3 Ways to Fund a Captive Insurance Entity
A captive insurance entity can be funded in one of three ways, but Regulation 114 Trusts have become the funding vehicle of choice for many captives.
Collateral requirements can be met through the use of current assets (cash), letters of credit (LOCs), or a Reinsurance Trust. The following is a review of the pros and cons of each option:
Cash – Whether as a cash deposit with the fronting insurer or under a formal “Funds Withheld Arrangement,” there are disadvantages to using cash for collateral. Not only does it tie up assets, but the captive must relinquish asset control and has no say as to how its funds will be invested. The captive receives no credit for investment income, and a Funds Withheld Arrangement will typically be given credit for only a small fixed rate of return tied to an index.
Letters of Credit (LOCs) – In the years leading up to the recent financial crisis, LOCs were the collateral option of choice. Many firms found LOCs readily available and the costs were not prohibitive. In today’s tight-liquidity climate, it can often be quite difficult to obtain a LOC, and a carrier may take issue with a LOC from a bank in which it may have too much exposure. Even if a LOC is available, costs and the need to allocate scarce credit resources to more urgent priorities often make it an unattractive option. If selected, the LOC must be clean, irrevocable, unconditional, and drawn on an NAIC/ Domicile-approved bank.
Establish a Regulation 114 Trust – In this form of collateral, a captive places assets in a Reg. 114 Trust (typically administered by a bank trustee) with the fronting insurer named as the beneficiary. The advantages of a Reg. 114 Trust include low cost, easy set-up, and minimal ongoing maintenance. Highly flexible and widely accepted in most domiciles, it provides a single trust vehicle where assets can be added, substituted or withdrawn. This is especially valuable to captives who need to “stack” their LOCs as obligations increase over time, eliminating the problem of tracking and negotiating multiple LOCs into a single liability with one carrier. In addition, a trust is a balance sheet restricted asset, while a letter of credit is a liability. Reg. 114 Trusts take their name from Regulation 114 of the Official Compilation of Codes, Rules and Regulations (11 NYCRR 4) of the New York State Insurance Department.
To avoid tying up current assets and as a response to the scarcity of reasonably priced letters of credit, Reg. 114 Trusts have become today’s collateral vehicle of choice for many captives. When establishing a Reg. 114 Trust, it is important to consult with an experienced service provider to maximize potential benefits.
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.