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Why Captive Insurers Prefer Using LOCs as Collateral

On June 19th and 20th, 2018, Chris Murray, the President of Caitlin Morgan Insurance services, presented educational seminars to the attendees of the 8th Annual Tennessee Captive Insurance Association Conference in Nashville, Tennessee. Among the topics discussed during the two seminars led by Chris, the concept of collateral in the captive insurance market was introduced. The most common form of collateral in the captives field is that of the bank Letter of Credit (LOC). In this article, we’ll take a closer look at LOCs and illustrate why this type of collateral is the preferred method of securing financial assets designed to satisfy future liabilities.

What are LOCs?

Captive insurance firms are required by the National Association of Insurance Commissioners (NAIC) to demonstrate that they have sufficient funding set aside to satisfy claims in the future. This is particularly true among admitted rated insurers, which must provide evidence to the NAIC that if they are not utilizing rated reinsurance, a sufficient amount of collateral has been secured to pay off future claims. To receive accreditation under the NAIC requirements, captive insurers are typically required to secure an amount of 200% or more of maximum possible losses for the potential risks of an insured party. This collateral most often comes in the form of a Letter Of Credit (LOC). An LOC is simply an agreement between a bank and another party – in this case a captive insurer – that payments to an insured party be paid on time and in the correct amount.

Benefits of LOCs as Collateral

While LOCs tend to be more expensive than other collateral funding options, captives tend to prefer LOCs over reinsurance trusts or other assets because of the investment flexibility they represent. By allowing investment in high-yield bonds, securities, and equities to secure the LOC, captives may bring in more investment income, thereby offsetting any added costs of choosing an LOC over a reinsurance trust. Captives and fronting insurance carriers also prefer LOCs because of their fixed dollar amount, which puts a ceiling on liability. LOCs are irrevocable and renew automatically, simplifying the process of administering this form of collateral.

LOCs can also benefit group captives, where each member of the group secures its own LOC and pledge them as collateral for the related LOC the captive issues to a fronting insurance carrier. Referred to as a back-to-back LOC, this option is commonly used and is not available if group captives use reinsurance trusts or other funding options.  

A final benefit is the ease with which LOCs may be amended. For a nominal fee (typically), the dollar amount or expiration date of the LOC can be changed with a simple amendment request. The amendment is issued by the bank after receiving approval from the beneficiary. This is far simpler than the complex legal process by which a trust is amended.

About Caitlin Morgan Captive Services

Caitlin Morgan Captive Services provides clients with captive insurance solutions supported by years of experience in establishing the successful formation and implementation of a wide range of captives. To learn more about how we can help you, please contact us at (317) 575-4440.