PERSPECTIVES: Collateral management requires discipline in slow market

ACCESS TO CAPITAL in the challenging economy is difficult for firms in the construction industry, and they need to manage their funds to make every dollar count. Policyholder collateral obligations, however, are unavoidable. Here, Brian McGrath, the national construction claims practice leader for Marsh Inc., and Dan Aronson, co-chair of the collateral solutions group at Marsh Inc., offer steps construction firms can take to reduce the amount of collateral dedicated to their insurance programs and thus free up working capital or gain additional borrowing capacity.

The construction industry's economic recovery continues to lag behind that of the United States overall, with an unemployment rate of more than 13%, according to the latest data from the Bureau of Labor Statistics. Although there are some pockets of growth—including in the health care and private education sectors—public and private capital to fund construction projects remains in large part on the sidelines, with no sign of significant improvement in the near term.

For construction firms operating in this challenging environment, access to capital and effectively managing it can mean the difference between staying viable and going out of business. One unavoidable capital outlay that has proved challenging for risk managers in all industries over the past few years involves the collateral obligations associated with fronted and loss-sensitive casualty insurance programs.

Insurers typically require organizations with such programs to post collateral to guarantee payment of claims falling within large deductibles. Most primary casualty programs are written as loss-sensitive; letters of credit are the collateral instrument most readily accepted by insurers.

During the economic downturn and credit crisis, banks have materially changed the parameters of credit facilities for many insureds. This has resulted in reduced LOC capacity, increased LOC fees and, in some cases, a requirement for cash collateral to secure an LOC. At the same time, insurers have become more conservative about their credit risk, often limiting the aggregate exposure to LOCs from individual banks.

Construction firms with deductible insurance programs cannot avoid collateral requirements, but there are steps they can take to reduce the amount of collateral dedicated to their insurance programs and thus free up working capital or gain additional borrowing capacity. Effectively managing collateral in today's difficult construction market is a function of having in place effective processes, products and programs.

The amount of collateral a construction company is required to pay depends, in general, on the value of claims the insurer expects to pay within the construction firm's deductible layer until the claims are closed. Quite simply, the fewer claims there are outstanding, the less collateral that is owed.

Effective claims management and loss control processes can go a long way toward this effort, and should include the following criteria:

• Active engagement with your selected claims administrator. Ongoing scrutiny of and discussions surrounding the extent of your reserve and your plan for claims disposition are essential to an effective claims program.

• An outcomes-driven analysis of the prospective claims administrator. When selecting or reviewing your claims administrator, focus on historical claims outcomes rather than claims handling fees, as such fees represent only a small percentage of the overall cost of claims. Failure to use an outcomes-based analysis can lead to longer claim duration, which often leads to more significant collateral requirements.

• A dedicated focus to resolve older and legacy claims. These claims typically result in a greater administrative and collateral strain on an organization. Through the resolution of these losses, an organization can expect to see a potential reconsideration of its collateral requirements.

• A robust safety and loss-control program. Preventing claims from occurring is the best way to reduce liabilities and associated collateral obligations. A culture of “safety first” with support from top leadership on down is likely to improve the effectiveness of a well-designed safety plan.

In order to ensure an accurate portrait of future liabilities, construction firms should conduct a thorough liability analysis of existing and new claims, looking at case reserves, reserving philosophies and loss-development factors. Once an accurate estimate of outstanding liabilities is established, a construction firm should meet with its insurer's senior credit officers—similar to its banking partners—to discuss the firm's financial strength, liquidity position and overall outlook. By establishing that relationship, insurers are apt to feel more comfortable with a client's risk profile and are more likely to accept a lower collateral amount than the liabilities they are fronting.

Product is an important consideration in reducing collateral obligations. Approved types of collateral depend upon the insurer's appetite and the insured's financial credit. For most situations, acceptable collateral forms will consist of a combination of one or more of the following:

• Letter of credit.

• Trust, which is cash and/or certain marketable securities held in trust.

• Cash collateral, which is cash paid to an insurer within the policy year to pay claims.

• Pledge and securities, which are marketable securities pledged to the insurer.

• Surety bond, which is rarely accepted and covers only up to 30% of the total collateral requirement.

• Credit fee, which is a fee to reduce the collateral requirement.

Several large construction firms have historically preferred to post LOCs and preserve cash for reinvestment into the company, as the internal rate of return was higher than the cost of an LOC. Given current economic conditions, some of these firms now have on their balance sheets excess cash that is neither being put to use nor earning a meaningful return.

Construction firms in this situation should weigh whether using excess cash makes more financial sense to the company than posting an LOC. Cash can be used in various structures and products, and in many cases produces a similar or better return than balance-sheet cash.

For example:

• One alternative cash option is a cash-backed LOC, which can generate a fixed or variable return on the posted cash (net of fees), thereby eliminating LOC fees and generating investment returns on the cash.

• For larger companies with significant collateral requirements, a capital market solution that provides an unsecured LOC may be an option.

Construction firms should work with their brokers to actively reduce collateral requirements and secure appropriate forms of collateral with historical insurers, not just the current one.

Program design changes are another option that construction firms can consider when seeking to reduce the cost of collateral. For example, a loss-sensitive liability program could be structured as a self-insured retention, thereby eliminating the collateral obligation altogether. When considering this option, however, a construction firm needs to ensure that contract and insurance certificate holders will allow it to maintain an SIR, as insurers only provide coverage in excess of the retention.

A loss portfolio transfer is another option to consider if there is available cash and historical liabilities on the balance sheet. An LPT is a fixed or adjustable payment of premium that satisfies reimbursable loss obligations for specific policy years. An LPT eliminates the applicable collateral requirement and associated fees.

There is no magic solution to relieve a construction firm of collateral obligations. However, taking a disciplined approach to collateral management that focuses on having in place effective processes, products and programs can help mitigate a company's overall collateral needs, thus freeing scarce financial resources to be used for other business strategies.

Brian McGrath is the national construction claims practice leader for Marsh Inc. in Grand Rapids, Mich. He can be reached at brian.j.mcgrath@marsh.com or 616-233-4267. Dan Aronson is co-chair of the collateral solutions group at Marsh Inc. in New York He can be reached at daniel.e.aronson@marsh.com or 212-345-5934.