By TIM DESETT, senior vice president and head of the Financial Solutions Advisory Team at Lockton
In today's environment of market uncertainty with access to global credit markets tightening and the cost of raising capital increasing, lending standards have become much stricter.
Even though insurance terms have softened over the last few years, these factors are creating a situation that makes the amount of capital a company has tied up in collateral with its insurer an increasing concern.
Collateral, especially in this credit market, can be a material component of the insurance program cost. To meet their collateral obligation, companies often have to tap existing credit lines or cash reserves, which represents a drain on the company's available borrowing capacity or ties up capital.
By re-evaluating their deductible insurance programs, companies may be able to get their collateral obligations reduced and free up capital for other uses.
WHY IS COLLATERAL REQUIRED?
Insurance companies typically require collateral for deductible insurance programs. That's because under these programs, the insurer agrees to pay all claims up front. Subsequently, the insurer goes back to the client to be reimbursed for claims that fell under the deductible limit. This creates a credit exposure.
While corporations typically are not required to put up collateral for other trade receivables, with insurance it's different. Insurance companies have ratings agencies evaluating their credit exposure and must maintain a certain level of collateral for their statutory reporting requirements. In addition, primary casualty and professional liability exposures are typically long term in nature and the potential loss is based only on an actuarial estimate. This makes it harder for the carrier to truly quantify its credit exposure.
To protect themselves from the risk that their clients will fail to repay them for the deductible losses, insurance companies require their clients to put up collateral. Only certain collateral instruments, however, are accepted, including letters of credit, cash and marketable securities.
While surety bonds have historically been accepted by some carriers (on an exception basis) for part of their collateral requirement, they are not an approved form of collateral by the state regulators and usually get discounted in value when the carrier assesses the amount of collateral held with an insured.
THE COLLATERAL BURDEN
Posting collateral for insurance requirements can pose a serious burden for many companies. Letters of credit deplete their available credit line, so every dollar of credit takes away a dollar of borrowing capacity. In addition, the letters of credit may trigger additional loan covenants as the aggregate borrowing gets closer to the available credit limit. This helps explain why senior financial management may be more concerned about the use of letters of credit for the insurance program than they have been in the past. With continuing tightening in global credit markets, this problem is likely to continue for an extended period of time.
Meanwhile, cash that is dedicated toward the collateral requirement is cash that is not being used to pay down debt or reinvest in the company.
The collateral requirement can also limit a company's ability to switch to a new insurance carrier. If a company's insurance carrier is holding redundant collateral--that is, more collateral than is warranted based on the remaining liability--this can be used as leverage to keep the company from leaving for another insurer. Rather than adjusting the collateral requirement downward, the carrier will use that redundancy to offset the new collateral needed for the following policy year.
While the prospective new carrier may offer advantageous pricing, its collateral requirement for the first year and the prospect of stacking that requirement for prospective years can overshadow pricing benefits, especially for a company with limited capital availability.
Another consideration in this economic environment is the potential volatility embedded in a deductible program. Although senior management may have been comfortable with the deductible levels in the past, circumstances can change. If there is an unexpected increase in the frequency or severity of claims, that could result in an unexpected increase in the company's self-insured accrual as well. An increase in the accrual will mean an expense on the income statement. In this market, the impact of an additional, unexpected expense could severely affect the company's bank covenants, cash flow and/or ratings evaluations.
As a result of all of these factors, corporate risk managers should evaluate their current insurance program in conjunction with their financial objectives. Given the impact of the collateral requirement on a company's cash flow and available borrowing capacity, risk managers might do well to make some changes to the terms of their deductible insurance programs.
However,in this environment, insurance buyers should recognize that insurance companies have pressures of their own. With the tightening credit market and weak economy, insurance companies are at increased risk that clients will fail to reimburse them for the up-front deductible payments. These defaults can range anywhere from a delay of payment to an actual bankruptcy.
Even if a bankrupt corporate client continues to pay its deductible losses to its insurer, there is still an additional cost to the insurer because the bankruptcy filing requires the insurer to engage legal counsel to navigate and administer the various filings to prove and protect its claims.
Insurers are, therefore, taking a close look at their credit portfolios and some have been re-evaluating certain classes of business because of financial failures, even though the underwriting profile was attractive.
This not only has a negative impact on the remaining members of those industries, but also affects other insureds as the carriers tighten their overall credit standards.
While it's true that insurers are concerned about the increasing counterparty risk, there are various ways that corporate risk managers can get the amount of collateral dedicated to their insurance programs reduced and gain additional borrowing capacity for other uses.
In most situations, collateral is a direct result of the structure of a company's insurance program. A classic example of this is where an insured might choose a $1 million general liability retention per claim, which is estimated to retain a total of $2 million in losses. Under a deductible program, this may call for anywhere between $1.5 million and $2 million in collateral.
The program could be structured as a self-insured retention, however, so that the insurance carrier would not be responsible for losses within the retention. As such, the program should not require collateral.
While this is a commonly used strategy, especially for general liability, there are a number of alternative strategies for other primary casualty coverages, captive programs and pure fronting structures.
These collateral terms should be clearly documented in the company's agreements, which will also include the timing of future collateral calculations and what should happen if the carrier experiences financial distress.
A carrier's financial stress will generally not improve collateral terms. There are separate considerations, which should be evaluated as to the insured's counterparty risk with financially distressed carriers.
As with any other business relationship, getting to know one another is also important. Corporate risk managers and other senior executives should build a relationship with their insurance company's senior management. All too often, the insurance buyer does not know the person making the credit decision at the insurance carrier and has never presented the company's case for consideration.
Knowing the person making that decision has never been more important for collateral decisions and for a company's understanding of the carrier's exposure to counterparty risk, as well as the subprime event.
This dynamic is not prevalent in corporate credit relationships, and it should not be the norm for the insurance program. This not only holds true for the relationship with the insured's current carrier but also should apply to the collateral adjustment process with prior carriers, especially if there has been a material change to the company's financial characteristics since the departure.
Finally, it is important to know the competitive landscape. An experienced insurance broker should be able to help clients project the amount of collateral any program will incur, not only for the current program, but also for future years.
This will help companies to make informed decisions about switching carriers or about insurance program structure. A broker can also provide advice on how a company's particular financial characteristics should be assessed by the insurance carrier and how much collateral may be needed. Because collateral is primarily based on three components--structure, expected deductible losses and financial characteristics--there is no easy rule of thumb as a guide.
Questions insurance buyers should ask their brokers include:
--How did the carrier calculate the collateral requirement?
--How does this compare with your assessment of the deductible losses?
--Should I receive a paid loss credit? If so, how much?
--How are future collateral adjustments determined?
--How do these terms compare with other companies with similar financial characteristics?
Despite the overall credit strain, carriers may be willing to consider trading lower collateral terms for pricing considerations. This decision cannot be made independently. Your broker should be able to analyze and help you determine the cost-benefit of each component and the various options available.
October 1, 2008
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