The tough financial market is forcing reinsurers to seek alternative routes to capital. Robert Quinn argues that trusts are the answer.
Though they are two sides of the same coin, the banking industry has the reinsurance market in a vice-like grip. The near-collapse of the banking system has left the money men wary of returning to the free-wheeling days of easy credit for all. But they now seem to have gone completely the other way, demanding 100 percent collateral from reinsurers to issue a letter of credit (LOC). Even when they do issue a fully collateralised LOC, the rates attached to it seem to be unreasonably high.
However, some reinsurers are fighting back by ‘carving out’ LOCs from their previously established credit facilities. These can be less expensive than the LOCs issued on a ‘stand-alone’ basis. But let’s be clear: the savings are nothing to write home about. So, with regard to reinsurance-related LOCs, the banks seem to be ‘having their way’.
But what is behind this upward spiral in credit costs? Does anyone really know? If you were to ask 10 finance experts, the chances are high that you would get 10 different answers. But those answers will all have some common themes. This article proposes to describe what is happening in the world of insurance collateral-related letters of credit and to briefly discuss an option that might be open to reinsurers.
Think loss reserve
When it comes to lending, banks are subject to the same rules that govern reinsurance companies (with regard to how much they can lend). That is, they can lend only as a function of how much they actually have.
Clearly, banks have taken some huge hits to their bottom lines. It’s important to remember that for each write-down a bank absorbs (due to bad loans, bad investments or otherwise), the result is a reduction in available lending capital. This would be tantamount to an insurance company suffering a number of huge losses, adjusting its books and then realising it had too much coverage in the market based on its loss reserves.
What this invariably means is that if a bank has less to lend, it will (in effect) lend what it has to the highest bidder. That would be you, the one in need of the LOC. If it were only one or two banks that suffered the kinds of losses we’re describing, then the buyers of the LOCs would continue to put downward pressure on pricing. But the massive losses suffered by banks were systemic and wide-spread. Almost no bank walked away from this crisis unscathed.
Net-net, the banking system has less to lend, so what banks do lend will be more expensive. It’s a case of Economics 101: supply and demand.
What banks are willing to lend is also a function of their potential losses. In a financially strained time such as this, the banks have to work into their lending formulas the very real probability that an increasing number of their creditors will not be able to pay them back. For this reason, they have to look more carefully at who it is they will lend to. It would likely be a safe assumption that most of you reading this article work within the insurance sector and so you know all about ‘being compensated for risk’. More risk mandates higher rewards or, in this situation, more fees. Hence, higher LOC fees. Clearly, banks would have been charging 75-100 basis points for a fully cash-collateralised LOC all along if they could have. But the market would not bear such a high price. Well, the tables have now turned. The number of companies needing LOCs has likely increased, but not nearly as many banks have the same credit to extend. Again, a case of supply and demand.
Is there relief in sight?
If you must have an LOC then the answer to this question is ‘no’. At present, there isn’t much that can be done. Even when things in the banking industry settle down, it will be fair to say that banks will not be rushing to lower their credit fees. But, as they say, there are always alternatives.
Fight another day
I work with a great many reinsurance companies (in Bermuda and London, to name a few places) that have given up fighting their banks on LOC charges. Unfortunately, some of them have just paid the fee. But others recall having heard me speak on the subject of reinsurance trusts used as collateral for reinsurance programmes in lieu of LOCs. I wish I were a fly on the wall during my clients’ initial internal conversations on this subject…
“What was that guy from Wells Fargo talking about that time?”
“Remember that guy who was in here a couple years ago talking about collateral alternatives? Who was that guy?”
“Did you save the business card of that bloke who was here talking about that thing? You know…that thing. That trust thing! Come on, you remember!”
Fortunately, many of them do, in fact, manage to track me down. And we’re both—Wells Fargo and the client—pleased they do. Here is why.
Say no to LO Cs
Hi Robert, we met a few years back when you came to our office. I wanted to follow up with you and get some more information about your alternative to reinsurance LOCs. Can you call me as soon as you can?”
That has got to be one of my favourite voice messages (second only to: “We just wired to you the trust funds!”). In the past year, I have received hundreds just like this. I fully understand that LOCs work for some people, sometimes. But lately, LOCs don’t seem to be working for many at all.
The regulations are clear. Rather than establish an LOC for reinsurance purposes, you can (and often should) establish a reinsurance trust. Clients that establish trusts in lieu of LOCs simply put their cash or cash equivalents into an account and designate the account as the collateral for their reinsurance programme. From a regulatory and cedants’ standpoint, this does the trick.
Let’s be clear about what you stand to gain by using a trust, and how the trust appears on your balance sheet and to your treasury group.
• The money you put into the trust remains on your balance sheet as restricted. You retain ownership of the money.
• The income generated from the trust is your property. It does not go to the cedant.
• The trust is listed as an acceptable form of collateral per US regulations. If established properly, the cedant is allowed the same Schedule F credit for reinsurance that it would usually receive with an LOC.
• The trust is simple to set up. While an actual LOC document is only two pages long, the work involved in securing an LOC is tremendous (think: credit review process).
• The trust will not need to be renegotiated or re-established each year (unlike LOCs).
• The same cash or cash equivalents that you might use as collateral for an LOC can almost always be deposited into the trust. And best of all…
• The trust will save you between 80 percent and 98 percent of what you might pay for LOCs.
Robert G. Quinn is vice president of the collateral trust division at Wells Fargo Insurance Trust. He can be contacted at: firstname.lastname@example.org
A quick note of thanks to our client friends (both reinsurer and cedant alike):
In all of the articles that I have written in the past few years, I have gone to great lengths to explain in detail how the trust works. Rather than repeat myself here, I want to thank our current clients who have trusted my team at Wells Fargo with their business (and their money!). I want also to thank the cedants with whom we work. Over the past few years, I have relied upon many of you to give me access to your internal groups. I have asked for your insight as to why they may or may not be comfortable offering the trust as an alternative to LOCs. I have also tried to take the information they give me and incorporate it into my overall message to the market about the Wells Fargo Reinsurance Trust. Further, you have created a tremendous value for your clients who have placed their reinsurance trusts with Wells Fargo. To all of you, as well as our captive manager, insurance and reinsurance broker, and other sources of referrals, thank you sincerely.