Collateral ConsiderationsManaging 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

INSTRUMENT

CREDIT ANALYSIS

(Financial Strength)

LOSS ESTIMATE(Exposure)

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

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

No Growth vs. 10% Growth

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6No Growth 10% growth

0

1000000

2000000

3000000

4000000

5000000

6000000

$3.8M

$5.2M

PY 1 PY 2 PY 3 PY 4 PY 5 PY 5

STACKING PRINCIPLE

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

• 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

Footnotes

Collateral DeterminationCredit Analysis

• 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

Ratios

Collateral DeterminationCredit Analysis

LOW HIGH

? Undesirable

Desirable ?LOW

HIGH

UNDERWRITING RISK

FIN

AN

CIA

L R

ISK

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

NUMERICAL RATING

NUMERICAL RATING

QUALITY RATING

COLLATERAL ADJUSTMENT

5 100 EXCELLENT DISCOUNT 24 Months Paid Losses

4 90 GOOD DISCOUNT 12 Months Paid Losses

3 80 FAIR NONE 100% of Financial Exposure

2 70 POOR SURCHARGE 100%+ to Aggregate

1 60 REJECT REJECT REJECT

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

Deductible Reimbursement

Claimants/State Carrier

Insured

Credit Risk

Evidence of Coverage

Deductible Programs with Captive Reimbursement

1.

2.3.

Insured Insurance Company

TPA

3. INSURED Contracts with Captive via deductible

reimbursement policy Transfer deductible obligation for a premium

*Captive

*Insurance Company has no contractual relationship with the Captive

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

2. 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

1. INSURANCE COMPANY

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.

Pros Most preferred vehicle Clean, irrevocable, evergreen Statutory acceptance Allows for cash flow friendly approach Easy to administer

Cons Reduces borrowing capacity High opportunity and actual cost (especially post 2008) Nonworking form of collateral Concentration risk – Financial Institution rating

Pros Same as cash Investment income inures to client Replacement for LC Standardized agreements

Cons Some carriers will not accept a “working” trust that pays claims as

billed; some will not accept a “nonworking” trust Not considered bankruptcy remote Limited investment options

Pros Investment income potential Eliminates need for LC Acts as collateral and loss fund

Cons Requires significant up-front cash flow Investment rate of return usually lower than client’s cost of capital More administration (not preferred form for carriers) Not considered bankruptcy remote Financial Institution rating

Pros Does not restrict borrowing or LC capacity May be cheaper than LC fees or opportunity cost of cash collateral

Cons Limited carrier acceptance: most will only accept surety for a

portion of the collateral requirement Limited number of acceptable sureties

Collateral Instrument

TRUSTS

SURETYCASH

LETTERS OF CREDIT (LCS)

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.