Collateral Insurance: Protecting Your Assets and Peace of Mind
What is Collateral Insurance?
Collateral insurance refers to a type of insurance policy that requires an insured individual or business to pledge an asset as security for the issuance of the policy. The pledged asset acts as collateral that can be liquidated by the insurance company to recoup losses in the event that the policyholder files a large claim or experiences some other financial difficulty meeting their premium payments.
Common Examples of Collateral Insurance
Some common examples of insurance policies that may require collateral include:
- Home insurance – Some home insurance carriers require collateral like a security interest in the home itself in order to issue a policy, especially for high-value homes.
- Business insurance – Certain large business policies like commercial property insurance may use business assets like equipment or inventory as collateral.
- Surety bonds – Collateral like cash or securities may need to be pledged for a surety bond to be issued.
The collateral pledged allows the insurer to limit their risk exposure on large policies. The requirements and specific types of collateral can vary greatly depending on the type of insurance policy, insured value, and the insurance company’s own underwriting guidelines.
Collateral Insurance in Action
For example, an affluent individual wishes to obtain homeowners insurance coverage for their $2 million beach house.
Due to the high value home, the insurance company requires collateral in order to issue the policy. The individual thus pledges a $500,000 bond investment account owned by them as collateral for the home insurance policy. If a major claim occurs and the individual can’t pay their policy deductible or premiums, the insurer now has the right to liquidate the pledged $500k in bonds to recoup funds. This minimizes the insurance company’s risk exposure despite issuing coverage for such a high-value residence.
Key Reasons Insurers Require Collateral
Insurance carriers may require collateral pledges on certain policies for a few key reasons:
- To reduce risk – Having collateral offsets potential losses for insurers.
- To provide access to coverage – Pledging assets allows consumers to obtain coverage that may otherwise be declined without collateral.
- To demonstrate insurability – Putting up collateral shows financial stability often required for large policies.
By pledging an asset as security for a policy, higher risk policyholders can often gain access to essential insurance coverage they would otherwise struggle to obtain through standard underwriting processes.
What Assets Can Be Used as Collateral?
Some examples of assets commonly pledged as collateral for insurance policies include:
- Cash or savings accounts
- Stocks, bonds, and other investment securities
- Real estate or physical property
- Business equipment, inventory, accounts receivable
- Certificates of deposit (CDs)
To be used as insurance collateral, an asset typically needs to be reasonably liquid and assignable to the insurer. For instance, illiquid assets like fine art collections tend to not make suitable collateral. The specific collateral terms like asset type, pledge amount, ownership rights, and liquidation process will usually be formally detailed in a collateral assignment or pledge agreement between the policyholder and insurance company.
The Bottom Line
Collateral insurance leverages pledged assets to allow issuance of policies requiring an extra layer of security for the insurer. By understanding how collateral works, higher net worth individuals, businesses, and consumers can gain access to essential coverage to properly protect their interests.