Magazine article Risk Management

Collateral Products: Not Just Letters or Credit

Magazine article Risk Management

Collateral Products: Not Just Letters or Credit

Article excerpt

Letters of credit are the most commonly used collateral, but they may not be the best option for your company due to financial considerations, program structure or tax position. In recognition of these limitations, insurance companies have developed alternative collateral products, including cash, surety bonds, escrow accounts and mutual funds. But how do you sort through the various options and select the best one for your company? A letter of credit is a legal commitment issued by a bank. It states that upon receipt of specific documents the bank will pay a debt. For an insured setting up with an insurer a long-term premium payment schedule (e.g., cash flow or large dollar deductible programs), a letter of credit assures the insurer that payments of both premiums and reimbursements for claims will be made. When a letter of credit is used for such assurance, the bank pays the insurance company if the insured does not meet its obligations, and then looks to the insured for recoupment. This is a demand instrument; if the insurer makes a demand for payment the bank must pay, without delaying to investigate whether the claim is justified.

A letter of credit is attractive to insurance companies because it is not part of an insured's estate. Therefore, in the event of an insured's bankruptcy, the insurer won't have to stand in line with the other creditors and obligees.

Since 1980, the National Association of Insurance Commissioners (NAIC) has required that letters of credit be irrevocable to be fully admissible on the insurer's balance sheet. This means that once a letter of credit is established by the insured it can be modified or revoked only with the consent of the insurer. In addition, the NAIC mandates that letters of credit contain an evergreen clause. This clause dictates that unless the bank notifies the insurance company of its intent not to renew 30 days or more before the expiration date, the letter of credit will be automatically renewed for an additional year. The amount renewed under an evergreen clause is the current value or the amount shown on any schedule included in the letter of credit.

Many of the governing documents for letters of credit include cross collateral language. Insureds provide multiple letters of credit to secure individual plans or plan years. If the insurance company ever needs to draw on a letter of credit, the individual letter of credit covering that particular year may be insufficient to cover the actual liabilities, while the letters of credit securing other plan years may be for amounts in excess of required security. In other situations, although the customer has given one letter of credit with a grand total schedule, there may be a year by year, plan by plan, supporting schedule. Should an attempt be made to draw on the letter of credit for an amount greater than any one of these individual plan schedules, a judge may take the position that the insurance company has overdrawn based on the schedule provided for that particular year or plan. This means that an insurer will generally be less willing to accept as collateral a letter of credit containing a finely detailed payment schedule.

Several years ago, the FDIC and the Federal Reserve Board issued regulations for banks issuing letters of credit. As a result of the risk-based capital requirements, they became more expensive. However, a letter of credit is still less expensive than a loan, assuming the letter of credit is not drawn upon. Letter of credit fees depend on the size and financial strength of a company and range from less than .25 percent to 4 percent of the amount of the collateral. If your company were to borrow the evergreen clause and thus automatically renew, there is also no annual paperwork burden.

One of the biggest disadvantages of letters of credit is that the amount necessary to secure the insurance plan stacks up over time. Another difficulty is that as the total amount increases, the insurer gains increasing leverage over the insured regarding the amount of collateral required to support the program and may, in certain circumstances, require collateral to secure the program to its ultimate value. …

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