How re-examining risks and insurance programs can free cash for your business

Edward X. McNamara, Senior Vice President, Regional Sales Director - East Central Region, Aon Risk Solutions

Lending standards are tough and not getting easier.

Even though insurance terms have softened over the last few years, the amount of capital a company has tied up in collateral with its insurer can be a threat to working capital and a barrier to growth, says Edward X. McNamara, senior vice president, regional sales director — East Central Region, Aon Risk Solutions.

“Collateral, especially in this credit market, can be a material component of an insurance program’s costs,” says McNamara. “To meet collateral obligations, companies often have to tap existing credit lines or cash reserves, each representing a drain on the company’s available capital or borrowing capacity.”

Smart Business spoke with McNamara about how re-examining your risks and insurance programs can help free up capital and increase borrowing capacity.

Why is collateral necessary for a business?

Insurance companies or carriers typically require collateral for deductible insurance programs because the insurer is obligated to pay all claims up front. Subsequently, the insurer goes back to the client to be reimbursed for claims that fell under the deductible limit, creating a credit exposure for the carrier. Insurers have credit officers to evaluate these, yet the analysis carries a high level of uncertainty due to the long-term nature of the underlying claims.

To protect themselves from failure to repay deductible losses, insurance companies require clients to put up collateral. Only certain instruments are acceptable as collateral, such as letters of credit, cash and marketable securities.

And while surety bonds have historically been accepted on an exception basis for a portion of collateral requirements, these are not an approved form of collateral by many state regulators. Furthermore, the values of these items are often discounted when the carrier assesses the amount of collateral held with an insured.

Does the collateral requirement pose a burden for companies when purchasing insurance?

Posting collateral for insurance requirements can pose a serious burden for many companies. Letters of credit can diminish borrowing capacity and require substantial fees to procure. Cash that is dedicated toward the collateral requirement is money that is not being used by the business to pay down its debt or to reinvest in the company.

Collateral requirements can also limit a company’s ability to switch insurance carriers. If a company’s carrier is holding redundant collateral — which is more collateral than is warranted based on the remaining liability of the policy — it can be used as leverage for keeping a company from switching to another insurer.

Rather than adjusting the collateral requirement downward, the carrier will use that redundancy to offset the new collateral needed for the following policy year.