Posted by Richard Klumpp on Thu, May 09, 2013
Although a new captive becomes operational when capitalized, its proper documentation is a key factor in its ultimate success.
A hasty move to actual operations without carefully thought-out documentation can cause significant problems over time. From the beginning, owners should focus careful attention on the content and structure of required organizational documents such as:
- Bylaws or operating agreements
- Articles of incorporation
- Agreements with services providers (such as captive manager and Registered agents)
- Executed policies
- Investment policy
- Code of ethics
- Executed conflict of interest policy statements
Whenever possible, owners are encouraged to avoid using standard templates. A more prudent course is to prepare each document keeping in mind the captive’s optimum future form and goals.
Because of the importance of this process, owners should look for documentation assistance from service providers and business partners such as their attorney and captive manager. Professional guidance in the documentation phase can pay major dividends over time.
Other critical external documents and relationships include executing the necessary reinsurance agreements, as well as setting up banking and investment relationships.
Once in final draft form, all organizational documents should be carefully reviewed and completely executed by those ultimately responsible for the captive’s operation.
Inattention to documentation details can lead to major problems down the road. For this reason, extra care and time should be taken to scrutinize all organizational documents before captive operations begin.
Lifecycle of a Captive -- For an informative review of the three lifecycle phases or stages of a captive insurance entity, download “Lifecycle of a Captive.”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Apr 18, 2013
Before “opening for business”, the final decisions in a captive’s organizational startup phase are the amount and form of its capitalization.
During this process, owners must answer three key questions:
- What is the "best" place to domicile the captive?
- How much capital will be needed?
- What form of capital is best?
Depending upon the location chosen for the captive or alternative risk transfer vehicle, domicile differences can greatly impact the amount of capitalization needed, and the form it may take. Important questions include:
What is the “best” place to domicile the captive?
From a capitalization standpoint, a particular domicile might be the optimum location for a particular captive, yet a poor choice for another.
As more US states have entered the captive insurance marketplace, most have crafted their captive laws and regulations to set themselves apart from other domiciles. These rules can have an impact on the amount of capital required, as well as the amount of regulatory and administrative reporting needed.
For example, a captive domiciled in the State of Vermont is required to maintain unimpaired capital and surplus of $250,000. In addition, its regulators will monitor parameters such as the premium-to-capital, surplus, and solvency ratios.
How much capital will be needed?
As a general rule of capitalization, captives typically begin life with solvency ratios somewhere between 3:1 and 5:1.
For example, a pure captive with a solvency ratio of 5:1 and a written premium of $3,000,000 will require capital and surplus of $600,000. Included in the $600,000 would be the $250,000 required unimpaired minimum in the previously mentioned Vermont example.
What form of capital is best?
Most domiciles allow options such as cash, letter of credit, surplus note, or a combination of the three.
There is no single “best” form of capital for every captive. Each form of capital has its own advantages and disadvantages. It is important for the captive owner to carefully analyze the impact of each form of capital being considered, and choose the option that provides the most economical solution over-time.
Lifecycle of a Captive -- For an informative review of the three lifecycle phases or stages of a captive insurance entity, download “Lifecycle of a Captive.”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Fri, Mar 22, 2013
At t
he end of 2012, there were 6,000+ captive insurance companies worldwide. Although different in size, complexity, and operation, most fit into one of three lifecycle phases.
A captive begins life as a start-up, spends most of its existence in the maturation phase, and then is sold or liquidated in the winding-down or run-off phase. By understanding the challenges of each phase of a captive’s lifecycle, owners can better anticipate and plan for what may come next, such as:
Phase 1: Start-Up -- Although no two captives are the same, most remain in the start-up phase for two to five years.
Initially, a captive’s application must be filed and approved by its domicile regulator. Its start-up phase officially begins when the captive is capitalized in line with its domicile’s capital and surplus requirements. Once capitalized, but before operations begin, its owners must successfully complete all required organizational documents and develop the appropriate corporate governance.
Phase 2: Maturation -- In many cases, there may be no clear transition point between the start-up and the maturation phase of a captive’s life.
Most successful captives spend years in the maturation phase while captives designed merely for tax reasons rarely survive over time. Mature successful captives are the result of a continuous process of self-evaluation and fine-tuning. Characteristics of a successful captive also include having a clearly defined risk management purpose, strong loss-control programs, acceptable loss experience, and increasing capital and surplus.
Phase 3: Winding Down/Run-Off -- To avoid unnecessary expense, the termination of an obsolete or failed captive is best done quickly.
Captives that fail to successfully launch move directly to this third and final stage of a captive’s life. Others terminate because market conditions may have made them inefficient, or they have simply exceeded their service life. The most common option for winding down a captive is liquidation, although selling the captive is sometimes an alternative.
To maximize the potential benefits of a captive insurance company, it is important for owners to understand where it is in its captive lifecycle, and what may come next. This is done through an on-going review of all aspects of the captive’s business, and the willingness to make hard decisions that may even include selling or terminating a failing captive.
Lifecycle of a Captive -- For an informative review of the three lifecycle phases or stages of a captive insurance entity, download “Lifecycle of a Captive.”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Feb 28, 2013
Part 3 of a Series: In a recent Wilmington Trust webinar, Jeff Kehler of the South Carolina Department of Insurance provided insights on what domicile regulators look for in Regulation 114 Trusts for captive collateral.
What are the most important aspects of a regulator’s job?
I think that regardless of whether we as domicile regulators are reviewing a Letter of Credit or a Regulation 114 Trust, it really comes down to our mandate to review, monitor and verify to avoid problems down the road.
How has the economy affected domicile regulators?
A regulator must constantly be aware of shifting economic trends in the marketplace. The regulators job is to anticipate economically caused problems that may necessitate a meeting with the captive manager to discuss alternate ways of funding the capital surplus. Have economic conditions changed to the point where captive owners who were creditworthy in the past may not be so creditworthy going forward? If so, they may end up having to provide more assets to back a similar amount to an existing Letter of Credit.
Can you comment on Lines of Credit vs. Reg. 114 Trusts?
Both a Regulation 114 Trust and a Line of Credit are great alternatives to cash. Each has its place, and either can provide owners with the flexibility to satisfy capital surplus or collateral requirements.
How do you monitor a Letter of Credit over time?
With a Letter of Credits, it is important to continue to monitor the financial condition of the bank which provides it. As we all know too well, banks can fail and it is important to monitor a bank’s financial condition. It is also important to verify that the Letter of Credit has not been retired and that it is still in full force and effect.
What is the biggest misconception about Reg. 114 Trusts?
When regulators look at a Regulation 114 Trust, there is sometimes confusion between trust funds and trust accounts. Obviously, what is needed is a trust fund with an independent third party trustee for oversight, with fiduciary responsibility to both the funding institution and the beneficiary. In short, it is important to ensure that the trust fund is set up properly in a qualified US financial institution which is qualified to act with fiduciary powers.
Compare the setup time between an LOC vs. a Reg. 114 Trust.
A 114 Trust typically takes between two and four weeks to setup and finalize. The upfront time for the Reg. 114 Trust is going to be longer because it is a more complex document. You need to make sure that investments are acceptable, distributions are in line with transactions, and that everyone is on the same page.
A LOC could be set up in just two or three days. A Letter of Credit can be a lot quicker as long as long as there are no credit issues or other factors with the underlying applicant. Often, if the captive owner already has a Letter of Credit in place, it’s just a question of modifying the existing paper work, which can be done quickly.
What types of collateral are required for a LOC?
What is considered to be acceptable collateral depends solely on the issuer and the circumstances. Issuers will take almost any asset, so it then becomes a question of how much they are going to discount that asset. Cash can always be used as collateral, but if it is an asset other than cash, chances are it will be discounted based upon its liquidity, i.e., its ability to be turned into cash. Typically, a discount rate of 20-25% is used, but there could be an even deeper discount applied to real estate or other illiquid assets.
Compare a Reg. 114 Trust vs. Posting Cash for a Beneficiary
The main difference would be the needed security, and where the assets are held. Some institutions will be fine with you holding cash provided that there is an annual audit, while others would want to hold the security. The actual circumstances are usually determined by the requirements of the beneficiary. If the cash is held in a Reg. 114 Trust, you could expect some investment return.
Can a 3rd Party Access Funds in a LOC or Reg. 114 Trust in a Bankruptcy?
Asset protection is one benefit of operating a captive. For example, we had a number of captive owners whose corporation’s declared bankruptcy and they went through the process of Chapter 11 reorganization. They had Letters of Credit for capital surplus for their financially sound captive company, with no solvency or liquidity issues. The courts never came after those funds, and they stayed in place. The captive continued to operate, although in a far limited fashion. As the company emerged from bankruptcy, the captive was never impacted.
Free Download: How Reg. 114 Trusts Work – For an informative guide to the potential benefits of providing collateral with a Reg. 114 Reinsurance Trust, download “ Reg. 114 Trusts: How They Work, Who Can Benefit, and Why They’re Not All Alike”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Fri, Feb 01, 2013
Part 2 of a Series: In a recent Wilmington Trust webinar, Jeff Kehler of the South Carolina Department of Insurance provided insights on what domicile regulators look for in Regulation 114 Trusts for captive collateral.
When reviewing a Regulation 114 Trust, the job of the domicile regulator is to make sure that the trust complies with reinsurance statutes, which usually comprise three areas:
The first is that the documents that support the trust have to be approved by the domicile’s insurance commissioner.
Second, the trust has to contain a provision that it will stay in effect for as long as the assuming insurer, as the captive has outstanding obligations as the result of that reinsurance agreement.
Third, in order to qualify for credit for reinsurance that most domiciles have on their books, the funds in the trust have to be held in a qualified United States financial institution. To qualify, the institution must meet the following criteria:
1. Licensed to Operate in The US -- The institution must be organized or licensed at either the federal or state level.
2. Properly Regulated -- It must be regulated, supervised and examined by either the appropriate federal or state regulatory authorities who have the statutory power to regulate banks and trust companies.
3. Qualified Financially -- It must meet the standards of financial condition and standings either by a state’s insurance commissioner or the Securities Evaluation Office of The National Association of Insurance Commissioners.
4. Qualified to Act as a Trust Fiduciary -- In addition to meeting the previous criteria, it must also be qualified to act as the fiduciary of a trust. It has to be organized or licensed under either federal or state statutes and granted to operate with fiduciary powers by the authorities. It must also be regulated, supervised or examined by federal or state authorities with the power to oversee banks and trust companies.
Free Download: How Reg. 114 Trusts Work – For an informative guide to the potential benefits of providing collateral with a Reg. 114 Reinsurance Trust, download “ Reg. 114 Trusts: How They Work, Who Can Benefit, and Why They’re Not All Alike”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Tue, Jan 08, 2013
The outgoing Chairman of the Subcommittee on Insurance of the Committee on Financial Services in the House of Representatives has reaffirmed that the Nonadmitted and Reinsurance Reform Act (NRRA), which is part of the Dodd-Frank Act was never intended to apply to captive insurance.
In a letter to the new Chairman and Ranking Member of the Committee, former Chairman of the Subcommittee on Insurance, Representative Judy Biggert wrote, “As a supporter of NRRA and an advocate for its inclusion and passage as part of Dodd-Frank, I can tell you unequivocally that the NRRA was never intended to include the captive insurance industry.”
Biggert went on to state, “This provision (NRRA) was intended to create certainty in the tax treatment and regulation of the surplus lines and in the reinsurance industry. Despite this very specific purpose, a couple of states are misinterpreting the application of NRRA’s definition of ‘Non-Admitted’.”
A coalition of the captive insurance industry, the Coalition for Captive Insurance Clarity (CCIC) has been formed under the leadership of the Vermont Captive Insurance Association (VCIA) to push for clarity that may include legislative language that would reaffirm that the NRRA was never intended to apply to captive insurance. This letter from Representative Biggert is a clear indication of Congress’ intent not to include the captive insurance industry in NRRA.
NRRA, a subsection of the Dodd-Frank legislation, has caused some confusion over whether it is applicable to captive insurance due to some misinterpretation of the current language. Richard Smith, president of the Vermont Captive Insurance Association (VCIA), expressed his thanks for the support of Representative Biggert. “This endorsement from the outgoing subcommittee Chairman, who played a substantive and important role in crafting the NRRA, makes it crystal clear – captive insurance is not and never was intended to be included in Dodd-Frank.”
The CCIC was formed by industry members to coordinate efforts to amend the law and provide clear and definitive language regarding the captive insurance industry and the NRRA. “A few domiciliary states and opportunistic service providers are clearly exploiting the present situation which is not in the best interest of their clients or the industry as a whole,” added Dan Towle, Vermont’s Director of Financial Services.
Representative Biggert suggested that a technical amendment may be necessary for solving this confusion, “In order to address the problem created, a technical amendment might be needed to reinforce the Congressional intent of this legislation.” For a complete copy of Representative Biggert's letter to the new Chairman and Ranking Member of the Committee, click here.
Article reprinted through the courtesy of the Vermont Captive Insurance Association.
Free Download: Captive 101 – For a complete guide to the pros and cons of establishing a captive insurance company, download “What to Consider When Establishing and Operating Captives”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Fri, Dec 21, 2012
Part 1 of a Series: In a recent Wilmington Trust webinar, Jeff Kehler of the South Carolina Department of Insurance provided insights on what domicile regulators look for in Letters of Credit used for captive collateral.
Letters of Credit are accepted for capital surplus in virtually every domicile in place of cash or cash equivalents.
Typically, regulators look very favorably at Letters of Credit vs. cash. Unlike cash used for capital, which can sometimes grow “legs” and walk away, a Letter of Credit is always there.
An important part of a regulator’s duties is to monitor banks providing Letters of Credit to captives in our domicile. Obviously, if a bank is facing insolvency, we’d want to have that the Letter of Credit moved to a different bank. Regulators want to avoid bankruptcy situations where a federal or state agency oversees the bank in place of the domicile state’s insurance department.
Another plus is that, from a security standpoint, no banker is likely to have their Letter of Credit go away without following the process of notifying the regulator.
Regulators will routinely review a LOC to make sure that it complies with the following requirements:
The issuing bank must be properly chartered -- In most US domiciles, what regulators like to see is that the bank issuing the LOC is federally chartered or is within the domicile. Most US domiciles have the discretionary power to approve a LOC even though the issuing bank is not federally chartered with an instate branch, nor chartered in their state.
The LOC must be irrevocable -- Once issued, the original Letter of Credit, or its replacement, must remain in place over time. If the LOC is revocable, it may not be approved by domicile regulators.
The LOC must have evergreen provisions -- State regulators need to know that the LOC will automatically renew each year and that a required notice is provided 30, 60 or 90 days prior to its expiration. This gives domicile regulators sufficient time to contact the captive manager or owner. Regulators will want to know if it will be renewed, replaced with a Reg. 114 Trust, or cash, or how the required capital surplus will be funded for the captive.
Recourse against the captive is not permitted -- In the event that the irrevocable Letter of Credit is drawn down or exhausted, the captive must have no obligation to reimburse the bank. Further, the bank must have no rights to any funds it holds for the captive.
Capital of the captive may not be encumbered -- The LOC must clearly state that the issuing bank has recourse only against the applicant, not the captive. If a Letter of Credit is encumbered by recourse to the captive’s assets, it typically will not be qualified for capital surplus.
Only the applicant is liable to bank recourse -- State statutes typically require that the assets of the captive, mainly the capital surplus that that Letter of Credit is providing, are free and unencumbered. This means that should problems arise the bank only has recourse against the applicant as the entity providing the assets backing the LOC.
Free Download: How Reg. 114 Trusts Work – For an informative guide to the potential benefits of providing collateral with a Reg. 114 Reinsurance Trust, download “ Reg. 114 Trusts: How They Work, Who Can Benefit, and Why They’re Not All Alike”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Nov 29, 2012
The following is a real-world case study of two solutions to providing collateral for a captive -- one using a Letter of Credit, the other using a Regulation 114 Trust.
The Case -- A captive insurance company is looking to assume a liability policy on a reinsurance basis through a fronting arrangement. The reinsurance policy contains an aggregate policy limit of $5 million; policy premiums total $2 million and are withheld by the fronting carrier to cover claim payments. An additional $3 million of “GAP” collateral is required by the fronting carrier each year to secure the total policy liability.
In this example, there is more than one form of cash being used. For the fronting $5 million policy limit, $2 million is being met with cash, leaving a $3 million GAP requiring collateral which can be secured either by a Letter of Credit or a Reg. 114 Trust. Here is how the two compare:
Letter of Credit Solution
Typically, there is no set-up or annual fee for a Letter of Credit. However, GAP funding of a $3 million LOC at today’s industry average cost of 2% equals a $60,000 annual charge for every year the LOC is in-place.
In addition, the applicant must post sufficient collateral to qualify for the $3 million LOC. The assets posted by the applicant may be discounted by the financial institution granting the LOC. For example, stocks or other equities could be discounted as much as 20-25%, which of course is a cost-factor in securing the LOC.
Regulation 114 Solution
The set-up fee and estimated first-year annual fee for a Reg. 114 Trust are estimated at $5,000 each, or $10,000 in Year 1. Only the $5,000 annual fee will apply in subsequent years, a remarkable savings over the cost of a Letter of Credit.
Assets held within the Reg. 114 Trust may be invested according to restrictions governed in the trust agreement, which can vary. These are usually conservative, highly liquid securities such as money market cash instruments, fixed income securities, etc. In addition, many Reg. 114 Trust agreements permit increases in the value of invested assets beyond the amount pledged as collateral to be returned to the insurer, a potential source of future revenues.
Cost Comparison
For illustration purposes, only a four year period is shown below. In practice, the annual costs of both of these solutions will be incurred over the total period that collateral is required. Here is an overview of the cost differences:
Although a major cost advantage is realized by the Reg. 114 Trust vs. the Letter of Credit, the decision to choose one or the other depends upon many factors. These include what the beneficiary will accept, how long the insurance transaction has been set-up, and many other factors specific to each individual captive owner.
Free Download: How Reg. 114 Trusts Work – For an informative guide to the potential benefits of providing collateral with a Reg. 114 Reinsurance Trust, download “ Reg. 114 Trusts: How They Work, Who Can Benefit, and Why They’re Not All Alike”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Oct 25, 2012
When major funding is needed for captive collateral, a Regulation 114 Trust could provide significant long-term savings vs. a Letter of Credit.
However, cost is not always the issue, and sometimes not the deciding factor. Each captive owner should weigh the pros and cons of each option based on their unique situation. Here are only a few of the nonfinancial factors that could impact how a captive is collateralized:
Individual Circumstances -- A firm’s ability to obtain a Letter of Credit depends upon many factors. These include the applicant’s financial position and creditworthiness, the availability of reasonably priced LOCs at the time funds are needed, the policies of the captive’s parent company, and debt covenants. Inability to obtain a LOC could leave them with only cash or a Reg. 114 Trust as collateral options.
Best Use of Assets -- A decision must be made that using company assets to fund a Reg. 114 Trust is the best use of the assets being considered for collateral. Usually, more conservative assets are found within Reg. 114 Trusts, assets which tend to hold their value over time. These include highly liquid securities such as money market cash instruments, fixed income securities, etc.
Internal Rate of Return Requirements -- Important considerations include cost-to-capital decisions made at the parent company level, as well as the decision to use the trust and the underlying assets to collateralize the trust, versus having the trust and its investments available to generate a rate of return.
Time Constraints -- A Letter of Credit can be set up quickly, while a Reg. 114 Trust is more complex and requires lengthier documentation. With a Reg. 114 Trust, all parties must agree on investment restrictions, whose funds are going to be distributed, and how the process will work. When time is short, a Letter of Credit may be the easiest choice.
In short, the decision to use a Letter of Credit vs. a Reg. 114 Trust for captive collateral is rarely based solely on cost. For this reason, there may be no single “right” decision when comparing a Letter of Credit to a Regulation 114 Trust -- only what is best at that moment in time for the captive’s owner.
Free Download: How Reg. 114 Trusts Work – For an informative guide to the potential benefits of providing collateral with a Reg. 114 Reinsurance Trust, download “ Reg. 114 Trusts: How They Work, Who Can Benefit, and Why They’re Not All Alike”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.
Posted by Richard Klumpp on Thu, Oct 04, 2012
When funding a captive insurance entity, the cost of collateral is a vital consideration, but not the only one.
In general, a Regulation 114 Trust can be far less costly over time than a Letter of Credit. However, each captive owner must weigh the pros and cons of both in light of their unique situation. On a cost-only basis, here is how the two options compare for a $10 million collateral requirement:
Setup Fee – There is no setup fee required for a Letter of Credit, and the paperwork defining the amount borrowed, its cost, and the renewal date can be relatively simple. The typical setup fee for a Reg. 114 Trust would be approximately $5,000.
Annual Fee – The annual fee for a Letter of Credit is usually priced as a percentage of its value, which today averages 2%. Therefore, the annual cost for $10 million in collateral would be $200,000. In comparison, the annual fee for a Reg. 114 Trust would average $10,000 in Year 1 and $5,000 for each year thereafter.
Cost in Year 1 – At an average cost of 2% per year, a Letter of Credit would cost $200,000 for $10 million in collateral. The Reg. 114 Trust would average $10,000, a major savings.
Cost Thereafter – The ongoing cost for a $10 million Letter of Credit would average 2% annually, or $200,000 per year. The Reg. 114 Trust would average just $5,000 each year, again a dramatic savings.
Accounting Treatment – A Letter of Credit is a contingent liability and until it is used it has no accounting implications. It will not be recorded in a firm’s financial statements until it is activated and is typically disclosed only in the financial statement notes. A Reg. 114 Trust is a restricted asset, and is only available for use for certain reasons.
Free Download: How Reg. 114 Trusts Work – For an informative guide to the potential benefits of providing collateral with a Reg. 114 Reinsurance Trust, download “ Reg. 114 Trusts: How They Work, Who Can Benefit, and Why They’re Not All Alike”
Wilmington Trust neither claims to nor provides legal or tax accounting services. Clients should consult professional tax and legal advisors regarding favorable tax treatment of any particular strategy.