Tightening regulation and the increased costs of providing security to fronting companies in the captive market has lead to the search for alternative collateral options

The forecast for global captive market growth continues to be positive.

Captives remain the longest running and, to date, the most successful providers of alternative risk financing. But with this growth comes specific challenges. The impact of an increase in captives, together with the desire for greater liquidity and the tightening of the regulatory environment, have increased the use of certain types of collateral. In turn, these methods are attracting significant attention because of their accumulated cost and impact on lines of credit and the financial performance of the corporations and captives using fronting services.

Criticism is levelled at the fronting market over its fee structures and administration costs. The falling number of providers continually prompts captives and corporations to review their requirements, and the fact that fronting insurers require collateral, including letters of credit (L/Cs) with the associated guarantees of payment, has prompted some captive owners to question the real level of value the insurer offers. One risk manager commented: "All they are really providing is the paper and the claims service." Harsh words, and largely unfair. There is no doubt that the captive model is a relevant and effective method for businesses to retain risks. Why should an insurer fronting a captive not have its exposures covered and be protected should the captive fail to meet its obligations?

The move to find alternative collateral solutions has emerged as a direct result of the success of the captive structure. With the number of captive insurance companies standing at over 4,000 worldwide, writing more than $20bn in premium, the issue of security is uppermost.

Traditional methods of providing collateral have come under increasing scrutiny. Such methods include letters of credit, parental guarantees and reinsurance arrangements. The costs associated with obtaining such securities are increasingly identified by captives and corporates as significant issues, and the need for less costly and more flexible collateral is recognised by the market as an important step forward. Other alternatives have included credit hedging, but these have not been popular with insurers given the cost and the difficulty in making the arrangements effective. Such arrangements never represent a cheap option and the risk management community increasingly appreciates this fact, acknowledging that choice comes at a cost.

Perhaps the most recognised form of collateral has been the irrevocable L/C. The L/C has been widely used to provide a 'financial guarantee' in order to enable the fronting insurer to draw funds from the captive's bank in the event of a failure to pay obligations. It has certain benefits for both the captive and the fronting company; sometimes the captive prefers a letter of credit arrangement as it has fewer restrictions on its investments, resulting in higher returns. For the fronting insurer, a claim against the captive means it receives cash as opposed to securities which then would have to be sold.

L/Cs have been widely used in the US to satisfy specific regulatory requirements, and enable insurance companies to cede liabilities to foreign reinsurers.

However, consolidation in the banking industry and a more sensitive credit environment has reduced the number of L/C providers. This limited availability, together with increased costs as a result of risk-weighted capital allocation requirements, has put direct pressure on the provision of L/Cs. As a result, the US is well advanced in its search for more readily available alternatives.

Trust fund standards

One particular option is the Regulation 114 Trust (Reg 114). Established by the Insurance Department of the State of New York, Reg 114 sets out generally accepted standards for the use of trust funds as reinsurance.

It allows for trust agreements to be made between the ceding insurance company, the captive insurance company and a bank. The bank must either be a member of the Federal Reserve System, or a New York State-chartered bank or trust company. It must also not be a parent, subsidiary or affiliate of the insurer or captive.

Under the trust agreement, the captive delivers to the bank securities with a market value of not less than the full amount of its obligations.

Securities are limited to cash and equivalents, US Treasury Securities and fixed income securities rated 'A' or higher. Reg 114 trusts are not allowed to hold equities. The insurer can demand possession of the funds in the trust to pay or reimburse any losses and allocated loss expenses or unearned premiums due not paid by the captive. In that event, the bank must deliver physical custody of the securities to the insurer which would then arrange to have them sold.

The National Association of Insurance Commissioners (NAIC) has put forward proposals for regulation closely following the Reg 114 trust model across all states.

In the European market the issues, while not as advanced, are evolving quickly. The emerging regulatory regime and the impact of the international accord on bank capital, Basel II, have contributed to the increased cost of L/C provisions. Another area of particular concern to corporations relates directly to the issuing of letters of credit. The very nature of the insurance contract will create a stacking problem over time. The L/C as collateral will need to be held by the fronting insurer to secure the captive's position, while it also posts additional security for each underwriting year. Under long-tail business the accumulation of L/Cs will have a direct impact both on the corporation tying up lines of credit on a year-by-year basis and its credit and security rating. It is not difficult to see why increasing numbers of CFO are failing to see the benefits of a fronted captive. Indeed, it is not inconceivable to see how, in the not too distant future, this tying of lines of credit may well be a significant issue for captive development.

As a reaction, attention is being turned to alternative arrangements that have a lesser impact on a corporation's balance sheet. Although not currently used a great deal in Europe, Security Trustee Arrangements (STAs) are attracting a lot of interest. The framework of the STA is similar to Reg 114 in ring-fencing a portfolio of assets owned by the captive.

STAs mean that the captive no longer needs to liquidate part of its current portfolio of assets to provide security. The captive agrees with the fronting insurer to hold assets in its favour. Should it then be necessary, a default notice can be issued and the assets are released. One of the first companies to offer STAs in the European market is The Royal Bank of Scotland's international division. Typically, STA collateralised assets include cash, interests in money market funds, bonds and equities. They are designed to be flexible enough to incorporate changing business circumstances, growing or reducing the size of the assets as required.

The growth in the use of L/C alternatives, particularly in the US, has raised issues and questions about their future impact on business performance.

Some commentators have already focused their attention on alternative collateral, claiming that captive owners will face a new kind of credit squeeze. I do not concur with this 'doom and gloom' view. The STA, as we have seen, does not make a direct call on lines of credit and in comparison with the impact of an L/C it is providing captives with a viable solution to a call for credit. The future of such solutions is not, as these market commentators claim, going to see captive owners turning their backs on fronting services.

There is clearly a need to remain focused on the role and value of the alternatives being identified. The impact on investment returns resulting from capital being tied up in trust structures is one such area. However, at this current point in the insurance cycle, the low return on capital may well be a cost of doing business.

Captive debate

The debate on the value of financial and security ratings for captives is also worth addressing. There is the potential for a captive which is not acting as a direct writer to see a reduction in fronting costs or the level of collateral needed as a result of achieving a rating. For certain types of risk being written on a reinsurance basis, there is an argument that the fronting company will recognise the independent measurement of the captive's financial security. But this comes with a number of caveats, not least the rating agency used.

It is important to recognise that future alternatives may be industry or business line specific. The rapid growth of group or associated captives and risk retention groups is a reaction to finding solutions for the most stressed classes. But even these set-ups are coming under stronger legislative, regulatory and operating requirements. Accounting and taxation across territories will also drive future developments. As fronting insurers, attributes such as flexibility and innovation will enable captives to compete and offer the global and local corporation the opportunity to take greater control of its risk retention.

- Jonathan Groves is Development Manager for ACE Risk Management International, based in London. Tel: +44 (0) 20 7173 733. Email: jonathan.groves@ace-ina.com.