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 Keith DeCoster, senior vice president, managing director, Aon Risk Solutions.
“Collateral, especially in this credit market, can be a material component of an insurance program’s costs,” says DeCoster. “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 DeCoster 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.
How does that prevent a company from seeking a new insurer?
While a prospective new carrier may offer advantageous pricing, its collateral requirement for the first year and the prospect of stacking that requirement for future years can overshadow cost-saving benefits, especially for a company with limited capital availability.
As a result of these factors, corporate risk managers should evaluate current insurance programs in conjunction with their financial objectives. Given the impact of collateral requirements on a company’s cash flow and available borrowing capacity, risk managers might do well to make some changes to the terms of deductible insurance programs.
In this environment, however, buyers should recognize that insurance companies have pressures, too. With tightening credit markets and a weak economy, insurance companies are at increased risk that clients might fail to reimburse deductible payments.
These defaults can range anywhere from a delay of payment to an actual bankruptcy resulting in a default on obligations owed to the insurance company.
How can companies benefit by pursuing a zero-collateral policy?
Property and casualty insurance brokers have watched premiums shrink and stagnate for the past five or more years. They understand that growth isn’t happening unless their clients grow, and collateral burdens hurt their clients’ ability to reinvest in new projects. Recognizing this axiom, brokerages are now offering zero-collateral deductible insurance programs that eliminate collateral requirements, freeing these funds in the form of cash or lines of credit for capital investments by their clients.
These insurance programs may still carry deductibles that allow customers to benefit from the cost and cash flow advantages. But rather than require collateral, the credit exposure is insured by an additional policy. As a result, there is no requirement to post collateral, which would otherwise be in place until all claims are closed, a process which can take many years from the program’s inception.
The value of these programs for clients can be tremendous, as it allows them to invest available cash and credit in the business and avoid tying it up with insurance companies.
With the help of an adviser, companies would be well-advised to look into the zero-collateral option.
Keith DeCoster is senior vice president, managing director, Aon Risk Services. Reach him at Keith_Decoster@aon.com or (317) 237-2400.