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The crazy business of collateralising letters of credit and the insurance trust solution
Robert G. Quinn looks at the pros and cons of collateralising letters of credit.
April 2008
The stage has been set; the foundation has been laid; the savings are there; interest is growing. The insurance trust is gaining momentum. While my clients are saving enormous amounts of money using the insurance trust in lieu of LOCs, the trust concept continues to be attacked by those who would otherwise have captives continue to post letters of credit. My most recent educational seminar at the Cayman Captive Forum 2007 is evidence of the fact that the trust is seriously encroaching on turf that has traditionally been that of the LOC. So let’s take a moment and go over what we know about collateral, and how best to fulfill captive collateral requirements.
The whole notion of posting 100 percent collateral (or more) to a bank so that it will issue an LOC seems flawed. The reason I say this is because (while the bank is fully secured) the cost of the LOC is somewhere between 15 and 50 basis points. I contend that the client can put the same collateral into a trust and pay less—far less. Granted, if the collateral requirement is $400,000, the LOC might be less expensive. If the LOC costs 25 bps, then that LOC would cost $1,000. But what if the collateral requirement is $2.5 million? Of course, the LOC would cost $6,250. In this situation, the letter of credit would be 250 percent more expensive than a trust. A $5.0 million requirement? The LOC would be 500 percent more expensive. So there is no question, especially as the size getslarger (say, over $750,000), that the trust would save the client fees—lots of fees!
It has been argued (often unsuccessfully) that when a client uses an LOC, the LOC-issuing bank is far more flexible on the investments than a trust would allow for (trusts are NAIC-regulated and therefore have minimum investment standards, while LOC collateral accounts are governed by the LOC-issuing bank). The argument continues that since the investment guidelines are more liberal, then the LOC collateral account will earn more investment income. And this extra income will more than compensate for any fees paid for the LOC. Well, that certainly sounds good. But let’s take a moment and look not just at what is possible, but also what is likely.
The collateral posted for a captive insurance programme is in place to insure payment of claims in the event that the captive itself cannot pay said claims. To that end, it is incumbent upon the captive to be sure that the collateral is always there, is always worth the stated amount, and that market volatility will not impede the captives’ ability to pay claims. So yes, the LOC-issuing banks might sometimes be more flexible in their investments. So (in theory), it is possible to make more investment return.
The question is this: as a captive owner, would you want to pick up a few dollars in investment return if it meant risking the collateral that you have posted? Most would say no. My experience is that most clients posting collateral to a bank for an LOC are very likely using investments that would qualify for a trust. And these are the very clients that should abandon the LOC all together. People can say all they want that “the LOC collateral account would possibly earn more money than a trust collateral account”, but most of the empirical evidence is in, and the facts support the use of the trust.
Trust detractors will say that not only are the savings not likely with a trust, but the trouble in setting up a trust is really not worth the effort. Clearly, we can see that the savings are real, meaningful and considerable. Now let’s look at setting one up.
The similarities between establishing a trust and an LOC are clear. Both require a financial analysis of the captive before one is established. Both require collateral. Both collateral accounts have limitations as to what can be invested in.
One of the stark differences between the two is the actual legal trust agreement used as compared to an LOC document. The trust agreement is considerably longer. This would lead one to believe that the trust, therefore,
must be more difficult to set up. LOC proponents would certainly like everyone to believe that. And with some banks, this might be true. However, my team has gone to most of the primary fronting insurance carriers and pre-established the required language of the required trust agreement. This is to say that 98 percent of the work required to establish a trust has been completed. So, there is no reason why setting up a trust should take long at all. It certainly isn’t as much work as some would have you think.
The LOC that is posted to an insurance carrier for US risk is required to be issued by a US bank or a US branch of a foreign bank. That said, some captives in Cayman (as well as other off-shore domiciles) have relationships with non-US banks (banks that have no US presence). So this is what they do: they post cash to secure a letter of credit from a local bank. That letter of credit is posted to an NAIC-approved US bank as collateral for the US bank. The US bank issues the final (or confirming) letter of credit to the insurance carrier. Sound redundant? Sound Expensive? It is on both fronts. In fact, the confirming letter of credit is often as (or more) expensive than the originating letter of credit. So the client posts cash so that it can pay twice for its collateral (if it is an LOC). The trust made more sense before this confirming issue was considered. Now, it makes twice the sense (and twice the dollars in the client’s pocket, too!).
This is a lingering issue that ‘trust detractors’ continue to harp about. I have said in the past that using a trust will free up a corporation’s credit lines. Well, that is indeed true. However, in the captive environment, this is not always the case. Captives that post collateral to establish LOCs don’t usually take a hit to their ability to borrow (neither do corporations). But where the LOC is not collateralised, then the point is worth making that using the trust will free up credit lines. This point is most relevant to clients using trusts for their corporate deductible programmes.
Captives that use trusts generally pay less in fees—often 60 to 90 percent less. And while it is possible toincreaseinvestment return by taking principal risk, most captives (and fronting carriers) want their collateral dollars safe, liquid and predictable in value. Most are not investing in things such as hedge funds and dotcom stocks. That would be putting their collateral at risk. Captives are likely to be keeping their money in short-term and liquid investments (especially in this crazy market). So think to yourself: “Am I collateralising my letters of credit? If so, shouldn’t I at least look into a trust?”. The savings could be amazing, and the work minimal.
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“Captives that post collateral to establish LOCs don’t usually take a hit to their ability to borrow.” |
