Insurance Trusts May Thrive as Banks Tighten Credit for Insurance Transactions

Changing regulatory attitudes in the United States toward collateral, combined with wider commercial trends, are pointing Bank of New York Mellon toward what it sees as a global market in insurance trusts.

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Pressure on the National Association of Insurance Commissioners in the United States to ease up on collateral requirements on foreign reinsurers amounts to a potential threat to “the business model that we have been operating quite nicely for a number of decades,” said Caroline Cruickshank, London-based vice president for global corporate trust for Bank of New York Mellon. A strategy of diversification would help mitigate such a loss.

Collateral is becoming more important in other areas. Examples include reinsurance contracts, the relationship between a captive and its fronting carrier and a large international transaction where credit quality is a concern, said Cruickshank.

Insurance trusts act as “an alternative form of collateral and can be used in place of letters of credit,” Cruickshank said.

In the bank’s view, the insurance trust has the added advantage of being less expensive to create. It also has no negative effects on the credit of the sponsor. The Bank of New York Mellon describes itself as the largest manager of insurance trusts by value in the world.

The insurance trust also has appeal in an environment in which banks — who act as the issuers of letters of credit — have become reluctant to extend credit, Cruickshank said. As a result of the financial crisis, banks have suffered credit downgrades.

“Banks’ own balance sheets today are obviously squeezed,” she said. “Liquidity is squeezed.”

Matthew Latham, London-based regional head of the major practice in risk finance for Chartis Insurance UK Ltd., said security trust insurance agreements “are starting to crop up more and more” as collateral has become an issue in the European captives sector.

“With everything happening in the financial crisis, the ability to get letters of credit, and the cost of those letters of credit, has obviously increased quite significantly,” Latham said.

As an insurer of the credit risk, Chartis would consider alternative means of collateral when fronting for captives, which “are not typically highly capitalized insurance companies,” Latham said.

He said Chartis has received a lot of interest from banks offering these services.

“We are agreeable to these, because we understand the pressures that the captives are under and want to be able to try and work with them to get the best possible solution,” Latham said.

Catherine Thomas, managing senior financial analyst at the A.M. Best Co. in London, said letters of credit are used to support funds within syndicates at Lloyd’s. Unlike trusts, letters of credit are renegotiated annually. By contrast, the trust would require start-up costs and small agency fees after that, she said.

“I don’t believe the cost of credit for LoCs has become too expensive, but there may be concerns that it could become so,” Thomas said.

Collateral could be an issue among European captives that are based offshore, or outside the European Union, Cruickshank said. Offshore domiciles include Guernsey and the Isle of Man. Unlike an onshore counterpart, a captive domiciled offshore would not benefit from its corporate parent’s credit rating.

Cruickshank, who focuses on insurance and client relationships, said the increasingly cross-border nature of insurance transactions has encouraged the use of collateral. Insurance trusts are also of interest to investors in insurance-linked securities, she said.

The idea might be of use where a specialist fund backs the use of a protected cell company, which is a variant of a captive that allows risks to be treated separately.

Bank of New York Mellon was formed by a merger in 2007 between Bank of New York and the Mellon Corp. Each institution brought expertise in custody administration, which is defined as the safekeeping and administration of client assets. These would include securities and cash.

Mellon brought a “boutique of asset management firms,” while Bank of New York brought such departments as her corporate trust group, Cruickshank said.

“Insurance trusts are a recognized concept” within the regulatory framework of the U.S. insurance sector, Cruickshank said, adding the product offered in the United States is both mature and sophisticated.

Units of Chartis have current Best’s Financial Strength Ratings of A (Excellent).

(By Robert O’Connor, London editor: Robert.OConnor@ambest.com)