Even when risk managers desire to deal only with insurers that are highly rated financially, the number of potential players may be decreased substantially because of the nature or difficulty of the risk. Some insurers simply may not want to participate on a particular risk.

And after the playing field is honed down to companies that want to write the business, risk managers must weigh many factorsin addition to financial strengthwhen choosing which programs and carriers to recommend. Chief among them, of course, is the extent and type of coverage being offered.

But the need for good judgment doesnt stop there. Price frequently becomes a factor that at times may be given more weight than the insurers financial stability. And explaining the need to pay a higher premium for coverage from a rock solid insurer may be a difficult task in many corporations.

So risk managers are faced with many tough decisions when deciding which program to recommend. For, after all, insurance and reinsurance is just thata promise to pay future claims according to the manner negotiatedand the future may be a long way off, especially with casualty insurance.

When I was working as an independent agent, we recommended only insurers that were rated “A” or better by A.M. Best. That is, unless there was no other insurer available and willing to write the risk.

Then the proposal was accompanied by the obligatory disclaimer stating that the decision to deal with the particular insurer was left up to the insured. But if there were no other options, was there really a choice?

Some insured clients insisted on cut-through endorsements to reinsurers when lesser-rated primary insurers were the only ones available. Cut-through endorsements, when available, permit the insured to recover directly from the reinsurer named in the endorsement in the event that the primary insurer becomes insolvent. They were (and still are) difficult to obtain. So they were not available to the majority of insured businesses.

Other clients perhaps decided to rely on the state guaranty funds to provide coverage in the event the insurer went under.

But how much will guaranty funds actually pay? And what are the differences among the various state guaranty programs?

Most state guaranty funds (keep in mind that state laws may differ) include both claims for losses and for the return of unearned premium as “covered claims” against the guaranty fund. Most funds cover direct, or primary insurance written for an insured, intentionally excluding insolvent reinsurers.

In other words, primary insurers are on their own in regard to the financial stability of the reinsurers with which they deal.

Warren Buffett, chairman of the board of Berkshire Hathaway Inc., made this point clear in his 2002 letter to shareholders. As Mr. Buffet pointed out: “Cheap reinsurance is a fools bargain. When an insurer lays out money today in exchange for a reinsurers promise to pay a decade or two later, its dangerousand possibly life-threateningfor the insurer to deal with any but the strongest reinsurer around.”

Obviously, then, any risk manager who chooses to rely on a cut-through endorsement to a reinsurer or backing up a self-insurance program with reinsurance must be absolutely sure of the financial strength of that reinsurer. Because theres no safety net guaranty fund for that reinsurer.

Likewise, its important to remember that state guaranty associations do not cover risk retention groups, captives and nonadmitted insurers. This isnt to say that these types of risk financing options should be overlooked. But it does mean that their financial strengthindependent of any state safety netsmust be carefully considered.

Most state guaranty funds also exact a deductible on each covered claimfor both losses and unearned premium.

Among the states that levy a deductible, amounts range from a low of $10 to a high of $250 per claim.

But the maximum amount payable per claim, rather than deductibles, may have more of an impact on corporate insureds.

Every state places a cap on the maximum payable per claim by the guaranty fund, although workers compensation claims are paid in full by either each states guaranty fund or state workers comp fund.

The lowest state cap is $100,000, which isnt a lot, especially for a casualty claim. The majority of state guaranty funds will pay up to $300,000 per covered claimstill not a tremendous amount in todays litigious society.

Perhaps the biggest shock, however, especially for larger businesses, is that more than half the state guaranty fund laws include a net worth provision. This provision excludes larger entities from the class of covered claimants.

This exclusionary provision is triggered by as low a net worth as $3 million in the state of Georgia, with a majority of states adopting the NAICs model act provision of $50 million net worth on third-party claims.

Its clear from this discussion that state guaranty association laws are designed to protect smaller insureds, as seen by the low deductibles, relatively low maximum amount payable per claim and the net worth provisions. Larger businesses often are left standing on their own, without even the guaranty fund safety net providing much assistance.

There also are other limits on what the guaranty funds will pay. Many states, if not most, exclude payments for punitive damages, pre-liquidation fees from attorneys and adjusters, interest on judgments, penalties and noneconomic losses.

And then theres the question of what triggers guaranty fund action. The vast majority of states require a final order of liquidation with a finding of insolvency as the trigger. So there is no recourse for insureds to most guaranty funds between the finding of insolvency and a final order of liquidation.

Most insurance departments try to salvage insurers through rehabilitation efforts before resorting to a liquidation order.

In the case of the Reliance companies liquidation, the Pennsylvania insurance commissioner placed the companies into rehabilitation four months before ordering liquidation. The mailing of claim packets was begun three months later. And thats just to start the process. Similar time frames are seen in other insolvencies.

All in all, insured businesses may have the advantage of a safety net of state guaranty associations. But the process of insolvency is a painful onefor risk managers, employees of the failed companies and claimants who expect to recover for their losses.

For large corporations, the relatively small amount of guaranty fund coverage and other limiting factors reduce the impact of this safety net.

All of this reinforces the idea that the financial stability of insurers should be prime among the factors considered when placing orders for coverage.

The first question risk managers should ask is not “how much will it cost,” but, rather, “will the insurer be around in five or 10 years to pay my claims?”

Diana Reitz is the editor of the National Underwriter Company publication, The Tools & Techniques of Risk Management & Insurance, as well as the Risk Funding & Self-Insurance Bulletins, both available at www.nationalunderwriter.com/nucatalog.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, May 26, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.