Global inflation could precipitate a move away from letters of credit (L/Cs) as the preferred option for collateral put up by captive insurers that are set up and wholly owned by non-insurance companies to act as a direct insurer or reinsurer for a parent company and its subsidiaries.

Inflation is forcing banks to raise interest rates, which increases the cost of credit. So captive insurers could now be considering whether a cash collateral trust would be a better option than an L/C to use as collateral to their insurance carriers on fronted programmes.

In fronting programmes, an insurance company (the fronting carrier) issues a policy and transfers some or all of the risk back to the insured.

Changing views

Earlier this year senior vice president and manager of Comerica Bank's global and captive insurance group, Martin Ellis, said standby L/Cs are still the most popular collateral choice for captive insurance companies and the usage of standby L/Cs is continuing to grow (DC World News, 5 September 2022).

But in an article published this week in Captive International, senior vice president, corporate debt and specialised services, at Computershare Trust Company, Charles Baker, argues that as a result of higher interest rates, many captives that have historically used L/Cs at a low cost of credit may now re-evaluate the cost of collateral.

Cost comparisons

"Captive insurance companies will evaluate the cost of the collateral that they're posting," Baker reportedly said.

"Is the cost of a letter of credit now more than the cost of posting cash or securities into a trust? I think there's going to be some conversations around doing a cost analysis of whatever collateral they may need or be currently posting."

Annual renewals

Baker said that both captives and their managers will be considering this. L/Cs typically renew on an annual basis, and he expects to see trusts replacing L/Cs because of the economics of each.

New captives meanwhile will seek a clear understanding of the costs associated with an L/C versus a trust.

The article published by Captive International, Inflation could cause captive funding rethink, can be found here.