Collateral is an asset (cash or securities) that is pledged by an employer as security to ensure payment of workers’ compensation benefits in the event of a default. Collateral is a significant part of the insurance expense for many employers.
Understanding the collateral process and the expense allows risk managers and claims examiners to make appropriate, conscious and focused business decisions — and perhaps reduce the employer’s collateral expenses — associated with the workers’ compensation process.
The amount of collateral required is usually based on an independent actuarial analysis of the projected ultimate retained loss, which might include claims administration expenses and IBNR (incurred but not reported) claims, as well as the total known outstanding benefit liabilities. It is unusual for employers to have to post collateral for benefits and expenses that have already been paid. But it is the paid benefits that are the basis of the calculations for future exposures.
The cost of collateral is usually determined by multiplying the total actuarial projected for outstanding exposure by a rate that is usually determined by looking at the financial strength or credit rating of the company and the current market for collateral insurance.
Credit ratings for employers are usually determined by Standard and Poor’s or Moody’s rating services.
There are some employers that have no financial rating because they are privately held or are nonprofit organizations that do not want to share their financial information with a rating agency. In these circumstances, the underwriting of the collateral might depend upon the market.
Determining the level of required collateral is usually done on an annual basis but may be done more frequently if there is a significant increase or decrease in the company’s level of exposure, risk retention or credit rating during the year.
Depending on the financial status of the company, as well as the jurisdictional and local requirements, collateral can be in the form of cash, surety bonds, pledged unencumbered assets, credit default swaps or other forms of convertible assets.
Retained risk and collateral requirements
Many employers are not 100% self-insured. Most self-insured employers have an umbrella coverage or excess policy or high retention insurance policy to protect their balance sheet from potential catastrophic events. These employers usually have to post collateral with the insurance company that is providing the excess coverage.
There are also employers that have determined that they prefer not to be subject to a state’s financial requirements, administrative and reporting costs, claims oversight and the collateral requirements of being self-insured. They might have a high-cost deductible or a high retention insurance program in which they retain a significant amount of risk.
If an employer retains some of the risk associated with its workers’ compensation losses, it is usually required to post collateral with its insurance company for the outstanding amount of risk it retains. Because of the shared risk, insurance companies utilize actuaries to determine the exposure and then require the employer to post collateral or charge the employer for the shared exposure.
Collateral requirements are not an exact science. Occasionally there are circumstances in which the collateral eventually exceeds the known exposure.
Because workers' compensation is a “long tail” insurance, once collateral has been posted with an insurance company, it is very difficult for the employer to extract that money from the insurance company, even if all of the claims have been closed. Some insurance companies utilize their collateral requirements as a financial incentive to help retain the insurance business. They might do this by charging lower rates for the collateral or by lowering their projected outstanding exposures.
Self-insured collateral requirements
Self-insured companies are usually required to post collateral by the state in jurisdictions where they do business. Since there is no one self-insurance certificate (or jurisdictional body) that covers the entire nation, large nationwide companies may end up posting self-insured collateral in many states.
Since every state has unique collateral requirements, purchasing, monitoring and managing cost-effective self-insurance collateral in many jurisdictions is a complicated process.
When companies merge, managing this process can be quite challenging.
Since some workers’ compensation claims can take decades to be reported or closed, once the collateral is posted with the state authority, it can take a significant time for any residual or unused collateral to be returned to the employer if it decides to give up its self-insurance certificate.
Many states have dedicated organizations that are designed to oversee the self-insurance process. They are responsible for determining whether the employer meets the requirements of self-insurance and also the amount of collateral required to cover the potential outstanding workers’ compensation exposure.
If a self-insured employer becomes financially or legally unable to meet its obligations to provide workers’ compensation benefits, the state then assumes the responsibility for benefit payment to injured workers. The state will use the posted collateral to provide those benefits. Some states have created self-insurance guarantee funds that are responsible for the oversight of the administration of claims for insolvent employers.
In addition to the posted collateral, most guarantee funds also assess fees against all of the self-insureds in that jurisdiction in order to ensure that there will be adequate funds to pay benefits to legitimately injured workers when there is insolvency.
Impact of the claims process on collateral requirements
Within workers’ compensation, benefits provision, settlement philosophy and reserving practices all have a significant impact on collateral requirements. This is partly due to the impact that these processes have on the actuarial projection for the ultimate loss.
As long as the file remains open, collateral will be required for the outstanding and projected liability and expenses. It is typically more cost-effective to settle a claim than to stipulate that lifetime future medical care for a specific injury. Delays in claims reporting, the reopening of claims, the number of IBNR files and the cost of closing files can all significantly impact the actuarial projections and could increase overall collateral costs.
Public agencies and collateral
Most public agencies are not required to post collateral to cover their outstanding workers’ compensation liabilities. Collateral costs for public agencies are thought to be an unnecessary extra expense foisted on taxpayers. Even if the agency becomes bankrupt, it is still required to (and will) meet its obligations to provide benefits to its injured workers because public agencies theoretically have an unlimited power to tax to meet their obligations. Public agencies might have to post collateral with the insurance company if they reinsure for catastrophic losses.
Collateral expense can be a significant cost for a company’s workers’ compensation program. A good claims administration process and settlement philosophy can positively impact the collateral exposure and related expense.
Understanding the costs and taking steps to mitigate the exposures that factor into the collateral calculations can help control this expense.
Bill Zachry is a member of the California State Compensation Insurance Fund board of directors and chairman of State Fund's Audit Committee. He's the former vice president of risk management for Albertsons and Safeway, and a former senior fellow of the Sedgwick Institute.
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