by Frank Huang & Jeff Adcock | December 3, 2021
The quote “in this world, nothing can be said to be certain except death and taxes” has been attributed to Ben Franklin at times. Collateral requirements can be added to death and taxes as well for many types of workers’ compensation insurance programs, most notably large deductible programs but also loss sensitive, risk-sharing or fronted programs, particularly captives.
But collateral need not be so grim or burdensome. In this three-part article, we share the common complaints from both insureds (Part 1) and insurers (Part 2). In Part 3, we share how both sides can resolve those issues far easier than it took Mr. Franklin to end the Revolutionary War. Without further ado, let us get into some commonly heard frustrations from an insured organization’s point of view:
“We (the insured) are paying the claims under the deductible, so why am I also putting up collateral?”
Insurance companies are assuming a credit risk when offering a large deductible program because, should the insured organization go bankrupt or otherwise not pay their deductible liabilities, the insurance company is ultimately responsible for paying the claims under the deductible. In the insurance industry, inclusive of PEOs, we have seen this financially harm and even bankrupt insurers.
For example, Lumberman’s Underwriting Alliance (LUA) went into rehabilitation in 2015 and then liquidation in 2016 driven by a large PEO that was unable to fund its collateral obligations and filed for bankruptcy. The financial impact of the unsecured credit risk on LUA was enough to push it into rehabilitation. This impacted the members of that large PEO, as well as many other insureds of LUA.
Bottom line, an insurance company will require collateral as part of good risk management practices to protect their balance sheet from this credit risk, and to ensure solvency so that they are able to meet their policyholder obligations.
“Collateral is too expensive.”
Collateral often is costly and, as we will discuss more below and throughout this series, can depend on a number of considerations. That said, collateral can be even more expensive than at first glance.
For example, insureds often underestimate the long duration and impact of stacking collateral over several policy years. Further, aside from explicit costs, there are implicit costs such as the opportunity costs of tying up capital and the impact on additional borrowing capacity as with letters of credit (LOC). LOCs are the most typical form of collateral and also involves an annual fee that can be significant depending on the financial rating of the insured organization.
Collateral is going to be a part of this type of program and the costs of adding collateral to the existing program costs should be considered relative to possible alternative programs.
“It’s hard to understand how the collateral requirement is determined and how it is adjusted/released over time.”
“The insurance companies hold over-weighted power in the collateral discussion.”
For some insureds, it can feel like the insurance company is out to “get them”. Insurance contracts related to collateral calculations can be vague, sometime deliberately. Insurance companies often hold collateral related to several prior years of an insurance program. Separately, but especially in combination, this can feel like, and often is, an oversized advantage for the insurer when it comes to program structure, pricing and collateral requirement.
First and foremost, insureds and their representatives should look to discuss and negotiate collateral terms and details before a policy year begins. For instance, some insurance companies use pre-determined loss development factors (LDFs) within the contract for calculating collateral adjustments. These LDFs may or may not be representative of your own claims development experience, your mix of business, etc.
Secondly, even if LDFs are not negotiated, there can at least be an understanding between the insured and the insurance company of how the collateral will be released. There are valid reasons for an insurance company not to share every detail of their collateral calculation, such as truly proprietary information, but insureds should insist on reasonable transparency of philosophy from their insurers. Again, an insured’s main opportunity to ask for specific details or terms is during the negotiation for the upcoming policy year. The insured’s broker and/or an independent actuarial resource can facilitate a smooth negotiation.
What can the insured do?
From our experience both working for insureds and insurers, one of the best ways to minimize collateral costs is to begin an open conversation with the insurer(s) about existing collateral and pre-emptively begin discussions about future collateral. These conversations can cover a range of issues pertinent to the risks being transferred, including but not limited to adverse development of known claims, estimation of unknown claims, and changes in the mix of business and/or underwriting criteria.
Insureds can also consider other financial instruments and arrangements, and even re-evaluate the costs of a deductible program relative to alternatives. For example, depending on the market cycle and pricing, a guaranteed cost policy may make more sense than a deductible policy when collateral and other administrative costs are considered.
This is by no means an exhaustive list of ways insureds can improve their collateral situation but we highlight the biggest drivers. Next, we will consider some of the frustrations that insurance companies experience from their side and what they can do to address those frustrations.
|Frank Huang has more than 15 years of actuarial consulting experience serving a wide range of clients, including serving as ADP’s Chief Actuary. Learn more about our PEO consulting practice here.|