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The LOC conundrum.

In the film "Casablanca", a letter of transit, or LOT, was the key that unlocked the door to freedom for people fleeing the Nazis through Morocco. Humphrey Bogart's Rick was tempted to use them for an ex-lover's revenge until his gold heart held sway in that last gauzy airport scene.

For about every employer, a letter of credit, or LOC, opens the door to self-insurance. Banks, which issue these LOCs, may talk amiably about issuing them but the lumps of coal they have for hearts are the rule at the close of business.

Given our financial sector turmoil and general slump, those lumps of coal have gotten even blacker. The cost of LOCs has doubled from a year ago.

I called Mark Wilhelm, president of Safety National Insurance, to ask how our economic malaise is affecting the self-insurance market. As an excess insurer, Safety National writes policies which assume claim liability after losses exceed a specified amount.

Collateral requirements have become more of a burden, Wilhelm told me. State regulators tell employers to put up collateral or bonds to cover their retained claims exposure. Employers hand over cash, securities or--most likely--a letter of credit. The letter of credit is issued by a bank, which charges interest on the balance of the LOC, used or not. Wilhelm says these LOCs now cost about 1.5 percent annually. Another industry source said he had heard of rates as high as 3 percent.

Wilhelm has yet to see such deterioration in cost or access to LOCs that self insurance ceases to be viable. He also does not see any crippling LOC-related aggravations in two other ways of retaining risk--high deductible insurance policies and insurance captives.

So, should we worry? Yes, enough to consider ways to make it easier and cheaper for employers to meet collateral requirements.

For collateral is a huge, huge business. For workers' compensation self-insurance alone, the value of LOCs outstanding is probably in the order of $20 billion to $25 billion. That estimate does not include demand for the instrument in high deductible insurance and in captives.

California self-insurers have figured out how, for publicly traded companies, to substitute another form of collateral, which is less than one-fifth the cost of an LOC.

This other form is a credit default swap. Yes, the device that helped blow up Wall Street. But major employers are in favor using it in this instance.

Here is how it works. Macy's is publicly traded and self-insured in California. It does not buy an LOC. Rather, the California Self Insurer's Security Fund buys a credit default swap (CDS) contract which will pay the fund if Macy's or one of its other hedged self-insureds declares bankruptcy. The fund would use the CDS proceeds to pay off its retained claim liability.

The fund follows this approach for many of the publicly traded self-insurers--especially those rated below an A. Other self-insurers still have to provide collateral the conventional way, by buying an LOC or posting cash. The overall cost of collateral is lower. In the bargain, the fund has amassed through assessments a large cash balance to respond to a bankruptcy if collateral provisions prove inadequate.

If I were the risk manager of a publicly traded self-insurer, I would call the Security Fund to find out how credit default swaps could slash my collateral costs.

PETER ROUSMANIERE is an expert on the workers' compensation industry He can be reached at
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Title Annotation:WORKERS' COMP
Author:Rousmaniere, Peter
Publication:Risk & Insurance
Date:Sep 1, 2009
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