Expert Commentary

Wrap-Ups and the Issue of Collateral (Part 2)

In Part 1, the basic foundation of collateral and its application to "loss-sensitive" insurance plans (insurance plans whereby the insured is obligated to pay a portion of each and every claim as well as be responsible for an aggregate number of those losses) was discussed.

Wrap-Up Programs
June 2007

I concluded that article with the following comment, which is a good starting point for Part 2:

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.

From an insured's perspective, what are some of these issues? This article will attempt to address, in a concise manner, typical questions posed by insureds relating to this subject. We will conclude with some observations as respects alternatives to posting the traditional letter of credit.

First, let's briefly revisit the illustration provided in Part 1 as a means of using an example to address the questions. We assumed a wrap-up project of $100 million with a workers compensation deductible of $250,000 per occurrence and a general liability deductible of $500,000 per occurrence. The insured's responsibility for total aggregate deductible losses is $3.25 million.


Wrap-Up Example

[Please note that the terms "collateral" and "security" where used have the identical meaning. When mentioned, a "letter of credit" (LOC) refers to the most common form of collateral.]

Will the Underwriter Allow Security That's Less than the Aggregate Losses?

Most underwriters today initially look to secure to 100 percent of maximum losses. In my experience, a lesser number is sometimes achievable, but not before a careful review of the insured's financials.

Will Underwriters Allow for a "Step-up" Arrangement on a Letter of Credit?

Most underwriters are willing to accept a step-up letter of credit. In the example used above, assuming the underwriter will secure to maximum losses, they may be willing to accept four quarterly step-ups, each in the amount of $812,500.

While this is an attractive alternative to the insured, it may not solve a side issue of what the insured's bank may require as cash "on deposit" in order to issue the LOC. Although the security may be "stepped up," the face value of the issued LOC will be in the full amount of the required collateral: $3,250,000.

The Named Insured Is an LLC

This has become a major issue when securing losses for condominium wrap-up projects. It is also a type of project where underwriters tend to be less flexible when discussing collateral. There are several overlapping issues, so let's try to keep this as simply stated as possible.

The first issue involves the LLC itself. An LLC is a limited liability corporation. As defined by the IRMI Glossary of Insurance and Risk Management Terms:

limited liability company (LLC)—A legal entity seeking to realize the benefits of both a corporate and partnership legal structure. More than 40 states have enacted statutes authorizing this form of legal entity. LLCs provide the liability protection afforded by corporations (i.e., unlike a partnership, principals are not personally liable for the debts and obligations of the organization) and offer the tax benefits afforded to partnerships (i.e., they avoid double taxation and permit allocation of taxable income and deductions). There are two key limitations associated with LLCs: they are available only for privately held companies and the equity interest in an LLC is not freely transferable.

We also need to understand that LLCs have a limited life as defined by state statute. The limited life may be defined in some states as "the fulfillment of the LLC's stated period of duration." This presents serious implications as respects the issuing of collateral when the named insured is an LLC. Let's explain further.

Underwriters are reluctant at times to accept a letter of credit in the name of an LLC because of its "temporary" structure and limited purpose for existing. At times, they may ask for "guarantees" from some other related entity. In most situations whereby the LLC is the developer of the project, its lifecycle may only exist until it has sold the units of the building. At that point, it may dissolve because it has fulfilled its stated purpose.

Collateral, as used by underwriters, remains in effect for a period of time that goes beyond construction and quite often beyond the sale of individual units. As LLCs look to close their "books" they look to do so without any lingering potential liabilities. This is sometimes contradictory to the mechanics of collateral and needs to be recognized up-front, especially when dealing with condo projects, extended completed operations, and statutes of repose. These are all reasons why underwriters are reluctant to close out wrap-ups sooner rather than later.

Reconciling Wrap-Up Losses and Closing Out Collateral?

I began addressing this issue in the previous question as it relates to condo projects. However, the issue of closeout is often questioned by all who sponsor wrap-up programs. The answer has as much to do with the methodology of claims development than anything else. In essence, once all claims are either paid or the insured has negotiated a closeout of all outstanding claims, then the collateral can be canceled and returned to the insured.

Underwriters have historically been reluctant to close out wrap-up projects too soon. This is a concern to the insured not only from the potential financial liability but the fact that the collateral is still in effect. Underwriters would be more than happy to close out the wrap-up when construction ends. However, due to potential development of reserves and the extended completed-operations exposure, they would most surely request that maximum contained losses be the final "closeout" offer.

By waiting a period of time for losses to develop, which gives the underwriter a comfort level, or for losses to remain as is, you may obtain a more equitable closeout offer. This period of time may be somewhere between 2 to 3 years after construction ceases. By this time, the actuaries have a finer sense of what the ultimate cost of the claims will be. The insured's best case rests with the fact that, hopefully, almost all the claims have been closed, and those few that are open have a high level of reserve confidence.

Keep in mind the ultimate prize is not just to close out the claims, but also the "return" of collateral that had secured those losses since inception of the program.

Periodic Adjustments of Collateral Based on Claims Experience

This is one of the great frustrations of collateral. Few realize it, but in practical terms, when an underwriter secures to maximum losses and the first claim is paid, the insurer is at that point over-collateralized.

Let us go back to our example. If the underwriter secured to maximum losses then the required collateral would be $3.25 million. On day one, the insurance company pays a $5,000 claim. Assuming deductible losses are reimbursed monthly to the insurer, just do the math. The insurer is now sitting with collateral plus paid losses of $3.255 million; $5,000 more then needed based on maximum premium. In a perfect world, I guess we can make a passionate argument here. Practically speaking, maybe not. Fixed expense premium and aggregate contained loss premium are estimated based on an exposure base (i.e., estimated project payroll). Once the final payrolls are audited, then a final maximum loss containment number can be established. Up to that point, it is just an estimate.

The simple answer is that underwriters usually will not make periodic adjustments of collateral. The best we can hope for is that possibly on an annual basis (contemplating a 3-year project term) the insurer will consider a review of collateral. If the collateral was in the form of a step-up LOC, I have seen underwriters willing to forgo the final step-up in the event the loss experience warrants so.

Final Observations

Let me reiterate a point. When we talk about collateral and loss-sensitive insurance programs, we are referring basically to those programs underwritten as "paid" loss programs. In other words, the insured reimburses the insurance company for losses as those claims are actually paid.

One way to eliminate the necessity of security is to utilize not a "paid loss" program, but an "incurred loss program." By using this method, the policyholder, in essence, pre-funds the losses.

Other means available besides the traditional LOC used by underwriters include:

  • Utilize a cash collateral account. The cash is placed in an interest bearing account. The cash account can be established on a depleting basis (no need then for loss billings) or nondepleting where it acts similar to a letter of credit (paid loss billings are necessary).
  • Utilize a trust account whereby the insured uses investments to secure the collateral. This can also be on a depleting or non-depleting basis.
  • Establish a captive insurance company to secure the collateral requirements.

In closing, hopefully these articles have been helpful in explaining a very critical aspect of risk financing. Collateral issues can be confusing but by understanding the landscape, the navigation can be smooth sailing.

Opinions expressed in Expert Commentary articles are those of the author and are not necessarily held by the author's employer or IRMI. Expert Commentary articles and other IRMI Online content do not purport to provide legal, accounting, or other professional advice or opinion. If such advice is needed, consult with your attorney, accountant, or other qualified adviser.

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