Shareholder Value Reporting in Europe - Solvency II Based Metrics
We consider the impact of the pandemic to firms’ supplementary reporting metrics, and their level of Solvency II Own Funds and solvency positions.
For insureds that are new to or unfamiliar with a large deductible program, these questions are quite common. The collateral need from a carrier can represent a large portion of an insured’s cash or revolving debt, so it is important for an insured to understand how that obligation is used by the carrier to securitize liabilities.
If an insured has a large deductible for its commercial lines of business, the carrier will require collateral to protect itself against the credit risk related to the structure.
With a large deductible program, the insured is responsible for the losses less than or equal to the value of the deductible for each claim. For example, if an insured has a workers’ compensation deductible of $250,000, the insured will pay up to $250,000 on each claim, and anything exceeding that deductible will be transferred to the carrier. The carrier is the first payer on all losses in a large deductible program, and it will bill the insured for the amount that falls within the deductible. In the case that the insured does not or no longer can pay its claims, the carrier is responsible for paying those losses. The collateral requirement represents the carrier’s view of remaining liability.
There are multiple forms in which collateral can be posted. The preferred form is a letter of credit (LOC), but other forms may include cash (static or depleting), a trust, or bonds. A conversation with the carrier can determine which form(s) it is most comfortable accepting.
With a depleting form (e.g., working cash fund), collateral is posted at renewal in the amount of the perceived loss expectancy, and the losses are paid out of the cash in the fund. With this type of collateral structure, the expectation is to post the full amount of the projected losses each year, and it is subsequently reevaluated at each go-forward renewal. If the collateral calculation shows a redundancy (too much cash held) or a deficiency (not enough cash held) in the historical years, then the amount required at the current renewal may be decreased or increased, respectively, to balance the collateral requirement.
With a static form (e.g., LOC), the carrier’s collateral requirement is in the amount of the unpaid loss estimate. In the first few years with a new carrier, the amount held will ramp up until a point of equilibrium is achieved. This occurs when the additional losses for the incepting policy year are balanced by the losses paying out in the historical years. The equilibrium point depends on loss improvement or deterioration; changes in risk profile; exposure (e.g., payroll) growth or shrinkage; and any credit awarded or surcharges imposed by the carrier.
Figure 2 illustrates the collateral need at the first five renewals. In 2XX1, the carrier will require collateral in the amount of the projected losses for that year (the blue bar). In 2XX2, the remaining liability for 2XX1 is added to the projected losses for the policy year incepting 2XX2 (the green bar). Once a steady state is achieved, the collateral need will flatten, and little to no additional collateral will be required at future renewals.
There are two components to a carrier collateral calculation: credit and actuarial. The credit component is determined by an insured’s financial condition and its ability to pay claims. If a carrier deems an insured creditworthy, the amount of collateral required may be reduced by a percentage of the remaining liability or by an amount equivalent to a specific number of months of paid losses, with the number of months determined by the insured’s financial rating. For example, if the insured’s financials are sound and indicate an ability to pay losses over the next 12 months, the carrier may reduce the collateral need by an amount commensurate to 12 months of paid losses.
The actuarial component requires an estimate of ultimate losses for all covered years and lines of business, including the estimate of projected losses for the full incepting policy year. The carrier’s actuary will estimate ultimate losses and subtract paid losses to date to determine the remaining liability, also known as the unpaid loss estimate.
As is typically seen in actuarial calculations, there is oftentimes a wide, reasonable range around ultimate loss estimates. Because of this uncertainty, with the right information a carrier may be open to discussing these estimates. The insured’s consulting actuary can help navigate this conversation.
Some potential points of discussion may include:
The qualitative information is sometimes as important, if not more so, than the quantitative results. These potential changes to an insured, as described above, tend to impact development patterns, and without this information, accelerated development may be misconstrued as adverse development, resulting in an increased collateral need.
Another thing to consider is that some program agreements have built-in components that may alter the way collateral is calculated. For example, some programs include contractual LDFs or require the loss conversion factor (LCF), a factor applied to represent claim handling costs, to be collateralized. It’s important for an insured, or its consulting actuary, to understand whether these features are included in the program, as these mechanisms may impact the ability to negotiate collateral.
Carriers require collateral to protect themselves against potential credit risk. There are several moving parts, and each of them may be open for discussion. If an insured has questions regarding the best approach to negotiating the actuarial component of the calculation, it can engage its consulting actuary for assistance.