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Analysing captives:
a banker’s perspective
Martin G. Ellis explains how captive insurance
companies are viewed by the banks that service them.
April 2007
When banks issue letters of credit (LOCs) to fronting insurance carriers on behalf of captives, they are generally secured
by high-quality marketable securities (e.g. US government securities). The question that bankers like me usually get asked
by captive managers and others is: “Why do you require financial statements if you are fully secured?” In this article, I will
explain why bankers require collateral in the first place, why financial statements are also required and what banks look at
on captive financial statements to assess risk.
One of the reasons banks require collateral is that, in most cases,
although the owners of the captive may be creditworthy, the captives
are usually thinly capitalised. A benefit of establishing a captive is the
relatively small amount of capital required (e.g. some US domiciles have a
minimum capital requirement of $150,000 and certain offshore domiciles
require even less). As a result, there is not much surplus for the banks to
rely on, should something catastrophic occur. Also, other alternative risk
management tools are available to captives (e.g. traditional market, selfinsurance,
no insurance).
The owners have the option of moving their insurance programme to one
of these alternatives when pricing and conditions are more favourable and
putting the captive into run-off. Run-off is a concept that is unique to the
insurance industry. In run-off, the insurance company ceases writing new
premiums and pays its claims in an orderly fashion as they materialise, by
liquidating assets. Run-off can be detrimental to a bank that is relying on
future cash flow to repay an unsecured loan.
Without collateral, the bank must hope there are sufficient assets to cover
any draws on its LOCs after the captive has paid its claims. Finally, banks
generally do not have direct recourse to the owners of the captive, because
the captive should be a stand-alone entity for tax reasons, with no reliance
on the owners for support. For these reasons, collateral is the bank’s
primary source of repayment in the event of a draw on the LOC. It should
be noted that draws conforming to the terms of LOCs are irrevocable and
unconditional obligations of the banks, whether or not they are reimbursed
by the captives.
An obvious benefit to captives of giving the banks collateral is that LOCs
are cheaper if they are secured. Currently, secured LOCs are generally
priced between 0.25 percent and 0.45 percent, depending on the type of
underlying collateral. Most unsecured LOCs are priced at 1.00 percent to
2.00 percent or more. Also, a captive that has its own financing, even if
collateral is required, strengthens the case for premium deductibility by its
owners since the captive is more of a stand-alone insurance company and
not dependent on its owners for support.
Banks generally want two ways to get repaid if there is an LOC draw.
The most obvious way is to liquidate the collateral into cash to pay the
LOC draw. Although liquidating collateral sounds simple, there are risks
involved, so banks should also assess the captive’s cash flow to see if the
captive is financially sound.
In addition to the quality of the assets, there exists an operational or
documentary risk of liquidating the collateral. For captives domiciled in the
United States, even if the bank is holding the assets in custody, the bank
must file a Uniform Commercial Code (UCC) financing statement over the
pledged assets, and a continuation must be filed every five years. This
filing is a public record that lets any potential creditors know that these
assets are pledged to the bank and are not eligible to be pledged to anyone
else. The UCC filing contains the captive’s name and address, the bank’s
name and address, and a description of the collateral. If a bank fails to file
a UCC statement or fails to file a continuation, there is a risk that another
secured party could take a pledge of the assets that the bank is holding.
Other domiciles have different filing requirements. In Bermuda, the
bank’s security agreement is filed with the Bermuda Monetary Authority
and a charge is registered over the assets. In Cayman, the captive must
record the charge in its register of mortgages and charges maintained
at its registered office. In any case, if the bank is not diligent in filing its
charge over the assets, there is a risk that it may not be able to liquidate
its collateral.
Relying on captive’s cash flow: financial statements required
As mentioned above, an LOC draw is an irrevocable obligation of the
bank. When a draw is made, unless there is immediate reimbursement
by the captive, the draw becomes an outstanding loan, since payment
was made by the bank to the beneficiary on behalf of the captive and this
loan is usually due on demand. Interest on the loan is much higher than
the LOC fees and is usually at the bank’s prime rate plus 2.00 percent to
3.00 percent.
Also, since this interest expense is most likely higher than the interest
income the captive earns on its investments, the captive would be in a
‘negative arbitrage’ situation and would want to pay off the loan as quickly
as possible. If the captive didn’t have the assets available to liquidate, or if
the assets were insufficient, the bank would have to rely on the captive’s
cash flow.
One of the main factors that affect cash flow is the profitability of the
captive. Since profitability is different for each captive, banks should
analyse the captive’s financial statements to determine the amount of
risk involved in the transaction, should there be a problem liquidating
collateral.
If there were an issue with liquidating collateral to pay an LOC draw, the
bank would be forced to rely on the captive for repayment. The owners
of a thinly capitalised captive could be tempted to walk away from the
obligations of the captive. The bank would have to go through a costly
legal process in an attempt to get repaid. Therefore, it is easier for banks
to issue LOCs on behalf of captives that are financially strong and where
there is no temptation for the owners to abandon the captive. Banks
should reflect these risks into their LOC pricing.
Banks should know the underlying business that the captive is
underwriting. Some lines of business, such as auto warranty, are
much less risky and have a shorter ‘tail’ than others, such as workers’
compensation. Other lines of business, such as medical malpractice,
would be considered even higher risk. Also, the risks to the captive should
be limited to a reasonable deductible with a limited annual aggregate loss.Reinsurance should be in place to cover catastrophic risks.
A single-parent owner of a captive generally has more time and money
invested in its captive than it would in a rent-a-captive structure, where
there are multiple owners. Also, the reputation of a single parent owner
is at greater risk and is more visible to the public than that of a rent-acaptive.
The larger investment and reputation risk of the single parent
make it less likely that the parent will walk away from its captive, so singleparent
captives are considered less risky than group captives.
Banks should determine the liquidity of the captive. In other words, are
assets available to pay claims? An easy way to assess this is to look at
the captive’s investments in relation to its loss reserves. This ratio should
be at least one times coverage, but the higher this ratio, the better. For
shorter-tail business, the investments should be more liquid (e.g. cash or
US Government securities) since claims are likely to be paid very soon. For
longer-tail businesses, such as workers’ compensation, the investments
can be a little more aggressive and less liquid (e.g. equities), since payouts
could be several years away. Also, the average rating and duration of
the fixed income investments should be considered. Bankers like to see
average bond portfolio ratings of at least A- and durations that match the
payout patterns on the loss reserves.
In addition to analysing the investments, banks should review the loss
reserves. If the captive has large incurred but not reported (IBNR) reserves
and there are few surprise reserve adjustments, this would be considered
relatively less risky. Conversely, if there are frequent reserve additions
and adjustments, there will be more fluctuations in profitability, and the
underlying business will probably be harder for actuaries to accurately
assess, and therefore would be considered more risky.
Banks should look to see if there are any ‘soft’ assets on the balance
sheet that could significantly affect net worth if deemed uncollectable.
Some examples of these would be disputed reinsurance recoverables, or
recoverables due from related parties.
Banks take collateral when issuing LOCs for captives since the captives
are usually thinly capitalised and there is no reliance on the owners for
support. Also, captives can be put into run-off, which can affect the bank’s
ability to get repaid. The captives benefit from this collateralised structure
and from much lower pricing than if they try to obtain unsecured LOCs.
Independent captive financing not only strengthens the owner’s case
for premium deductibility, but also assures that insurance risks are
adequately addressed. If there are documentation errors or charges that
are improperly registered, banks may have a tough time realising the full
value of their collateral and may have to rely on the captive for repayment.
As a result, a review of the captive’s financial statements can determine
which captives are better risks and hence warrant better pricing.
A profitable captive free of questionable assets, with a large surplus,
appropriate investments, consistent reserving, and whose financial profile
stacks up well against its captive peers, is what bankers like to see and
what warrants the best pricing.
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