Assessing your options for insurance collateral

An insurance collateral trust is a segmented trust account established for the benefit of the insurance company that cedes a portion of the risk to the insured or to a reinsurer. In the case of corporations insuring risks with large-deductible programs, high self-insured retentions, or captive arrangements, collateral is typically required, and an insurance collateral trust can be the funding mechanism.

Trust accounts are governed by a trust agreement and held at an independent financial institution (the trustee bank). Each state establishes regulatory guidelines that specify the eligible asset types the account may hold, which typically include cash, Treasury notes, and high-grade securities.

An agreement between the insured and the insurer determines the level of required reserves needed to fully fund the trust (100% or more); these agreements usually stipulate periodic reporting and mark-to-market adjustments. As the insured party, you are typically allowed to make withdrawals when trust funds exceed capital requirements.

Assets within the account appear on the balance sheet of the entry funding the trust and require disclosure as restricted assets. Because the insured is the legal owner of the restricted funds, these assets can affect liquidity ratios and asset encumbrance metrics.

While both are valuable financial tools that can provide required collateral in insurance arrangements, there are important differences between the two approaches.

An insurance collateral trust requires assets to be separated and reduces the amount of cash that is immediately available.

Conversely, an LOC may preserve cash by using bank credit capacity, which may restrict credit availability. If you use an LOC, the lender may require collateral as well, and that can impact your access to funds.

Key points:

• Insurance trusts offer an advantage to companies that need to preserve credit.
• LOCs provide an advantage for companies that are pressed for immediate liquidity but have assets available to secure the LOC.

An insurance collateral trust typically incurs significantly lower fees. However, these structures still tie up assets, meaning they may impact yield or affect strategic investment opportunities.

LOCs usually come with higher annual fees in the form of basis points on the face amount and can include unused commitment fees. Costs increase as interest rates rise, whereas trust costs are relatively flat. LOCs can also reduce your borrowing flexibility.

Key points:

• Insurance trusts offer an advantage for companies that prioritize lower fees.
• LOCs offer an advantage for those more concerned about the impact on the weighted cost of capital.

There is minimal risk associated with an insurance collateral trust.

LOCs carry annual bank renewal risk that could become an issue during credit-tightening cycles. There’s also concentrated risk if a single bank or limited syndicate provides the LOC.

Key points:

• Insurance trusts offer an advantage for those looking to avoid risk around LOC renewal.

Insurance collateral trusts are widely perceived as transparent, “clean” collateral with high asset visibility.

Insurers only accept LOCs from NAIC-qualified banks that meet the insurer’s credit rating standards.

Key points:

• Insurance collateral trusts provide a straightforward approach to providing necessary collateral.
• Insurers will sometimes look to evaluate an organization’s reliance on its LOC during times of financial stress.

An insurance collateral trust does not require an annual credit review. Once it’s set up for a multiyear collateral obligation, it just rolls over. These structures allow you to direct management of the assets within the terms of an agreed-upon investment policy and provide simple reporting with mark-to-market compliance.

An LOC requires initial negotiations with the lending bank, followed by annual renewals and coordination with the bank to reissue the letter each year. You’ll also need reporting for covenant compliance. Timing adds additional complexity, as the renewal conversations typically begin three or four months before your current LOC expires.

Key points:

• Insurance trusts offer an advantage by their simplicity once the trust is established.
• Insurance carriers often prefer a trust account over an LOC so they can avoid the additional operational step of ensuring that the LOC is being renewed each year.
• Insurers also gain full and immediate transparency with a trust, and they can often receive a full or partial drawdown from a trust account, when needed, faster than with an LOC.

As you evaluate the economic differences, you’ll want to model the internal rate of return (IRR) differential between the return on treasuries or marketable securities posted in an insurance collateral trust versus deploying that capital another way in your business. Calculate that differential spread compared to the total amount of fees you’ll pay with an LOC over time.

Conduct stress tests as part of your scenario planning so you can forecast the impact of rate hikes or changes to the company’s creditworthiness.