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The Edge of Risk Podcast by IRMI
Reinsurance Trusts in Captive Insurance: Structure and Strategy
00:22:26
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- [00:00]
A
Foreign. Welcome to the Edge of Risk podcast. I'm Joel Appebon, the Chief Content Officer for ermi and captive.com and on today's podcast we're joined by Donnie Tong, senior Vice President at Troost bank where he specializes in collateral solutions and trust agreements for the insurance and captive insurance sector. Donnie has extensive experience working with captives reinsurers, fronting carriers to design trust structures that meet regulatory standards while balancing operational needs. He's here to talk with us today a little bit about reinsurance trusts, or more specifically called collateral trusts, a widely used but sometimes misunderstood collateral tool in the captive insurance world. So, Donnie, welcome to the podcast.
- [00:52]
B
Thank you so much. I really appreciate this.
- [00:55]
A
Awesome. I would love it if we could get started by you sharing a bit of your background and how you became involved in the captive insurance space.
- [01:05]
B
Yeah, absolutely. So I've personally worked in the corporate trust banking for over 23, almost 24 years now, with most of that, I would say almost 22, 22 years of that focused in the reinsurance trust vertical. My career originally began at the bank of New York Mellon, followed by roles at Wells Fargo, HSBC and now Truist Bank. I entered the insurance trust space somewhat honestly unexpectedly. I was assigned to a project when I was at the bank of New York, Maryland with the insurance trust team. And from there that opportunity shaped the trajectory of my career. Over the years I've had the privilege of working alongside with some of the most knowledgeable professionals within the corporate trust industry, which really has given me a deep understanding of the reinsurance trust business, specifically in regards to utilization structures and most importantly, relationships within the market.
- [02:11]
A
Well, I think that's a helpful overview and I want to begin with the fundamentals reinsurance trusts or you know, and I want to make sure specifically called collateral trust are used across the industry. But many listeners may not realize how crucial they are in captive or fronting arrangements. So explain for our listeners what are reinsurance trusts and why are they such a core collateral mechanism for captives and why are they beneficial to both fronting carriers and and regulators?
- [02:46]
B
So I'm going to first start off with explaining in a very high level what a reinsurance trust and what a collateral trust is. So for a reinsurance trust, generally speaking, that usually involves a underlying reinsurance transaction, the cedent, in many instances, they cede their risk to a reinsurer who in turn who provides collateral in a trust to support any potential obligations that they're responsible for pursuant to their underlying reinsurance arrangement. Now that is a purely a traditional reinsurance Trust. Now, the account set up assets are put in and it secures the reinsurance obligations. Now, a collateral trust, very similar to a reinsurance trust usually involves corporations are sometimes known as insured to carrier programs or captive companies where in some instances they work with a front end carrier. And in these instances the front end carrier requires either a letter credit or a collateral trust, very similar to a reinsurance transaction. They require collateral in a trust account to secure obligations pursuant to their insurance program. Now, with that said, whether we say reinsurance trust or collateral trust, these trust accounts are really a core collateral mechanism for captives simply because trust accounts can be set up much quicker, have lower upfront cost and have a bit more flexibility in comparison to more traditional collateral posting methods. One thing I always say is that once a trust account is set up, there is no annual renewal reviews like a letter of credit for the fronting carriers and regulators. The trust is a very simple vehicle where they can request for statements from a neutral bank acting as the trustee. You know, more and more fronting carriers are preferring the trust structure over credits due to the simplicity of the setup and ongoing maintenance for the collateral. And you know, once the trust is in fact set up, the carrier can view the trust account and asset market value online. They have 24,7 access to the account and know exactly how much or what type of assets are securing the underlying obligations. And then as for withdrawals, the carrier just needs to send a direction letter to the trustee or release of funds. And on average it generally takes anywhere between one to two business days to complete any withdrawal request.
- [05:29]
A
Great. I think that helps set the stage for understanding how these structures function day to day. Actually. My son Jake is a consultant for RSM and he audits trusts all the time. So I know reinsurance trusts have a lot of components, right? There's trust agreements, eligible assets reporting the oversight that I was just maybe talking about. And from a practical standpoint, Donnie, can you walk us through how a reinsurance trust actually operates in a captive insurance program?
- [06:06]
B
Yeah, absolutely. So the trust is treated as a restricted asset on the captive's balance sheet. As such, any income such as dividend or interest earned in trust purely belongs to the captive since the collateral is posted into the trust account for the full benefit of the beneficiary. And in some cases they're referred to as the carrier. The assets are generally invested in very safe and liquid securities. Most common types of assets held in the trust accounts are cash, AAA rated Treasury money market funds. From time to time at Direct US Treasuries and in some instances, acceptable fixed income securities that meet certain credit quality characteristics. These eligible assets allow the grantor to have some flexibility while maintaining high quality assets. In the event of an above withdrawal event, clients can invest the assets themselves by directing us as the trustee to buy or sell eligible assets. Or they can hire an outside manager and fully invest the trust accounts pursuant to the trust Agreement's investment guidelines. We as a trustee, we always remind our clients that they should be aware of any upcoming expected or anticipated claims and advise their investment manager to leave enough liquidity to fulfill any withdrawals by the carrier. Otherwise, the client may need to sell securities prior to prior to maturity to raise cash for any such withdrawal which may end up resulting in a realized loss position.
- [07:48]
A
There's a lot of key moving parts here and I want to make sure our listeners understand all of them. You use the word grantor, so maybe just quickly identify who a grantor and is there a grantee?
- [08:02]
B
Great question. So the trust agreement itself is a tri party arrangement. So you have the grantor, you have the beneficiary, and then you have the trustee. Whenever we reference the grantor, it solely references to In a reinsurance trust transaction, the grantor will be the reinsurer who's depositing assets to secure underlying reinsurance arrangement. In a corporate deductible, workers comp or a traditional corporate program or Catholic program, the grantor will be generally either the captive or the insured in a corporate program. So always think of the grantor as the individual or the entity that will be depositing the assets into the trust. And then the beneficiary is always whom the trust is being set up for. In many instances it will be the insurance companies.
- [08:56]
A
Great, thank you Donnie, that's really helpful. And I want to build on that operational perspective. Another area that often draws attention is the protection these trusts offer. So one topic that has come up is the level of protection and control that trusts provide to the beneficiary. Right. So and now we know who the beneficiary is. So how do provisions around withdrawal rights, permitted investments, trustee responsibilities create security for the fronting insurer while still enabling the captive to manage its investment strategy?
- [09:36]
B
So the trust accounts allow both parties, the grantor and the beneficiary, full time access to view the trust assets and market value online. This really provides a level of comfort for the parties, especially for the beneficiary. Now you need to keep in mind why is it important for the beneficiary? Because these accounts are set up for their full benefit with 24,7. Access to the accounts online. The beneficiary can monitor the trust assets and determine if trust assets are still in fact eligible. In the event there are ineligible assets, then the beneficiary will be able to advise the grantor to replace the assets with eligible assets or securities. This also brings up another comfort point for the beneficiary. Most carriers prefer larger banks with specialized teams and large banks that are highly credit rated that handle this type of trust account because beneficiaries are aware that not all banks fully understand the reinsurance trust account.
- [10:35]
A
Right? And of course, right when captives evaluate collateral tools, they're rarely looking at trust in isolation. So I think captives frequently compare collateral options, right, the letters of credit, cash, trust. Different things are right for different folks. But from your vantage point, where do reinsurance trusts offer advantages and what trade offs should captive owners understand when considering them?
- [11:02]
B
Okay, so this is going to be very long winded response, but I'm going to start off saying that, you know, you're absolutely correct with the three primary collateral posting options that you just mentioned. And again, let me preface that there are no best solutions or right solutions. Every client, every situation is slightly different. The best collateral option boils down, and this is, in my opinion, boils down to cost efficiency for the client. So let's start with letter credits, right? Letter credits have been the most utilized collateral posting options for a very long time. And because most market participants, such as captive owners, captive managers, insurance carriers, and even banks are familiar with the structure of a letter of credit, they are familiar with it and it's easy to understand. So in many instances, that's sort of the path of least resistance. You know, the pros for a letter of credit are that it's widely available and relatively standard in terms of acceptance. The downsides of a letter credit are most clients will probably still need to post some sort of cash or acceptable assets to secure the letter of credit. And then you have the cost of a letter of credit that can range anywhere between 50 basis point and in some cases 200 basis points. Now, you still have an annual credit review and renewal. For the clients who are balance sheet sensitive, a letter of credit can be treated as a contingent liability on the balance sheet. So for some clients that may be an issue or will be an issue for, I would say for cash or direct funds, withheld straight structures, it's quick and it's easy because you're handing the cash directly to the carrier as collateral. The carrier will hold the cash in an account and they may or may not provide interest earning on that cash that's being withheld. The captive has no control over the cash once it's handed over or sent to the carrier. From time to time, as we enter liquidity tightening events, and we've seen this before, carriers may not want to utilize allow utilization of the funds withheld because it's classified as a liability on the balance sheet. Trust accounts have been around for a long time, probably well over 40 years, but it hasn't been widely utilized until the last 18 to 20 years. In the last 20 years, I would say trust account setup and administration is much more streamlined than it was before. This has allowed the cost of trust accounts to be more cost efficient than ever. Most carriers that allow for trust to be a collateral posting option will most likely have their own trust agreement from form templates and prefer trust banks that they're comfortable with. This really helps the cost and setup to be more efficient than it once was. Once the assets are deposited into a trust account, the assets can be invested pursuant to the trust agreement, which is again set by the beneficiary or the insurance company. This gives the captive to have control over the assets and earn additional income off the trust. From a balance sheet perspective, a collateral trust is treated as a restricted asset and very similar to a letter of credit or a cash withheld option. The trust allows the beneficiary unfettered access to withdrawal from the trust account in whole and in part. So from a operational perspective, there's no difference for, for a carrier.
- [14:37]
A
Great. Thanks, Donnie. So, you know, we've kind of touched on this, but I just want to make sure we really lay it out there for the listeners that comparison naturally leads into how trust intersects with investment strategy. So I want to explore asset management. So collateral trust allow captives to hold qualifying assets directly within the trust. We said that earlier, but sometimes it really enables a more flexible investment mix than other collateral forms. So I'd like you to explain how you see captives leveraging that flexibility and then what guardrails need to be in place for my favorite word, compliance.
- [15:20]
B
My favorite word as well, compliance. Well, I always say one thing is this, right? In all of this structure, whether it's funds with how letter of credit or a trust, we need to keep in mind one thing is that the collateral's first purpose is to ensure the carrier can pay claims and related expenses directly related to the underlying insurance program. Plus the investments are generally very safe and very, very liquid. With that said, we are seeing more and more captive clients taking advantage of the investment flexibility that comes with the trust to help increase a bit more yield based on the trust assets, either managing the assets themselves or hiring a professional outside third party investment manager that is familiar with the insurance market. Most carriers will utilize what we call state insurance regulations as their permitted investment guidelines from the state guidelines. Some carriers will allow guidelines as is as prescribed by the state or some may restrict the state guidelines to further ensure more safety and liquidity. We always suggest to our clients to make sure they are aware of their loss rate ratios and they must advise, particularly if they hire an outside manager, they must advise their investment manager of any changes to their program to ensure investment durations match the upcoming future claims and expected expenses. And this goes back to the point that we made earlier is that we don't want to see our clients selling their securities before maturity, particularly fixed income bonds, otherwise they may have a loss situation.
- [17:11]
A
Great. I guess, you know, for some cap is a structure, it's more straightforward. But for others, right. Complexity becomes part of the design. Group captives and larger multi line captives sometimes use more complex structures. Multiple beneficiaries, multi cell frameworks, quota share arrangements. So I was hoping you could share how trust structures adapted these more layered programs, more complicated if you will. And what considerations become especially important that listeners should be aware of.
- [17:47]
B
So our team supports a wide range of trust structures from simple one to one arrangements to multi cell frameworks. The most common structure still today is the single grantor to a single beneficiary structure. However, I would have to say in recent years we've seen increased demand for what we call master trust structures which include a main account and multiple sub accounts. And each sub accounts will have its own unique account number. This design works well for what we call multi cell programs because the funds remain fully segregated and there's no monies or funds or assets commingled. Multi beneficiary trusts do come up from time to time, but it is significantly more complex simply because is that all beneficiaries must agree to the identical terms in one trust agreement. The challenges that we see often arise around termination provisions, investment guidelines. Again, they may be from different domiciles and standard of care. And again this boils down to how the beneficiary operate because again, they may be from a different state jurisdiction.
- [19:06]
A
Okay, all right. Before we wrap this up right. I love to look out on the horizon. I guess it's our look into your crystal ball question if you will. Regulatory expectations and investment environments are evolving. And what are you seeing as an emerging trends? Whether it's regulatory economic or market driven that could influence how captives and fronting insurers use reinsurance trust or collateral trusts over the next several years?
- [19:40]
B
That's a good question. I would have to say, and this is purely in my opinion, in my view, there's nothing we can do about regulatory side. If there are regulatory changes, tax code changes, there's nothing we can do. But market conditions I believe will be the biggest driver of trust adoption in upcoming years. As letter of credit spreads increase, captives and carriers will seek more cost efficient collateral solutions. Reinsurance trusts have existed for well over 40 years, but hasn't really gained traction until after the 2008 financial crisis when credit markets just overnight froze. We saw similar spikes in trust account interests during the 2011 and 2020 market disruptions. And again, that was all purely had to do with liquidity tightening and today most major fronting carriers maintain established trust programs with preferred banks because they recognize trusts as a reliable alternative to letter of credits and fund withheld programs. I really expect that trend to continue as markets continue to evolve. We have a lot of conversations with everyday onboarding new carriers and helping them establish trust programs. And you know, to date we work with probably most of the multinational carriers already, so we're they're pre approved trustee and we expect to see that to continue to grow.
- [21:14]
A
Great Donny, thank you so much for sharing your expertise and providing a clear look into how reinsurance trusts, also called collateral trusts, support captive insurance programs. It's been an absolute pleasure to have you on the podcast with some real detailed insight into the answers about this topic. So thank you so much for that and I'd also like to extend a special thanks to Troost bank for its partnership and support of captive.com over the years. And I want to say having you on the podcast, conversations like this help our captive community better understand the tools and structures that keep our industry running and options that people need to understand. So to our listeners, if today's discussion sparked new questions or encouraged you to explore trust arrangements more deeply, you can visit captive.com for free articles, interviews and unbiased expert insights sites. And if you like the podcast, please follow us, share it with a friend and thank you for listening.