Captives are an unfamiliar concept for some business owners—let alone many brokers in the traditional market. Knowing what you have to pay for is already a headache. Hearing “you need to put in collateral” has you wondering how much more you need to put in on top of your premium.
Understanding collateral in captives can be a difficult concept for anyone to wrap their head around. At ReNu Insurance Group, we have taught plenty of captive owners about collateral. And we’ve made all the expenses as transparent as possible for the 130+ captive owners we’ve worked with, whether in premium costs or collateral.
In this article, you’ll learn what collateral is, why you need it, the different types, and how much you can expect to pay. That way, you can understand the usage of collateral and know what else you need to pay on top of your premium when becoming a captive owner.
What is collateral, and why does my captive need it?
Collateral is a line of credit or cash used to secure funding for the payment of claims in a captive.
When you don’t have any money, that’s where the collateral steps in. It’s basically reserve money for your captive labeled “break in case of emergency.”
With a fronting carrier involved, they have credit risk. (A fronting carrier is a traditional insurer allowing captives to use their paper in exchange for a small portion of the premium.)
They’re on the paper as part of your insurance company. Their name is attached to everything. If you don’t pay a claim for whatever reason and your captive goes bankrupt, it’s on them. They’ll have to pay the claim.
Your fronting carrier must know and feel competent that you have enough money to pay for claims.
But even if you somehow don’t need a fronting carrier for your captive, you’ll still need to put in collateral.
Collateral is paid through a line of credit, though typically in cash for captives.
The group captive model allows you to stack collateral over three years. If you have a fronting carrier for a single-parent captive, they might want it all paid at once.
If you're wondering what you would need to invest to join a captive insurer (including collateral) and your underwriting profit, use our pricing calculator to get your results.
What type of collateral can I use for my captive?
The most common form of collateral is cash—as in straight from the bank account.
Some will allow you to give a letter of credit to the fronting carrier. Let’s pretend you have $1,000,000 in an account and need a letter of credit for $500,000. What the bank will do is charge you $500,000 to keep that money in your account. You can’t use that money. So, if you have to write a check for that $1 million, it would bounce. It’s sitting there like it’s in ESCROW.
As for a Reg 114 trust, this is a fancy way of saying an ESCROW account–an intermediary with your money and won't allow any of it to be released until certain conditions are met. The money for the collateral lives in a particular bank.
How much collateral will I pay into my captive?
Depending on your captive or fronting carrier, your collateral could be as much as your premium. It depends since collateral is on top of your premium. For liability lines of business, it can be an additional 45% of your gross premium. For property coverage, collateral can be as much as much as the original premium.
When looking at the calculation about the cost of collateral, you should plan to have it be as much as your premium. It's better to be prepared, after all.
How much you put in depends on your premium and how your captive is set up. Most group captives allow the business to fund the collateral over the first three years.
How often will I pay collateral?
Your collateral is generally paid yearly, whereas your premium is quarterly (for most captives).
Thankfully, your collateral sits in there and earns interest. It is still your money. However, the fronting carrier, regulators, or captive manager wants to see that you have it.
Your collateral can move. So, as you either add lines of business or change your exposures, you’ll have to recollateralize that, meaning the cost of collateral could be increased.
You can also use surplus—excess money—to replace collateral. This allows you to get a refund of your original cash or reduce the letter of credit. When you replace all the original collateral with a surplus, we call this “playing with house money.” It’s a good practice to leave all of the surplus in your captive for at least the first five years.
Remember, captives are a long-term solution to your insurance needs. Having a surplus can only help you, whether it’s accumulating more profit or used “in case of emergency.”
Can I use more than one bank to collateralize?
Yes. If you have assets in different banks, you can do that.
Know the financial advantages (and disadvantages) of captives
While you may have learned about collateral, it might make captives look more off-putting with the amount of money needed to be put in on top of your premium. Thankfully, captives can be suitable for companies that are the right fit.
Next, you need to read our articles about captives and their financial advantages and disadvantages. That way, you will understand how your business can be profitable within a captive.
You must also read our article on how captives help you with cash flow. Reading this will help you understand what captives do with cash flow, what helps with cash flow, and what can inhibit your cash flow.
You might also be wondering how much you can save on insurance premiums. Take your assessment to get your results!
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