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Derivative deal aids comp funding

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RALEIGH, N.C.—In an arrangement under consideration in other states, the North Carolina Self-Insurance Security Assn. has arranged a $510 million derivatives deal to bolster its fund that pays workers compensation benefits for insolvent employers.

The move earlier this month follows a similar structure set up in 2003 by the California Self Insurers' Security Fund, which now provides about $5.5 billion in collateral for 335 self-insured employers in the state.

Employer members of California's security fund have suggested the success in that state could be replicated in other states where they also self-insure, including North Carolina.

Supporters praise such capital market arrangements, saying they help security funds shore up reserves while relieving self-insured employers from having to post collateral--such as letters of credit--that can compromise a company's ability to borrow for other purposes.

State regulators typically require employers that self-insure their workers comp risks to post collateral that can be tapped to pay a portion of their outstanding liabilities should they be unable to pay workers comp claims.

Instead of requiring employer participants to post such collateral, California's Alternative Security Program and, more recently, North Carolina's Collateral Replacement Program allows security fund administrators to charge each employer member a fee based on its credit rating and a proportional share of its liability.

The fund can use the fees to post employers' state-mandated collateral requirements, pay outstanding claims or build the security fund's surplus.

Meanwhile, credit derivatives, such as credit default swaps and collateralized debt obligations that are provided by capital market investors to guarantee credit, would be triggered should the security fund experience a large loss.

The capital market arrangements essentially allow state security funds to become a fourth form of credit for posting employer collateral, said Quentin Hills, global head of financial risk products in San Francisco for MMC Securities Corp., a unit of Marsh Inc. The other three are letters of credit, sureties and cash.

The funds take on the employer's credit exposure--making it a credit risk addressing an insurance problem rather than an insurance risk, said Mr. Hills, who helped California and North Carolina with their capital market arrangements.

In North Carolina, employers that have won state Department of Insurance approval to self-insure their workers comp risks must become members of the security association.

The association, created by North Carolina's General Assembly in 1986, has statutory authority to assess all security fund members to pay claims against members who are insolvent. The association's board of directors is made up of employer and industry associations.

It paid MMC an undisclosed fee to make the capital market arrangements, just as California did.

California faced about $55 million in unfunded liabilities when it created its program three years ago. The shortfall stemmed from several self-insured employers filing for bankruptcy just as several providers of sureties that employers relied on for collateral arrangements also filed for bankruptcy (BI, April 28, 2003).

North Carolina's fund did not face a deficit when it began transforming its collateral system, said James L. Stuart, principal at Stuart Law Firm P.L.L.C. in Raleigh and general counsel for the state's Self Insurance Security Assn.

"We were looking at it prospectively" to ensure that the fund could pay claims should several employers simultaneously go into bankruptcy, start liquidation and stop paying their claims, Mr. Stuart said.

Approximately 150 employers that participate in North Carolina's fund have combined workers comp claim liabilities of $510 million, but more than 60% of that liability is concentrated in about a dozen companies, Mr. Stuart said.

Apart from ensuring that North Carolina's fund can meet future obligations, it is also hoped the new system will allow enough reserve buildup to lower fees charged to employer participants, Mr. Stuart said.

Other states also are looking to California's success, said Andrew Morrison, general counsel for the Minnesota Self-Insurers' Security Fund in St. Paul.

Today, California's fund has $187 million in assets with only $45 million in liabilities, said Jeff Pettegrew, executive director of California's SISF.

Member savings

Members of the California fund are saving about 50% on their costs for obtaining collateral, Mr. Pettegrew said. The fund currently assesses members $43 million in fees annually, far less than the estimated $75 million it would cost employer members to obtain letters of credit for the $5.5 billion in collateral they must post.

"Obviously, in a matter of four years we have made tremendous strides," Mr. Pettegrew said.

California's surplus is largely due to its alternative collateral system arrangement, Mr. Pettegrew said. But he acknowledged that an improved economy and state workers comp reforms also helped.

Still, regulators and fund administrators from states such as Minnesota and New York have visited California to see how they might implement a similar strategy.

Minnesota is moving cautiously, but a consultant has completed one study and the fund has hired a financial consultant for additional analysis, Mr. Morrison said.