At least once a year, risk managers and corporate financial executives engage in the "retain versus transfer" decision process in the evaluation of their insurance renewals.
The underlying premise is to determine whether it is more efficient to use an insurance company's balance sheet rather than its own corporate resources to protect the business from the financial impact of claims. The two parties to each renewal negotiation, the corporate buyer and the insurance company, usually have different views of the risk being contemplated.
On one side of the equation, the buyer weighs its own philosophy and ability to control and mitigate claims expense against the "transfer" premium cost. At the same time, the insurance company calculates the financial risk of underwriting the business against the backdrop of prior relevant industry experience, book of business performance and cost of capital.
More often than not, because of a belief that certain claims can be effectively managed and controlled better than an industry norm, the corporate buyer decides to retain the risk that is expected -- the frequency layer -- and transfer the catastrophic exposure, or the severity layer. The corporate buyer determines that its diligent risk management processes will more efficiently preserve the frequency layer capital versus an insurance premium payment.
In the "retain" decision, companies choose a strategy to drive down cost, create better cash flows, and avoid "trading dollars" with the insurance company for expected losses. In the primary casualty insurance world, companies purchase programs with large deductibles in order to achieve these goals. The insurance company issues the statutory or required policies and collects premium for the policy administration and catastrophic loss coverage. The corporate buyer now has its needed policy with the desired cost and cash flow efficiencies. All is good.
A current bad word in boardrooms across America, "collateral," is the trade-off for the lower pricing, greater control and efficiencies in loss-sensitive insurance programs. Collateral is required by insurance carriers to secure the reimbursement obligations of its customers in loss-sensitive programs.
Because policies such as workers' compensation, auto liability and often general liability are statutorily or contractually issued as "first dollar" evidence of coverage, the insurance carriers must first make payments to claimants and then turn to the insured for reimbursement of claims paid within the insured's chosen deductible.
This dynamic is a Catch-22 for the loss-sensitive buyer. The insurance carrier calculates the reimbursement exposure to the insured over the life of the policy and secures that obligation through holding collateral posted by the insured.
What factors determine the amount of collateral required by the insurance carrier?
First, the carrier estimates the amount of claims to be paid within the deductible portion of the policy during its term. Second, the carrier estimates the creditworthiness of the insured to determine its financial ability to meet the deductible reimbursement obligations over the term, keeping in mind that an insured's bankruptcy could jeopardize these reimbursements. Lastly, the carrier contemplates the instrument -- letters of credit, trusts, cash -- that the insured posts to meet this obligation.
Experienced risk managers, corporate finance executives and their insurance brokers know all too well that these three components are the subjects of intense negotiations at each renewal. Prudent insurance professionals know that well-prepared strategies for all three components are essential to drive efficiencies in the collateral requirement.
Before the recent credit crisis, corporate balance sheets were flexible with regard to available credit and capital that could be used for collateral purposes. Revolver-based letters of credit were relatively abundant and inexpensive. Additional capacity was available, when needed.
However, as a result of banking catastrophes and a general economic slowdown, the pool of available credit and capital began to constrict. Corporate finance chiefs across all industries turned a laser-like focus onto the preservation of capital. Banks re-evaluated their portfolios and adjusted pricing on credit lines. Insurance carrier credit officers analyzed their client base for potential default risks. Financially strong companies fared much better than businesses that were struggling through the slowdown.
Today, with many businesses still dealing with a sluggish economy, there are three key concerns affecting corporate insurance collateral requirements. One of them is the restriction of credit lines. Many companies found that post-2008 credit facility renewals often meant reduced credit availability and also increased letter of credit costs. Companies now have to weigh the available capital for use in their businesses with the collateral requirements for their insurance programs.
A second is the increased scrutiny of insurance carrier credit departments. As insurance carrier credit officers dealt with increased financial stress and bankruptcies within their client base, there emerged a renewed focus on the evaluation and security of the outstanding credit exposure on deductible reimbursement obligations across their books. Significant attention was directed toward financially distressed businesses that ran the risk of default on obligations or of increased claims frequency, especially workers' compensation, due to declining operations, or "claims creep." Today, many insureds are faced with little to no unsecured obligations, and some are surcharged above the expected loss exposure.
A third key concern is counterparty risk. Insurance carriers have also reassessed their credit exposure to financial institutions that post the collateral on behalf of their insureds. In reality, this is a much larger concern than an individual clients' financial health as credit officer alarm bells sound each time another "too big to fail" bank makes headlines. Insurance carriers hold billions of dollars of security in letters of credit from banks across the world. Many customers found that letters of credit were no longer accepted from certain banks due to the banks' own declining economic health.
While the volatile economic climate has tempered as of late, these are still ongoing concerns that buyers need to contemplate in all collateral negotiations. While you find news reports that show economic improvement, today's environment is still delicate.
Insurance carrier credit officers are keenly aware of indicators across the economy that highlight the challenges that still face corporate America. For example, one measure of corporate default risk, S&P Dow Jones Credit Default Indices, has improved since 2008, but the spreads, or the degree of default risk, still hover near the levels of late 2009.
More scrutiny is given by insurance carrier credit officers to financial ratings, individual clients' liquidity positions, overall financial projections, and qualitative measures of companies' record of reimbursements and borrowing histories. Understanding this prism through which the insurance carrier views a company's financial health is critical in tackling collateral negotiations.
DULLING THE PAIN
In light of these challenges and keeping in mind the goals of each company to use its capital in the most efficient manner possible, there are strategies to optimize collateral.
Noting that claims experience is the foundation for the collateral requirement, an active loss control platform, an effective claims management strategy, and a thorough actuarial analysis are keys to mitigating this component. Engaging the insurance carrier underwriter and actuary in a detailed discussion of a specific insured's own experience versus its peers can help drive down the expected loss calculation. Buyers must make the case that distinguishes the company's own exposure, practices, and experience from a carrier's overall book and/or industry benchmarks.
Understanding the macro- and micro-economics of each business as it relates to collateral reimbursement ability is also critical. Because insurance collateral is capital restricted from use in its business, company executives should challenge assumptions made about its creditworthiness in efforts to lighten this capital burden. In the spirit of partnership, insurance carriers can offer unsecured portions of the overall reimbursement obligation, referred to as "paid loss" or "liquidation" credits.
Buyers should also investigate the efficiency of the various collateral instruments they use, especially in this protracted low-interest rate environment. Discussions about capital-efficient program structures and alternative collateral instruments should be an integral part of each renewal negotiation. Insurance carriers can change their appetite for acceptable instruments without much fanfare, leaving buyers with limited options. There is a hierarchy of carrier-preferred collateral instruments -- letters of credit being at the top -- but companies should continue to explore other options that may use their available capital in the most efficient manner.
The risk managers and corporate financial executives who understand the interrelated dynamics of these components will be best suited to optimize their insurance programs, achieve their financial objectives and weather this economic storm.
This is truly a team effort. Companies should explore optimal strategies with their partners: insurance carriers, actuaries, brokers, banks, claims professionals, investors, accountants and other professionals that understand the dynamics of not just the insurance marketplace, but the overall economy and the capital markets. A capital-efficient, optimized collateral strategy can dull the pain of that bad word, "collateral."
GARY SHERTENLIEB is a senior vice president in Lockton's Kansas City, Mo., office, advising clients on risk finance and collateral issues.
December 17, 2012
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