Large organizations with predictable loss experience make a strategic decision to retain a portion of their workers compensation risk with a large deductible or retrospectively rated insurance program. In exchange, they pay lower premiums, increase their cash flow and gain more control over claims outcomes. Under a large deductible insurance policy, the insurance company contractually agrees to pay all claims as they occur, while the insured is obligated to reimburse the insurer for all claims that fall under the deductible amount. Because this “first-dollar” regime exposes the insurer to some risk of the employer’s insolvency, the carrier typically requires the insured to secure its obligations to pay the deductible amounts by posting collateral. (In a number of states, the administration of such collateral is regulated by specific provisions of insurance or workers compensation law.) Negotiating such collateral arrangements can be delicate, and if done improperly from the insured’s standpoint can have a devastating impact on the insured’s business.
How Much Collateral is Required?
The amount of collateral required is based on estimating the amount of claims (loss pick) that the insured can expect to incur during the term of the policy. This loss pick is typically calculated based on the company’s currently valued loss history (usually dating back five years), payroll by workers compensation class code correlating to each prior year’s losses, and other factors, including but not limited to rising medical costs, inflation, the jurisdiction where work is conducted, and attorney fees and similar costs. A loss rate is then calculated and applied to the projected payroll for the new policy year. These calculations are performed by the carrier’s actuaries, but frequently insureds engage their own actuarial resources to get a second opinion.
Workers compensation claims are known as long-tail claims, which typically get paid out over a long period of time, often seven to 10 years. Since losses are paid out gradually over time, the amount of required collateral diminishes over the life of such payouts until that particular policy year’s claims were closed. However, new amounts are required for each renewal year and its corresponding loss pick. Consider a hypothetical loss pick for a given insured of $1 million for losses that occur during the 2017 policy term. The insured posts the collateral, which can be diminished over time dollar-for-dollar with losses or reserve releases until the projected $1 million in losses has either been paid or reserves have been fully released.
Consider further, that the hypothetical insured incurs, by the time of the 2018 renewal, $200,000 of losses ascribed to 2017. The collateral requirement for the 2017 policy year is now $1 million less $200,000 or $800,000. For policy year 2018, the loss pick is fixed at $1.2 million. The total amount of collateral required is therefore the $800,000 remaining from 2017 plus the new $1.2 million for policy year 2018, or $2 million. This is referred to as collateral “stacking.” However, it is important to note that recourse to the stacked collateral is not segregated as to year. For instance, if losses for 2017 end up exceeding the $800,000, the remaining $1.2 million set aside for 2018 can be “invaded” so as to pay deductible amounts for 2017.
What Factors Affect the Amount of Collateral Required by Carriers?
A carrier may be motivated by a number of factors to relax the amount of collateral required and thus increase its exposure to insured credit risk. These factors include future paid loss credits, financial strength of the insured, and changes in operation—for example, discontinued or divested operations and/or movement to a jurisdiction with a more favorable tax or regulatory environment. It is also important to consider the realistic mobility of the client’s program from one carrier to another and whether another carrier would offer a more favorable collateral regime (i.e., require less collateral). For instance, an employer shifting carriers may find that the old insurer is still requiring an onerous amount of collateral to be held in respect of legacy risks. This, together with the new and future requirements from the new carrier, may exceed the utility of shifting carriers. A related factor is longevity of the particular business—the lengthier the look-back on an employer’s risk, the more difficult it may be to extricate oneself from onerous collateral requirements.
Policyholders often scrutinize requests to increase collateral. If an insurance company indicates that a particular open claim requires certain reserves and justifies an increase in collateral, the policyholder might request and review the claim file. Judgments can differ in determining the exposure or in updating reserves after a claim is closed. Policyholders can engage the insurance company in a discussion concerning the reserves and collateral required. The circumstances under which an insurance company may—and may not—draw down on collateral can also be ripe for discussion.
What Sorts of Things are Discussed Between the Insurer and Policyholder?
Insurance policies and payment agreements are typically specific as to the circumstances under which the insurance company may access that collateral through a drawdown on a letter of credit or otherwise. Policyholders should understand the remedies for an improper drawdown of collateral and also understand what legal action is available to prevent an improper drawdown. At the onset of negotiating a large deductible program, policyholders often take one or more of the following steps:
- Understand the methodology and loss development factors used by the insurance company. The higher the loss pick, the more collateral will be required from the policyholder. Insurance companies will often use industrywide data to calculate a business’s “loss pick” instead of the business’s individual claims history, and a policyholder might explore whether this is sound, particularly when its experience is significantly more favorable than the industry norm.
- Negotiate process for discretionary collateral calls. Payment agreements often permit the insurance company to demand additional collateral at any time. The payment agreements usually impose penalties if a policyholder fails to satisfy a demand for increased collateral. Penalties can include cancellation of the workers’ comp policy or liquidation of the existing collateral. Loss development factors (LDF) are used to project potential future costs on claims, such as unexpected medical complications, verdicts that exceed the claims’ reserves, and costs for losses that have not yet been reported. Payment agreements will often permit the insurance company absolute discretion in setting the LDF, which in turn can lead to otherwise unsupported high increases in collateral demands. Businesses often ask their insurance companies disclose their LDFs at the outset of the program or try to negotiate a more favorable LDF if necessary.
- Consider unbundled claims management. With traditional insurance, an insurance company has every incentive to minimize claims payments so as to maximize the return on premium, and a policyholder might choose not to file a claim in respect of some loss (for instance, where the loss would fall within the deductible, and the insurer does not expect to hit to deductible). By contrast, in a large-deductible workers comp scenario where the insurer handles all claims (a “bundled” policy), all meritorious claims filed by workers hit the policy, and either count against the deductible or, if the deductible is exceeded, are payable by the carrier. Thus, an employer has no discretion over whether to forgo coverage (with the result of leaving any remaining deductible unreduced) or to invoke it. In a year in which the deductible is not exhausted, the employer may face the worst of all worlds—exposure for the losses, no benefit from the insurance and a claims history adversely affected. Because each claim within the large deductible policy deductible is the responsibility of the policyholder, the insurance company may be incentivized to settle claims within the deductible for more than they are worth in order to expedite recovery of collateral. Not only does the policyholder end up paying more for those claims—this practice also could create a negative “artificial” loss history that may translate into a basis for the insurance company to impose increased future collateral and higher premiums. An “unbundled” policy in which the carrier is not the claims administrator allows the policyholder to exercise more discretion over loss events and thus realign incentives as with a traditional policy.