Collateral Damage: How to Avoid the Pitfalls of Collateral Agreements

Although collateral agreements provide security for insurers on policies with large deductibles, they can create hardships for insureds that are out of proportion with the insurers’ security concerns. Insurers require collateral as security for the repayment of insureds’ deductible obligations for large-deductible liability insurance policies. But collateral agreements also can tie up millions of dollars of insureds’ money for long periods of time and leave insureds with no way of recovering their money once the collateral has served its purpose.

Unfortunately, the terms and conditions of collateral agreements are usually more favorable to insurers. For example, an insurer may be able, at its sole discretion and without any limitations on how the collateral requirements are decided, to determine the amount of collateral and the time period it holds the collateral. This broad discretion puts the insured in a difficult position if the insurer decides to unilaterally raise the amount of collateral or hold the collateral for an inordinate period of time. Holding too much collateral for too long may prevent the insured from applying for and receiving future financing for new projects and business needs. It may also prevent an insured from changing insurers because the new insurer will also require collateral for the deductible obligation under the new policy.

The best time for negotiating the terms and conditions of a collateral agreement is before coverage is bound. But insureds who are already bound to onerous collateral agreements should not despair. They may be able to demand a portion, or even all, of the collateral be returned from the insurer. While there is limited authority applying the “sole discretion” language, in the context of bonds, courts have been reluctant to strictly apply the “sole discretion” language against the bond’s principal. See Luzar v. Western Sur. Co., 692 P.2d 337 (Idaho 1984) (finding collateral may be returned to the principal of a bond agreement prior to the end of the statute of limitations if the principal can demonstrate with competent evidence that it has fulfilled its obligations under the agreement); Cent. Mut. Ins. Co. of Chicago v. St. Paul Mercury Indem. Co. of St. Paul, 9 N.E.2d 355 (Ill. App. Ct. 1937) (finding that the principal was not required to provide additional collateral when the collateral agreement did not state with specificity in the collateral agreement what information it required of the principal to prove its liability had terminated); and Universal Bonding Ins. Co. v. Bay Prop. Assoc., No. 09 CIV 10030, 2011 WL 4790885 (S.D.N.Y. 2011) (finding the principal provided adequate evidence to the surety that its obligations under the bond had been satisfied and the collateral was to be returned). Courts that have construed collateral agreements have focused on the factual nuances of the parties’ relationship and the circumstances at the time of the principal’s demand for the return of its collateral. Generally speaking, courts try to apply the applicable language in a manner that is fair to both parties. It is reasonable to expect that courts would be at least as accommodating to insureds stuck in onerous collateral agreements.

Insureds should carefully review collateral agreements prior to entering into them. A careful review will allow the insured to identify terms and conditions overly favorable to the insurer and will provide an opportunity to negotiate more favorable terms and conditions.

To learn more about this topic, contact Anna Perry at APerry@sdvlaw.com or Brian Clifford at BClifford@sdvlaw.com.