Collateral Considerations Managing Collateral Amounts and Instruments in Today's Insurance Market
Collateral Considerations SPEAKERS: • Raymond J. Rocchio, Jr.,Vice President – Specialty Markets, The PMA Insurance Group • Lisa K. Wall,CPA, CPCU, ARM, Senior Vice President – Captive Consulting, Lockton Companies • Hugh Barit, Chairman & CEO, PRP Performa Limited MODERATOR: • Thomas R. McMahon, B. Comm, FCA, President, Cedar Management Limited
Agenda • Purpose of Collateral • Collateral Components • Collateral Determination • Loss Estimate • Stacking Principle • Credit Analysis • Carrier Rating • Collateral Documentation • Collateral Instrument • Deductible Programs • Captive Reimbursement • Recent Developments • Investment Considerations
Purpose of Collateral • Statutory Requirements/Benefits • Rating Agency Considerations • Mandate to Pay Claims • Non Admitted Reinsurance
Collateral Components Insurance Company’s collateral requirement is based on three components: • Estimated deductible losses for the applicable policy periods • Actuarially determined • Based on insured’s own experience, if credible • Financial strength of insured • Strong insured credit ratings allow for unsecured credits • Poor credit ratings may result in surcharged requirement • Each carrier has its own criteria and process • Collateral instrument to be provided • Letters of credit are preferred • Other forms may preclude credits earned on financial strength Loss Estimate (Exposure) Credit Analysis (Financial Strength) Instrument
Collateral Determination • Financial Exposure Analysis • Line of Business, Severity, Predictability, Form of Security • Financial Statement Analysis • Combining the Two • What is the “Loan”?
Collateral DeterminationLoss Estimate • Aggregate Limits • A Cap on a Policy’s Reimbursement Obligation • Specific Limits • A Cap on One Loss’ Reimbursement Obligation • Reimbursed Losses/Expenses • Line of Business Considerations • Tail • Payout Pattern • Development Factors
Loss Estimate – Cumulative Collateral Requirement Stacking Principle No Growth vs. 10% Growth
Collateral DeterminationCredit Analysis Balance Sheet • List of Assets and How they are Financed • Focus on Trends • Assets • Asset Quality • Accounts Receivable • Inventory • Intangibles • Current Assets • Fixed Assets • Age • Depreciation Methodologies • Replacement Requirements
Collateral DeterminationCredit Analysis Balance Sheet • Liabilities • Current Liabilities • Long -Term Debt • Equity • Paid in Capital • Retained Earnings • Tangible vs. Intangible • Working Capital • Current Assets Less Current Liabilities
Collateral DeterminationCredit Analysis Income Statement • Focus on Trends • Revenues • Operating Income • One Time Gains/Losses • Net Income • Retained Earnings • Dividends
Collateral DeterminationCredit Analysis Cash Flow Statement • Hardest Statement to Falsify • Must Tie to Balance Sheet • How Cash is Generated; How it is Utilized • How Operations are Financed • Focus on Trends
Collateral DeterminationCredit Analysis Cash Flow Statement • Operating Cash Flow • Net Income • Non-Cash Expenses • Changes in Working Capital Items • Investing Cash Flow • Fixed Asset Purchases/Sales • Securities Purchases/Sales • Financing Cash Flow • New Borrowings • Debt Repayments • Dividends • Shareholder Withdrawals
Collateral DeterminationCredit Analysis Footnotes • Banking Relationships • Debt Secured/Unsecured • Interest Rate • Payback Period • Covenants • Credit Line – Letters of Credit • Asset Quality • Accounts Receivable • Inventory • Intangibles • Litigation/Contingencies • Subsequent Events • Environmental Exposure • Sales Backlog • Significant Customers/Suppliers • Off Balance Sheet Transactions • Affiliates • Officers • Guaranties • Accounting Methodologies • Inventory • Depreciation • Bad Debt Allowance • Managing Results
Collateral DeterminationCredit Analysis Ratios • Liquidity • Current Ratio • Current Assets/Current Liabilities • Quick Ratio • Working Capital • Solvency • Debt/Equity • Long -Term Debt/Equity • Profitability • Operating Income/Sales • Net Income/Sales • Cash Flow • Time Interest Earned • Debt Service Coverage
Collateral DeterminationCredit Analysis Underwriting Risk High Financial Risk Low
Collateral DeterminationCredit Analysis • Consistent Methodology Over Time • Establish Collateral Requirement • Amount • Equal to Loss Exposure • Surcharge • Discount • Why?
Collateral DeterminationCredit Analysis – Carrier Rating Credit rating and unsecured balance varies by Insurance Carrier
Collateral Documentation • Security Agreements • Language Requirements • Clean, Irrevocable, Evergreen • Benefits Clients Who Have Provided Collateral • Events of Default • Remedies • Documents collateral review timing and minimum parameters
Deductible Programs Claimants/ State Carrier Evidence of Coverage Credit Risk Deductible Reimbursement Insured
Deductible Programs with Captive Reimbursement Insurance Company • Issues deductible policy to Insured • Requires an Indemnity Agreement from Insured and collateral for deductible obligation • Insured • Pays Insurance Company premium for large deductible program • Promises to reimburse for losses Insured Insurance Company 1. 3. 2. Insurance Company • Insurance Company allows TPA to manage and pay claims • Obligated for Insured’s losses within the deductible • Credit exposure for Insured’s losses within the deductible • Collateral required to secure future obligations *Captive TPA *Insurance Company has no contractual relationship with the Captive Insured • Contracts with Captive via deductible reimbursement policy • Transfer deductible obligation for a premium
Recent Collateral Developments • Letters of credit are more desired by insurers than ever. • Alternative collateral instruments have been less frequently and less favorably accepted in the last 12 months. • Insurance Companies in general have increased the surcharge (provided less unsecured credit) for trusts and accept bonds on a very limited basis. • Select Insurance Companies are having capacity issues with select banks. • List of acceptable banks are dwindling due to rating downgrades and consolidations. • Unencumbered verifiable asset-backed letters of credit capacity is available.
Collateral Instrument Trusts Letters of Credit (LCs) Surety Cash
Investment Considerations Making the Right Choice • If the captive has a considerable amount of “free funds” and a longer term investment horizon, then LOC makes more sense. • Important that bank is comfortable with underlying collateral and are seen to be in the LOC business for the long term. • If a trust is the answer, make sure that excess funds can be withdrawn from the trust effectively.