Trust versus LOC: the smackdown, part II

As I was preparing to present a session on collateral alternatives at the Cayman Captive Forum 2009, I fondly recollected the last such session I delivered at this conference. Those of you who were there will remember that it was somewhat of a ‘dust-up’ between me—discussing insurance trusts as an alternative to letters of credit—and a bank representative discussing said letters of credit. That was at the 2007 conference.

Fast forward to the following year: the night before the 2008 Cayman Captive Forum, I was sitting at the bar at Bamboo (the sushi restaurant in what was the Hyatt Grand Cayman) minding my own business (as best as I ever can!). Someone at the bar kept looking at me. It took him nearly five minutes to remember how he knew me. He said: “Aren’t you one of the guys that got into a ‘smackdown’ during a session at the conference last year?”

I need to quash any rumours or false stories…there were no fisticuffs. You all would have heard about that if there had been. However, it was a more spirited discussion of competing alternatives than I have ever been involved in before, to be sure!

All that said, things now are much different to the way they were in 2007. We have all seen the financial crisis hit us in our workplaces and (unfortunately for many) in our homes. With regard to captive collateral requirements, I do believe that my position two years ago is even more ‘correct’ than it was then.

Then versus now

Back then, I was saying that letters of credit (LO Cs) were too expensive. I am sure many of you were saying that too!

Ah, the ‘good old days’ of the 25 to 40 basis point (BPS) LO C. Good old days? I think not. Given the trust alternative, 25 to 40 BPS wasn’t a bargain. I guess it doesn’t matter now anyway, as most of us aren’t enjoying that ‘luxury’ any more. But to be clear, when a $10 million LOC costs 40 BPS, the fee for that LOC is $40,000. The trust would not have cost you much more than $5,000. That would have been an 87.5 percent saving.

Clearly now, for most, the situation is drastically different. LO Cissuing banks are charging much, much more for the same LO Cs. It isn’t uncommon to pay 75 to 100 BPS for the same LO Cs. So what was $40,000 could be costing $75,000 to $100,000 now.

And to be clear, the trust should still cost you around $5,000 or less. The savings now are 93 percent and 95 percent, respectively.

Collateralised LOCs

The LO C option (in most situations), now more than ever, seems silly. Here is why: most captives are put in place to realise certain tax and accounting benefits. One way to demonstrate that you are eligible for these benefits is to demonstrate to the Internal Revenue Service that the captive is ‘separate’ from the parent. Therefore, captives are reluctant to use ‘parental guarantees’ to help them secure their LO Cs. Therefore, most captive owners must collateralise their LO Cs with their captive’s cash. This collateral has to be at least 100 percent of the LO C amount—but is usually more.

The collateral backing LOCs

So what happens to the collateral supporting the LO C? What can the captive expect in the way of rate of return? Well, that really depends on the LO C-issuing bank as well as the captive itself. I say this for two reasons.

First, the LOC-issuing bank does not want to risk the collateral that is being posted to it. So, most of the time, it asks that the collateral be invested in such instruments as money market funds, Treasuries or other investments that are safe, liquid and predictable in value. And if the client wants to invest in securities that will return more (meaning that they are both riskier and more apt to fluctuate in value), then the LOC-issuing bank will ask for more collateral than the LOC is worth. Often 10 to 30 percent more than the LOC amount. So, while you, the captive owner, are fighting to keep your collateral requirements to the carrier down, the bank issuing the LO C is effectively increasing the collateral requirement by asking for more collateral for the LOC.

LOC-issuing banks might suggest to you that using a collateral trust, while less expensive, would cause you to forego too much investment income to make it worthwhile. Stated a different way, people might tell you that the trust ‘investment restrictions’ are too stringent; that any additional costs of a letter of credit would be covered by the increase in investment return.

The truth is that, most of the time, captive owners are more concerned with the safety of their money than they are with picking up a few dollars of investment return. They want to be sure thattheir captive’s money is always available to pay claims. They don’t want to run into a situation where their ‘aggressive’ management strategy causes them to lose money. So even though, with an LOC, it is possible to invest more aggressively to maximise yield, the practical application is that this does not happen very often.

So what we have is a situation where the captive is putting up its cash to obtain an LOC, and paying often nearly 100 BPS to do so. If this were the only way to collateralise a captive programme, then it would not be ‘silly’ at all. It would just be part of the normal course of business.

But there is another way. A much more cost-effective way. A much more efficient way. And a much less time-consuming way.

The right way to ‘do’ collateral

Captives that use a collateral trust in lieu of LO Cs are doing something very simple yet both efficient and effective. They are taking the very collateral that they use to secure their LO Cs and putting that money into a trust. The trust is then pledged to the insurance carrier to whom the captive would otherwise post the LO C. That’s it!

When they do this, they pay a trustee around $5,000 or less, not 75 to 100 BPS on the value of the LO C. And to be clear, the money in the trust remains on the balance sheet of the captive. The income generated from the trust investments is the property of the captive, and the trust is explicitly listed in the regulations as an acceptable form of collateral.

Trusts reduce workload…seriously!

A standard LOC document is usually a page or two. A standard trust document is 15 pages. So on the surface, the trust seems to be more work. And on the front end, it can be a little more work. However, I (personally) have gone to most of the larger fronting carriers and pre-established the required language of the trust agreement. So while the trust document is a bit longer, it is 99 percent complete (from a carrier, regulator and trustee standpoint). The message here is this: the trust isn’t that much more work to put in place. But to be clear, once the trust is established, the trust will require significantly less work to maintain.

With LO Cs, there is that ‘stacking effect’ that most captive owners are familiar with. This is to say that as the collateral requirement grows over time, the captive has to obtain new LO Cs for the incremental amount the following year. This goes on for a number of years. Each year, the captive has to find an LO C-issuing bank, negotiate the fees and terms, negotiate the collateral for the LO C and so on. As time goes on, the captive has to manage the spreadsheet that has the list of LO Cs, the LO C-issuing bank, the fees, the expiration dates, the collateral posted, and so on (and so on). Managing the LO C ‘process’ is a well-known drag!

Conversely, once the collateral trust is in place, you are done. If the collateral requirement goes up in a subsequent year, you simply put more money in. And that is a simple Fed wire. You do not need to establish a new trust each year. You do not have to renegotiate the trust agreement. You do not even have to revisit the trust agreement itself. So clearly, even though establishing a trust will take a quick legal review of the document, the long-term work load is much less.

One last thing: some of my clients (before they established a trust with me) have voiced a concern. It goes like this: “If I have a trust in place, then the carrier can just ‘take my money’ and leave me out in the cold, right?” I respond with this: “Well, yes, it can. But if you have an LO C in place, then the carrier can just draw down on the LO C and you would have to give the money back to the bank.”

The point is this: the carriers would not accept an alternative to LO Cs if the alternative were not as ‘identical’ to the LO C as possible—especially when it comes to the ‘draw-down’ characteristics.Therefore, when considering a trust versus an LO C, neither one offers more or less protection than the other when it comes to draw-downs.

So please do keep in mind the massive savings that the trust has to offer over LO Cs. Think to yourself, am I using LO Cs, am I cash-collateralising my LOCs, am I paying more than $3,000 to $5,000 for those LOCs? If you are, consider the trust as an alternative. It should save you 80 to 95 of your fees, and actually reduce your workload.

Robert Quinn is vice president at Wells Fargo Collateral Trust. He can be contacted at: robert.g.quinn@wellsfargo.com