With escalating workers’ compensation premiums, many organizations are turning to large deductible policies, giving them greater control over claims exposures and costs. While this option can be widely beneficial, insureds need to understand how the collateral requirement is developed for a large deductible policy.
Why is collateral required? A carrier will need it if the insured is unable to reimburse them for the claims already paid within the deductible.
“Sometimes large collateral numbers are quoted to an organization with little framework or understanding of how it was developed,” said Joe Braun, Assistant Vice President – Credit Risk at Safety National. “A great carrier or broker partner will explain their approach to credit risk and collateral with transparency, but it is just as important for an employer to provide details on why their financial risk profile may be more favorable than what is projected from the carrier’s analysis.”
Assessing Developed Exposures
Insureds must understand their prior year losses and how the carrier has actuarially developed those losses. The carrier analyzes these prior years’ losses, applies development factors and then creates a go forward loss pick. For a renewal account, the prior years’ developed exposures combined with the go forward year loss pick are the total developed exposures. This total provides insight into what the carrier could ultimately be exposed to if the insured could not pay their claims under the deductible. The carrier’s overall comfort level with the insured’s financial wherewithal will then determine how much of this total exposure number they need to collateralize. The higher the total exposures, the more collateral a carrier will likely require.
Incorporating the Carrier’s Financial Assessment
The next step involves the carrier’s assessment of the insured’s financial wherewithal. All carriers have an internal or external financial rating model that helps them assign the insured an overall financial grade. This grade is based on several quantitative and qualitative factors. Quantitative factors such as the insured’s financial statements and various financial ratios are reviewed and analyzed to see how they compare to other entities in their same class.
In addition to quantitative analysis, many qualitative factors are reviewed, such as understanding the company’s debt structure (interest rates, when debt is maturing, compliance with loan covenants), ongoing material litigation, mergers and acquisitions, and any economic-related concerns. Once the quantitative and qualitative factors are contemplated and weighed, the carrier will settle on a final financial grade. Every carrier will have a different model that produces a different financial grade due to the factors they feel are most important in determining an insured’s future solvency.
The insured needs to develop a relationship with the carrier’s credit team. The insured should be available to answer any questions the credit team may have and be forthcoming with any other information they can disclose that could impact the company financially. An open dialogue with the carrier’s credit team will give them a holistic view of an insured’s overall financial wherewithal.
Using the Financial Grade to Determine Collateral
How does the financial grade assigned by the carrier determine the collateral amount? The stronger the financial grade, the less collateral an insured will likely need to post. The weaker the financial grade, the more collateral the insured will likely need to post. Once the insured knows how much collateral the carrier requires, it is communicated to the broker, and the policyholder can negotiate the amount if they believe it is too high.
Understanding the collateral requirement for a large deductible insurance policy can be difficult. If an insured has questions about their collateral requirement, they should reach out to their broker as well as the carrier to gain a better understanding of how their losses were actuarially developed and what factors impacted their financial grade. Understanding these two key factors should help them demystify the collateral conundrum.