Wrap-Ups and the Issue of Collateral (Part 1)
January 2007
Turning somewhat away from the Wrap-Up 101
approach previously utilized, I have been thinking about an insurance/wrap-up-related
subject that appears to cause confusion, some consternation, and other bewildering
adjectives. It generally becomes a cause for discussion at the time the insurer
proposes the wrap-up program. It is the issue of collateral.
by Richard
Resnick
Willis of New York
Why such a "simple" 10-letter word can cause blood pressures to rise and
give otherwise calm risk managers an anxiety attack will become evident in this
two-part article. In Part 1, we will deal with some technical issues regarding
what collateral is and the reasoning behind why underwriters require it. In Part 2 we will take some of the mystery and anxieties
out of this discussion by focusing on some of the issues of collateral requirements
and provide suggestions that may help in mitigating those issues.
What Is Collateral?
The dictionary defines collateral "as property or goods used as security
against a loan and forfeited if the loan is not repaid." The most basic form
of collateral familiar to many of us is using one’s home as security against
a mortgage. Also, an automobile collateralizes an automobile loan. These instruments
are examples of physical properties. Other forms of collateral may be cash,
letters of credit, stocks or bonds.
Why the Underwriter Requires Collateral?
To explain this, we must go back to some risk financing basics. Very simplistically,
one can look at the insurance transaction as a single dollar of premium payment.
The insurance company pays claims and pays their administrative and overhead
expenses from that dollar of insurance. The three most common risk financing
insurance programs are guaranteed cost plans, incurred plans and paid loss plans.
In short, under the guaranteed cost plan, the entire $1 of insurance is paid
to the insurance company. Regardless of the policyholder’s loss experience,
the premium remains $1. In an incurred plan, you still pay the dollar of insurance
but your final cost will be determined by your losses. (Actuaries tell us that
out of the insurance dollar, the insurance company will use approximately 35
percent of the dollar for expenses and the remaining 65 percent is anticipated
for losses.)
So is everyone still with me? Good, let us move onward. Now to the real issue
at hand. In a paid loss plan, the underwriter will require that the insured
pay in the "deductible" expenses (that’s the 35 percent we referred to) and
will defer payment of losses until they are actually paid out, or in other words,
when the paid losses need to be reimbursed to the insurance company (generally
monthly or quarterly). Under the theory that the typical loss payout matrix
is spread over time, then the insured obtains a valuable cash flow advantage.
Think of the deferred losses as a loan from the insurance company. Keep in
mind that although the losses will be reimbursed by the insured, the insurance
company has no guarantee that all the deductible losses will be paid. There
is one other technical issue to address and we will better understand the use
of collateral. The deferred deductible losses—in addition to being capped on
a per "occurrence" basis (i.e., $250,000 or $500,000)—are also "capped" by an
aggregate loss deductible. That is defined as the total amount of per occurrence
deductible losses the policyholder is responsible for paying. That is really
what the underwriter needs to secure through some form of collateral.
An example will illustrate this point.
EXHIBIT
1
In the above example, an insurance company has offered the policyholder a
wrap-up quotation based on project hard costs of $100 million. The total estimated
primary premium is $5 million with $1.75 million representing deductible expenses
and $3.25 million for maximum losses.
The underwriter has given the insured two payment options.
- Pay in the $5 million in installments over the project time period and
adjust the premium based on actual losses.
- Pay in $1.75 million in installments over the project time period and
defer reimbursement of deductible losses until the time they are actually
paid.
For the underwriter to secure for the possible payment of maximum losses,
they will ask (in option 1.) for a letter of credit in the amount of $3.25 million.
In some instances, underwriters may be willing to consider security in an amount
less then maximum losses. This will only be considered subsequent to a thorough
review of the sponsors financials.
Collateral Issues
While collateral has become an everyday reality of wrap-ups, there are still
issues that need to be confronted and understood before embarking down this
road. As the use of collateral has become so prevalent, clients, brokers, and
underwriters are coming to grips with many facets of their use and limitations
they present in certain scenarios. These issues and more are addressed in Part 2.
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