Introduction

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.

Collateral Calculations

Collateral requirements are typically derived from an independent actuarial analysis, which estimates the projected ultimate retained loss. This calculation encompasses claims administration expenses, Incurred But Not Reported (IBNR) claims, and a reserve loss development factor for known outstanding liabilities. Employers and insurance carriers are exempt from posting collateral for benefits and expenses that have already been paid.

The annual collateral cost is determined by factoring the total actuarial projected ultimate costs at a rate influenced by the company's financial strength or credit rating and the current collateral insurance market. Credit ratings for employers are commonly assessed by rating services such as Standard and Poor's or Moody's.

The amount of collateral required for insurance companies is established by the State Department of Insurance, which utilizes AM Best and IRIS Ratios scores to gauge the relative risk of the insurance company and its likelihood of insolvency. The Department of Insurance then applies the risk of total outstanding liabilities to determine the surplus that the insurance company must maintain to operate within the state.

Certain employers, such as privately-held companies, religious organizations, or non-profits, may not have formal financial ratings due to their desire for privacy. In these instances, collateral underwriting might depend on market conditions, or these organizations may be charged the highest possible rates.

Collateral requirement assessments generally occur annually but may be conducted more frequently if a company experiences significant fluctuations in exposure, risk retention, or credit rating throughout the year. Depending on the company's financial status, access to various collateral forms, and jurisdictional and local requirements, collateral can take the form of cash, surety bonds, pledged unencumbered assets, credit default swaps, or other convertible assets.

Retained Risk and Collateral Requirements

Many employers do not opt for complete self-insurance. Instead, they often acquire umbrella/excess policies or high retention insurance policies to safeguard their balance sheets from potential catastrophic events.

Some employers may choose not to subject themselves to a state's financial requirements, administrative and reporting costs, claims oversight, and collateral obligations associated with self-insurance. In such cases, they might opt for high-cost deductible or high retention insurance programs, retaining a significant amount of risk.

When employers retain a portion of the risk linked to their workers' compensation losses, they are typically required to post collateral with their insurance company to cover the outstanding risk. Insurance companies employ actuaries to assess this exposure and either require employers to post collateral or charge them for the shared exposure.

Collateral requirements are not an exact science, and occasionally, posted collateral may exceed the known exposure. Once collateral has been posted with an insurance company, it becomes challenging for the employer to recover that money, even if all claims have been closed.

Insurance companies use the posted collateral as a financial incentive to retain customers. They may offer lower rates for the collateral or reduce their projected outstanding exposures to achieve this.

Self-Insured Collateral Requirements for Obtaining and Maintaining a Self-Insured Certificate

Companies that self-insure must post collateral in each state where they conduct business. As there is no single self-insurance certificate or jurisdictional body covering the entire nation, large nationwide companies may find themselves posting self-insured collateral in multiple states.

Each state has its own unique collateral requirements, making the process of purchasing, monitoring, and managing cost-effective self-insurance collateral across various jurisdictions complex for risk management teams. This complexity intensifies when companies merge or face insolvency.

Workers' compensation is classified as a "long tail risk" because some claims may take decades to be reported or closed. Consequently, once collateral is posted with the state authority, it can take a considerable amount of time for any residual or unused collateral to be returned to the employer, should they decide to relinquish their self-insurance certificate.

Self-Insurance Oversight

Many states have established dedicated organizations to oversee the self-insurance process. These organizations are responsible for determining whether an employer meets the self-insurance requirements and assessing the necessary collateral to cover potential outstanding workers' compensation exposure. In cases where a self-insured employer becomes financially or legally incapable of fulfilling its obligations to provide workers' compensation benefits, the state assumes the responsibility of benefit payments to injured workers, utilizing the posted collateral to cover these expenses. Several states have created self-insurance guarantee funds, which oversee the administration of claims for insolvent employers.

Besides the posted collateral, most guarantee funds also levy fees against solvent self-insured employers to ensure there are adequate funds available to pay benefits to legitimately injured workers in the event of a self-insured insolvency.

Impact of Claims Processes on Collateral Requirements

Within a workers' compensation program, factors such as prompt reporting, early claims determination, timely benefit provision, settlement philosophy, and reserving practices significantly influence collateral requirements. This is attributed to the impact these processes have on actuarial projections for ultimate loss.

Delays in claims reporting, reopening of claims, the frequency of IBNR claims reported, reserving philosophy, and file closing costs all substantially affect actuarial projections, which form the basis for calculating collateral costs. As long as a file remains open, collateral is required for the outstanding projected liability and expenses. It is generally more cost-effective to settle a claim rather than committing to lifetime future medical care for a specific injury.

Despite their importance, collateral costs are often overlooked in the analysis of claims exposure when determining settlement value.

One strategy to reduce collateral costs is to transfer the future risk of open claims (and any IBNR claims) to an insurance company or another self-insured company through a "loss portfolio transfer." This approach effectively shifts the risk, allowing companies to manage their collateral costs more efficiently.

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.

Conclusion

Collateral expenses represent a substantial cost within a company's workers' compensation program. These costs result from a combination of the total outstanding risk and the credit rating of the company posting the collateral. Proactive measures, such as injury prevention, effective claims administration processes, and a well-defined settlement philosophy, can all contribute to reducing collateral exposure and associated expenses.

By understanding these costs and implementing strategies to mitigate the factors that contribute to collateral calculations, companies can better manage and control this significant expense.