For many years, SIGMA has had the pleasure of knowing and working with Steve Coombs, CPCU, ARM. Steve recently co-authored the 2nd Edition of Workers Compensation Guide: Coverage and Financing published by The National Underwriter Company.
I bought the book and found it to be a straightforward summary excellent for experienced workers compensation professionals and perfect for younger professionals in our industry.
You can purchase a copy of the book at the National Underwriter site:
As I was reading through the book, I particularly liked the section on collateral issues. Here at SIGMA, we frequently get involved in helping brokers and their clients negotiate collateral requirements. There seems to be a need to better address this issue on the front-end of policy negotiations and to have an ongoing process to manage the subsequent years after policy placement. Steve and his co-author David D. Thamann, JD, ARM, CPCU do an excellent job of addressing both of these issues.
For this blog, I interviewed Steve about his experience and recommendations for collateral issues. I hope you find this information helpful as you work with clients that struggle with collateral related challenges.
Interview with Steven Coombs, CPCU, ARM
Steve Coombs: Tim, thank you. We have received a lot of positive feedback on the book and it is nice to be able to share it with your blog readers.
SIGMA (Tim): Here at SIGMA we are engaged to help a lot of organizations work through collateral related issues. It is a common hot spot for problems and I know a frustration for many of the brokers we work with. So, first, could you explain what collateral is, why some organizations have to put up collateral, and why it is often a source of difficulty?
Steve Coombs: Sure Tim. My experience is that the method for calculating and annually adjusting collateral is frequently a mystery to the insured. But, if you have a paid loss retro, large deductible, or are self-insured then it is going to be a very important topic to understand.
SIGMA (Tim): Steve, aren’t those types of plans frequently referred to as "cash flow plans?"
Steve Coombs: Yes, financing plans that allow an insured organization to hold insurance premiums that would otherwise be paid to the insurer are known as "cash flow plans." Cash flow plans allow the insured to retain the loss portion of the insurance premium amount. The remaining fixed costs portion funds insurer expenses and related costs.
SIGMA (Tim): Ok, then how are the loss payments handled in such a plan?
Steve Coombs: Claims are paid by the insurer and the monies are drawn from an escrow account (bank account) that is initially funded by the insured and then replenished monthly by the insured. This is called the loss fund but it only holds a small amount of the total loss dollars that will ultimately be required to satisfy all claim obligations.
SIGMA (Tim): So it appears that the insurance company has some exposure here if the insured were to get into financial difficulty.
Steve Coombs: Exactly, the insurer is essentially assuming the credit risk of its insured. To guarantee that the insured will continue to replenish the loss fund, and to secure total expected ultimate loss amounts, the insurer requires that, at the program’s inception, the organization provide them with collateral (usually a letter of credit). The collateral remains in place until all claims have been paid and closed (or as otherwise set forth by the rating plan documents). The amount of collateral grows with each additional year of a loss sensitive program. This is because the financial obligations grow in concert with unpaid claims.
SIGMA (Tim): I think if I were the insurance company I would make sure the computation of collateral was very conservative. And, I know that the insured is typically not focused on the collateral issue during the negotiating phase of the process.
Steve Coombs: Yes, the situation you describe creates the problem. The insured is typically not focused on this issue at the start of a cash-flow plan and when they do focus on collateral they frequently feel powerless to influence the amount or process for adjustments. Also, the insurance company is going to take a very conservative position concerning the computation of collateral requirements. But, there are some things the insured and broker can do to influence the amount of collateral required.
SIGMA (Tim): Steve, great, but before we get to your suggestions can you give me a general outline of what the insurer looks at when initially setting collateral requirements?
Steve Coombs: In setting the amount and terms of the initial collateral, the insurer typically considers three factors:
- The insured’s creditworthiness.
- Five years of historical loss experience and ratable exposures.
- Calculation of expected losses (at a given retention level).
SIGMA (Tim): Well, that all sounds reasonable. So, tell me what the insured and its broker can do to influence the process.
Steve Coombs: The insured and broker need to provide appropriate information and address some key factors. I'll give you a list… first, the following financial information should be provided:
- Provide the most recent audited and interim financials.
- Provide a brief overview of the trends and expectations.
- Allow plenty of time for the insurer to become familiar with the credit profile.
Next, you want to provide loss data:
- Provide accurate up-to-date historical loss experience. If needed, provide longer than the normal five-year requirement.
- Provide explanations of any large losses, especially if these are considered to be "one time" events and not to be repeated.
- It is very helpful for the insured’s insurance broker to independently calculate the expected losses as a check on the calculations of the insurer. While there are some analytical software tools that can assist in doing this, I would suggest that an independent actuarial firm like SIGMA is certainly an appropriate solution. Insurers pay far more attention to a report authored by an actuary, as compared to an off-the-shelf software tool.
And finally, you want to take time to review the rating plan documents.
- Become familiar with how collateral is treated and adjusted. With a new program, collateral builds for five to seven years.
- The language of these agreements is typically one-sided (in favor of the insurer) and is not usually negotiable. However, some insurers will make modifications if there is a good reason to do so.
SIGMA (Tim): Basically, it sounds like you are recommending that the broker and insured be proactive about providing sufficient quality data to the insurer so that the insurer does not add an "uncertainty" premium to the collateral requirement. So, once the insurance company has all of the data, what are they going to do with it?
Steve Coombs: When an insurer has all the necessary information it needs, it will calculate the expected losses at a given retention level. The insurer reviews rating exposures and loss data for at least five years. It takes the incurred claim amounts and applies loss development factors (to account for incurred but not reported claims and the development of known claims) and trend factors (to account for inflation). These are compared with trended rating exposures to arrive at an "expected loss rate." This rate is applied to the projected exposures (payroll) to arrive at expected ultimate losses. The insurer will then determine the collateral needed. The range is usually between (a) ultimate expected losses and (b) ultimate expected losses less expected payments at 18 months after program inception.
SIGMA (Tim): That all sounds reasonable and is exactly what SIGMA does for many of its clients. So, where does the problem arise?
Steve Coombs: There are a few aspects of the calculation that can sometimes cause controversy. They are:
- What losses did the insurer use when conducting its analysis?
- Why did the insurer use the loss development factors it did? These factors vary considerably between insurers.
- What percentage of ultimate claims does the insurer require to be collateralized? 100% of expected losses? Expected ultimate losses less actual paid losses at policy expiration? Or what?
SIGMA (Tim): If the insured has any chance of influencing the process, it seems like the best opportunity is during the initial negotiating process. Do you have a set of guidelines or suggestions for what a collateral agreement should look like?
Steve Coombs: The agreements governing the initial amount and subsequent adjustments are most typically found in a the document which governs the rating plan, such as "Deductible Agreement" or "Rating Plan Agreement". Before embarking on a cash flow program with a new insurer, there are a few items which should be explored:
- Obtain and review the contract provisions which address collateral and adjustments.
- If there are terms contained therein that are not commonly understood or are proprietary to the insurer, ask for an explanation. For instance, if a provision states that the "collateral amount will be calculated based on IBNR factors applied to loss reserves . . .", you should ask to see the IBNR factors that will be used.
- Look for a formula that gives credit to the insured for all claims amounts paid, along with the escrow fund on deposit with the insurer.
SIGMA (Tim): Those are great suggestions and fit with SIGMA’s suggestions on how to structure the agreement. In your book, you also provided some recommendations for an annual process that the broker and insured should go through in order to favorably impact the required collateral amount. Can you go over that process for us?
Steve Coombs: Sure Tim, here are the recommended steps that the broker and insured should go through each year:
- The insured, broker and insurer claims adjusters should meet periodically to review large claims and determine a strategy leading to closure for each.
- Ninety days prior to renewal, the broker should prepare a report for the insurer which:
- Shows the results of the most recent claims review
- Summarizes the loss experience in a clear, meaningful way
- Includes projections for ultimate losses for each policy year
- Includes a projection of a reasonable collateral amount
- Provide up-to-date financial information, expanding beforehand in those areas where the insurer may have questions.
- Prepare a short summary of business and financial expectations.
- Provide all of the above to the insurer no later than 45 days before the program renewal date.
- Meet with the insurer to present specific concerns and desired outcomes, and supply answers to any questions the insurer may have.
SIGMA (Tim): Steve, this has been a tremendous amount of helpful information. I encourage all of our blog readers to purchase your book. I will make sure we provide links to where the book can be purchased. Also, in closing, please provide a short summary of the type of consulting work you are engaged in and how our readers might contact you for more information.
Steve Coombs: Risk Resources is an independent risk management and insurance consulting firm. By not selling insurance or other products/services we may recommend, we are entirely objective. Common projects include insurance program audits, preparation of RFPs, agent/broker selection, risk financing feasibility studies and litigation support services. Additional information is available at our website: www.riskresources.net. Your readers can always contact me by email email@example.com
Thanks Tim. It is always a pleasure to chat with you.
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