In an insurance contract, carriers typically require the insured company to provide collateral as a guaranteed source of funds, with three of the most commonly accepted forms being letters of credit (LOC), marketable securities and cash. 

Letters of credit are generally the most widely used and accepted form because they represent an irrevocable guarantee of payment in a specified amount. Market securities, by contrast, fluctuate in value over time with no guarantee of their future worth, and thus are typically undervalued as a cushion against the potential decline in their market value. And cash collateral, while the most straight forward, requires payment of the full amount up-front, tying up capital the company could better use for other purposes.

For these reasons, many risk managers choose to obtain a letter of credit. And beginning the process is relatively simple. Insured companies typically look to a line of credit established with their bank and draw upon that line of credit. The insured company's total available credit is then reduced by the amount of the LOC, which limits how much more of the debt obligation can be collateralized. Banks charge a fee to issue a letter of credit, and the company pays this cost. 

For companies that use letters of credit, however, the job is never entirely done. Risk managers must, at a minimum, review all existing LOCs at least annually. While these obligations are typically reviewed during insurance program placements and renewals, run-off insurance programs present an especially ripe opportunity for LOC reductions as claims continue to close and no new claims are reported. This way, the risk manager can ensure that she has not allocated loss funding in excess of what is required, as that would unnecessarily tie up valuable corporate capital.

Mergers and acquisitions present another time when credit obligations must be re-evaluated. The key is to determine how much of the outstanding security obligations must be retained and how much, if any, can be released or discharged. Be sure to clearly establish, in any applicable agreements, which company is responsible for maintaining the security obligations to avoid any post-transaction confusion, disagreement or surprise.

In a case at Dr Pepper Snapple Group, due diligence surrounding a recent de-merger from our former parent company determined that collateral commitments were overstated by $13 million, which represented roughly half the outstanding collateral being held by insurers. By pursuing collateral reviews and scrutinizing outstanding losses, we cut $13 million in LOC obligations and saved another significant sum of money in bank fees associated with maintaining them.

But if an insured wants to benefit from using a letter of credit, the burden is on it to ask. Although they can be useful risk management tools and most insurance agreements address the process for potential LOC decreases, few insurers voluntarily initiate an LOC reduction without prompting from the insured. Some insurers require a formal written request for a collateral review, while others may be willing to accept an email or telephone request. Be sure to check with your insurer to confirm its specific collateral review process and requirements.  

Turnaround time for the completion of these reviews by insurers can also vary widely depending upon how many other insureds may have requested reviews or other competing priorities. On average, insurers should complete collateral reviews within 90 to 120 days. Remember that the squeaky wheel does get the grease-regularly follow up with the insurers on the status of the review to make sure it is not delayed or put on the back burner. 

Written by Marva Barbour:

Marva Barbour is the risk manager for Dr Pepper Snapple Group.

The above article is reprinted from the May 2010 edition of Risk Management Magazine.