The “114 trust”: The rules behind captive collateral

Ask a captive owner, fronting carrier or captive manager how a captive secures its reinsurance and you will likely hear one of two phrases: a “114 trust” and/or a “clean, irrevocable, evergreen letter of credit”. Some know the origin of both phrases come from New York State insurance regulation. Few know the meaning behind the words.

The “114” in “114 trust” is New York Insurance Regulation 114, codified at 11 NYCRR Part 126. The letter of credit standard comes from New York Regulation 133, codified at 11 NYCRR Part 79. Together with the National Association of Insurance Commissioners (NAIC) model laws, also constructed from NY Regulation, these rules decide which assets fronting carriers can count when ceding to a captive not licensed in the fronting company’s state.

Why fronts need admitted assets

A fronting carrier issues a policy,then cedes some or all the risk to a captive or other reinsurer. Most reinsurance captives are classified as non-admitted, unauthorized, or alien relative to the ceding (fronting) company’s domicile.

An authorised (or admitted) reinsurer is licensed directly by the state or jurisdiction where the ceding insurer is located. A captive not licensed in the ceding insurer’s state is considered unauthorised for statutory accounting purposes. An alien captive reinsurer is licensed under the laws of a jurisdiction outside the US. A ceding insurer can take credit on its statutory statement for reinsurance placed with an unauthorised or alien reinsurer only if the reinsurance is secured. Unsecured reinsurance is charged against the front through the provision for reinsurance on Schedule F, which reduces its policyholders’ surplus dollar for dollar. Industry shorthand calls this the “Schedule F penalty.”

To avoid the Schedule F penalty, fronting carriers require captives to post regulator-approved collateral equal to the reinsurance credit claimed. The required amount covers ceded losses and loss adjustment expenses, incurred but not reported (IBNR) losses, and ceded unearned premium. Fronts often also require collateral for the difference between those reserves and the captive’s maximum exposure under the programme.

How New York became everyone’s rule book

New York built its credit-for-reinsurance framework from three regulations:

NAIC’s Credit for Reinsurance Model Regulation (786) and its companion Model Law (785) carries much of the same wording, into all the other states. The model’s trust provisions track Regulation 114. Its letter of credit section requires a letter of credit that is “clean, irrevocable, unconditional”, with an evergreen clause and at least 30 days’ notice of non-renewal, as Regulation 133 does. Credit for reinsurance is a standard every state and must meet for NAIC accreditation. Every state has adopted some version of these provisions.

The result: a fronting carrier domiciled in Texas, Delaware or Illinois will ask for the same collateral a New York carrier would, often in the same words. When a front asks for a “114 trust,” it is asking your trust to meet the New York’s standard, regardless of where the front or captive is domiciled.

Trust language starts in the reinsurance agreement

The obligation to post collateral rarely starts with the trust agreement. Most reinsurance agreements include a security or “unauthorised reinsurance” clause. That clause commits the reinsurer to provide collateral that qualifies for credit in the cedant’s domicile, names the acceptable forms (a trust, a letter of credit, funds withheld or a combination), and sets the amount, timing and true-up of the obligation.

The reinsurance agreement is also where the cedant’s withdrawal rights are spelled out. The regulations limit what the front may use trust assets for: reimbursing the reinsurer’s share of losses and premium refunds, funding an account at least equal to the credit taken and paying other amounts due under the agreement. Any excess withdrawn must be returned. The trust agreement then puts those terms into practice with a bank.

Captive owners should read both documents together. A trust that satisfies the regulations is of little use if the reinsurance agreement’s collateral formula, funding deadlines or release conditions are vague.

The three parties to the trust

Every reinsurance trust has three parties, each with a defined role.

The trustee’s independence is central to the arrangement. New York requires the trustee to be a member of the Federal Reserve System or a New York-chartered bank or trust company. It also bars the trustee from being a parent, subsidiary or affiliate of either the grantor or the beneficiary. A trustee with ties to either has a conflict of interest. That conflict undermines the security the trust is supposed to provide.

A trustee’s duties are specific. It furnishes a statement of the trust assets at inception and at least quarterly, notifies both parties within 10 days of any deposit or withdrawal and allows no substitution or withdrawal without the beneficiary’s written instruction. It also may not withdraw its own fees from the trust. The trustee also must give the beneficiary 30 to 45 days’ written notice before the trust terminates.

Making trust assets count

An asset in a trust counts as an admitted asset for the front only if the front can turn it into cash without the captive’s help. The trust provisions adopted across the states put this in almost identical words. Before depositing assets with the trustee, the reinsurer must execute assignments or endorsements in blank, or transfer legal title to the trustee, for all shares, obligations or other assets requiring assignment. That way the beneficiary, or the trustee at the beneficiary’s direction, can negotiate the assets whenever necessary without consent or signature of the reinsurer or anyone else.

The other rules on trust assets follow the same logic:

• Permitted assets. Cash in US dollars, certificates of deposit issued by a US bank, and investments of the types permitted for insurers under the cedant’s insurance law. New York excludes investments issued by a parent, subsidiary or affiliate of either party.
• Valuation. Assets are valued at current fair market value. Bonds must be topped up if their value falls.
• Withdrawals by the captive. The captive may withdraw assets only with the front’s approval, and only if it substitutes assets of equal fair market value or the trust remains at 102% or more of the required amount after the withdrawal. The front may not unreasonably or arbitrarily withhold approval.
• No letters of credit. A standard single-beneficiary reinsurance trust does not hold letters of credit as trust assets. A letter of credit is a separate form of collateral with its own rules.

Cleaner than your search history

The words “clean, irrevocable and evergreen” are all New York’s, too. Regulation 133 sets out what a letter of credit must look like to secure reinsurance. The NAIC model repeats the terms. Each word has a specific meaning:

• Clean and unconditional. The front can draw the LOC by presenting a demand to the trustee. No proof of loss, invoices or other documents are required.
• Irrevocable. Neither the bank nor the captive can cancel or amend the letter of credit without the front’s consent.
• Evergreen. LOCs run for at least a year and renew automatically unless the bank gives at least 30 days’ written notice of non-renewal. That notice is also sent to the front.  Fronts typically draw the full LOC amount if a replacement isn’t posted.
• Qualified bank. LOCs must be issued or confirmed by a qualified US financial institution and be presentable and payable at a US bank office. New York also caps the dollar amount one bank can issue for a grantor to any one beneficiary at 5% of the bank’s capital and surplus.

I am sometimes asked, what happens if a bank is not on the NAIC approved list. The bank can still issue the LOC if they get it confirmed. In the state of NY, any bank approved by the New York Department of Financial Services (DFS) or an NAIC-approved institution can act as a confirming bank. The confirming bank adds its own payment guarantee, making the LOC legally acceptable. Sounds like fronting, right? That’s exactly what it is. The term fronting in insurance came from the banking industry. The confirming bank is paid a front fee for adding their financial guarantee to a transaction.

For a captive, the main LOC cost is hidden. Banks seldom issue letters of credit on an unsecured basis. Captives often pledge cash or securities to the bank as well as paying an annual fee. The captive’s capital ends up tied up with the bank instead of in a trust. The front receives a single, easily drawn upon instrument.

Funds withheld

Funds withheld is the simplest form of collateral. The front keeps all or part of the reinsurance premium instead of paying it to the captive. It uses those funds to pay claims. The NAIC model recognises this as a reduction from liability equal to the funds held. Credit is given only if the funds are under the exclusive control of the front.

There is no trustee, no bank fee and no assignment paperwork. There are, however, trade-offs. The first is control. The captive gives up custody of its premium and depends on the reinsurance agreement for an interest credit on the fund balance, a reporting schedule and the release of excess funds as claims are paid. A captive using funds withheld should make sure the reinsurance agreement spells out how the balance is reconciled and how surplus funds are returned. The second trade-off is the return on the funds held. Fronts typically pay a modest interest on the funds withheld balance. Today that return is around 2-2.5%.  If those funds were in a trust, the money could be invested in bonds or other liquid assets generating almost twice the return.

Collateral comparison

Many programmes combine forms. A common pattern is funds withheld for the expected losses, plus a trust or a letter of credit for the gap up to the captive’s maximum exposure.

A checklist for captive owners

1. Read the reinsurance agreement’s security clause first. Confirm collateral formula, funding deadlines, true-up frequency and how excess collateral is released.
2. Choose a trustee with no ties to the captive, its manager, the front or the front’s affiliates.
3. Execute the assignments or transfers of title before the assets go in, so the trustee can confirm every asset is negotiable without the captive’s signature.
4. Fund with assets the front’s domicile permits. Plan for top-ups if fair market values fall.
5. For LOCs, confirm the issuing bank qualifications, diary the non-renewal notice date and line up a replacement well before it.
6. For funds withheld, negotiate the interest credit and a regular reconciliation schedule.
7. Agree in advance on what the front may use withdrawals for and on the return of anything withdrawn in excess.

Conclusion

“114 trust” and “clean, irrevocable, evergreen letters of credit”, terms contained in New York regulation, are now commonplace in the captive lexicon. Knowing their source helps captive owners read and understand the documents they sign. It allows for negotiation that optimises pledged collateral. When it comes to posting collateral, captive owners have choices. They are limited by the parties to the contract and by regulation.

Greg Lang can be contacted at: glang@rainllc.com

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