In evaluating fronted casualty programs, most organizations pay close attention to their overall premium level. What they may not have realized is that variations in the level of collateral required by insurers can be more costly than fluctuations in the premium. Understanding the aggregate implications of program design can save money and minimize collateral intensity of fronted casualty programs.

Most fronted casualty programs require that the organization taking out the program provide the underwriter with sufficient collateral to cover the anticipated claims. In fact, depending on the trend in claims history, the amount of collateral required could be less than a full year's claims, or significantly more—anywhere between 25 percent and 300 percent. That represents a significant cost to the firm, either in outright cost of capital or in the opportunity cost of how else that capital could have been deployed. Given that these losses pay out over several years, the total amount of collateral cost linked to any single policy year will be the net present value of the collateral cost over the payout period. This amount is likely to be higher than the program fronting costs and in certain situations the premiums for the primary program.

DEVELOPING A CLEAR PICTURE OF YOUR FIRM'S COLLATERAL POSITION IS CRUCIAL

While organizations are prepared to spend significant time trying to manage the premium they pay, either through negotiation or by improving their claims performance, many do not have a clear picture of the organization's collateral position or understand the multiple dimensions of the negotiation process.

"Historically, the process of determining what level of collateral an underwriter requires has been relatively opaque and often misunderstood," says John D. Meyers, CFA, director and senior strategist, Aon Global. "For the vast majority of carriers, the ultimate decision is often the responsibility of chief credit officers, or a credit committee—not underwriting. While carriers may have varied appetites for bearing unsecured credit risk, there is a natural tendency to err on the side of over-collateralization when setting the collateral requirements."

Because of the relative lack of transparency in the process, it is difficult for firms to determine whether the level of collateral required is high, low or in line with comparable firms. And even if they feel it is too high, many firms have not invested appropriately in the right relationships and developed communication paths to the relevant people within the carrier.

"One of the ways that we help clients address their collateral issues is to support them in getting the right dialogue going with their carrier," says Henry Maddocks, senior managing director, Aon Global. "That's more than just knowing who to talk to in the carrier—we guide and advise clients how to present their firm's position in order to get an optimum collateral level established."

AN ONGOING EFFORT

What determines the level of collateral is not only the level of claims, though clearly that plays a role. More important are the payout patterns over time and the developing financial profile of the company for the foreseeable future, especially with regard to developments that directly impact a firm's liquidity.

Establishing the appropriate level of understanding generally requires the direct involvement of the client's treasurer or chief financial officer and is a continuing process rather than a one-off event. "It's important that clients keep their carriers informed about any significant changes that may materially impact a firm's liquidity position," Meyers says. "It doesn't need to be a weekly or monthly conversation, but we would suggest that the position is reviewed more than just annually, so that when renewal date nears a sophisticated level of understanding has already been achieved."