THE COLLATERAL CONUNDRUM ALL CAPTIVES MUST CONSIDER

For first-time captive owners, the process of forming a captive can be overwhelming. From deciding on the type and structure of the captive, choosing a domicile, selecting a captive manager and other advisors, owners have a lot to think about to ensure the successful setup and longevity of their captives.

Depending on the type of business and the jurisdictions in which the captive will operate, the captive may require a fronting company to provide necessary insurance regulatory licenses for liabilities of the captive owner. The use of a fronting company is much simpler and quicker than the captive obtaining the licenses itself.

A limited number of traditional insurance companies offer fronting arrangements, so a captive has limited ability to negotiate terms and conditions. With a fronting arrangement, the fronting company will issue the captive owner an insurance policy or contractual liability policy. The fronting company will issue a reinsurance policy to the captive insurance company.

This reinsurance policy results in the captive retaining an appropriate amount of the underlying risk. The risk appetite and the ability to fund the expected losses will determine the amount of risk the captive will retain. A fronting arrangement offers many benefits to a captive, but these benefits come at a cost. The fronting fee, usually expressed as a percentage of the premium written, depends on the scope of services provided.

In addition, a fronting company is exposed to the credit risk of the captive not meeting its obligations under the reinsurance policy. It will require the captive to secure its obligations via some form of collateral. This may be done via a trust agreement or third-party letter of credit.

Collateral

What amount of collateral do captives need to provide? The fronting company’s actuaries will evaluate the financial stability of the captive, its owner, and the expected losses under the reinsurance arrangement. The amount of collateral will usually be significantly above the expected losses, especially if the captive financials indicate that the captive is thinly capitalized, such that the fronting company demands the collateral and security above reserves.

This collateral is an initial cost to the captive that needs to be funded, which will be financed by the reinsurance premium and additional funds as needed. The collateral amount will typically be reviewed annually, but the amount is determined at the sole discretion of the fronting company. As a captive grows, the amount of collateral will increase such that a significant portion of a captive’s assets and, more importantly, the surplus will be tied up in collateral.

“Trapped” collateral is a common issue for many captives. As a result, more captive-focused fronting companies are being formed to address this issue. These newer companies seek to provide a less onerous collateral solution as they have a better understanding of, and closer relationship with, a captive.

Eyes on the balance sheet

Once the agreement is established, a captive still has options to manage the impact of collateral on its balance sheet. It can use its own actuaries to review the fronting company’s calculation of expected losses. Depending on the line of business, a large part of the expected losses will be incurred but not reported (IBNR) losses so there is judgment involved in this calculation.

Other tools such as a loss portfolio transfer reinsurance (with a cut-through retrocession trust) or, in particular, novating the reinsurance policy, can reduce the financial burden of collateral on the captive. Both approaches require the agreement of the fronting company.

With both these mechanisms, the captive can transfer a portfolio of reserves for known and unknown losses to a specialist reinsurer for financial consideration. This portfolio may be certain policy years, a line of business, or the entire portfolio if a captive is seeking an exit solution.

Since the financial liability for the portfolio is transferred to the specialist reinsurer, the captive’s balance sheet and financial statement are enhanced by the reduction in reserves, and a potential surplus increase depending on the cost of the transaction.

The advantages of novation

For example, when novating individual policy years, the specialist reinsurer assumes both the claim liabilities and the collateral responsibility with the fronting company. This arrangement releases a captive’s trapped capital, enhances the liquidity of the assets, and reduces the required surplus by reducing claim liabilities.

Specialist reinsurers often have a much stronger balance sheet than a captive and are well-versed in managing collateral and dealing with fronting companies.

Consider the following hypothetical captive with a significant amount of collateral tied to the fronting company if the captive novates a number of older policy years. The novation reduces the claim liabilities by 50 percent and the required collateral by the same amount (Table 1). It will also reduce the amount of surplus the regulator would require to support the claim liabilities.

The specialist reinsurer will charge a premium above the claim liabilities so there is an overall reduction to surplus. However, the liquidity (+70 percent) and the free surplus (+17 percent) are enhanced. This may enable the captive to take a dividend without impacting the financial stability of the captive.

The bottom line

Collateral management is a significant issue for a captive that uses a fronting company. The use of a fronting company is essential to enable the captive to fulfill its main purpose of providing insurance. The financial cost of the collateral can be significant especially in the first few years of the captive. This cost is magnified if the captive significantly reduces or stops writing premium.

As we have outlined above, there are options available to the captive to mitigate collateral costs. There is a cost to some of these options but the captive needs to weigh that cost against the enhanced liquidity and the free surplus. Every situation is different but given the choice of waiting for the claim inventory to decrease over time versus an immediate solution today that cost can be worth it.

Table 1: Effect of novating older policy years

Matt Kunish is chief business development officer at RiverStone. He can be contacted at: matt_kunish@trg.com