Reg 114 Trusts: How They Work, Who Can Benefit, and Why They re Not All Alike

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1 Captive COMMENTARY Reg 114 Trusts: How They Work, Who Can Benefit, and Why They re Not All Alike Doug Lavelle Senior Vice President, Wilmington Trust FSB Tom Mackay Senior Vice President, Wilmington Trust FSB As corporations and other entities that buy commercial insurance have increasingly discovered over the past decade and a half, captive insurance products can be a cost-effective solution for many types of insurance needs. The captive market has grown steadily and continues to grow, fueled in particular by the availability of captive choices, which have made captives a potential alternative for companies of all sizes. Today there are over 5,000 captives around the world, many of which serve multiple insureds. The top three captive domiciles Bermuda, Cayman Islands, and Vermont account for 45% of all captives, although there are at least 25 active domiciles, some of which may be more advantageous for certain insurance customers than the most popular domiciles. An abridged version of this article was published in the issue of Captive Review magazine. The Role of Collateral In the most common scenario for a captive, the insured entity establishes a captive reinsurer to participate in the risk being underwritten by a fronting carrier. The insured entity pays a premium to the fronting carrier, which then passes (reinsures) some or often the bulk of the premium to the captive in exchange for the captive s assumption of insurance risks. While U.S. insurers are free to reinsure risk with any reinsurance company, regulatory guidelines require that the reinsurance be obtained from an admitted carrier in order for the insurer to be able to take credit for the reinsurance purchased and avoid seeing a statutory reduction to its surplus balance. Under current rules, in order for an insurer to take credit for reinsurance ceded to a non-admitted carrier, the insurer must be provided an approved form of collateral from the reinsurer in an amount equal to at least the amount of reinsurance reserves the insurer is recording in its financial statements. Any difference between the amount of reinsurance reserves and the collateral provided in reinsurance transactions with a non-admitted carrier would result in a direct reduction in surplus equal to the difference. This statutory accounting adjustment is commonly known as the Schedule F penalty, referring to the reinsurance schedules in the NAIC Annual Statement. In the current era of credit difficulties and pressure on capital needs, no carrier can afford taking a Schedule F penalty. This is especially important in

2 captive transactions because captives are almost always considered non-admitted carriers, therefore captive reinsurance transactions will almost always result in captives needing to pledge collateral to the fronting carrier. While the Schedule F penalty is the main driver behind collateral needs in captive transactions, a close second reason is the fronting insurer s desire to protect itself against the credit risk under a fronting arrangement (i.e., the risk of the reinsurer not being able to make good on its reinsurance obligations). Since most captives tend to be small companies with relatively small surplus balances, fronting insurers perceive captive transactions as transactions with significant credit risk. The Three Collateral Options A captive that needs to post collateral has three main options: Cash: this option consists of an actual cash deposit with the fronting insurer either via an informal cash transfer or under a more formal Funds Withheld Arrangement Letter of Credit (LOC): if selected, the LOC would need to be clean, irrevocable, unconditional, and drawn on an NAIC/ Domicile approved bank Establish a Regulation 114 trust Let s examine the advantages and drawbacks of each of these options. Setting aside the collateral from current assets definitely solves the collateral problem, but in almost any financial climate it is a very poor option. Not only does it tie up assets that could be doing far more good elsewhere, but the captive that chooses to go this route will have very limited flexibility in how it is permitted to invest those assets. Since the captive will have relinquished control of the assets it will have no say at all as to the investment of the funds. With a pure cash collateral situation, the captive will get no credit for investment income at all, and with a Funds Withheld Arrangement, the captive will typically be given credit for a small fixed rate of return tied to some index. A letter of credit (LOC) was for many years the collateral option of choice. Prior to the recent financial crisis, many firms found LOCs readily available and the costs were not prohibitive. In today s tight-liquidity climate, however, it can often be very difficult to obtain an LOC. Even if an LOC is available, current costs are likely to make it an unattractive option. The need to allocate scarce credit resources to more urgent priorities only provides a further disincentive to use an LOC to satisfy captiverelated collateral needs. So-called Reg 114 trusts have become increasingly attractive in recent years. These trusts, which take their name from Regulation 114 of the Official Compilation of Codes, Rules and Regulations (11NYCRR4) of the New York State Insurance Department, have evolved to the point where they can offer a potent combination of low cost, easy set-up, minimal ongoing maintenance, and widespread acceptance and flexibility. How a Reg 114 Trust Works In the most common configuration for a Reg 114 trust, the captive places assets in a trust with the fronting insurer named as the beneficiary. The trust is established and administered by the trustee (typically a bank), and the trustee also holds the collateral assets. In the event that the captive is unable to meet its insurance liabilities, the trustee may direct that some or all of the collateral assets be transferred to the fronting insurer. The fronting insurer also has the right to direct the trustee to release funds to it for the payment of claims. While the captive in this arrangement may be onshore or offshore, the Reg 114 trust must be onshore. The collateral remains in the trust and can only be removed with the consent of the beneficiary. The value of the collateral in the trust is the ini-

3 tial collateral amount minus allowable debits (commissions and claims) plus investment income earned on the collateral. Setting up a Reg 114 Trust Like captives themselves, the first Reg 114 trusts were somewhat costly to set up, limiting their appeal to the very largest entities. At this point, however, just as the cost of setting up or accessing a captive program has fallen over the years, so has the cost and difficulty of setting up a Reg 114 trust. An experienced Reg 114 trustee will be able to work from existing model documents that have been approved by regulators and reflect the comments and business needs of a wide range of insured entities and their counsel. There are various ways to set up the investment of collateral assets. These assets can remain invested in a static pool of investments that is chosen at trust inception and left unchanged, or they can be actively managed. In this second case, the manager can be the insurer or the trustee, or another third party investment manager. Whether the captive chooses a static approach or an active one, all funds must be denominated in U.S. dollars and invested in eligible instruments. These instruments include: Cash CDs issued by U.S. banks U.S. federal and state obligations Short-term instruments rated at least A Obligations of U.S. institutions rated at least A Money market funds Financial Advantages of a Reg 114 Trust Anyone looking for a driving factor behind the surge in acceptance and creation of Reg 114 trusts need look no further than a cost comparison of an LOC and a Reg 114 trust. In the typical case shown below, the overall annual cost of a trust can be 80% less than the cost of an LOC. While the difference will not be as dramatic for insured entities with immaculate credit, there will still likely be a difference in favor of the trust. And for entities with weaker credit, the difference may be even greater: LOC costs of 150 basis points are not unheard of. In addition to benefits on the cost side, a Reg 114 trust can offer financial advantages on the earnings side. While it is true that the range of investment vehicles for Reg 114 collateral is limited, a capable trustee will still be able to identify approved investment vehicles that offer incrementally higher yields. Since most Reg 114 trust agreements allow any increase in the value of the invested assets beyond the amount that must be pledged as collateral to be returned to the insured, incremental yield differences here can have direct ongoing financial benefits to the captive and, by extension, to the insured entity. These benefits are over and above the cost differential shown in the table above. Where the Choice of Service Providers Does and Does Not Make a Difference The coming of age of Reg 114 trusts has been the product of numerous factors and has benefited from the experience of many service providers and insureds. In the marketplace today there are numerous providers that can help you or your clients establish a Reg 114 trust offering many of the basic benefits. These benefits include:

4 Acceptance in virtually all domiciles The freeing up of scarce credit resources for more productive uses The ability to earn a return on investment Minimal ongoing maintenance required (other than actively managed portfolios) One-time implementation; no need for annual renewal Significantly lower cost Ability to increase the amount of collateral without obtaining a new LOC Finally, and perhaps most significant, it can be beneficial to work with a trustee who is not only well-proven in the world of captives and in Reg 114 trusts but also has no conflict of interest in offering Reg 114 trusts over LOCs. Such a provider can help you reliably assess the benefits of a trust over an LOC by virtue of the fact that they do not stand to lose LOC revenues by recommending a Reg 114 trust. Regardless of which service provider you choose, in the current environment one fact appears very clear: Reg 114 trusts can benefit most entities that utilize an insurance captive, and these trusts are here to stay as a practical part of the captive insurance world. Ability to set up multiple trusts all of which are segregated and can be easily monitored While these benefits alone are compelling, there are additional benefits that currently are available only from a small number of service providers. These include: Availability of skilled portfolio management capable of earning incremental yields Access to in-house and third-party investment vehicles, including vehicles ideally structured for Reg 114 use Availability of separately managed accounts

5 CORPORATE CLIENT SERVICES Douglas J. Lavelle Senior Vice President Doug is responsible for leading the Global Capital Markets Sales and Marketing effort, which introduces national and international business organizations to Wilmington Trust s capabilities within the Corporate Client Services Department. Doug joined Wilmington Trust in 2009 with more than two decades of experience in Sales, Account Management, and Product Management in the Trust and Securities Industry, specializing in Debt Capital Markets, Project Financings, Latin American Financings, and Insurance and Escrows. Doug most recently served as a senior vice president and head of Business Development for Corporate Trust and Loan Agency for HSBC Bank USA, where he led business development for Project Finance, Insurance, Escrow, Structured, and Conventional Debt Capital Markets. Earlier in his career, Doug held various senior management positions in corporate trust departments for institutions such as JPMorgan Chase and The Bank of New York Mellon. Doug holds a bachelor s degree in Economics from St. John's University and has completed Harvard Business School s Executive Education Project Finance Series. Doug is also a noted speaker for Debt Capital Markets, Latin American Finance, and Insurance-related issues. CONTACT INFORMATION: 166 Mercer Street New York, NY Phone Fax dlavelle@wilmingtontrust.com EXPERTISE IN: Project Finance Regulation 114 Insurance Trust Global and cross-border trusts Administrative Agent and Collateral Agent services Trustee, Escrow and Agency services Global high yield trusts Default and Bankruptcy administration Debt restructurings Exchange and Distribution Agent services Post-bankruptcy administration, litigation and liquidation trusts Structured finance Loan Syndication Escrows