SEPTEMBER 20198IN MY OPINIONMore and more, today's risk managers and insurance buyers are choosing to finance their risk with high deductible, loss sensitive programs to reduce their overall insurance premium costs. While many will analyze the cost of expected losses and compare against the reduction in premiums, some might underestimate the long-term impact of collateral required by the insurance carrier. Collateral can have a long-term impact on your access to capital and the ability to change carriers. In this article, we'll focus on casualty loss exposures, in addition to reviewing why insurance companies require collateral, forms of collateral, basics of the collateral calculation including paid loss or financial credits and other issues to consider.Why do insurance companies require collateral?Insurance companies take on a credit default risk when offering a deductible or fronted program option because they are ultimately responsible to pay for claims within the deductible if the insured is no longer in business. This credit risk is the reason insurance companies often require insureds to post some form of collateral to secure this exposure. In addition, there are statutory requirements designed to protect policyholders under Statutory Accounting Principles (SAP) that are more demanding accounting standards than Generally Accepted Accounting Principles (GAAP). Under SAP, the penalty for under-collateralization is a reduction of surplus which restricts a carrier's ability to write additional business. While the overall collateral held by a carrier is governed by SAP, the amount of an individual insured's collateral portion is a negotiable amount determined by many factors that will be discussed later in this article. Forms of Collateral· The most common and preferred form of collateral is a letter of credit (LOC). A letter of credit is a financial instrument that guarantees payment if the insured is in default. LOCs have an annual fee that is based on the financial strength of the company. LOCs typically reduce the amount of remaining borrowing capacity for the insured and can restrict access to capital to be used for areas other than insurance obligations. LOCs offer the most credit protection for the insurer since they are bankruptcy remote, meaning that the insurer's LOC cannot be used for other creditors in the event of a bankruptcy. Most insurers require the LOC at policy inception, although some insurers will agree to a predetermined step-up of the LOC on a monthly or quarterly basis depending on the financial strength of the insured. · Pre-funded deductible plans/working cash funds are not always bankruptcy remote, but they are somewhat more protected than segregated cash collateral or trusts. An incurred Understanding Insurance Collateral: Why it's Required and How it is CalculatedBy Marcia Linton, SVP, USI Insurance Services
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