This paper provides insight into workers’ compensation insurance collateral requirements and collateral processes affecting employers that are self-insured or that retain risk associated with their workers’ compensation program.
Collateral, which 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 its default, 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 their 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 usually includes claims administration expenses and incurred but not reported claims, as well as the total known outstanding liabilities.
Rarely do employers have to post collateral for benefits and expenses that have already been paid.
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 changes to the 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/excess policy or high retention insurance policy to protect their balance sheet from potential catastrophic events.
There are also employers that have determined 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 the 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. Once collateral has been posted with an insurance company, it is very difficult for the employer to extract that money, 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 local 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 a wide variety of self-insured collateral in different 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 workers’ compensation is a “long tail risk” (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 benefits payment to injured workers. The state will use the posted collateral to provide the benefits. Some states have created self-insurance guaranty funds that are responsible for the oversight of the administration of claims for insolvent employers.
In addition to the posted collateral, most guaranty funds also have the authority to 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 an insolvency.
Impact of the claims process on collateral requirements
Within workers’ compensation, benefit 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 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 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 board member of the California State Compensation Insurance Fund.
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