Captive Collateral Options

Martin G. EllisSenior Vice President

November 2008

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Reasons Captives Must Pledge Collateral to Fronting Carrier• Security for Fronting Carrier if Captive Becomes Insolvent or Doesn’t Honor its Obligation

Front is licensed to do business in a particular state, whereas Captive generally is not. Front issues insurance policy and cedes some or all liability to Captive. Front wants to limit its risk, so requests collateral to cover deductible, actual losses, unearned premiums, etc. in case Captive cannot or does not pay.

• Avoid Regulatory Schedule F Penalty

Since Front is regulated and issuing the underlying insurance policy, it must report the liability (i.e. take a surplus penalty) on the balance sheet of the annual statement it prepares for the insurance regulator unless it has qualified reinsurance or acceptable and sufficient collateral (e.g. cash, letter of credit or trust).

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Types of Acceptable CollateralI. Standby Letters of Credit

According to recent industry surveys, this is still the most popular option preferred by Fronting carriers.

Advantages: Internationally recognized and accepted.Easy for Front to monitor.More flexible investments.Fixed liability.Can handle “back to back” LOC’s.Better for Front should the Captive go bankrupt.

Disadvantages: More expensive than trust.Bank must approve credit.Bank has to allocate capital.Annual renewals.

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STANDBY LETTERS OF CREDIT

• Definition – Document issued by a Bank that “assures” payment of an obligation.

• Purpose – Standby letters of credit are issued by a Bank in favor of the Captive’s “Fronting” insurance company (the beneficiary) to secure the Captive’s obligation under a reinsurance contract.

• Reason – The letter of credit assures the Fronting insurance company that the Captive will pay its share of losses (e.g. deductible) on any and all claims and enables the Fronting insurance company to exclude these reserves for losses from its balance sheet for regulatory purposes. Also, since the Captive is not a publicly held company which regularly publishes its financial results, the Fronting insurance company cannot or doesn’t want to monitor the financial condition of the Captive. Therefore, the Bank which issues the LOC substitutes its creditworthiness for that of the Captive to assure prompt and full payment of any valid drawing on the letter of credit.

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SAMPLE STANDBY LETTER OF CREDIT

Issuing Bank: ABC Bank Date of Issue: November 15, 2008Beneficiary: Fronting Insurance Co. Applicant: Captive Insurance Co.

We (ABC Bank) have established this clean, irrevocable and unconditional standby letter of credit in your favor as beneficiary for drawings up to U. S. $10,000,000 (ten million U.S. dollars) effective November 15, 2008.

This letter of credit is issued, presentable and payable at our office and expires on November 15, 2009. Except when the amount of this credit is increased, this credit cannot be modified or revoked without your consent.

We hereby undertake to promptly honor your sight draft drawn on us for all or any part of this letter of credit upon presentation at our office on or before the expiration date hereof or any automatically extended expiry date.

This letter of credit is deemed to be automatically extended without amendment for one year from the expiration date or any future expiration date, unless at least 30 days prior to such expiration date, we shall notify you by registered mail or overnight mail that this letter of credit will not be renewed for any such additional period.

This letter of credit is subject to and governed by the laws of the State of New York, including Article V of the Uniform Commercial Code, and the International Standby Practices ISP98 of the International Chamber of Commerce (Publication No. 590).

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CHARACTERISTICS OF STANDBY LETTERS OF CREDIT

• Letter of Credit is “clean, irrevocable, and unconditional.”

• Letter of Credit may only be decreased, modified, or cancelled with the approval of BOTH the applicant (Captive) and the beneficiary (Fronting insurance company).

• Annually renewable with non-renewal or “evergreen” clause of 30, 60, 90 days (i.e. unless you hear otherwise from Bank within 30-90 days before expiration, the letter of credit automatically renews for an additional year).

• Partial drawings are permitted by the beneficiary.

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CHARACTERISTICS OF STANDBY LETTERS OF CREDIT (CONT.)

• The Bank which issues the letter of credit must review the creditworthiness of the Captive in order to approve the credit exposure, even though the letter of credit is fully collateralized.

• The fees are generally paid annually in advance and are non-refundable if the LOC is cancelled. LOC fees generally range from 25-50 bps depending on the collateral and the financial condition of the Captive.

• Banks issuing standby letters of credit must be NAIC (National Association of Insurance Commissioners) approved.

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COLLATERAL FOR LETTERS OF CREDIT

What – Banks require Captives to pledge marketable securities (collateral) to secure outstanding letters of credit. In the event of a draw on a letter of credit, the bank can liquidate the collateral to reimburse itself for funding the letter of credit obligation.

Benefits of Collateral – There is generally no recourse (liability) to the owner of the Captive. Since the letters of credit are secured, the Captive should pay lower letter of credit fees. The Captive gets to keep investment income from the marketable securities the bank holds as collateral.

Eligible Collateral Advance RatesCash 98-100%US Government and Agency Securities 90-95%Fixed Income Securities (Rated A- or higher) 85-90%Equities 60-70%Incoming Collateral LOC’s from approved banks 100%

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TYPES OF ACCEPTABLE COLLATERAL

II. Regulation 114 Trust

Trust agreement governed by New York Department of Insurance regulations that have been adopted by most states. This is often times cheaper than a letter of credit, but collateral is often times more restrictive. Some Fronts charge administration fees and require expensive portfolio monitoring software.

Advantages: Less expensive than LOC’s.No bank credit approval required.

Disadvantages: Harder for Front to monitor.Investments are generally more restrictive (e.g. no equities or offshore mutual funds allowed).Must get Front approval to remove excess

assets.

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REGULATION 114 COLLATERAL TRUSTS

• Definition – Eligible assets are placed by a Captive into a trust held by a trustee (usually a Bank) to guarantee payment of an obligation.

• Purpose – As with standby letters of credit, the trusted assets are placed with a Bank trustee in favor of the Captive’s “Fronting” insurance company (the beneficiary) to secure the Captive’s obligation under a reinsurance contract.

• Reason – As with standby letters of credit, the Reg 114 collateral trust assures the Fronting insurance company that the Captive will pay its share of losses (e.g. deductible) on any and all claims and enables the Fronting insurance company to exclude these reserves for losses from its balance sheet for regulatory purposes.

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SAMPLE REINSURANCE TRUST AGREEMENT – TABLE OF CONTENTS

REINSURANCE TRUST AGREEMENT

dated as of September 30, 2008

Among

ABC CAPTIVEas Grantor,

XYZ INSURANCE COMPANYas Beneficiary,

And

COMERICA BANK & TRUST, NATIONAL ASSOCIATION,A NATIONAL BANKING ASSOCIATION

as Trustee

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TABLE OF CONTENTS

SECTION PAGESection 1. Deposit of Assets to the Trust Account; Trust Account Structure 2 Section 2. Determination of Amount of Assets to Be Deposited in the Trust Account 3Section 3. Withdrawal of Assets from the Trust Account 4Section 4. Application of Assets 5Section 5. Maturing Assets and Redemption of Assets; Investment and Substitution of Assets 6Section 6. Dividends and Interest 7Section 7. Right to Vote Assets 7Section 8. Additional Rights and Duties of the Trustee 8Section 9. The Trustee’s Compensation, Expenses and Indemnification 9Section 10. Resignation of the Trustee 10Section 11. Termination of the Trust Account 11Section 12. Certain Definitions 11Section 13. Governing Law 13Section 14. Successors and Assigns 14Section 15. Severability 14Section 16. The Entire Agreement 14Section 17. Amendments 14Section 18. Notices 14Section 19. Tax Identification Number 16Section 20. Transaction Confirmation by Call-back 16Section 21. Reliance on Account Information 16Section 22. Headings 16Section 23. Counterparts 17Schedule 1 Assets Originally Deposited in the Trust AccountSchedule 2 Telephone Number for call-backsSchedule 3 List of Reinsurance Agreements

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REG 114 TRUST AGREEMENT MAJOR PROVISIONS

• 3-party agreement between Captive, Front and Bank.

• Amount and type of investments (e.g. minimum rating) allowed in trust and pledged to Front.

• How withdrawals are made by the Captive or Front to reimburse for losses and expenses paid or unearned premiums.

• How much over collateralization (e.g. 102 – 110%) is required.

• Statement reporting responsibilities and timing (e.g. 15 days after month end).

• How dividend and interest income are handled.

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PERMITTED TRUST INVESTMENTS

• Cash

• Deposits in NAIC approved domestic money market funds

• US Government, State or Agency Obligations

• US Corporate Bonds Rated “A” or higher

• Equities generally are not allowed by Fronting carriers

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TYPES OF ACCEPTABLE COLLATERAL

III. Funds Held

Captive deposits cash or excess premiums with Front who may or may not pay the Captive interest. This is the least popular collateral option.

Advantages: No cost to Captive.

Disadvantages: Difficult to get money back from Front.No control over investments.Investment returns are minimal.