CITI
“In the US, up to 80 percent of collateralisation uses LoCs and around 20 percent insurance trusts, but does this always represent the best choice of structure?”
some banks to encourage the use of trusts, which do not carry a capital charge; this trend was accelerated by the credit crisis when LoC costs rose dramatically and some banks withdrew from the market.
Closer examination of costs From the perspective of captive insurance companies, trusts have a clear attraction: they often appear cheaper than LoCs. However, costs are not as simple as they seem at first glance.
Marsh’s report shows that 55 percent of trusts have an associated explicit cost of between zero and 50 basis points of the facility value, compared to 68 percent for LoCs. Trusts are often provided on a flat-fee basis: the larger the value of the trust, the more cost-efficient the deal becomes. With LoCs, the basis point fee is constant, and higher-value LoCs carry higher charges. For this reason, to allow a simple comparison, Citi routinely offers trusts for an all-in equivalent cost of two or three basis points.
The assets that go into Regulation 114 trusts—the de facto standard in the US market—are restricted: cash and equivalents, US Treasury securities, and US fixed income securities rated single-A or higher; in some states only Treasuries are permitted.
It is pertinent to add at this point that the collateral composition of Regulation 114 trusts is regulatory-driven and consequently restrictive; that of LoCs, on the other hand, is driven by the credit policy of each bank. For example, Citi in particular offers tremendous collateral flexibility, including accepting money market funds and other instruments.
On the other hand, outside the US, insurance trusts do not have restrictive regulations regarding assets, although many often follow the Regulation 114 model and remain conservative. Nevertheless (and similar to a LoC), provided the beneficiary agrees, almost any assets can be placed into a trust, the lower cost of which could potentially offer a significant yield enhancement. Moreover, an investment fund, managed by a reputable fund manager, can be tailored for the trust to meet specific risk-return criteria.
Ease of establishment and flexibility Another key issue is how easy it is to work with each product.
84 CICA | Forty years of captive leadership
LoC facilities are straightforward to establish, and can be set up in advance, with LoCs then issued when needed. Some banks, such as Citi, offer electronic facilities that make LoC issuance as simple as making a wire transfer.
In contrast, a Regulation 114 trust requires new documentation for every trust with new beneficiaries, and although standardised documents are used, this can take a little longer than LoCs. However, in Europe the documentary requirements for setting up an insurance trust are relatively straightforward and can be easily replicated.
Once established, there are differences between the flexibility of LoCs and trusts. Both LoCs and trusts are relatively flexible solutions because it is possible to reduce collateral requirements as loss payments are made.
Making an informed choice Captive insurers need to consider the requirements of their fronting companies when deciding between a LoC or insurance trust. Some fronting companies may prefer bank obligations because they are familiar with them and do not want to have to monitor trust assets.
Equally, a fronting company may favour the simplicity of LoCs compared to trusts: should they need to make a claim they can simply draw on the LoC.
In contrast, the claims process relating to a trust can be more involved, requiring multiple signatories before the release of securities. Furthermore, LoCs are seen by some as safer: not only does a bank act as guarantor but the collateral buffer is more generous than for trusts. Conversely, in the event of bank liquidation, a trust would survive the insolvency process, whereas a LoC would not.
Captives also need to take into account their own credit strength when selecting a product. Smaller companies may have limited access to credit and therefore may not be able to obtain cost-effective LoCs. Other captives may be eager to free up existing credit for other business requirements by moving from LoCs to trusts.
The final word Ultimately, captives need to ascertain what is driving their choice
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