Balancing Higher Deductibles and Lender Requirements: Strategies for Real Estate and Property Management
For clients in real estate and property management, balancing the cost savings of higher deductibles with lender requirements can be a challenging task. While higher deductibles often unlock premium savings and provide access to competitive insurance markets, lenders may impose restrictions, limiting clients' flexibility. Fortunately, there are solutions that allow clients to benefit from higher deductibles while remaining compliant with loan terms. Below are three strategies to help insureds manage their deductible structure effectively without compromising on lender expectations.
Clients aiming to control property program costs often consider higher deductibles as a viable option; however, lender restrictions may limit this approach. Opting for higher deductibles can lead to significant savings, especially for high-risk properties or accounts with challenging loss histories. By taking on a higher deductible, clients gain access to more competitive insurance markets, often resulting in a more affordable property program. For instance, a client willing to take a $100,000 deductible typically attracts greater interest from insurers than one with a $10,000 deductible.
However, lenders may not always approve higher deductibles.Despite these constraints, insureds can still benefit from higher deductibles while complying with loan terms. The following three strategies enable clients to meet lender underwriting requirements while managing insurance expenses effectively:
1. Deductible Buy down Policy
A stand-alone deductible buy down policy allows insureds to bridge the gap between the lender’s requirements and the optimal deductible for cost savings. Depending on market conditions, this policy can cover “All Risk”perils or specific named perils like windstorm or earthquake. For example, if a property program has a $100,000 deductible but the lender requires no more than$25,000, a buy down policy would cover the $75,000 difference above the lender’s required $25,000 deductible.
2. Deductible Indemnity Agreement
A deductible indemnity agreement may offer a cost-effective solution without requiring a separate policy. Here, the insured’s property carrier endorses the existing policy to treat losses as if a lower, lender-required deductible applies. Losses are generally adjusted and paid based on the policy’s original deductible, with the insured indemnifying the carrier for any deductible difference. Insurers may require a letter of credit as a financial guarantee for this arrangement.
3. Deductible Reimbursement Policy
A deductible reimbursement policy (DRP) provides another economical option. This structure allows the insured to fund the deductible gap upfront through a letter of credit, potentially earning investment income on the deposited funds. Similar to a captive, any funds not used to cover losses are refunded at the program's end, although losses must be replenished by the insured. DRPs work well as a long-term strategy, especially for insureds with prior losses who have implemented measures to reduce future risks. Although commonly used for casualty risks, this arrangement can yield long-term savings that offset the deductible difference, assuming low or no losses occur.
In a large deductible insurance policy, the insurer commits to paying all claims as they arise, while the policyholder is obligated to reimburse the insurer for any claims within the deductible threshold. To secure this liability, insurers require the insured to post collateral, protecting the insurer from risks such as:
· Credit losses due to the insurer's statutory obligation to cover the deductible portion.
· Regulatory compliance with state-imposed requirements on insurers.
· Meeting surplus requirements set by financial rating agencies, which measure the ratio of policyholder surplus to written premiums.
· Preserving the insurer’s financial rating, as collateral serves as a safeguard for the insurer’s financial health.
In recent years, evolving conditions have led to stricter underwriting standards, greater collateral requirements, and increased costs of posting collateral. Much of this shift stems from heightened oversight on insurers’ financial accountability by rating agencies and regulatory bodies.Additionally, collateral requirements are influenced by the decreasing availability of bank credit, the strength or weakness of the client’s balance sheet, and insurers' return on capital. As a result, collateral requirements have become more burdensome and costly for clients with loss-sensitive insurance programs.
Key Determinants of Collateral Amount
Insurers determine the amount and cost of collateral on a case-by-case basis, taking into account specific client factors, such as parental guarantees, pension obligations, union relationships, and debt maturity. Major factors driving collateral requirements include:
· Program structure and duration: The retention/deductible level relative to historical loss experience.
· Actuarial loss projections and development triangles: This includes projected losses for historical policy years and the expected payout pattern of prior-year losses.
· Financial review: This involves analyzing the client’s historical, current, and projected financial statements, liquidity, debt ratios, and other key metrics. Industry-specific trends also affect evaluations; for instance, a client in an industry with longer asset lifespans may be viewed more favorably than one with rapidly depreciating assets.
· Completeness of underwriting data: Factors include operational changes, past losses, potential mergers and acquisitions, banking relationships, legacy collateral, and other relevant details.
· Safety measures: The presence of initiatives aimed at loss prevention and protocols for post-loss management.
· Type of collateral: Options include letters of credit (LOCs), trust funds, cash, surety, and credit buy downs, each of which has different implications for both the insurer and the client.
Understanding Collateral Pyramiding
One critical aspect when selecting retention levels is that each increase in retention can significantly impact collateral requirements.This is also an important factor when considering whether to switch insurance carriers. Over time, a buildup of collateral, often termed"pyramiding," can occur as insurers require additional collateral each year to maintain secure ratios. Key factors related to pyramiding include:
· Loss development: Losses are projected using client-specific or industry-standard loss development factors (LDFs), which account for potential increases in reserves and incurred but not reported(IBNR) losses. These projected losses often grow faster than actual loss payments, leading to a cumulative increase in collateral requirements overtime.
· Cumulative policy year losses: Until the total paid losses for all policy years exceed the expected losses for the upcoming policy year combined with developed losses from previous years, the required collateral will continue to increase.
· Compounding effects: Each new policy year adds to the initial program, which can significantly amplify collateral requirements over time.
Certain financial improvements can help clients reduce the effect of collateral pyramiding, including:
· Strengthening the balance sheet: This can reduce leverage, especially if profit-and-loss results improve.
· Debt maturity extensions: Longer debt maturities reduce immediate cash demands.
· Enhanced debt terms: This includes lower rates or more favorable covenants.
· Improved cash flow: Stronger cash flow from operations can allow clients to finance operations without using credit lines.
· Industry-specific trends: Positive trends within an industry, like a recovery in homebuilding, can favorably impact collateral needs.
In some cases, companies may experience a growth in collateral similar to the illustration shown over a ten-year period, especially if they maintain the same insurer and experience a steady annual loss projection.
Availability of Letters of Credit
Clients may secure LOCs from their bank or through a third-party trust arrangement. The availability and cost of LOCs largely depend on the borrower’s financial strength and its banking relationship. However, concerns are rising over the cost and availability of LOCs due to the capital requirements embedded in global standards like Basel III, which treat LOCs with contingent obligations similar to loans. Under Basel III, stricter capital requirements are being phased in, potentially impacting the cost and accessibility of LOCs for clients.
Notably, major banks considered “systemically important financial institutions” face additional capital requirements. This status applies to several key LOC-issuing banks in the U.S., which often act as agents on syndicated credit lines. As the Basel III rules take full effect, they may further limit credit availability and drive up LOC costs.
Third-Party Trust Arrangements
Third-party trust arrangements have become a viable alternative to LOCs, especially for clients facing bank-imposed credit restrictions. In these setups, clients provide cash as security to a third party, which then issues the necessary LOC to the insurance carrier. This arrangement can provide LOC capacity for clients who cannot secure LOCs directly.
Cost of Letters of Credit
The rising demand and limited supply of LOCs have allowed banks to adopt more conservative pricing. Alongside increased LOC costs, some clients are now required to provide cash collateral, depending on their financial position. However, insurance carriers are increasingly willing to accept alternative collateral forms, which can help clients reduce costs and preserve credit lines.
Alternatives to Traditional LOCs
Insurers are becoming more open to alternative collateral forms, though these options are not universally accepted and often require negotiation. Common alternatives include:
· Trust or pledge of security: This widely accepted option often combines LOCs with cash or rated securities.
· Cash: Accepted by fewer insurers due to a 90-day period during which cash is not bankruptcy-protected.
· Surety bonds: Limited to a percentage of the total collateral and structured as demand instruments rather than standard surety bonds.
· Credit buy downs: Allows clients to pay a credit charge to reduce collateral requirements, especially beneficial for clients with limited credit availability.
Collateral Negotiation Process
Negotiating collateral typically involves three steps:modeling, financial review, and tactical goal setting with the insurer.
· Modeling: Begins with an analysis of the existing collateral position, including outstanding liabilities, loss development factors, legislation, and trends.
· Financial Review: Involves evaluating financial ratios, credit line restrictions, and the internal rate of return on capital versus LOC costs.
· Goal Setting and Tactical Planning: Focuses on understanding unsecured credit extended by the insurer, selecting the appropriate program structure, and assessing the mobility of the client’s program between carriers. In some cases, a meeting with the insurer’s credit officer can be advantageous, particularly when exploring options like loss portfolio transfers.
Insurance carriers are typically reluctant to extend unsecured credit to past clients as readily as they would to existing clients.This provides clients with an opportunity to consider a loss portfolio transferor a closeout of older policy years.
Conclusion
Managing collateral requirements continues to challenge many clients. However, with early planning, open dialogue, thorough modeling, and consideration of all alternatives, insured companies can minimize the collateral burden and retain credit for reinvestment into their business.
