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Understanding Insurance Collateral: Why it's Required and How it is Calculated

By Marcia Linton, SVP, USI Insurance Services

Marcia Linton, SVP, USI Insurance Services

More and more, today’s risk managers and insurance buyers are choosing to finance their risk with high deductible, loss sensitive programs to reduce their overall insurance premium costs. While many will analyze the cost of expected losses and compare against the reduction in premiums, some might underestimate the long-term impact of collateral required by the insurance carrier. Collateral can have a long-term impact on your access to capital and the ability to change carriers.

In this article, we’ll focus on casualty loss exposures, in addition to reviewing why insurance companies require collateral, forms of collateral, basics of the collateral calculation including paid loss or financial credits and other issues to consider.

Why do insurance companies require collateral?

Insurance companies take on a credit default risk when offering a deductible or fronted program option because they are ultimately responsible to pay for claims within the deductible if the insured is no longer in business. This credit risk is the reason insurance companies often require insureds to post some form of collateral to secure this exposure.  

In addition, there are statutory requirements designed to protect policyholders under Statutory Accounting Principles (SAP) that are more demanding accounting standards than Generally Accepted Accounting Principles (GAAP). Under SAP, the penalty for under-collateralization is a reduction of surplus which restricts a carrier’s ability to write additional business. 

While the overall collateral held by a carrier is governed by SAP, the amount of an individual insured’s collateral portion is a negotiable amount determined by many factors that will be discussed later in this article. 

Forms of Collateral

• The most common and preferred form of collateral is a letter of credit (LOC). A letter of credit is a financial instrument that guarantees payment if the insured is in default. LOCs have an annual fee that is based on the financial strength of the company. LOCs typically reduce the amount of remaining borrowing capacity for the insured and can restrict access to capital to be used for areas other than insurance obligations. LOCs offer the most credit protection for the insurer since they are bankruptcy remote, meaning that the insurer’s LOC cannot be used for other creditors in the event of a bankruptcy. Most insurers require the LOC at policy inception, although some insurers will agree to a predetermined step-up of the LOC on a monthly or quarterly basis depending on the financial strength of the insured.  

• Pre-funded deductible plans/working cash funds are not always bankruptcy remote, but they are somewhat more protected than segregated cash collateral or trusts. An incurred loss retro is a pre-funded mechanism that is bankruptcy proof since it is considered a premium. A deferred incurred loss retro is another example that defers part of the premium to the first adjustment.

• Cash collateral is not bankruptcy remote until held for a minimum of 60 days. Cash collateral can tie up cash for years, so it is important to understand that the cash will not be available for other are as of the business for some time.

• Trust funds are typically used for captives or risk retention groups. Fees may or may not be less expensive than LOC, but insureds lose the use of funds tied up in the Trust. A benefit to a Trust is that the Insured can earn investment income.

• Loss portfolio transfer is a mechanism to convert a deductible plan to guaranteed cost. Premiums are typically costly and are based on the net present value (NPV) of developed outstanding liability, plus a risk premium or hedge factor.

Collateral Calculation

Loss and exposure data accuracy is critical since it is the basis for the collateral calculation. There should be a minimum of five or more years of data and enough claim volume for a credible loss projection analysis.It is important to conduct a claims review and examine any opportunities for claims closure six months prior to the calculation. Tighten up any hidden charges such as medical bill review pricing and factor in any improvements when determining next year’s loss pick. Other items to factor into the future loss projection are changes to safety or claims procedures, divestitures or acquisitions, discontinued products or services, changes in fleet makeup or usage, incentive-based cost of risk allocation systems, and changes in TPA or claims handling practices. Communicate any changes to your actuary or broker so that your loss projection accurately represents your current operations.

Carriers typically utilize their book of business to determine the loss development factors (LDFs) in the collateral calculation. Client LDFs can often be more favorable than the industry or carrier factors. If you have at least seven to ten years of credible data, it might be beneficial to share your loss triangle data and/or actuary report with the carrier to get a more accurate calculation of outstanding liability.

The Insured’s financial rating is a key factor in the amount of collateral required. The insurer’s credit department determines collateral guidelines by credit tranche. Strong financials can translate into material credits against ultimate outstanding losses (up to 50% for AAA-rated clients). While weak financials can equal 25-50% additional collateral required. 

The initial collateral calculation is based on ultimate retained losses, less losses already paid within the retention. This outstanding liability is the starting point in the collateral negotiation discussion. It is imperative to calculate future paid and financial credits (depending on your financial rating discussed above) as these financial deviations can be a significant reduction to the collateral owed.

Other Considerations

Collateral can have a long-term impact on your access to capital and the ability to change carriers. Consider your company’s financial profile and how it will impact collateral owed. If changing carriers, consider the transition time and additional collateral impact as the prior carrier will most likely discontinue any paid loss credit benefits and the new carrier will need to collateralize the new loss pick. Factor in the stacking of collateral as you add additional years of deductible losses. Include both the hard costs (LOC fees) and opportunity costs (access to capital) when comparing alternative programs. Most importantly, educate your management team so that there are no surprises.

Marcia Linton is a senior vice president and national analytics practice leader for USI Insurance Services, based in Tampa, Florida. She can be reached at marcia.linton@usi.com.

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