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Earlier this year at the annual conference of the Risk and Insurance Management Society Inc., the broker on a panel provocatively titled "Are You Overcollateralized?" began the session by asking the attendees that question, "How many of you are overcollateralized?" After a collective moan along with a few chuckles, several hands went up.

So what does it mean to be overcollateralized? Simply, when your collateral, usually letters of credit, originally set up to cover your anticipated workers' compensation claims, exceeds the actual value of your claims, then you're overcollateralized. How does this happen?

Unless home values plummet, the lender is protected. You, the homeowner, on the other hand, can become overcollateralized when the value of your home exceeds your outstanding loan balance.

In that case, you can decide what to do with the excess value. You can sell the property and reap the rewards of the higher market value, or use the equity as a loan or line of credit. The lender doesn't control that enhanced value, you do.

Although there are similarities with home values, unfortunately the process of buying loss-sensitive insurance programs for workers' comp coverage doesn't necessarily put more money in the employer's pocket should the collateral letter of credit exceed the value of the employer's claims. These are considered restricted funds, earmarked to cover the insurance company's expectations of future claims.

"This is money that you can't spend to grow your business," points out Mark Noonan, Marsh's managing director and workers' compensation practice leader in Boston.

Even though it doesn't sound like a terribly appealing approach, for many companies it's a better option than the standard guaranteed cost policies, and can potentially save an employer as much as 10 percent to 20 percent in workers' comp insurance costs.

"Employers are most likely to carry collateral as a risk financing mechanism," says Diana Rich, director of risk management at Remedy Temp, a temporary light-industrial staffing firm in Aliso Viego, Calif. Rich has used this loss-sensitive workers' comp program since California approved an open-rating system in 1995, opening the doors for higher-deductible/lower-premium plans.

"Compared with buying a guaranteed-cost plan, they (employers) have the use of their money, and they end up paying claims out as they come due," says Noonan.

It's a better method of controlling workers' comp costs, he also says, because you don't pay the entire premium up front as with a guaranteed-cost plan. Instead, you can hold on to your cash through the higher deductible. You're investing in yourself and your commitment to control your claim costs, and you have more control over claims spending.

Noonan believes most any employer, even those with less than 50 employees, could benefit from a loss-sensitive insurance program, as long as they're not too risk averse.

THE ALL-IMPORTANT "LOSS PICK"

When setting up a higher-deductible/lower-premium program, the most critical part is negotiating what's known as the "loss pick," or the forecasted loss that the underwriter and its actuaries compute based upon loss rates for past years and the carrier's anticipated future exposure. The original loss pick sets the stage for your collateral requirements.

The negotiation involves you and your broker and covers many factors, including your company's loss history and data. Have you changed any claims practices? What's your TPA's track record? Have there been any major changes in your business, such as acquisitions, divestitures or abandoning operations in a high-cost state? Also, the insurer scrutinizes your creditworthiness and financial stability, your state's statutory standards, the carrier's experience with other firms in your industry and the industry's outlook.

Once actuaries crunch the data, they determine your rating, which establishes how much collateral the insurer will require.

An insurer might have as many as 18 different ratings. John Edmonds, senior vice president, credit management, at Ace-USA, based in Philadelphia, says Ace uses 11 different ratings.

During renewals the insurer will also use actuarial studies to look at incurred losses, paid losses and its loss reserves, and apply what's known as the loss development factor, or LDF, which corrects errors in estimating loss reserves and projects the additional expected costs for a group of claims.

If you're lucky and your claims are predictable or, as a risk manager you're adept at keeping a tight grasp on your losses, you're less likely to end up in an overcollateralized situation.

However, let's say you've instituted a new safety program so your $1 million original claims cost prediction has dropped to $900,000, reducing your collateral demands by $100,000.

Do you think your insurer will reduce your collateral requirement? Not necessarily, or even likely.

TRUST ERODED

Understandably, some employers are a bit skeptical at how carriers arrive at their collateral figures and letters of credit requirements. And that's a growing problem. The old "trust me" smile that insurers have used for years to placate clients just doesn't hold water anymore.

Insurers are not known for sharing their collateral computations with a client, even when the employer's actuarial figures differ by millions.

"Would you buy a business from someone if they wouldn't tell you how they ran it," asks Eric Miller, vice president at USA Risk Group, an alternative risk solution provider based in East Setauket, N.Y. "The lack of transparency in the alternative risk deals are not only unacceptable but are unethical," he says.

Whatever you want to call it, even though "transparency" has become the buzzword of the insurance industry, it hasn't yet caught on in the loss-sensitive plans. "It's being used very selectively as a competitive tool," says Michael Adreani, partner at Roxborough, Pomerance & Nye in Woodland Hills, Calif. But the odds of convincing an insurer to reveal its computations are slim to none.

However, Adreani points out, from a collateral and claims perspective, you're entitled to evaluate the computations during annual reviews, regardless of what your agreement says, a frequent defense.

"If there is a vast discrepancy between the collateral required and the outstanding reserves on file, particularly if you are two or more years into your policy, there may be grounds for challenging the good faith of those claims practices," Adreani says.

So after a five-year program, for example, your actuaries might compute your collateral letter of credit at $18 million, while the insurer's actuaries insist it's $22 million.

It becomes a battle of the actuaries. You and your broker want the insurer to justify the amount of collateral they're holding, and they politely decline. You demand the insurer release the $4 million difference. Again, they politely decline.

Frequently, this is where the marriage between the insurer and the employer breaks up, and you end up switching to another insurer who offers a better deal with lower collateral requirements. Unfortunately, then your initial insurer has no real motivation to swiftly release your collateral.

"Collateral is increasingly becoming an important issue because of the amount of money involved," says Noonan. That's why there have been a growing number of threats of legal action to force insurers to reveal their computations and/or release the collateral.

"We didn't have to litigate before," Adreani says, because in past years the client, broker and insurer were able to work out an amiable solution. That's not necessarily the case anymore.

Noonan believes insurers need to remember that workers' compensation is only one product line, and by treating a client fairly and with respect, there may be additional business down the pike. Besides, "insurers don't want the reputation that they have to be sued to get action," Noonan says. "Reasonable minds will find a reasonable ground."

SUSAN GUREVITZ writes regularly for Risk & Insurance® and is the editor of Workers' Compensation Report, an LRP Publications' newsletter.

October 1, 2006

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