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June 17, 2011

Self-Insured Retention vs. Collateral – What is the True Cost of Risk?

Summary:

Knowing that virtually every high deductible or self-insured option you choose requires collateral, how do you decide which option is the most cost-effective? It’s important that you have a very savvy, experienced, and knowledgeable insurance broker or consultant assisting you in weighing these options. Furthermore, your broker must understand the implications of collateral demands when risk is retained.

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Each year, the corporate risk manager scrutinizes workers’ compensation excess insurance proposals from one or more insurers, trying to figure out the cost-benefit of the company’s self-insured retention (SIR), such as $250,000, $500,000, or even much higher. The “SIR” terminology applies whether the company is utilizing an insured high deductible, captive or legally self-insured workers compensation program. As we all know, claims below the chosen level of retention are “retained” (paid for) by the entity, not the excess insurer. And despite what level of self-funding is chosen, the risk manager gambles that the company’s injury/illness prevention program and competitively safe working environment is going to beat industry statistical odds. Why buy insurance on something that has little likelihood of occurring anyway? Your hope is that the premium money you save choosing a higher deductible will more than offset the claim costs associated between a lower and a higher deductible / self-insured retention.

With that decision made, the risk manager then dutifully works on an annual operating budget to project the direct and allocated costs of the entity’s “expected” workers’ comp claims, including excess insurance. With that task done, the workers comp risk factors have pretty much been addressed, right? Not really. The unaddressed factor in this self-insured/high deductible scenario — which goes up most corporate ladders to the CFO or Treasurer — is the issue of collateralization. Collateral, by definition is that which serves as protection for a lender against a borrower’s default (failure to pay an obligation).

For example, when you take a mortgage out on your house, the amount you owe the lender is supposed to be adequately collateralized — at least since the ’08 housing bubble burst — by the sales value of your home. In fact, in today’s post-recession real estate market, banks are requiring excellent lender credit ratings as well as a real estate loan that is typically no greater than 80% of the appraised value of your home. After all, your home is the bank’s only secured collateral in the event you default on your mortgage.

So, who is taking the risk if your company fails to make its workers compensation claim payments within the self-insured retention — which is often 90% or more of all corporate claims costs? The fact of the matter is simple. No insurer, captive, or state/governmental agency has any intention of bailing out your company if and when it goes bankrupt, or for whatever reason, fails to meet its workers compensation obligations under the law. In the event of default, therefore, the company’s excess insurance policy must drop down to pick up any unpaid claim costs on a “first dollar” basis. Does this mean the excess insurer is out of pocket for the losses paid within the self-insured retention/high deductible?Simply put, no insurer is willing to take the risk that its insured may be unable or unwilling to pay its high deductible. Similarly, no state government wants to assume to liability of a legally self-insured entity failing to pay its workers compensation obligations. The only sure way to avoid having the excess insurer, captive, or the State assuming the costs arising from a default is to require sufficient collateralization of the policy periods covered by high deductible or self-insurance.

In the case of insurers, the terms, timing, and amount of collateral is negotiated and typically requires that the insured put up: a cash deposit; an irrevocable letter-of credit; securities (i.e. certificates of deposit); or a surety bond payable to the insurer in the event of default. For insurers, the collateral target is determined by actuarial estimates, including the estimated ultimate cost (including IBNR and ULAE) of all claims within the entity’s high deductible or SIR retention level.

Obviously, the collateral requirement grows in the aggregate with each policy year of workers comp coverage. Now, you understand why the entity’s CFO is concerned. Tying up your company’s collateral or its credit revolver (the amount your bank(s) provides your company as a line-of-credit) is a huge issue. While the cost and amount of this may vary to some degree depending upon your company’s credit rating and banking relationships, the fact of the matter is that this collateral can build up to significant amounts over the years. In California alone, there are dozens of large companies with sizable self-insured retentions with aggregate workers compensation claim risks from $100 to $500 million. The amount of collateral required is almost always determined by an actuary — usually the insurer’s unless you are a true self-insured entity.

Knowing that virtually every high deductible or self-insured option you choose requires collateral, how do you decide which option is the most cost-effective? It’s important that you have a very savvy, experienced, and knowledgeable insurance broker or consultant assisting you in weighing these options. Furthermore, your broker must understand the implications of collateral demands when risk is retained. This is a much more challenging process than simply selecting an SIR based upon excess insurance quotes.

So the question arises … How much collateral do we need to post? What will it cost our entity to tie-up this amount of money each year? To the CFO, this issue may be the driving factor in your workers compensation strategy. Essentially, there are two major factors that determine collateralization: (1) the expected amount of aggregate claim exposure; and (2) the entity’s credit risk rating or factor.

In general, the only break you’ll get in posting the actuarially determined deposit is if you’re with an insurer that may consider your company a “good credit risk” and allow you to post your annual collateral (keep in mind that it’s in aggregate) on a delayed basis, such as 3 to 6 months into your new policy year. In my previous experience as a VP of Risk Management for an international company doing business in 38 states, we hired a leading actuarial firm to challenge the quarterly actuarial numbers asserted to us by our excess insurer’s in-house actuary. Usually, we were able to negotiate some minor concessions relating to the collateral posted with the carrier. The amount of collateral was revisited at a minimum of every quarter.

Most states allow a self-insured the opportunity to choose its own self-insured retention (up to a certain limit); its excess carrier (if any); and in many states, self-insured’s are allowed to self–administer their workers comp claims — as opposed to using the excess insurer or a designated Third Party Administrator.

In California, the Self-Insurers’ Security Fund (a non-profit entity that guarantees the take-over and payment of private and group self-insured entities in the event of default) pioneered an option in 2003 that no other state, except North Carolina, has been able to offer. Individual self-insured entities with equivalent credit ratings of AAA (A+) to B3 (B-) are eligible for the Alternative Security Program (ASP). Under this arrangement, qualified self-insured’s have their “deposit” (State-required collateral) covered by the Security Fund. In short, the self-insureds pay an assessment that mimics their cost of securing a Letter of Credit (LOC) from a bank. The Security Fund uses a sliding scale with 16 intervals, AAA to B3, to determine the factor (multiplier) used to determine its annual assessment. Included in the assessment calculations are the Security Fund’s operating expenses, hedging costs, as well as any funds targeted to build the Security Fund’s reserves. In 2010-11, this factor ranged from 16 basis points (AAA) to 355 basis points (B3).

The distinct advantage to this unique ASP program option is that nearly 350 California individual self-insured entities are able to free-up large sums of monies or a Letter of Credit. The Security Fund annual assessment is a fee, and the company’s credit revolver is not impacted since there is no secured debt arrangement. This frees up nearly $5.9 billion of workers’ comp collateral each year, and it allows these self-insured companies — including non-profit and religious organizations — to use their creditworthiness to pursue business and organizational goals.

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About the Author

As a renown workers’ compensation expert and industry thought leader for 40 years, Jeff Pettegrew seeks to promote and improve understanding of the advantages of the unique Texas alternative injury benefit plan through active engagement with industry and news media as well as social media.

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