Collateral Obligations and the Credit Crunch
Securing collateral for a deductible insurance program can be a daunting task in a tightening credit market. And, posting collateral for insurance requirements can pose a serious burden on any company affecting both your cash flow and borrowing capacity. The good news is that there are a number of alternative strategies that an entity can implement to deal with the problem.
But first, lets discuss the reasons for the collateral requirement. Under a typical deductible insurance program, the insurer agrees to pay for all legitimate claims upfront. The insurer then goes to the insured for reimbursement on the claims that fall beneath the deductible limit. This clearly creates a credit exposure for the insurer. And since Insurance companies are constantly being rated for their credit exposure, they must maintain a certain level of collateral for their statuatory reporting requirements. As an additional factor, liability exposures can be long term exposures, hense their potential losses are often based an an actuarial estimate. As such, insurance companies must protect themselves from their insureds failure to pay. Thus, the need for a collateral requirement.
So, how does this relate to the current credit crisis? Well, clearly, an insurance carriers financial stress will not improve any insured’s existing collateral terms. And right now most insurers are evaluating their portfolios, as well as certain classes of business, since in this tightened market, companies are at an increased risk of their clients defaulting on the payment of their upfront deductibles. These defaults can be either a delay in payment or bankruptcy. Regardless, they add stress to the whole system.
So, what can be done? The first option is to create a program that has a self-insured retention. This would make the insurer not responsible for the losses that fall within that retention. This is the most common strategy since a program that includes a self-insured retention eliminates the need for collateral in the first place.
Since collateral is based on structure, expected deductible losses and financial charecteristics, there are other options to consider that deal with these three items directly. So, the creation of a collateral agreement can include negotiating the future timing of obligations, pricing considerations, and paid loss credit. Since these terms are, in gerneral, rather complicated, they should always be spelled out and clearly documented in the insuring agreement.
As an insured, it is necessary for you to examine these issues more carefully with an experienced, licensed and knowledgable broker. And, now more than ever, it is imperative to analyze your collateral terms and do what you can to preserve your business’ cash flow.
