December 11, 2009

By: Mark Gordon

Capital Gains

Risk-sharing programs, commonly referred to as “loss-sensitive programs,” have been in existence for decades. Large insureds rarely seek to purchase guaranteed cost coverage because it is expensive, it is unavailable in hard-market cycles and because the sophisticated insured recognizes that the transfer of risk to an insurer for losses that are anticipated, based on the insured’s historical experience, is not financially prudent.

In more recent years, large deductible programs have become in vogue, although other risk-sharing programs remain in existence, including retrospectively rated premium programs and reinsurance programs with reimbursement features.

In each of the above-referenced risk-sharing programs, the insured pays a finite fixed cost to its insurer and will fund a certain amount of the losses incurred within the program. The carrier, in turn, issues a policy, which, on its face, provides coverage for the casualty line of business that the insured seeks to protect. The policy itself obligates the carrier to pay losses on behalf of its insured. The insured, through contractual obligations with the carrier, is to reimburse the carrier for claims paid up to the level for which the insured is contractually at risk. Not surprisingly, the carrier has a vested interest in making certain that its insured has the financial capability and incentive to reimburse the carrier to the level of the insured’s risk share. Thus, the need for collateral.

Risk managers who enter into risk-sharing programs on behalf of insureds recognize the potential financial benefits that are afforded to insureds that manage their risks through loss control measures and claims management. However, many risk managers did not contemplate the adverse financial effect that the pyramiding of collateral would have on their respective companies’ finances when the programs were first entered into.

Increasing collateral demands to support new policy years, where losses in prior years had not developed as adversely as anticipated, creates great tension between the insured and its carrier. Increasing collateral demands on the insured deprives the insured of allocating monies to operations that would generate corporate growth. Ignoring collateral issues is not an option. The cost of collateral, in many instances, can exceed the costs of a premium for the insured’s primary casualty program.

Collateral is, however, a necessary evil. Statutorily mandated, collateral protects the financial strength of an insurance company by providing to the carrier a safety net that can be accessed by the carrier in the event that the insured fails to meet its promise to pay or reimburse its carrier for paid losses, premiums and assessments.

Importantly, our clients today are confronted with an unstable economy where capital and credit are difficult to access. There is, therefore, greater pressure on insureds to manage collateral requirements. The best way to manage collateral is to understand how collateral works, why carriers want it and what one can do to control it. While carriers have a legitimate need for collateral, there is a need for the insured to monitor the collateral that is actually required versus that that becomes excessive and detrimental to its growth and stability.

Why So Much?

Collateral allows a carrier to recognize the losses or premiums that its insured will pay to it in the future. To have a greater understanding as to what the carrier requires and to secure a greater understanding as to what the insured may do to protect its own interests, an example is in order.

The best example to highlight these issues is the large deductible workers’ compensation policy. In the case of the large deductible workers’ compensation policy, the carrier assumes full statutory liability for all workers in the scope of coverage. High-deductible policies, in the end, perform in the same manner as a guaranteed cost workers’ compensation policy, even though the employer (the insured) contractually retains a significant portion of the risk. Regardless of the funding mechanics, deductible claims are paid by the carrier. The insured, thereafter, reimburses the carrier for claims paid within the insured’s retention.

While the high-deductible feature requires the insured to pay back to the carrier those amounts the carrier pays out within the insured’s retention layer, the carrier remains responsible to pay those claims covered by the policy. Thus, the insurer retains both the credit risk and the timing risk of reimbursement. Insurers manage their credit risk with collateral and their timing risk with a loss escrow, loss fund or sweep account.

The amount of collateral required by the carrier is predicated on anticipated losses, which are based on the insured’s historical loss profile. This figure may be adjusted based on the financial health of the insured, which accounts for a carrier’s ongoing request of its insured for financial statements. An insured with strong financials may be so attractive a risk to an insurer that an insurer may elect to contribute its own surplus to underwrite the insured that is seeking a reduced level of collateral. Clearly, there is less willingness for an insurer to contribute its surplus to collateralize an account when the insured’s financials are weak.

Steps the Insured SHould Take at Policy Inception

It is vital for the insured and its carrier to set the insured’s loss pick correctly. Accurately estimating losses prospectively is crucial to the equation. If a loss pick is too high, the financing obligations of the insured will be greater than that which is necessary. Similarly, if the loss pick is too low, the insured’s initial cost may be lower, but the insured may be in for an unanticipated expense thereafter. The estimate of the loss pick should be reviewed carefully. The insured, with the aid of an experienced broker, should determine whether there have been changes within its company that would favorably affect the historical levels of losses. A capable broker should communicate those changes within the client’s company that would have such a favorable effect to the carrier.

Some examples that might favorably affect a company’s loss pick would be a reduction in the workforce, improvements in automation that effectively eliminate some or all of the physical aspects of the work performed by the employees of the company or an insured’s commitment to better loss prevention and claims management.

The more sophisticated brokers have the ability to form their own actuarial assessments that may have greater credibility than the actuarial data utilized by the carrier. Oftentimes, underwriters will agree to compromise on the loss pick where independent actuarial data is shared with the carrier.

You Can Change Your Actuarial Profile

An insured’s loss pick will take into consideration the carrier’s estimate of ultimate losses that will be incurred in a given policy year. The actuaries and underwriters assigned to the insured’s program evaluate how, from a historical perspective, the insured’s losses had developed over time. If losses are permitted to fester, the carrier will pay out more benefits and expenses over the life of those claims.

An insured that appropriately involves itself in the loss prevention and claims process, and that intelligently partners with its carrier and defense counsel to resolve claims early on, reduces the prospects of adverse development. In turn, this will have a favorable effect on actuarial projections as to how the insured’s losses will develop, thereby reducing collateral requirements.

Utilize Your Broker in the Process

A sophisticated and capable insurance broker is equipped to present your company’s story to a carrier. Presenting a credible story as to the efforts the insured is making sure to reduce the risk of loss or in mitigating losses once they occur to avoid adverse development is an important tool in reducing loss expectations and, accordingly, collateral requirements. Further, a capable broker has the resources to identify trends within its client’s casualty programs that could justify a reduction in collateral requirements.

Choose the Right Program Structure

Once a client understands the true cost of collateral — in terms of the cost of capital that is unavailable for other business purposes — the client’s strategic decisions about the size and type of retentions will include collateral in the equation. The question becomes not simply how much risk to transfer and how much to retain, but the manner in which the retentions are handled. Retention represents a significant unknown, but the certainty of a loss-sensitive program comes at a price, and that price includes the burden of collateral.

Many risk managers assume that retaining a higher level of risk share will necessarily reduce the costs of insuring the risk of the insured. That is not, however, always the case. The insured that decides to take on greater retention in a layer where losses have not historically occurred may find that the reduction in premium by the carrier for this new self-insured layer is outweighed by the adverse impact of the increased collateral requirements. A competent broker can aid the insured in an appropriate analysis as to what retention levels the insured should seek.

Include the Carrier’s Credit Management

The carrier’s prime goal in collecting collateral may be to secure its surplus, but the carrier is also hedging against its own credit risk; and with that in mind, the insured should work with its credit management to open the lines of communication on the perceptions of the insured’s credit worthiness. Collateral should be manageable if the right loss pick is developed, the correct structure is utilized, and the insured makes an effort to build the correct relationship with its carrier.

What if Insured feels Carrier isn’t Treating it Fairly?

As noted above, many companies that were involved in programs where increased risk sharing occurred have not always seen a reduction in costs and improvement of cash flow that were initially anticipated. The constant requirement to securitize current policy years with collateral will undoubtedly lead to adverse financial consequences.

Oftentimes, our clients are asked to continuously collateralize a current program where the insurer retains the benefit of collateral protection provided in earlier policy years, which the insured perceives is far more than necessary to protect the carrier against losses reported in the earlier program years. It is anticipated that the carrier will contend that fresh collateral is necessary because of anticipated future adverse developments on existing claims incurred in prior program years, which includes a component of Incurred But Not Reported, or IBNR, claims. At some point, there may be a need to challenge the carrier’s rationale for retaining collateral. An independent actuarial assessment may be appropriate to challenge the assumptions of the insured’s actuaries and underwriters.

One should routinely review the underwriting assessment that the carrier constructed that generated the loss pick in a given policy year. This would include a review of the carrier’s actuarial assessment that led to the ultimate predictions for the insured in that policy year. Thereafter, the insured should objectively assess whether the losses in a given policy year occurred with the frequency and severity that were anticipated when the loss pick was initially derived.

This assessment should not be made in the first or second year after the end date of a given policy, as losses that are known to have occurred within the policy will not be credibly developed. Other losses may not be known to the insured and carrier at all.

The insured should work diligently with its carrier’s claim representatives and, when appropriate, defense counsel, to rapidly and accurately assess the likelihood that a claim can be successfully defended. In those instances where the likelihood of success is high, those claims should be defended. Other claims should be evaluated early on for settlement potential. All claims have settlement value, ranging from nuisance value to values that will exceed the insured’s retention levels. Claims that are aggressively handled at the outset can be intelligently valued for settlement early on in the claim process if the insured’s vendors (claim representative, broker and defense counsel) are performing their jobs correctly.

In reducing the time gap between the occurrence and the closing of the claim, an insured should be able to keep small claims from becoming large and large claims from becoming catastrophic. Each insured should have the objective to close all claims within three years of presentation. Substantially meeting this objective will vastly eliminate legacy claims, which will favorably impact the company’s actuarial profile and reduce collateralization requirements.

To meet these objectives, the insured must be intimately involved in its programs. Frequency issues should be addressed through loss prevention. Severity issues should be addressed through post-loss mitigation efforts. The insured needs to understand its programs, how claims impact its finances and what the insured’s involvement in the process, coupled with the involvement of a capable broker and counsel, can do to mitigate ultimate loss exposure and collateral requirements.

Reprinted with permission from the December 11, 2009 edition of the Legal Intelligencer© 2009 ALM Media Properties, LLC. All rights reserved.