Regulation versus business decision
Collateral for reinsurance Most ILS transactions are derivations of reinsurance transactions.
That is to say, they are substantially similar but not identical. Since this article is not meant to describe ILS transactions, I will just say that both reinsurance and ILS transactions generally have collateral requirements. It is these collateral requirements that I would like to address.
With reinsurance transactions (where there is some component of
US-based risk), there is the whole concept of ‘Schedule F Credit for Reinsurance’. This is to say that the cedant does not have to take a charge against its surplus for ceded insurance if it is fully and properly collateralised (per the relevant regulations regarding collateral). Of course, Schedule F is an accounting standard for US cedants.
Where there is no US risk and the cedant is not subject to the US regulators, there may still be a collateral requirement. However, such a requirement is driven more by credit risk issues than regulatory or accounting requirements.
In short, with reinsurance, there may or may not be a collateral requirement. It depends on, among other things, where the risk resides and the regulatory jurisdiction in which the cedant resides.
Collateral for insurance-linked securitisations
ILS transactions are not reinsurance (of course). They are a ‘transformer’ arrangement, meaning that the transaction is not subject to the same rules as a reinsurance transaction. Therefore, Schedule F Credit for Reinsurance is not a consideration. There is no accounting benefi t created for the sponsor (the ‘cedant’ in reinsurance terms) by asking for collateral. And there is no ‘accounting penalty’ if the question is not asked. However, sponsors generally recognise the credit risk that they assume in ILS transactions. Therefore, they will often (usually, if not always) ask for collateral.
In discussing this concept with some of my clients that are sponsors
of active ILS transformer arrangements, it was explained to me this way: “Our insistence that the investors in these arrangements post collateral is more about protecting ourselves, the sponsor, from a worst-case scenario where we might, in the end, be compelled to pay out.”
Stated another way, collateral posted to secure ILS transactions is a business decision, not a regulatory requirement.
The similarity in question
If I were to draw a schematic of an ILS arrangement, with all of its arrows, lines and directions, it would look like an air traffi c control map. ILS arrangements are certainly a bit more complex than traditional reinsurance transactions. However, if actual names were associated with 25 different reinsurance schematics and 25 different ILS schematics, the reader would notice that many of the names would actually be the same. This is to say that while the investors involved in ILS transactions might be names unknown to many, the ‘sponsors’ of these transactions are often the same benefi ciaries as on reinsurance transactions. The fact that the names are often the same has a direct impact on the way ILS transactions are collateralised.
In the reinsurance world, the benefi ciaries of collateral are often compelled to follow the relevant regulatory and accounting requirements for collateralised programmes. Therefore, since ILS transactions (often) have the same benefi ciaries, said benefi ciaries apply the same (or substantially similar) requirements.
The collateral options
Sponsors of ILS transactions simply want to be sure that they are not exposed to credit risk from their counterparty. In short, they just want to be sure that they protect themselves from potentially massive problems. Requiring collateral in conjunction with an ILS transaction is one way to achieve the security they are seeking. There are generally three acceptable forms of collateral: letters of credit (LOC), funds withheld and trusts. Let’s briefl y (and fairly) look at each.
Letters of credit
While LOCs do offer a quick way to resolve the collateral issue, the devil here (as they say) is in the detail. In evaluating the out-of-pocket costs of the standard LOC, it is fair
to say that credit charges have increased tremendously. Even when the LOC in question is fully cash-collateralised, the applicant for the LOC can expect to pay 50 basis points (bps), 75 bps, or more. An uncollateralised LOC could cost three times that.
Additionally, one must fairly agree that in order to obtain an LOC from
a bank, the applicant for the LOC must go through the bank’s credit review process. This credit review process can be long and involved; it isn’t easy.
So while LOCs might seem like a quick way to go, there is a lot of work involved in setting them up. And with costs increasing the way they are, evaluating the alternatives would certainly be worth the effort.
Funds withheld The process known as ‘funds withheld’ occurs when you give your
cash (in the amount that the LOC would otherwise be) to the benefi ciary. Often there are no ‘out of pocket’ costs associated with funds withheld (or stated another way, there is no fee from the sponsor to hold your
22 emea captive 2011
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