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.
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.
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.
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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