"Why do we need to post collateral to an insurance company?" This question is often asked by treasury teams and Chief Financial Officers when arranging the collateral required within their insurance policies. The answer lies in understanding how these programs are designed, who ultimately bears the financial risk, and what role collateral plays in the arrangement.
To answer this question fully, it helps to start with a clear picture of how different insurance program structures work, specifically, how a traditional guaranteed-cost program with a captive compares to a large deductible program.
Traditional guaranteed-cost programs are those in which the premium paid by the insured is used to cover the insurance carrier’s operating expenses/profits and to pay estimated future claims. All claims covered under the traditional guaranteed cost program are the responsibility of the insurance company. When a captive is incorporated into this structure, the insured's captive typically reinsures a portion of the risk from the carrier, assuming exposure for claims within the agreed retention.
Under a large deductible program, the insured pays a significantly reduced premium to the carrier because the insured agrees to reimburse the carrier for all losses within the large deductible. That reduced premium is intended to cover the carrier's operating expenses/profits, but not the expected claims costs within the deductible layer. The carrier that issues the insurance policy is legally responsible for all covered claims, including those that are within the insureds deductible layer. Consequently, a carrier will seek collateral from the insured to cover the risk of non-reimbursement for large deductible claims.
Rating agencies such as A.M. Best routinely evaluate a carrier's financial health and its ability to pay claims. If the fronting carrier’s credit risk becomes too large and its ability to meet its financial obligations is questioned, its financial strength ratings may be adversely affected. Collateral ensures the carrier has sufficient financial resources to continue meeting statutory accounting requirements and other financial obligations, helping maintain its financial strength ratings.
One of the primary reasons insureds use fronting carriers, whether in a large deductible or traditional captive arrangement, is to gain access to licensed, admitted insurance paper and the regulatory infrastructure that comes with it. Admitted carriers are licensed in each state, meaning their policies meet mandatory insurance requirements, allowing their insured to operate within the respective states.
Collateral is part of the price for that access. The fronting carrier extends its regulatory license and financial backing, and the collateral ensures the carrier is protected for doing so.
Collateral is a key component of both traditional guaranteed-cost programs with captive reinsurance and large deductible programs, as it is the financial backstop that gives carriers, regulators, rating agencies, and other insureds the confidence to participate in and support these structures.