Finding the Right Collateral Fit
Collateral can be complex and potentially impact a company’s borrowing capacity, but there are ways to optimize and improve the total cost of risk transfer. We dive into the various collateral options available and what benefits they can provide for an insured.
June 29, 2022
Most organizations are familiar with the bank letter of credit (LOC) as a collateral option. Still, other offerings can provide more freedom for a company attempting to use credit in additional areas of its operations. While not all options will be available to an insured due to capacity and financial requirements, they should be familiar with the various forms of collateral and the advantages offered by each to aid in discussion with their carrier.
“Insurance carriers will vary in the types of collateral they accept to differentiate themselves and provide more options for insureds,” said Joe Braun, Assistant Vice President – Credit Risk at Safety National. “Regardless of what type is chosen, it is important for the insured to find the right collateral fit and also understand the carrier’s position on exit collateral should the insured want to move to a different carrier down the road.”
There are various types of collateral accepted by a carrier.
What are the accepted forms of collateral in most states?
- Letter of Credit (LOC) – As the most secure form of collateral, LOCs are widely accepted amongst carriers. LOCs are a three-party agreement between a carrier as the beneficiary, the insured as the applicant, and the bank as the issuer. These are typically easy to obtain for insureds with strong financials. One disadvantage of an LOC includes cost, as a bank may require 0.5% to 1.5% of the stated LOC amount depending on their relationship with the insured. Additionally, an LOC can tie up an organization’s credit when it could be deployed elsewhere.
- Surety Bond – This is a three-party agreement between the principal purchasing the bond, in this case, the insured, the obligee requiring the surety bond and often the beneficiary of the bond, and the surety that guarantees the obligation under the bond, oftentimes the insurance carrier insuring the bond. Most surety carriers will cap the amount of surety bond collateral held at 25% to 30% of the total collateral required. The surety carrier issues a surety bond for the obligee to hold. The surety carrier underwriting the bond will look at the insured’s financial condition when determining the bond’s rate and whether any collateral will be needed. These can be costly in terms of bond premiums, as surety carrier bond rates could be anywhere from $5 to $15 per thousand of the bond amount. However, the benefit to the insured is that they can free up their bank credit, allowing them to use it for other endeavors.
- Non-Depleting Trust Account – Popular with small- to medium-sized businesses, this option is a custodial account between the insurance carrier, insured and the bank. The trust account is funded by cash, securities or other liquid assets that the insurance carrier is comfortable holding. This type of trust account can be a less costly alternative than the costs associated with an LOC or surety bond, but the assets held in the trust account are tied and will not be accessible to the insured or can be used as collateral for any other purpose.
- Depleting Trust/Cash Account – Collateral is posted based on the perceived loss expectancy projected by the carrier. Claims under the deductible are paid out of the cash from the account. The insured posts the full amount of the projected losses, and it is reevaluated at each go-forward renewal. The required renewal collateral amount may be decreased or increased depending on whether the calculation shows a redundancy or a deficiency. The advantage for the insured is that it makes it easier to budget cash flows. The disadvantage is that the insured does not have the cash flow benefit (float period) like they would with a static form of collateral. With depleting collateral, they are funding upfront the full amount of the projected losses at each inception/renewal. However, all of their claims payments will not be paid out for several years.
Other considerations when managing collateral with your insurance carrier:
- Depending on their comfort level with the insured’s financial wherewithal, some carriers may agree to accept the collateral requirement in installments over the year versus requiring the entire collateral required to be posted at policy inception/renewal. Talk to your carrier to see if they will allow the collateral to be posted in installments over a year.
- Discuss the various collateral forms with the insured’s management team, specifically the CFO. They understand the opportunity costs associated with the various forms of collateral.
- Understand the collateral requirement, how they are regulated, and acceptable forms of collateral should the insured decide to leave and move to another carrier. Many insurance carriers will take away most or all of the paid loss credits once they lose an account. They may also require that any collateral held going forward be in the form of an LOC.
- Some carriers may agree to offer a collateral commitment to help make the requirements more transparent, depending on their overall comfort level with the insured’s financial wherewithal. A collateral commitment outlines the financial ratios or other financial triggers, which, if met or exceeded, will allow the carrier to collateralize the same collateralization percentage as the previous year. This type of agreement offers the insured some transparency as to what kinds of triggers would require an increase in a carrier’s collateralization requirement.