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letter of credit (LOC)

A letter of credit (LOC) is a legal commitment issued by a bank or other entity stating that, upon receipt of certain documents, the bank will pay against drafts meeting the terms of the LOC.

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LOCs are frequently used for risk financing purposes to collateralize monies owed by an insured under various cash flow programs such as incurred but not paid losses in paid loss retrospective rating programs, fulfillment of the capitalization requirements of captives, satisfaction of the security requirements of the excess insurer in "fronted" deductible or retention programs. For captives, LOCs serve two possible purposes: they may be used in lieu of or in addition to cash or other securities as capital and/or to securitize the fronting insurer's reinsurance receivable created by a nonadmitted reinsurer (i.e., the captive).