier acceptance remains a hurdle in the process. Here the issues behind securing the green light are addressed.
The topic of collateral has been discussed extensively over the past few years and for good reason. Many risk managers and treasurers consider it one of the most pressing issues they are facing today. Despite this fact, I am surprised how little is still known about the options corporations have before them when it comes to satisfying their collateral requirements. Collateral has always been an issue for corporations to address. Whether it’s for a traditional corporate deductible programme, a surety bond or captive programme, it has gained attention in recent years due to the meltdown in the credit markets. What do the credit markets have to do with it? Simply stated— until a few years ago—letters of credit (LOCs) were far and away the most common way that corporations posted collateral. There are a few reasons why this was the case, but one of the primary reasons is that it was the only option known, but clearly not the only option available.
When the financial markets started to collapse in 2008, one of the first things that happened was credit became very expensive and difficult to obtain, the effects of which we are still seeing today. For corporate ‘deductible programmes’, many firms would use their corporate credit lines, which had fixed costs associated with a defined term. As these terms started to expire, corporations were seeing their cost of credit skyrocket, often doubling and tripling at renewal. For captives, even though the LOCs were ‘cash collateralised’, we saw similar increases in LOC costs. In addition, as many banks’ balance sheets started to deteriorate and their credit ratings suffered, the carriers themselves began feeling uncomfortable with the amount of LOCs they had posted to them from the same banks. All of these factors led to the carriers, captives and corporations looking for other alternatives to the traditional LOC.
Enter the collateral trust
For many years, our group has been travelling the country meeting with brokers, captive managers and treasurers to explain the collateral trust alternative, how it works, and what its benefits and limitations are. Our discussions invariably gravitate to the issue of carrier acceptance. Although we don’t and can’t speak for the carriers, we do offer up generalities on what we have seen. Fortunately for us, our group only works on insurance-related collateral trusts, which has allowed us to focus exclusively on this special market. This specialised focus has helped us better understand the carriers and their individual requirements. When evaluating the trust option, it’s important to note that a trust requires a tri-party agreement, which consists of a grantor—the entity actually funding the trust; the trustee—which would be the bank asked to administer the fiduciary duties associated with the trust; and the beneficiary—the entity requiring the collateral. Once all three parties have signed the trust agreement, the trustee provides wire instructions, the trust is funded, and it’s done.
Like any business decision, there are benefits and limitations that must be weighed when analysing the trust option. The benefits include significant cost savings, depending on a few factors such as the collateral amount and your cost of credit, favourable accounting treatment and ease in adjusting the collateral amount over the life of the programme. To be clear, the trust must be funded with investmentgrade financial assets. For captives that have cash-collateralised LOCs, the trust is usually a very easy decision. I say this because the same cash that is being used to collateralise the LOC can be placed in a trust, thus eliminating the LOC fee completely.
The carriers’ perspective
For reasons mentioned earlier, carriers have been more willing to accept trusts in lieu of LOCs than they were in years past. That said, it’s important to note that carriers don’t patently accept these trusts from everyone. Acceptance of the trust by the carrier is usually decided on a case-by-case basis, with several factors determining the decision.
A few carriers might charge a nominal fee to help cover the cost of establishing these trusts and monitoring them for compliance. These fees, along with the bank’s trust fees, are, generally speaking, still considerably less than most LOC fees—often 80 to 90 percent less.
I have had a few clients interested in a trust, only to find out that the carrier wouldn’t allow for it in its situation. For this reason, I always preface trust discussions with this comment: it is solely up to the carrier to decide if a trust will be allowed. You should approach it first before getting too far down the road in setting one up.
The insurance trust team at Wells Fargo has great relationships with most of the carriers asking for collateral for these programmes. We clearly understand that the carriers have to look at the situation before they allow for alternatives to LOCs. Some of the factors the carriers look at when deciding on which collateral options to allow for include:
1) Collateral amount: Some carriers prefer to see a significant collateral amount before they will entertain the idea. When the collateralamount is on the small side (say $300,000), LOCs might actually be less expensive than a trust (even in this market). The reason: a $300,000 LOC might cost a captive $3,000 per year. The trust would likely cost about that much, and the carriers often don’t like to incur the extra effort required to establish a trust if the client doesn’t stand to gain anything.
2) Financial standing: If the financial standing of the grantor is precarious, the carrier may not want to have a trust in place, thinking a Chapter 11 filing might be on the horizon.
3) Client is no longer with the carrier: Since the trust is considered a concession by the carrier, it takes more time to set up and monitor. Some carriers are reluctant to spend time and capital on programmes in run-off.
Other factors are considered too, such as the overall relationship with the client and the banks involved.
Most carriers have a list of preferred or required trustees they use for these trusts. Of course, Wells Fargo is on nearly all of those lists, but the important thing to remember here is that if a carrier tells you which banks they would like you to use, they have good business reasons for doing so. The carriers already know that the banks they have approved are experienced in the nuances of insurance and reinsurance trusts. They know that their preferred banks ‘know what they are doing’. Additionally, the preferred trustees have alreadynegotiated the agreement with the carriers, which will save a lot of time and legal expense.
Investment strategy within trusts
When considering a trust, keep in mind that the investment income belongs to the depositor. However—and this is a big however—the trust should not be used as a way to maximise investment return. Trying to maximise return means that the trust money is invested in things that are a little more risky and a little more volatile in their day-to-day market value, and because of this fact, most carriers only allow for very safe and liquid investments within the trust. The trust should be viewed as an option to eliminate credit costs, while maintaining the assets on your books and collecting the conservative investment income.
While we can’t say that the trust is the perfect option for everyone, it is a great option for most. It will save most of your LOC fees, free up your credit availability and, unlike LOCs, does not need to be renewed each year. The big question, and the one that I can’t answer, is whether or not your carrier will accept one for your programme. But that is an easy phone call to your underwriter.
Mike Ramsey is vice president, Wells Fargo Collateral Trust. He can be contacted at: firstname.lastname@example.org
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