Collateral requirements can come as a confusing surprise for insureds with large deductible programs or captives with fronted arrangements. In this article, we’ll answer some of the most common questions around when collateral is needed, how carriers determine these requirements, and how an independent actuarial analysis can provide clarity and, in some cases, reduce the collateral burden.

When Is Collateral Required?

Insurance carriers are in the business of assuming risk in exchange for a premium. So why would they require collateral on top of that? The answer lies in scenarios where the carrier takes on credit risk. This happens in two common situations:

1. Large Deductible Programs:
   In a large deductible arrangement, the insured is responsible for the first layer of payment in any given claim. This exposes the carrier to the risk that the insured may be unable to pay, due to insolvency or other financial issues. Since this credit risk is not covered in the premium, collateral (e.g., letters of credit, cash, or trust funds) is required to secure future reimbursements.
2. Captive Fronting Arrangements:
   In a fronted captive structure, a commercial insurer (the “fronting” carrier) issues the policy to the insured and cedes all or a portion of the risk to the captive via reinsurance. If the captive cannot fulfill its obligations (e.g., it becomes insolvent), the fronting carrier remains liable for claim payments. To mitigate this credit risk, the carrier requires collateral from the captive based on the expected liabilities it is ceding.

It is important to note collateral goes to support the ceding insurer’s Schedule F requirements in the U.S. statutory accounting framework.  Schedule F requires collateral for unauthorized reinsurers or increased risk based capital charges.

How Do Carriers Set Collateral Requirements?

Collateral requirements are typically based on the estimated unpaid losses retained by the insured or a captive, whether through a large deductible or a captive reinsurance agreement. The process typically includes the following steps:

1. Estimation of Ultimate Losses:
   For each policy year, the carrier first estimates “ultimate” retained losses and loss expenses for the insured or captive using actuarial methods. These ultimate losses include the following three claim components:
   • Paid losses (claim payment on closed and open claims)
   • Case reserves (reserves set typically by claims administrators for known open claims)
   • IBNR (incurred but not reported claims, including late-reported and under-reserved claims)
2. Calculation of Unpaid Losses:
   Unpaid losses = Ultimate losses – Paid losses
   This amount includes case reserves and IBNR.
3. Adjustments Based on Financial Strength and Other Factors:
   Carriers may reduce required collateral depending on the insured’s financial standing, claims-paying history, or other negotiated factors, such as expected payments over the next policy period.

Depending on the carrier’s risk appetite and underwriting philosophy, they may require collateral above and beyond the actuarial estimate of unpaid claim liabilities. For fronting arrangements, the ceding company often considers the limits of the reinsurance contract with the collateral requirement to satisfy their reporting requirements. Additionally, since many captives are not rated, their financial strength cannot be considered as much as the insured with a large deductible plan. As a result, a fronting carrier’s required collateral is often greater than collateral for a large deductible program at a similar retention. This variability makes it critical for insureds to understand and, when appropriate, challenge the assumptions behind collateral determinations.

Another important issue to understand with collateral obligations is the staking of policy year collateral particularly with long tailed lines. With each additional policy year of exposure collateral will grow as the reserve need grows to payout unpaid claim liabilities. This is driven by factors such as the payment pattern, exposure size, and trend but may be offset by claims from older years settling and closing out. This is illustrated in the next section.

Explanation of why IBNR and Reserve Development Assumptions So Important

The inclusion of IBNR in the calculation of unpaid liabilities for the retained losses of the insured or captive ensures that liabilities are not understated, especially for more recent policy years that are still developing. Without IBNR, estimates would only reflect known and reported claims, missing the potential for future loss emergence. Actuarial assumptions, such as loss development factors and trends, play a large role in determining the size of IBNR and thus the total collateral needed related to each policy year.

Graphical models (as seen in other collateral guidance) often illustrate that unpaid losses increase over the first few policy years with a carrier, then flatten out as payments catch up and fewer legacy claims remain. However, any increase in deductible levels or rapid expansion in exposure can restart the “ramp-up” of collateral needed. This is illustrated in the following graphic between 2019 and 2020 with a doubling in company size. Also illustrated is the stacking of collateral for a long-tailed line like workers’ compensation. At each policy year renewal historical reserves decrease as claims are paid and closed but prospective policy year exposure is added.

How Can an Independent Actuarial Review Help?

Collateral is often based on the carrier’s actuarial projections, but these projections vary widely depending on the methodology, assumptions, and data quality. An independent actuarial review offers the following benefits:

• Transparency: Clarifies what’s driving collateral changes year-over-year.
• Validation or Challenge: May identify overly conservative assumptions (e.g., inflated loss development factors).
• Negotiation Support: Offers third-party credibility in discussions with carriers.
• Strategic Insight: Helps explore alternate program structures that may reduce or eliminate collateral needs altogether.

Here are two real-world examples of how an independent analysis made a difference:

Case Study 1: Workers’ Compensation Collateral Reduction

A Florida-based employer approached us with concerns over their self-insured workers’ compensation collateral. Their existing independent actuary had supported a collateral requirement of approximately $1M. Upon review, we found the prior analysis used conservative loss development factors inconsistent with actual experience. Our revised projections reduced the necessary collateral to under $400K, a 60% reduction, without compromising conservatism or adequacy.

Case Study 2: Auto Liability & Workers’ Compensation Program

A private equity-backed client with a multi-state deductible program was facing significant collateral hikes from their carrier. Our team conducted an independent review and found that the carrier’s actuaries used industry-standard payment patterns, which were misaligned with our client’s much faster claims payment history. By recalibrating the payment patterns and addressing a few minor methodology concerns in a call with the carrier’s actuaries, the client’s collateral requirement was reduced by over $1 million.

When a Collateral Requirement Is Justified

Not every independent analysis leads to a reduction. In some cases, we’ve found the carrier’s requirement to be reasonable or even favorable based on the insured’s data. Factors such as competitive pressure, strong credit ratings, or favorable development may contribute to a conservative collateral stance. Even then, an independent report helps the insured understand the process and strengthens their position in negotiations.

Alternative Program Structures to Avoid Collateral

An actuarial analysis can also inform a longer-term strategy. For example:

• Switching from Large Deductible to Self-Insured Retention (SIR):
  In an SIR structure, the insured pays claims directly up to the retention, which eliminates the carrier reimbursement risk and often reduces or eliminates the need for collateral.  While a SIR may reduce collateral, it could have other tradeoffs and is not always an option for all lines of coverage
• Utilizing a Captive to Post Collateral:
  In some cases, an insured’s captive can post the collateral instead of the parent company even if the captive is not fronted. This makes use of surplus or other captive assets to secure the required amount.  Not all domiciles allow unrestricted use of captive surplus as collateral.

These strategies must be evaluated with regulatory, financial, and operational considerations in mind, but they are worth exploring for insureds facing increasing collateral burdens.

Collateral requirements are a critical but often misunderstood part of large deductible and captive insurance programs. Independent actuarial analysis not only sheds light on how those requirements are set but also equips insureds with the tools to question assumptions, potentially reduce collateral, and explore smarter program structures. Whether validating the carrier’s position or uncovering opportunities to save, actuarial expertise can be a powerful asset in navigating the complexities of collateral.