The ABCs of ILS collateral

In July 2010, I had the opportunity to address the IQPC Insurance Linked Securities (ILS) conference at the Southampton Princess in Bermuda. The conference seemed to be a great success. The speakers on both the life and property sides of the conference were not only very knowledgeable, but also presented very timely concepts to the ILS industry. I will deliver a similar presentation during the IQPC ILS conference in Hong Kong this October. For those who didn’t have the opportunity to attend the Bermuda conference and won’t be in Hong Kong, I would like to take a moment to go over what is likely to be one of the ‘hotter’ topics in the industry: collateral.

By way of background, I have been working in the insurance and reinsurance space for over 10 years. I have been involved in the establishment and administration of tens of billions of dollars of collateral accounts over the years for both reinsurance (captive and traditional) and ILS transactions. The benefits of the alternative forms of collateral mentioned below truly apply to each.

Regulation versus business decision

Collateral for reinsurance

Most ILS transactions are derivations of reinsurance transactions. That is to say, they are substantially similar but not identical. Since this article is not meant to describe ILS transactions, I will just say that both reinsurance and ILS transactions generally have collateral requirements. It is these collateral requirements that I would like to address.

With reinsurance transactions (where there is some component of US-based risk), there is the whole concept of ‘Schedule F Credit for Reinsurance’. This is to say that the cedant does not have to take a charge against its surplus for ceded insurance if it is fully and properly collateralised (per the relevant regulations regarding collateral). Of course, Schedule F is an accounting standard for US cedants.

Where there is no US risk and the cedant is not subject to the US regulators, there may still be a collateral requirement. However, such a requirement is driven more by credit risk issues than regulatory or accounting requirements.

In short, with reinsurance, there may or may not be a collateral requirement. It depends on, among other things, where the risk resides and the regulatory jurisdiction in which the cedant resides.

Collateral for insurance-linked securitisations

ILS transactions are not reinsurance (of course). They are a ‘transformer’ arrangement, meaning that the transaction is not subject to the same rules as a reinsurance transaction. Therefore, Schedule F credit for reinsurance is not a consideration. There is no accounting benefit created for the sponsor (the ‘cedant’ in reinsurance terms) by asking for collateral. And there is no ‘accounting penalty’ if the question is not asked. However, sponsors generally recognise the credit risk that they assume in ILS transactions. Therefore, they will often (usually, if not always) ask for collateral.

In discussing this concept with some of my clients that are sponsors of active ILS transformer arrangements, it was explained to me this way: “Our insistence that the investors in these arrangements post collateral is more about protecting ourselves, the sponsor, from a worst-case scenario where we might, in the end, be compelled to pay out.”

Stated another way, collateral posted to secure ILS transactions is a business decision, not a regulatory requirement.

The similarity in question

If I were to draw a schematic of an ILS arrangement, with all of its arrows, lines and directions, it would look like an air traffic control map. ILS arrangements are certainly a bit more complex than traditional reinsurance transactions. However, if actual names were associated with 25 different reinsurance schematics and 25 different ILS schematics, the reader would notice that many of the names would actually be the same. This is to say that while the investors involved in ILS transactions might be names unknown to many, the ‘sponsors’ of these transactions are often the same beneficiaries as on reinsurance transactions. The fact that the names are often the same has a direct impact on the way ILS transactions are collateralised.

In the reinsurance world, the beneficiaries of collateral are often compelled to follow the relevant regulatory and accounting requirements for collateralised programmes. Therefore, since ILS transactions (often) have the same beneficiaries, said beneficiaries apply the same (or substantially similar) requirements.

The collateral options

Sponsors of ILS transactions simply want to be sure that they are not exposed to credit risk from their counterparty. In short, they just want to be sure that they protect themselves from potentially massive problems. Requiring collateral in conjunction with an ILS transaction is one way to achieve the security they are seeking. There are generally three acceptable forms of collateral: letters of credit (LOC), funds withheld and trusts. Let’s briefly (and fairly) look at each.

Letters of credit

While LOCs do offer a quick way to resolve the collateral issue, the devil here (as they say) is in the detail.

In evaluating the out-of-pocket costs of the standard LOC, it is fair to say that credit charges have increased tremendously. Even when the LOC in question is fully cash-collateralised, the applicant for the LOC can expect to pay 50 basis points (bps), 75 bps, or more. An uncollateralised LOC could cost three times that.

Additionally, one must fairly agree that in order to obtain an LOC from a bank, the applicant for the LOC must go through the bank’s credit review process. This credit review process can be long and involved; it isn’t easy.

So while LOCs might seem like a quick way to go, there is a lot of work involved in setting them up. And with costs increasing the way they are, evaluating the alternatives would certainly be worth the effort.

Funds withheld

The process known as ‘funds withheld’ occurs when you give your cash (in the amount that the LOC would otherwise be) to the beneficiary. Often there are no ‘out of pocket’ costs associated with funds withheld (or stated another way, there is no fee from the sponsor to hold your cash). However, many of the beneficiaries of these transactions are moving away from this option. There is some ambiguity as to who actually owns the money and what would happen in the event of a bankruptcy by one of the parties to the transaction. Whatever the view on this option, it seems to be that TV’s Judge Judy is right, when she says: “In legal terms, it is far easier to keep something than to try to get it back.”

Trusts

The trust option might just be the one that ‘cracks the code’ of collateral problems. Rather than the sponsor putting its money into a collateral account for an LOC (and paying the LOC fees), users of trusts simply put the same money into an account at an independent third-party bank to be held in trust, in case there is a problem. In other words, the sponsor funds an account and the trustee holds the money to the sponsor’s benefit.

Yes, the trust agreement is a much longer document than a standard LOC. But Wells Fargo has pre-negotiated the required language of the trust agreement itself with most of the ILS sponsors out there (meaning that 90 percent of the work required to establish a trust is already finished). Historically, negotiating the trust agreement used to take a lot of time and effort. Now, with Wells Fargo, the trust is fairly turnkey.

Costs

This is the easiest part of the comparison, but often the most important one.

Suppose that you have collateral requirements, in total, of $50 million. If this is the case, then a 75 bps LOC will cost you $375,000 per year. If that overall collateral requirement is $100 million, the cost will be $750,000 per year. And it goes on from there. I know personally of investors with collateral requirements of over $500 million. Imagine what that would cost!

Funds withheld? Usually no charge. But keep in mind that there is usually a very low (often zero) rate of return.

Trusts? This is a bit more of a story, but a single $50 million trust might cost $30,000 (at the high end). However, it is often considerably less, even 80 percent less. But even if it costs $30,000, that is a 92 percent reduction from LOC fees. And in the end, it will be less work.

One great investment choice

Usually, both the investors in, and the sponsors of, ILS transactions and parties to reinsurance transactions (both captive and otherwise) are conservative in their investment policies. Many of the investors would simply put their money into a money market fund if they could. However, non-US taxpayers earning ‘dividend income’ (which money market funds pay) are often subject to a 35 percent withholding tax. So they look to purchase US Treasuries, often very short-term.

"The trust option might just be the one that 'cracks the code' of collateral problems. Rather than the sponsor putting its money into a collateral account for an LOC (and paying the LOC fees), users of trusts simply put the same money into an account at an independent third-party bank to be held in trust, in case there is a problem."

Wells Fargo has developed a deposit account that pays interest, not dividends. And pursuant to trust law, these accounts are fully collateralised. Equally importantly (for the past three years), it has outperformed one-month and three-month US Treasuries—often substantially. And since the income is ‘interest’ not ‘dividend’, there is no withholding event associated with our deposit account. It has garnered great positive attention for both use of the trust and for Wells Fargo. When it is used, not only is the client’s investment income greatly enhanced, but the fees for the trust are greatly reduced. It has been a winning solution for most of our ILS, reinsurance and captive clients.

Bringing it all together

When it comes to collateral issues, ILS transactions are very similar to reinsurance transactions. While the ILS sponsors make a business decision to require collateral, they generally offer two options, sometimes three. Although the LOC is the most familiar form of collateral, the costs can be punitively expensive. Further, in the end, they are not as ‘quick and clean’ to establish as some would have you believe. The trust option offers a way to reduce costs by (often) over 90 percent, while reducing the amount of work required to establish and maintain them. And with Wells Fargo as trustee, the income associated with the collateral can be meaningfully enhanced without creating investment risk.

Robert Quinn is vice president of the collateral trust division at Wells Fargo Insurance Trust. He can be contacted at: robert.g.quinn@wellsfargo.com