Captives Use Trusts To Reassure Fronts

The most obvious liability is the difference between what a captive has paid in and claims that have exceeded that amount up to the aggregate amount of liability of the captive. This can be as much as 150 percent or more of the amount paid in to the captive. This exposure is commonly called the "gap."

Until the captive has matured or has otherwise shown experience, funding the gap has been done with cash. Where cash is not obtained, the most frequently used instrument of collateral is a letter of credit, usually in favor of the front.

The letter of credit may also serve to satisfy regulatory requirements in dealing with foreign reinsurance companies and unlicensed captives with the front, as well as compensating its ability to write more business under risk based capital guidelines.

Letters of credit or LOCs, however, may be difficult to obtain. They also cost money, do not return any investment income, and use up sources of credit in the owners business. And, since captives in their early years of experience may be still establishing creditworthiness, a captive may be required to post LOCs for several yearsthe letter of credit representing the entire amount to be collateralized.

What are the alternatives for a captive? To varying degrees and dependent on the resources of the owner and acceptance by the fronting company, other tools may include reinsurance, buy-downs, deductibles and finite insurance.

One alternative, the insurance trust, seems to be generating some interest.

Commonly called a "Regulation 114 trust," named by the Insurance Department of the state of New York, an insurance trust, like an LOC, serves not only to fund the exposure in the captive but also covers the fronting carriers need to comply with underwriting guidelines and regulations.

Unlike a letter of credit, the trust can be paid into over a period of time, and investment returns can be realized. Over time, these trusts can be less expensive than letters of credit and possibly more flexible.

In a Regulation 114 trust arrangement, the captive owner, called a "Grantor," enters into an agreement with a fronting carrier, called the "Beneficiary," as well as a bank. The bank cannot be affiliated with either the captive or the fronting carrier.

The agreement would require the captive to deposit with the bank cash and securities representing either the full amount of the captives funding exposure or the limit of the reinsurance agreement. The bank would then invest and manage these funds.

There are restrictions on the types of investments the bank can make, basically fixed income securities, which have a high rating and no equities.

In the event that funds from the trust have to be used, either for nonpayment of premium or for losses in excess of the funds already paid into the captive, the fronting carrier can draw upon the trust and use the funds to pay for terms and responsibility under the reinsurance agreement.

There are advantages and disadvantages to Regulation 114 trusts. The advantages to the captive/reinsurer are that costs associated with the trust are comparably lower than an LOC.

For example, the trust may have no draw-down fees or comparably lower maintenance fees. The trust is unlimited in size while the LOC may have to be renewed annually with an evergreen clause in favor of the beneficiary. Higher fees may come from an unsecured LOC. The trust may have a higher investment potential, coming from a mix of guaranteed fixed returns and allowable securities.

There also may be several variations of trusts, developed to be more flexible to the captive owner as well as the beneficiary.

This may come in the form of the types of investments allowed, or perhaps more importantly to the captive owner, the terms under which contributions to the trust may be made over time. This flexibility can be important to a captive or its shareholders if an option is available to make periodic payments to the trust rather than obtaining a significant amount of collateral all at once.

For example, lets say a fronting carrier needs a letter of credit to guarantee the solvency of the captive to pay unexpected claims and to avoid impairing its ability to underwrite additional risks. As a potential owner or shareholder wishing to explore the use of a captive, you find that while securing a letter of credit is not a problem, you know you will be facing this same situation for next years renewal and possibly for the next several years (called "stacking").

Additionally, the amount of the credit would impinge upon your ability to secure credit for later business expansion.

An available option may be a trust agreement in which monthly payments are made to the trust. These payments would equal the obligation the front is required to pay under the reinsurance contract with the captive.

Since you have a good relationship with your bank, which is approved by the front, the front can agree to set up and manage the trust at a cost far lower than a letter a credit.

In addition, the investment return from the trust would now be higher and could be used to reduce the amount of contribution necessary to fully fund the trust.

A disadvantage might be the time it takes to develop a trust agreement with a fronting carrier and to set up process. The fronting carrier, in addition, will want to monitor the trusts performance on a quarterly basis.

I can foresee the use of insurance trusts growing in popularity in most areas where collateral tools are needed.

While 2002 saw a record number of captives being formeda trend that is expected to continueone of the fastest growing types of captive is the segregated cell. The segregated cell is used more and more by middle market accounts with less access to cash and credit than their larger Fortune 500 brethren.

These accounts could include physician groups, hospitals, nursing homes, public entities, associations, manufactures and law firms.

For many of these owners a trust, rather than a letter of credit, may be the solution to help finance their risk.

Christopher L. Kramer is senior vice president for Neace Lukens Management Services in Cleveland, Ohio, and Washington, D.C. He can be reached at chris.kramer@neacelukens.com.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, February 13, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.