Caroline Cruickshank, BNY Mellon


Challenging times call for innovative measures


In the face of challenging economic conditions, greater regulatory scrutiny and rating agency oversight, captives are increasingly turning to collateral trusts to satisfy their credit and risk management needs, as Caroline Cruickshank reports.


a recession that is claiming its sovereign victims like dominos, civil unrest and protests spanning diverse regions—and for equally diverse reasons—and an increase in environmental catastrophes with greater global consequences. The changing regulatory landscape affecting many jurisdictions also plays a significant and challenging part in these times, whether it involves the introduction of new international financial reporting standards, sweeping reforms under Dodd-Frank, or new capital adequacy regimes dictated by Solvency II and Basel III, to name but a few.


W Change may indeed be challenging to deal with but it can also present


an opportunity to be innovative and to find new approaches to everyday demands that may help us to be more efficient. For reinsurance buyers and sellers, the changing financial and regulatory conditions have certainly underpinned a drive towards more innovative approaches to meeting collateral requirements.


Traditionally, the letter of credit (LoC) has been the most common type


of collateral sought, especially in years gone by when credit availability seemed plentiful and the creditworthiness of a LoC issuer seemed almost beyond reproach. However, in today’s climate, many institutions are re-evaluating their business strategies and re-balancing the cost of their credit exposures. This has been a direct result of the continuing erosion of balance sheet capital, and further pressures caused by rating downgrades and a lack of market confidence.


e have witnessed many challenges over the past year, political, economic and social. Globally, we continue to deal with the effects of a credit crisis that is still putting a squeeze on bank liquidity and lending practices,


Change is inevitable here too. We have seen a significant increase


in the cost of credit and a widespread lack of credit availability in the market. A shift in bank appetite from unsecured credit lines also means that LoC applicants are having to cash-collateralise their LoC arrangements, yet still pay a high price for the privilege. Further scrutiny also raises concerns over whether an LoC-issuing bank’s own security can in fact improve an LoC applicant’s creditworthiness to other counterparties. In the case of captives, fronting carriers often impose a security requirement to mitigate risks which may invariably increase the captive’s cost of doing business. In this sensitive financial environment, any additional cost may have an impact upon whether a captive’s contract would even be viable.


An innovative solution that achieves security and reduces costs is available via the reinsurance trust.


A reinsurance trust is not a credit instrument but an account that meets collateral requirements for re/insurance obligations. Methods vary according to the jurisdiction, but under this concept the captive’s obligations are secured by a deposit of eligible financial assets pledged to a designated insurance carrier as beneficiary. A trustee acts with fiduciary and contractual obligations over the account until a default or a claim triggers a call on the assets. A reinsurance trust is often significantly cheaper than a LoC and is easy to set up using standard documentation. Arrangements are typically evergreen, and the collateral amount can be adjusted as more or less business is undertaken. Liabilities can also be aggregated into a single trust per carrier to provide greater efficiencies and any income generated by the portfolio of assets in trust may even be directed back to the captive.


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