Some employers that self-insure their workers compensation risks are having a tougher time obtaining the surety bonds they often use to meet regulators' collateral requirements.

There has been a reduction in the number of insurers operating in that market, observers say, and those that remain often demand substantial collateral to back their bonds, set higher underwriting criteria and provide less capacity than was available before.

As a result, some employers are turning to letters of credit where state regulators permit their use. Letters of credit can be relatively easy to obtain, although banks are becoming more conservative about issuing them. While rates vary depending on the situation, letters of credit generally tend to be less expensive than surety bonds, industry observers say.

Napa, Calif.-based building materials producer Syar Industries Inc. found letters of credit to be "lots more cost-effective," said John Walker, risk manager. Surety bond insurers "kind of wanted belts and suspenders as far as their collateral went, so we chose to take (the letter of credit) option," Mr. Walker said.

Karen Banks, vp-risk management for Pleasanton, Calif.-based Shaklee Corp., said her company also is using a letter of credit rather than a surety bond. The market for surety bonds "had pretty much dried up, and you ended up having to post letters of credit to secure the surety bond anyway, so it's just better to post the collateral directly with the state," said Ms. Banks, whose company makes personal care and household products.

Observers say although they do not personally know of any cases where an employer has left the self-insured market because of this issue, it may at least give pause to employers who are considering self-insurance.

Market changes

There are several reasons for the reduction in insurers willing to write surety bonds for workers comp self-insurers. For one, bankruptcy filings by Enron Corp. and Kmart Corp. encouraged some surety writers-who were never large in number to begin with-to exit the surety market altogether, observers note.

Much of the surety bond liability for Houston-based Enron, which was estimated to be more than $2 billion at the time of its 2001 bankruptcy filing, is in the form of guarantees for product deliveries. But in Kmart's case, the Troy, Mich.-based retailer held $275 million in surety bonds for workers comp liabilities, which was a key factor in its 2002 bankruptcy filing. According to court papers, many of the companies providing the retailer with its surety bonds had demanded that Kmart post supplemental security.

Some underwriters entered the business in the early 1990s because it appeared to be a "pretty easy bond to write," but subsequently discovered the "financials can deteriorate very fast" as the overall economy worsened, said Bill Martin, vp at St. Louis-based Safety National Casualty Corp., which still offers surety bonds to self-insured employers. "Things really went bust, and some of the larger sureties may not have been knowledgeable about these types of bonds," he said. They "found out it was harder than they thought, and they just got out of the market."

The situation was exacerbated by the overall hardening of the market, the disappearance of some insurers and the merger of the St. Paul Cos. Inc. and Travelers Property Casualty Corp., which effectively left one fewer surety insurer in the market.

"We're in a tight underwriting cycle right now, and perhaps the effects are felt more with respect to workers comp bonds," given some of their inherent risk characteristics, including their larger amounts and long durations, said Robert Duke, director of underwriting for the Washington-based Surety Bond Assn. of America.

As a result, relatively few insurers are even available to write the business today, say observers.

"There's only been a handful of insurers that even considered this market, so it's not a competitive market" as it is for primary workers comp insurance, said Gregory Krohm, executive director of the Madison, Wis.-based International Assn. of Industrial Accident Boards & Commissions. "There's probably five or six that offer it in most markets."

"The surety market has shriveled up and is almost nonexistent for collateralization of workers comp programs," said Jeff Pettegrew, executive director of the Sacramento-based California Self Insurers' Security Fund. He noted the security fund offers an alternative security program for self-insured, investment-grade companies whose participants pay a fee to the fund in lieu of collateral.

"It's just not as easy as it used to be, and when you have a good surety, pretty much you're there, and you're going to stick there, because there just isn't the market that was there before," said Ellen Vinck, risk manager for U.S. Marine Repair Inc. in San Diego, which uses both a surety bond and a letter of credit.

Those insurers now in the market, though, are likely to remain, say observers.

"The sureties that provide the product today understand it, underwrite it well, and have sufficient capacity to service the industry at this time," said Ronald Richter, Plymouth Meeting, Pa.-based manager of marketing and reinsurance for Liberty Mutual Insurance Co.'s bond services group, which remains a market.

Remaining insurers are demanding more collateral, though, in some cases in the form of letters of credit. There has been little change in actual pricing, "but the collateral requirements have changed and increased," said Dale Haug, assistant vp at third-party administrator Berkley Risk Administrators Co., a Minneapolis-based unit of Greenwich, Conn.-based W.R. Berkley Corp.

Underwriters say, though, that companies that are in strong financial shape have no problems obtaining surety bonds. "We provide the product for strong credits. We do not provide the product for weak credits," said Mr. Richter.

"The whole underwriting process is really subjective," he said, "and it depends on the creditworthiness of any given risk. So, it's very difficult to make any broad statement."

Safety National's Mr. Martin said self-insured employers that make a lot of money "probably don't have any trouble, but other companies might have trouble getting surety bonds, and might have to get a letter of credit because they can't get an uncollateralized bond for security."

Depending on the company, Safety National may ask for either no collateral at all, or up to a full 100% of its exposure to back a surety bond, said Mr. Martin. Even once the bond is issued, "you really have to have a sharp eye, looking at the company's financials once or twice a year, checking things out," he said.

The surety market "remains in, I would say, a conservative or cautious position, with credit quality continuing to be a prerequisite for even consideration for providing a surety bond for self-insured status," said Geoff Heekin, managing director of commercial surety services for Aon Corp. in Chicago.

The traditional players are providing self-insured workers comp bonds only for investment-grade companies, and even for those employers, "there is a finite amount available to any one name," said Mr. Heekin.

Furthermore, the cost advantages of surety bonds compared with letters of credit, which were "startlingly apparent in the '90s, have been tightened up, but I would say surety remains, from a total cost of capital (perspective), still a preferred product for those who could secure it vs. a letter of credit," he said. This is because a letter of credit calls for a capital commitment from the employer, and there are utilization and opportunity costs to consider as well. "The surety industry continues to offer an alternative capital pool to call upon outside of banks," said Mr. Heekin.

Use of letters

As a result of the difficult market, many self-insured employers are turning to letters of credit instead.

"I've found, overall, that more people are getting letters of credit as a percentage, compared to surety bonds, than they used to," said Mark Johnson, manager of the office of self-insurance plans at the California Department of Industrial Relations in Sacramento.

The Tallahassee-based Florida Self-Insurers Guaranty Assn. Inc. now has $112 million in posted surety bonds and $167 million in letters of credit, "and the trend has been most definitely the replacement of surety bonds with letters of credit," said Executive Director Brian Gee.

With some insurers asking for letters of credit to back their surety bonds, employers are simply replacing their bonds with the letters of credit, said Jeff Lapham, Helena, Mont.-based program manager for the Workers Compensation Regulation Bureau's self-insurance unit, which is part of the state Department of Labor and Industry.

Montana regulations permit both approaches, he said. "It doesn't make any difference to me whether it's a letter of credit or a surety bond, but (a letter of credit) does save the employer money," he said.

Certainly, banks "have an ability to secure and/or structure their credit in a variety of manners that aren't available to sureties," said Mr. Heekin. "The universe of customers who could secure a letter of credit is greater than those who might be able to qualify for sureties. In the past, we could have seen low-investment-grade companies being able to secure (sureties), whereas today that market really does not exist."

Observers say that, at least so far, the supply of surety bonds has apparently not led employers to leave the self-insured market.

"I haven't seen that be an issue," said Alan McLain, Little Rock-based self-insurance director for the Arkansas Workers Compensation Commission. "I'm sure it's a factor for people evaluating whether to come into self- insurance, but I haven't seen anybody leaving who's already self-insured."