Why you need it and how to manage it.

• Position: Collateralizing Insurance Liabilities

A common question regarding collateral is "why does the insurance company need it, and why does it always seem to need more?" To effectively address this question, it's important to first take a step back and review the insurance mechanism from a high-level perspective.

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Then it's possible to delve deeper into loss sensitive insurance programs and why these programs require insurance carriers to address their credit risk exposure via various collateral approaches.

Insurance plays a critical role in the free enterprise economic system, allowing the investment of capital into business ventures by providing a "safety net" of sorts, to protect assets both tangible and intangible. Some types of insurance, such as workers' compensation and property insurance, are required by state statute or by lenders to protect the public interest and to allow for increased security in lending funds for business ventures.

Other lines of coverage--such as directors and officers (D&O) or umbrella coverage--may not be required but are purchased to protect a company's assets from potential future litigation.

Historically, business owners paid an agreed amount of premium in order to secure their desired coverage for their desired policy limits. As businesses grew, the amount of premiums paid to insurance carriers increased substantially, driven by large and growing exposure rating bases.

Rather than paying premiums that didn't reflect the "economy of scale" discounts they desired, many business owners began to pursue loss-sensitive insurance programs that would be reflective of their own specific loss experience. In many cases, this approach greatly impacted projected loss costs for accounts with favorable experience.

For businesses that wanted to further reduce the amount of insurance premiums paid over time, large deductible programs began to gain popularity for those accounts that invested in controlling their exposure to loss, with a focus on managing their total cost of risk.

Rather than pay an insurance carrier a large premium, based on pre-determined payroll or sales rates, these well-controlled accounts began to purchase large deductibles that allowed them to essentially "self-insure" for losses within their retention levels. This focus then allowed insurance carriers to focus on their required loss funding for losses that exceed the retention levels of their customers.

For businesses that effectively controlled...