Keeping Pace with Carriers’ Changing Collateral Requirements
Under a large deductible insurance policy, the insurer contractually agrees to pay all claims as they occur, while the policyholder is obligated to reimburse the insurer for all claims that fall under the deductible amount.
To secure the policyholder’s liability, the insurer requires the insured to post collateral. This collateral requirement is intended to safeguard the insurer against risk by:
- Protecting against credit losses — carriers are liable through the statutory obligation of the deductible portion of the policy.
- Fulfilling statutory requirements levied upon the insurers by the states.
- Meeting financial rating agencies’ insurer surplus requirements, which is the ratio of total policyholders’ surplus to written premiums.
- Preserving their financial rating.
Recent changes have resulted in more stringent underwriting, increased collateral requirements, and higher costs of collateral. Much of this evolution is due to greater scrutiny of insurers’ financial accountability by rating agencies and regulators.
Insurers’ collateral requirements are also affected by the shrinking amount of available bank credit, client balance sheet strength or weakness, and insurers’ return on capital. Posting collateral has become an increasingly burdensome and expensive requirement for clients with loss-sensitive programs.
Drivers of Collateral Amount
Insurers assess the amount and the price of collateral required on a case-by-case basis, taking into account an individual client’s unique factors, such as parental guarantees, pension obligations, union relationships, and debt maturity. The main drivers of collateral requirements include:
- The program structure and duration — retention/deductible level versus historical loss experience.
- The actuarial loss projections and triangles, including historical policy years’ ultimate losses and the traditional payout pattern of prior-year losses.
- Results of a review of the client’s historical, current, and pro forma financial statements, as well as the perspective on current trends, liquidity, debt/leverage, coverage ratios, etc. Financial reviews may vary by industry. For example, a client in an industry with a greater useful life of its assets may be viewed more favorably than a client in an industry where assets depreciate or become obsolete at a faster rate.
- Completeness of underwriting data, including operational changes, losses, financials, potential M&A activity, banking relationships, legacy collateral outstanding, etc.
- The existence of safety initiatives to prevent losses and protocols to mitigate losses after they occur.
- Form of collateral — letters of credit (LOCs), trust, cash, surety, credit buydowns, etc.
An important consideration when selecting retention levels is that each increase in retention level may have a material impact on the collateral requirement. This is also an important consideration when determining whether or not to change carriers. Over time, there is a buildup of collateral that is commonly referred to as pyramiding. Insurers require additional collateral each year a program renews in order to maintain the proper ratio for security purposes. Factors around pyramiding collateral that should be noted include:
- Losses are incurred and developed using client-specific or industry loss development factors (LDFs). LDFs contemplate increases in the original reserves and estimated incurred but not reported (IBNR) losses. This combination of developed old losses and newly occurring losses builds up at a much faster pace than losses are actually paid — therefore, the collateral required by the insurer will pyramid over time.
- Until the actual paid losses for the cumulative policy years surpass the expected losses for the upcoming policy year combined with the developed outstanding losses for the cumulative policy years, the collateral amount required of a client will grow.
- The potential impact becomes highlighted and burdensome as each new policy year is added to the initial program.
Certain economic/financial improvements can help clients accelerate the reduction of the collateral pyramiding phenomena, including:
- Balance sheet strengthening: reduction of leverage as the result of improving profit-and-loss (P&L) results.
- Extension of debt maturity: less restriction on immediate cash outlay.
- Improved terms on the debt (rate and covenants).
- Secured debt versus unsecured debt.
- Improvement of cash flow from operations: ability to finance operations without using credit availability.
- The client’s particular industry’s improved projections/trends, for example, the homebuilding industry and how it was dramatically affected by the economy.
Pyramiding of collateral over a ten-year period for a company with an annual loss projection of US$4.75 million and whose program continues to be written by the same carrier — all financial variables being equal — may see a growth in collateral similar to that illustrated in Figure 1.
Availability of Letters of Credit
Clients can obtain LOCs through their bank/financial institution or, in some cases, through a third-party trust arrangement. The availability, as well as the cost of a LOC, greatly depends on the financial strength of the borrower and its relationship with its bank.
Some concern is arising regarding the cost and availability of LOCs simply from the amount of capital banks will have to allocate to the LOC obligation. This is due in part to capital requirements embedded in global standards — albeit tailored by country or regions like Eurozone — called Basel III. Basel III rules treat the LOCs with a contingent obligation very similar to a loan.
Additionally, there are capital requirements on loans under Basel III. Many newly incepting credit lines — often called revolvers — already charge the same spread for LOCs as for money drawn off the revolver. These new capital requirements are not fully phased in; however, full implementation is scheduled over the next few years. Going forward, these new capital requirements may have a negative impact on both the availability and cost of LOCs.
An interesting development is that those banks that are considered “systemically important financial institutions,” which may be global or national, will have imposed on them capital requirements that will be more stringent. These are some of the largest LOCs-issuing banks in the US, as they are often the agent bank on credit lines. Often, the credit line is backed by a syndicate of banks with an agent essentially fronting the credit line.
The Basel III rules, while not yet fully understood, are not expected to have a positive impact on credit availability and/or its cost.
As a result of the current state of the US and worldwide economies — combined with the new regulatory oversight — banks are becoming more restrictive on the total amount of LOCs they extend to their customers, and LOCs can be quite costly. In addition, insurance carriers have limitations or aggregates that restrict the total amount of LOCs they will accept from any one bank or financial institution over multiple insureds, thereby causing additional concerns for those posting collateral.
Financial ratings by Moody’s, Fitch, or Standard & Poor’s can affect a carrier’s willingness to accept LOCs from a particular bank; but, in general, carriers will accept banks on the National Association of Insurance Commissioners (NAIC)-approved list. There may be exceptions to the NAIC requirement, but they are rare.
Third-Party Trust Arrangements
Third-party trust arrangements are viable alternatives to LOCs and are more prevalent than they have been in the past. They are usually only for clients that are experiencing a restriction of credit from their bank or investors and can provide LOC capacity for clients unable to secure their own LOCs. Under this arrangement, the client must provide cash as security to the third party, which in turn will provide the needed LOC to the insurance carrier.
Cost of Letters of Credit
Banks and financial institutions are enjoying a period of heavy demand and shorter supply for LOCs, which allows them to price more conservatively. In addition to increased costs for LOCs, some clients (depending on their financial strength) are seeing a requirement to provide cash as collateral to the bank. Insurance carriers, however, have have been more willing to look at alternative forms of collateral, which has in many cases improved the overall cost and preserved credit lines.
Alternatives to Customary Letters of Credit
Carriers have recently become more flexible in accepting alternative forms of collateral to secure deductible responsibilities. These alternatives to the customary LOC come in varying forms and are inconsistently accepted by different carriers writing loss-sensitive casualty programs. Not all forms are universally accepted, and each needs to be negotiated based upon the carrier’s guidelines and the specific financial merits of each client.
The most common alternative forms of collateral are:
- Trust, or pledge of security.
- Surety bond.
- Credit buydown.
A trust, or pledge of security, arrangement is widely accepted by many carriers; however, the trust usually is in combination with an LOC. Trusts are simply cash or rated securities in the amount of the collateral needed. Not all carriers will accept a trust as a form of collateral; but in those circumstances in which they will, the overall cost for many clients will be less than the cost and constriction of credit imposed when securing a LOC.
Cash is an alternative that far fewer carriers will accept, as cash is not bankruptcy remote for 90 days. This lack of bankruptcy protection exposes the carrier to the potential of the loss of the cash collateral to the trustee and other creditors. This can occur as a result of other liens the insured/client may have granted against the cash.
Cash is a form of collateral that must be negotiated early and structured such that the carrier has minimized its exposure. In the circumstance of bankruptcy, cash can and usually will be considered by the bankruptcy courts as a challengeable asset of the client — therefore accessible by all creditors.
Surety can be an alternative form of collateral but is accepted by only a few carriers. In cases where surety is allowed, most carriers will limit the percentage of the total collateral they will accept as well as the provider of the surety. The standard percentage is no more than 25%, although some will go to 50%; and on a very rare occasion, a carrier may agree to 100% of the collateral in surety. The surety form used is not a customary surety bond, but rather structured to be a “demand instrument,” and must be approved by the carrier accepting the surety.
An increasing number of carriers will provide a credit buydown for a portion of the required collateral. A credit buydown is simply a credit charge paid to the insurance carrier in exchange for a reduction in required collateral. The amount of the credit charge varies considerably from one carrier to the next and depends heavily on the client’s financials. In circumstances where a client has a material restriction on its credit position with its lenders, the credit buydown alternative can serve it well.
Collateral Negotiation Process
The process of negotiating collateral encompasses three distinct steps: modeling, financial review, and goal setting/tactical discussion and direction.
The negotiation process should always begin with modeling and analysis of the existing collateral position, including:
- Outstanding liabilities, including legacy and incumbent carriers.
- Determination of the appropriate loss development factors.
- Recent or impending state legislation or reforms.
- Current trends.
- TPA reserving practices.
- Existing or planned loss mitigation, such as accelerated claim closure activity, etc.
- Loss projections.
- Collateral ramp-up projection.
As stated earlier in this report, financial reviews may vary by industry. A thorough client financial review includes:
- Examining pertinent ratios, including liquidity, debt/leverage, coverage ratios, etc.
- Discussing financial objectives specific to collateral — present and future LOC capacity, credit line restriction, and the client’s ability to use credit for operational or growth needs.
- Assessing the internal rate of return on capital versus the cost of a LOC, including any requirement of cash backing of a LOC.
- Evaluating the current forms of collateral and exploring alternatives.
Clients with distressed financials and/or potential bankruptcy will be subject to far more aggressive postures in securing collateral before binding coverage. Insurance carriers do this in order to avoid challenges from the debtor suggesting the collateral was for “antecedent debt,” or already existing obligations. In bankruptcy scenarios, collateral or additional collateral requested for obligations that existed before the bankruptcy filing must have the court’s approval and demonstrate that the carrier’s possession of the collateral provides the debtor with some form of value.
Goal Setting/Tactical Discussion and Direction
The first steps in the tactical discussion with a carrier should entail:
- Developing a critical understanding of the existing amount of “unsecured credit” extended by the insurer or deviation from the insurer’s projected collateral need. This includes future paid loss credits, financial strength deviation, or change in operation — for example, discontinued or divested operations and/or change in state venues/improved jurisdiction.
- Selecting the program structure — self-insured retention, deductible, treatment of defense, or nonsubscription that best responds to the coverage requirement and most effectively mitigates the collateral requirement.
In many cases, a meeting between the insured and the carrier’s credit officer may be advantageous. In these scenarios, it is extremely important to prepare the risk manager and/or treasury personnel for the discussion, including preparing for any and all questions the insurer’s credit officer may ask. At this time, it is also important to discuss the realistic mobility of the client’s program from one carrier to another — for example, the impact on legacy and overall collateral.
Insurers are not inclined to extend any unsecured credit/deviation to past clients in the same manner as they do for existing clients. In certain circumstances, this provides the opportunity for the client to consider a loss portfolio transfer or closeout of older policy years.
Collateral remains a challenge for many clients. With early and proper preparation, open and frequent dialogue, thorough modeling and analysis, and the exploration of all alternatives, insured companies can mitigate the amount of collateral required and free up credit to reinvest in their business.