Martin G. Ellis examines some of the major banking services for captives and explains why using a bank that specialises in captives saves owners precious time, frustration and money.

There are many steps involved in forming a single-parent captive insurance company such as choosing a captive manager, completing a feasibility study and business plan, selecting a domicile, meeting with the regulators, incorporating and capitalising the captive, obtaining an insurance licence, executing reinsurance contracts, etc.

One step often overlooked is establishing a banking relationship exclusively for the captive. Captive owners in the US usually think their local bank who handles their domestic needs can also handle all of their captive’s banking needs.

In many cases, they are not the best choice because they may not understand how captives work or what banking services the captive needs. I often hear a sigh of relief when speaking with owners of prospective captives when they finally speak to a banker who understands how captives work, how the various service providers work together and what services are needed.

Also, their local bank may not have the capabilities to handle offshore accounts if the captive is domiciled offshore and they may not understand or may overlook some of the new regulatory requirements. Finally, the local bank will end up being more expensive if they have to first learn about captives and then ‘invent the wheel’ and draft legal documents, letters of credit (LOCs) specimen language, trust language, and so on, from scratch.

Establishing a relationship with a bank that specialises in captives can save the owner time, frustration and money.

This article explores some of the major bank services for captives and how using a bank that specialises in captives will be well worth it to the owners of the captive. Also, it touches briefly on some of the new banking regulatory requirements that apply especially to offshore accounts.

Letters of Credit

Most captives are required to post LOCs to the ‘fronting’ insurance company that is actually issuing the insurance policy and then reinsuring some portion of this liability with the captive. An LOC is a legal document issued by a bank that assures payment of a reinsurance obligation between the captive, called the ‘applicant’, and the fronting insurance company, called the ‘beneficiary’.

The LOC enables the fronting insurance company to exclude these loss reserves from its balance sheet for regulatory purposes, and is an irrevocable and unconditional obligation of the bank. The LOC is issued for a fixed amount and generally expires one year from the issuance date, but usually has an ‘evergreen’ clause which means it automatically renews for an additional year unless the beneficiary is notified otherwise.

Changes to the LOC are done by amendments, which require approval from both the beneficiary and the captive as the applicant. A bank that specialises in captives generally has market acceptance among the beneficiaries, knows the LOC language requirements of the beneficiary, and the beneficiary is comfortable with the bank’s LOC draw process.

The LOCs are almost always secured by collateral in the form of marketable securities (eg cash equivalents, US government and agency securities, corporate fixed income securities, equities, etc.). A bank specialising in captives should also have standard legal documents and the systems in place to monitor collateral, which should result in lower costs for the captive.

Custody

The captive will collect premiums and invest these in various investment vehicles until it is time to pay claims.

These investments need to be held in safekeeping in an account called a custody account. The bank will provide monthly custody statements detailing assets, transactions and investment income. The captive and its investment manager should have online access to these statements.

A bank specialising in captives generally has the ability to place assets in either an onshore or offshore account and provides the captive and its investment manager with online access to these accounts at no extra charge.

Regulation 114 Trusts

An acceptable statutory alternative to an LOC for securing either an onshore or offshore captive’s reinsurance obligation to a US fronting insurance company is a Regulation 114 Trust.

The term ‘Reg 114’ is derived from Regulation 114 of the Official Compilation of Codes, Rules and Regulations (11 NYCRR 4) of the New York State Insurance Department and is generally viewed as the model for all US states.

The trust agreement is a three-party agreement between the captive (the grantor), the fronting insurance company (the beneficiary) and the bank.

The bank must either be a member of the Federal Reserve System or a New York State-chartered bank or trust company.

Under the trust agreement, the captive delivers to the bank securities with a market value of not less than the full amount of the captive’s obligations due under a reinsurance agreement between the captive and the fronting insurance company.

Securities are limited to cash and equivalents, US government and agency securities and other fixed income securities such as corporate bonds rated A or higher.

The beneficiaries of Reg 114 Trusts generally do not allow investments in equities due to potential market volatility.

The beneficiary can demand possession of the trust funds to pay or reimburse the beneficiary for the captive’s share under the reinsurance agreement regarding any losses and allocated loss expenses paid by the beneficiary, but not recovered from the captive or for unearned premiums due to the beneficiary, if not otherwise paid by the captive.

The bank must then immediately deliver physical custody of the securities to the beneficiary and notify the captive.

The beneficiary would then arrange to have the securities sold and converted into cash to reimburse any unpaid obligation. Although Reg 114 Trusts are generally less expensive than LOCs, many captives still prefer LOCs because there are fewer investment restrictions which should result in higher investment income, and it is easier to remove excess funds securing the LOCs since beneficiary approval is not required.

Investment and treasury management

Most banks also provide investment management services and have become very good at managing assets. Banks specialising in captives offer various onshore and offshore funds and individual portfolio management.

These banks have the expertise to match the maturities of investments with the projected payouts on liabilities to maximise investment returns. They also have the systems and reports necessary to help the captive prepare its regulatory filings (eg Schedule D for investments).

Banks should also offer treasury management services, which permit online access to both onshore and offshore deposit accounts and allow the captive to move funds electronically as needed.

New banking regulations

To comply with the US Patriot Act and similar ‘know your customer’ and anti-money laundering requirements in other jurisdictions, banks have begun and will continue to ask for more information on their customers.

US banks are required to check the names of the owners and account signers against various government lists and assign risk ratings to all accounts. Those that are classified as ‘high risk’ will require more frequent monitoring and reporting.

Offshore accounts are generally considered more risky than onshore accounts. US banks will be asking the captive managers for copies of their anti-money laundering policies to make sure they are doing their necessary due diligence on the captives as well.

To comply with the US Foreign Account Tax Compliance Act (FATCA) and the International Common Reporting Standard (CRS), banks must gather and supply the required tax and beneficial ownership information on their offshore captive customers on forms such as an IRS W-8 BEN-E.

Banks specialising in captives should be aware of these new regulations and know what information is required to avoid regulatory problems and possible fines or sanctions in the future.

Conclusion

While often overlooked, establishing a banking relationship for a captive is an important step in the captive formation process and can actually save the owners both time and money if they use a bank that specialises in working with captives and knows what is needed.

The main services banks offer are letters of credit and Regulation 114 Trusts which are required collateral for statutory purposes to make sure the captive honours its reinsurance obligation, custody services and investment and treasury management of the captive’s assets and cash.

You want to be sure your captive’s bank has the specialised knowledge, capabilities, experience and market acceptance to provide these banking services in a cost effective and efficient manner.