The high cost of collateral is pushing more captive owners to leverage their facilities' financial assets to offset the expense, several captive experts say.

Captives more often are using their assets, such as cash premiums paid into the facility or money that's been invested to pay captive losses, to back letters of credit or fund trusts that fronting insurers can tap should a captive owner fail to pay claims and leave the insurer on the hook, experts say.

In addition, high collateral costs are keeping certain captives from forming, said Mark Bernfeld, a senior consultant in Boston at Towers Watson & Co.'s reinsurance brokerage business.

As upper management pressures a company's captive operations to rely less on the parent's line of credit, several sources say the asset-leveraging strategies are being applied more often to satisfy collateral needs.

“That is becoming much more prevalent—shifting the responsibility to post collateral down to the captive rather than it being (provided) at the parent company level,” said Jason Palmer, director of Willis Management Hawaii, a Honolulu-based captive manager and unit of Willis Group Holdings P.L.C. “It's a shift in the party that is providing that collateral.”

Constricted credit markets have made it more costly for corporations to obtain the credit limits they desire from their banks, prompting the change.

“What we are seeing is the cost of capital is such that, at the parent level, they don't want to tie up that line of credit,” said Jason Flaxbeard, senior managing director in Denver for broker Beecher Carlson Holdings Inc.

Collateral cost increases have been substantial in some cases, said Lisa K. Wall, a senior vp at Lockton Cos. L.L.C. in Kansas City, Mo. For “a lot of companies, their letter-of-credit costs have doubled and if not, tripled (then) quadrupled,” she said. “Those increases in cost are material to their business.”

Captive owners rely on collateral to meet fronting insurer demands. The insurers traditionally require collateral to offset their credit risk resulting from an obligation to pay claims should their insured fail to do so.

Requiring collateral is most common when workers compensation claims are at stake and insurance regulators would insist that a fronting insurer bear the burden if a captive insurer could not meet its statutory obligations.

But collateral arrangements also are common for other lines of coverage, such as general liability and auto liability policies, sources said.

Simultaneously, with credit becoming more challenging to obtain from banks, insurers are demanding that policyholders provide greater financial assurance claims will be paid, sources said.

To mitigate collateral costs, the use of bank instruments referred to as Section 114 trusts has grown in popularity recently although the trust arrangements have been available for years, Mr. Flaxbeard and others said. Under the three-party agreements involving the captive owner, a bank and a fronting insurer, the insurer is named as the trust's beneficiary.

For example, the Alliance of Schools for Cooperative Insurance Programs won't pay ever-increasing basis points for letters of credit for the captive it owns, said Paula Chu Tanguay, CEO. Instead, the Cerritos, Calif.-based school insurance program continues earning interest from investment funds it places in an escrow trust for its captive's fronting insurer.

In this case, however, ASCIP provides the investment assets placed in the trust account, not its captive, Ms. Tanguay said. ASCIP's Hawaii-domiciled facility, Captive Insurance for Public Agencies, insures an owner-controlled insurance program for school construction.

Not all insurers allow replacing letters of credit with trust accounts, Ms. Tanguay said.

Regardless, negotiating with the insurer to reduce the collateral amount is the most important step for a captive owner, she said. “That is all negotiable,” Ms. Tanguay said.

To remain competitive and retain clients, more insurers have begun accepting the trust arrangements, rather than only letters of credit, sources said.

“It's becoming more of an issue at the carrier level because companies are coming to them and saying, "We would like to use our captive assets to provide collateral. What can you do to help us?'” Mr. Palmer said. “And carriers respect the fact that if they don't do something, someone else is going to.”

Using captive assets to back letters of credit also is a growing strategy that reduces a bank's risk.

In return for using captive assets to secure LOCs, rather than relying on unsecured LOCs, captive owners should see their banks reduce the basis points charged for the collateral instruments, Ms. Wall said.

But in other cases, entities that otherwise might form an association or group captive are not doing so in part because banks normally view them less favorably than they do larger companies that already have an established captive, Towers Watson's Mr. Bernfeld said.

Association captives typically are set up by smaller entities that would face high costs for LOCs if they could obtain them, Mr. Bernfeld said. That additional cost, along with competitive pricing for insurance, is a likely factor in a recent slowing of captive formations, he said.

“It's just one more factor (slowing the formation of facilities), but I do think it's an important factor,” Mr. Bernfeld said.

Copyright © 2010 Crain Communications, Inc.