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Letters of Credit: Challenges to insurer collateral requirements

A letter of credit can cost insureds tens of thousands of pounds in fees each year. How can an insured more analytically challenge its demanded level of collateral, and minimise the costs?

Insurers will typically request insureds or their captive to provide collateral as security for their obligations under a reimbursement or reinsurance agreement. This most commonly comes in the form of a Letter of Credit (LoC). Each year, a LoC can cost insureds tens of thousands of pounds in fees – especially if they do not have headroom within existing credit facilities. As LoC requirements are reviewed annually, fees are recurring and the collateral requirement ‘stacks’ year-on-year.

Over the past five years, harder insurance market conditions and evolving insurer collateral requirements have resulted in many insureds facing such accumulating costs or a drain on existing credit facilities. How can an insured more analytically challenge an insurer on its demanded level of collateral, and minimise the costs?

Why and how do insurers set collateral requirements?

Insurers set collateral requirements when ‘fronting’ insurance coverage provided to underlying insureds. Typically, this is for statutory insurance classes, such as UK employers’ liability or UK motor third-party. This involves clients who can’t take a retention, but agree to reimburse the insurer for claims below a certain threshold, and/or where an insured operates a reinsurance captive not admitted to directly underwrite within a certain jurisdiction.

The collateral requirement value set by an insurer will be largely based on an insured’s historic loss experience and base exposure (turnover, headcount, and vehicle numbers, for example). The value itself is intended to cover all future claim costs below the insured’s retention level (excess or deductible) or within the layer reinsured to the captive, for the period which that insurer ‘fronts’ the risk[1]. These could be costs from:

  • New claim events expected to occur.
  • Outstanding reported claims that are yet to be paid or settled.
  • Historical incurred but not (yet) reported (IBNR) claims.

Insurers’ actuarial calculations[2] will form a quantified view of the future claims costs and the collateral requirement is set around that value. When projecting claims costs, an insurer’s actuary may take a more prudent approach than an independent actuary.

Where an insured’s retention is capped or aggregated over the policy year, in addition to a per occurrence retention, sometimes an insurer’s collateral requirement is set against the full value of the annual aggregate retention. This is more common for low frequency and high severity exposures, such as property or cyber risks. For higher frequency casualty risks, this would be an overly conservative stance – unless the insured comes close to breaching its aggregate each year.

Current relevancy for insureds

Premiums have increased in recent years – in part due to reduced competition across the market. In efforts to offset or mitigate premium increases, many insureds opted to raise their excesses/deductibles – with some opting for a ‘non-conventional’[3] programme structure for a statutory insurance class for the first time.

While new excesses or deductibles will have helped optimise the insured’s risk financing costs, in those market conditions they will have been accompanied by new costs related to obtaining collateral (for example, an LoC) and some insureds may now have between three and five years of increased cost and annually stacking collateral. In the current market cycle, annual costs and levels of stacked collateral may reach their peak for insureds. This could create significant financial strains in an already challenging macroeconomic environment.

However, more favourable market conditions are starting to lead to more competitive commercial terms – including insurer long-term agreements (LTAs), fixing coverage, and pricing for multiple policy years (subject to agreed parameters). With a pre-set placement structure and pre-set insurer, LTAs can create additional opportunities for insureds to turn their attention to challenging LoCs – ideally, supported by appropriate, specialist actuarial analysis.

Hypothetical example of how insureds can benefit

There may be potential upsides for insureds. For a hypothetical example, an insured has a collateral requirement from its insurer of £12 million for the coming policy year and any historic years. The insurer’s preferred form of collateral is an LoC and subject to credit rating and other factors, a bank’s fee for an LoC may be approximately 0.75% of the value of collateral required. Therefore, with a collateral requirement of £12 million, the LoC would cost £90,000 per annum.

Subsequently, the insured and their broker negotiate with the insurer, using an independent actuarial calculation of expected retained claims costs (the credit risk borne by the insurer) to achieve a £2 million reduction in the collateral requirement. Therefore, with a proportionate reduction in the cost of the LoC from the bank, the insured could save £15,000. With a reasonably consistent risk and claims profile and consistent self-insured retention level, the insured could then stand to save that £15,000 on an annualised basis, or £75,000 over five years.

Additionally, £2 million of credit would be freed in an insured’s existing facility – which could be used elsewhere to support strategic growth objectives. As many companies have a cost of capital of around 8%, £2 million of freed up credit capacity could have an indirect benefit of approximately £160,000.

What can you do?

Ahead of upcoming renewals, insureds should open communication with their broker as soon as they expect their collateral requirement will require revising. Leading indicators for collateral requirement revision, include:

  • Material changes to business or risk profile (for example, M&A activity, new geographies, and rapid growth).
  • Material changes to loss/claims experience (for example, sudden increased loss frequency, emergence of new types of losses, or new large losses).
  • Planned changes to the level of self-insured retention (increased excess/deductibles).
  • Planned remarketing or change of insurer.

Subsequently, insureds should then engage with an actuary to gain an independent view of suitable collateral for retained claims costs for the coming policy year, plus unpaid claims and IBNR for historic years. Collaboration with your broker to ensure this forms part of the renewal process and negotiations prior to inception is also important.

It is important to regularly review collateral requirements with legacy insurers from historic policy years. Your claims experience will be maturing towards an ‘ultimate’ position over time as claims materialise and are settled – which should be reflected in collateral levels for historic years.

[1] For example, a collateral requirement can relate to multiple underwriting years with the same fronting insurer.

[2] Typically allowing for factors such as inflation, changes in base exposure, and claims frequency and severity development – the latter sometimes based on industry ‘development patterns’.

[3] For example, with an excess or a deductible.