Insurance Program Collateral Strategies That Balance Protection and Flexibility

When it comes to insurance programs that require collateral, particularly large deductible or retention plans, the type of collateral selected can significantly impact an insured’s financial flexibility, cash flow, and risk profile. Several collateral options are available, each offering distinct advantages and limitations depending on the insured’s financial health and strategic priorities.

“As both insurers and insureds navigate complex risk arrangements, having a clear understanding of collateral options is not just smart, it is essential,” said Mitch Klauser, Credit Risk Underwriting Manager at Safety National. “The right choice balances protection for the carrier with financial flexibility for the insured.”

With today’s evolving insurance landscape, understanding the variety of collateral types is more important than ever.

Letters of Credit (LOCs)

Most beneficiaries prefer LOCs as collateral. Considered the safest form of collateral, LOCs require only a two-party agreement between the bank and the beneficiary. In the event of bankruptcy, an LOC cannot be taken from a beneficiary, offering the most significant bankruptcy protection.

• Advantages to an insured: 
  • This form of collateral is relatively easy to obtain, as most banks are familiar with the language beneficiaries want to use in an LOC agreement.
• Disadvantages to an insured:
  • Often, the LOC is sourced from an insured’s line of credit, which reduces the insured’s borrowing ability. This can make an insured’s line of credit inaccessible when they need it for other business purposes.
  • Banks typically charge an LOC processing fee, ranging from 0.5% to 2% of the LOC amount.

Bank Trust Accounts

Currently, most insurance carriers have an appetite that allows them to hold a portion or the entire collateral required in a trust account.  While this form of collateral is not as strong as an LOC for the beneficiary to hold, it is still a trusted, acceptable type.

• Advantages to an insured:
  • Bank fees for administering a trust account can be much more affordable than the LOC bank fees or the fees associated with obtaining a surety bond.
  • Insureds can fund the trust using various investment accounts, which can provide returns back to the insured.

Surety Bonds

For insureds with average-to-strong financial status, surety bonds can be another form of collateral that an insurance carrier is willing to hold. Typically, most carriers will allow 20-30% of the total collateral requirement to be posted in a surety bond. For high investment-grade rated insureds, some carriers may even agree to take more than 30% of the total collateral requirement in surety.

• Advantages to an insured:
  • Collateral is not required to be posted to the surety carrier issuing the surety bond.
• Disadvantages to an insured:
  • In most cases, the costs associated with a surety bond are more than the fees an insured would pay to a bank for an LOC or a trust account.
  • Only highly rated financial accounts will qualify for this form of collateral.

Working Cash/Trust

This form of collateral requires continual management by both the beneficiary and the insured, and it is only accepted by a limited number of insurance carriers. Many times, insurance carriers will require 100% (or nearly 100%) of the loss pick exposures to be sent to them in cash at the policy’s inception. The carrier/TPA will use this cash to fund all claims payments under the deductible as they arise. Working cash/trust accounts may be preferred by insureds who are uncomfortable with posting static collateral and would prefer to use the cash/trust collateral posted to make claims payments under the deductible as they are due.

• Disadvantages to an insured:
  • There is no cash flow advantage. In most cases, the carrier will require all the go-forward-year projected losses to be posted in cash/trust to the carrier at the policy’s inception. Unfortunately, it could take many years for these projected payments to be paid out, especially for workers’ compensation policies.

Other Innovative Collateral Solutions

In the last few years, some new companies have entered the collateral marketplace, helping insureds with below average or weaker financials obtain LOCs. These companies will charge a fee to an insured for building an LOC facility. This fee can be similar to what an insured would pay for taking out senior debt/notes. Often, these LOCs can be posted with the insured having to post very little or no collateral. The LOC provided to the beneficiary is from a beneficiary-approved bank, and the LOC is prepared using the beneficiary’s LOC language.

Some brokers and companies have surety-backed LOC facilities that insureds can tap into. In these instances, the bank provides the LOC, but a surety company guarantees the bank’s obligation instead of the bank.

This article is provided for informational purposes only and does not constitute legal advice. You should consult with qualified legal counsel before acting on any of the information.