Captives and Collateral
August 2007
An element of a captive program that is usually
not fleshed out in detail upfront is the subject of collateral. Collateral posted
to fund future losses is also used in the traditional market but can be an ugly
surprise to the new captive owner.
by Michael
R. Mead
M.R. Mead &
Company, LLC
When establishing a captive, or considering it, in my experience collateral
is often left out of the talk until well down the road. Perhaps it is time to
bring it forward a bit more.
The purpose of the captive is to finance one’s own risk when capable of doing
so. The purpose of collateral is to formally set aside funding for payment of
claims arising from that risk. Both regulators and fronting risk partners require
that an amount of collateral be posted with them to cover expected claims.
The ugly surprise is that the amount of collateral can far exceed the other
costs of the captive and the form taken, usually a letter of credit, can remove
the captive as a viable option. Many businesses, especially in construction,
find it difficult to obtain extensive and expensive letters of credit which
are needed more urgently in their main business.
Many captive owners feel, with some justification, that since they are by
definition a superior risk, with well-managed risk management and claims management
programs in place, there is no need to provide more financing for future losses.
In their view, since there will be few if any claims, and the purpose is to
save money through financing their own risk, why should they be required to
put in place expensive collateral against losses that may never occur?
NAIC Requirements
The answer of course is that admitted, rated insurers, the fronting and risk
sharing partners with whom you must work to achieve your reduced cost goals,
are required by the National Association of Insurance Commissioners (NAIC) to
show evidence that if they are not using admitted, rated reinsurance, they are
receiving firm collateral against future claims as projected by an actuary.
For its own purposes, the NAIC requires that the collateral be in a very
limited form, usually a letter of credit from a federally chartered bank on
an "evergreen" noncancellable form.
The NAIC position then supports a highly conservative position by the fronting
insurer. With the NAIC accreditation threat before it, the insurer can then
require that the letter of credit be in an amount of as much as 200 percent
or more of the maximum possible losses for the risk of a traditional insured.
This, to me, flies in the face of the very purpose for establishing a captive.
But, if you need a fronting partner, this is reality.
One of the problems with posting collateral is the length of time that it
is held. The amount is determined by the common actuarial process of pushing
and pulling numbers until all parties are satisfied that sufficient funds are
at hand to finance all possible doomsday scenarios.
The standard approach is to determine the “gap” between the total of capital,
surplus, and earned premiums and subtract that from potential maximum loss or
maximum probable loss, which are not the same, to arrive at a figure. The difference
is the gap that must be collateralized. Some regulators and insurers want more
than the gap covered however. Some demand a percentage of the gap of as much
as 200 percent. I must say that I fail to understand how this transaction is
insurance, but so be it.
As time passes, the amount of the gap grows, and with it the requirements
for collateral increase. After several years, this can become a quite significant
figure. In fact, this can be a material deterrent to forming and maintaining
a captive.
Remedies
A partial remedy is to aggressively take down claims. What that means is
to be highly proactive in closing claim files and then pursuing with the holders
of the letters of credit—the fronting partners—a reduced gap figure supported
by the lowered claims amounts. This is not easily accomplished and requires
the engagement of a hard working professional to get it done.
Another partial remedy is to use what are called 114 trusts. This tool is
a simple trust administered by a financial institution for the benefit of the
risk partner. Funds are held, interest is earned and paid, and the overall cost
is usually quite a bit lower than a letter of credit. The name 114 comes from
the section of the New York Insurance Code allowing such a device. This device
can save quite a bit of money versus the letter of credit.
Conclusion
No matter the form or the amount, the prudent captive owner will address
the collateral issue early in the formation process and often throughout the
life of the captive.
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