“ THE TRUST OPTION MIGHT JUST BE THE ONE THAT ‘CRACKS THE CODE’ OF COLLATERAL PROBLEMS. RATHER THAN THE SPONSOR PUTTING ITS MONEY INTO A COLLATERAL ACCOUNT FOR AN LOC (AND PAYING THE LOC FEES), USERS OF TRUSTS SIMPLY PUT THE SAME MONEY INTO AN ACCOUNT AT AN INDEPENDENT THIRD-PARTY BANK TO BE HELD IN TRUST, IN CASE THERE IS A PROBLEM.”


cash). However, many of the benefi ciaries of these transactions are moving away from this option. There is some ambiguity as to who actually owns the money and what would happen in the event of a bankruptcy by one of the parties to the transaction. Whatever the view on this option, it seems to be that TV’s Judge Judy is right, when she says: “In legal terms, it is far easier to keep something than to try to get it back.”


Trusts


The trust option might just be the one that ‘cracks the code’ of collateral problems. Rather than the sponsor putting its money into a collateral account for an LOC (and paying the LOC fees), users of trusts simply put the same money into an account at an independent third- party bank to be held in trust, in case there is a problem. In other words, the sponsor funds an account and the trustee holds the money to the sponsor’s benefi t.


Yes, the trust agreement is a much longer document than a standard


LOC. But Wells Fargo has pre-negotiated the required language of the trust agreement itself with most of the ILS sponsors out there (meaning that 90 percent of the work required to establish a trust is already fi nished). Historically, negotiating the trust agreement used to take a lot of time and effort. Now, with Wells Fargo, the trust is fairly turnkey.


Costs


This is the easiest part of the comparison, but often the most important one. Suppose that you have collateral requirements, in total, of $50 million.


If this is the case, then a 75 bps LOC will cost you $375,000 per year. If that overall collateral requirement is $100 million, the cost will be $750,000 per year. And it goes on from there. I know personally of investors with collateral requirements of over $500 million. Imagine what that would cost!


Funds withheld? Usually no charge. But keep in mind that there is usually a very low (often zero) rate of return.


Trusts? This is a bit more of a story, but a single $50 million trust might cost $30,000 (at the high end). However, it is often considerably less,


even 80 percent less. But even if it costs $30,000, that is a 92 percent reduction from LOC fees. And in the end, it will be less work.


One great investment choice Usually, both the investors in, and the sponsors of, ILS transactions


and parties to reinsurance transactions (both captive and otherwise) are conservative in their investment policies. Many of the investors would simply put their money into a money market fund if they could. However, non-US taxpayers earning ‘dividend income’ (which money market funds pay) are often subject to a 35 percent withholding tax. So they look to purchase US Treasuries, often very short-term.


Wells Fargo has developed a deposit account that pays interest,


not dividends. And pursuant to trust law, these accounts are fully collateralised. Equally importantly (for the past three years), it has outperformed one-month and three-month US Treasuries—often substantially. And since the income is ‘interest’ not ‘dividend’, there is no withholding event associated with our deposit account. It has garnered great positive attention for both use of the trust and for Wells Fargo. When it is used, not only is the client’s investment income greatly enhanced, but the fees for the trust are greatly reduced. It has been a winning solution for most of our ILS, reinsurance and captive clients.


Bringing it all together When it comes to collateral issues, ILS transactions are very similar


to reinsurance transactions. While the ILS sponsors make a business decision to require collateral, they generally offer two options, sometimes three. Although the LOC is the most familiar form of collateral, the costs can be punitively expensive. Further, in the end, they are not as ‘quick and clean’ to establish as some would have you believe. The trust option offers a way to reduce costs by (often) over 90 percent, while reducing the amount of work required to establish and maintain them. And with Wells Fargo as trustee, the income associated with the collateral can be meaningfully enhanced without creating investment risk.


Robert Quinn is vice president of the collateral trust division at Wells Fargo Insurance Trust. He can be contacted at: robert.g.quinn@wellsfargo.com


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