Perspective: Free Up Valuable Investment Capital by Reducing Insurance Collateral
- Nov 24, 2008
By Tate McCoy, Lockton Companies, DenverMarket uncertainty has led to tightening of global credit markets and increased the cost of raising capital. To make the situation even more painful, real estate developers and apartment owners are likely to face increased insurance premiums. The property/casualty industry has seen a decrease in revenues of between 30 to 40 percent from last year due to lower premium volumes, large catastrophe losses from tornadoes, hail and hurricanes and reduced investment income from the downturn in the stock market. All of these factors make the amount of capital a company has tied up in collateral with its insurer an increasing concern. But, all is not doom and gloom. By re-evaluating their deductible insurance programs, companies may be able to reduce collateral obligations and free up capital for other uses.The Collateral BurdenPosting collateral for insurance requirements can pose a serious burden for many companies. Letters of credit deplete their available credit line, so every dollar of credit takes away a dollar of borrowing capacity. In addition, the letters of credit may trigger additional loan covenants, as the aggregate borrowing gets closer to the available credit limit. Meanwhile, cash that is dedicated toward the collateral requirement is cash that is not being used to pay down debt or reinvest in the company.The collateral requirement can also limit a company’s ability to switch to a new insurance carrier. If a company’s insurance carrier is holding more collateral than is warranted based on the remaining liability, this can be used as leverage to keep the company from changing carriers. Rather than adjusting the collateral requirement downward, the carrier will use that redundancy to offset the new collateral needed for the following policy year.While the prospective new carrier may offer advantageous pricing, its collateral requirement for the first year and the prospect of stacking that requirement for prospective years can overshadow pricing benefits, especially for a company with limited capital availability.Another consideration in this economic environment is the potential volatility embedded in a deductible program. Although senior management may have been comfortable with the deductible levels in the past, an unexpected increase in the frequency or severity of claims could cause an unexpected increase in the company’s self-insured accrual as well. Think StrategicallyThere are many ways that corporate risk managers can reduce the amount of collateral dedicated to their insurance programs, thereby gaining additional borrowing capacity for other uses.In most situations, collateral is a direct result of the structure of a company’s insurance program. Here’s a classic example of this: A company might choose a $1 million general liability retention per claim, which is estimated to retain a total of $2 million in losses. Under a deductible program, this may call for anywhere between $1.5 million and $2 million in collateral.The program could be structured as a “self-insured retention,” which means the insurance carrier would not be responsible for losses within the retention. As such, the program should not require collateral.As with any other business relationship, getting to know one another is also important and it has never been more important for collateral decisions and for a company’s understanding of the carrier’s exposure to risk. Finally, it is important to know the competitive landscape. An experienced insurance broker should be able to help clients project the amount of collateral any program will incur, not only for the current program, but also for future years.Because collateral is primarily based on three components—structure, expected deductible losses and financial characteristics—there is no easy rule of thumb as a guide.Questions insurance buyers should ask their brokers include:• How did the carrier calculate the collateral requirement?• How does this compare with your assessment of the deductible losses?• Should I receive a paid loss credit? If so, how much?• How are future collateral adjustments determined?• How do these terms compare with other companies with similar financial characteristics?Despite the overall credit strain, carriers may be willing to consider trading lower collateral terms for pricing considerations. Tate McCoy is an executive vice president with Lockton Denver, an insurance brokerage firm serving the multifamily industry.