Workers' Comp Collateral, What Is It Good For?
Workers' comp, collateral, huh yeah...
What is it good for?
Wait, what? Say it again. Now that the song is in your head, ‘listen to me.’ As a follow up to my last blog post on large deductible programs, I wanted to expand upon one of the more challenging items—collateral. In terms of collateral, “what is it good for” – well, if your answer falls in line with the famous Edwin Starr song “War”—absolutely nothing—then you’re in good company. In my experience, collateral obligations can be the single most difficult item for a company to fully appreciate and prepare for.
There’s good reason for this. The actuarial components behind collateral requirements can be complex. Obtaining collateral not only costs additional money outside of your premium payments, it can potentially have a large impact on your company’s borrowing capacity given the requirements stack year over year. While this can be financially taxing, there are ways to optimize and improve your total cost of risk transfer. The key to understanding and successfully negotiating these requirements is to break it down into two very basic questions: why & how.
When you have a large deductible, you take on the risk of having the financial ability to pay for those claims within your deductible. While those claim payments are ultimately your responsibility, the carrier is still contractually guaranteeing the payment of all covered claims. If one of their policyholders files for bankruptcy, without collateral set aside to draw on, the insurance carrier will be legally obligated to pay for claims they haven’t budgeted for. Setting aside adequate liquid funds to pay for future losses is not only a surplus requirement for insurance carriers, it’s also key factor in their overall financial rating and profitability.
“How do insurance companies evaluate the appropriate level of collateral needed for my company’s risk?”
There are two major ways in which a carrier determines how much collateral to ask for: an actuarial loss projection and a financial review.
The goal of a loss projection is to predict your future losses for the quoted term. This figure is then used as a basis for your required collateral. To this end, an insurer will review your historical payroll exposure and loss experience against industry claim development factors. The projected figure will include your total developed loss exposure for the annual term or, in other words, what your total incurred will be when every claim has been reported and closed out.
The projections shouldn’t, however, be automatically accepted at face value. While the analysis may be actuarially sound, the insurer is ultimately trying to predict the future. If actuaries could fully predict the future, there would be no reason to purchase insurance to begin with. Secondly, there are many different actuarial methods when projecting losses, and no one method is right every time. Your broker should develop their own analysis to best position themselves to negotiate a favorable outcome on your behalf.
Additionally, factors that may not be immediately apparent to the underwriter may need to be considered as well. You may have moved geographically, stopped working with a loss prone client, or built a new and robust safety program. It’s important the insurer has the complete picture when attempting to predict future losses.
The second step in determining your collateral obligation is a financial review which is commonly comprised of a detailed analysis of your audited and interim financial statements. This review will determine the insurer’s financial rating for your company which is a reflection of your ability to reimburse future claims.
While a carrier’s collateral requirement will be based upon their estimated loss projection, a company considered financially strong may have the required collateral adjusted to provide a discount. Alternatively, if there’s a perceived risk of default, collateral may be adjusted upwards. It’s important to know how your company is being perceived financially by the insurance carrier. Your broker should be facilitating a discussion between you and the insurer’s credit analysts.
Though the most commonly requested form of collateral is a letter of credit issued by your bank, there are alternatives that can be utilized, such as a trust, cash, or a surety bond. Your broker should review all options that may have a positive impact on your balance sheet and work with your insurance carrier to accept all alternative forms of collateral.
When structured correctly, a large deductible plan can significantly reduce your total cost of risk. At Assurance, we have the loss tools and resources to help you minimize the cost of your risk transfer, and maximize the effectiveness of your program. While building the right program can be a risky business—it’s what we’re good at.
- Workers' Compensation e-book
- Workers' Compensation Videos
- 2016 Industry Outlook Video: Staffing
- Collateral Calculator
- Workers' Compensation: Are You a Fair Weather Fan
- Workers' Compensation Dethroned
- Staffing Case Study: Large Loss Impacts Workers' Comp Program Options
- 3 Ways to Reduce Workers' Compensation Costs
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