The Credit Insurance Link to Corporate Fundraising

By using their experience and insurance market relationships, risk managers can play an important part in this process by arranging credit insurance, which can help enhance the quality of the receivables pool and make it better suited for securitization. Credit insurance can be structured and customized to create optimal securitization programs for corporate fundraising. It is an example of the benefits accruing from the convergence of the insurance and capital markets, with insurance coverage being used to optimize a capital markets transaction. By partnering with their colleagues in treasury, risk managers can maximize the size and the cost savings associated with such securitizations.

What Does Securitization Entail?
Securitization can best be described as the creation of debt securities supported by specific pools of financial assets, such as loans, leases or trade receivables. Such a financing solution can provide cheaper financing than other alternatives such as bank lines or traditional bond issuance.

This financial alchemy is a consequence of the tranching or segmentation of credit risk, which creates value by matching each segment of the investor base with its desired risk profile. A properly structured securitization can achieve debt ratings that are higher than the corporate debt ratings of the originator of the financial assets, and therefore can provide funding at attractive cost levels.

This market has developed significantly over the years, and a wide range of asset classes have been securitized including equipment leases, premium finance loans, dealer floor plans, franchise loans, recreational vehicles and so on. The debt securities can generally be sold in two broad sets of markets, either as longer-dated Term Asset Backed Securities (TABS) or as short-dated Asset Backed Commercial Paper (ABCP).

A typical securitization deal begins with an originator who establishes a bankruptcy-remote special purpose entity (SPE), which issues the debt securities into the market. The SPE buys the receivables from the issuer in a true sale, and then sells debt securities backed by these receivables into the capital markets. The risk retained by the originator in the SPE is the equivalent of a first loss layer, and the tranching of risk in securitization is similar to the various layers of excess-of-loss reinsurance in a treaty. In the case of a securitization-related SPE, the retention is a function of the quality of the assets, and the SPE is often treated as an off-balance sheet entity depending on specific criteria. ABCP can be issued through multiseller or single-seller programs. 

Securitization of receivables can be an attractive means of reducing funding costs by as much as 200 to 250 basis points. The benefits of accessing a secured form of financing using a balance sheet asset such as receivables allows the company to borrow at funding costs associated with the higher ratings for asset-backed debt versus their own borrowing costs. Even if the cost savings are not as significant, companies may still choose to tap this market for funding, since it allows them access to a different investor base, as compared to the traditional bank and debt funding sources. The key, however, is that companies that are rated in a band around the BBB/Baa level can best utilize these benefits, since cost savings may not be as attractive for higher-rated companies.

The Impact of Risk
The most important criteria in structuring a securitization is the credit quality and dispersal of risk within a portfolio of receivables. The tranching and pricing of risk in a securitization transaction draws upon the law of large numbers from the world of insurance. Having a diverse pool of receivables without any excessive concentrations of risk based on counterparty, geographic location or other such criteria is important in structuring a deal that will be acceptable to investors.

The credit rating assigned to a portfolio of receivables is a function of the overall quality of the underlying receivables. A large proportion of accounts in trade receivables portfolios may not be public companies and therefore not rated by Moody’s or Standard & Poor’s. How the rating agencies and the investors perceive the receivables directly impacts the cost of the securitized offering. 

In a typical company’s portfolio of receivables, it is not uncommon to have four or five obligors representing a large proportion of the total risk. The percentage of receivables in a portfolio that are concentrated with a few key customers affects the perceived quality of the book. Excessive exposure to a few clients increases the probability of loss if a major economic downturn scenario comes to fruition. Portfolio risk also increases if any major accounts have poor ratings or are not rated at all. Having pockets of concentrated risk can make it difficult to extract the maximum possible loan-to-value or size of financing from a portfolio of account receivables.

In addition, multinational companies and others with overseas sales have another problem associated with the existence of foreign obligors. Just as poor or unrated credits are viewed negatively because of the risk they pose in a downturn, non-U.S. receivables are considered to be too risky in analyzing and rating a portfolio. In addition to credit risk, foreign receivables are subject to currency, political and many other risks that are difficult to quantify, and that do not apply to domestic receivables. 

For these reasons, many securitization agreements explicitly exclude receivables that represent concentration risk or higher-than-normal credit risk. These receivables are excluded to mitigate the risk that investors face from default by any single obligor or risky class of obligors.

The disadvantage from the borrower’s perspective is that this not only limits the amount of funding that is available, but it also acts as a disincentive to do business with some of the best customers of the firm. For example, an automotive component supplier may have Ford or General Motors as its single largest customer, constituting over 30 percent of its revenues. In order to get a sufficiently diverse portfolio, however, the maximum amount of receivables derived from sales to such key customers may have to be limited.

Likewise, these restrictions put limitations on sales in foreign markets, which can often be the most attractive and rapidly growing markets from a strategic viewpoint. 

The Risk Manager’s Role in Fundraising
Credit insurance can be a powerful tool for risk managers to maximize the funding that can be generated from an accounts receivable securitization, by making otherwise excluded obligors eligible for the program. The basic concept is to have an insurance wrap for ineligible obligors by purchasing a credit insurance policy. A wrap is a credit insurance policy that can cover credit losses resulting from adverse events such as buyer insolvency, failure to pay or repudiation of contract. 

By doing this, the issuer mitigates the risk that made these obligors ineligible and makes them eligible to be included in the securitization program. By using credit insurance for credit concentrations and for foreign receivables, an issuer can significantly maximize the value created by its securitization program. Risks relating to quality, concentration and even historical performance can also be addressed by means of a credit insurance policy that provides compensation for nonperforming receivables.

Credit insurance is ideally suited to enhance securitization since it is often available at a lower cost than letters of credit, sometimes 30 percent to 40 percent cheaper. Moreover, credit insurance is arguably better suited for short-term receivables included in securitization programs. Another advantage of using credit insurance to enhance securitizations is that it taps into a different source of credit capacity with terms that can often be less onerous than those typically imposed by LoC banks. 

Credit insurance can also reduce the amount of retention required to achieve a desired rating for the debt securities, and therefore increase the advance rate or loan-to-value for financing. For example, for companies with foreign obligors, using insurance such as export credit insurance to cover foreign receivables may allow a company to minimize the retention needed and also help achieve a “true sale” of foreign receivables. 

Credit insurance policies can be designed to be effective on a variable basis and therefore can provide credit enhancement on an as-needed basis, as distinct from a traditional policy. In some instances, this also translates to lower fees and other allied costs of securitization, which are often related to the debt rating. 

Using credit insurance can also allow a company to assure future revenue growth by permitting sales to clients, which may have otherwise been put on a restricted list, and including the resultant receivables in the securitization program.

Export credit agencies such as the Multilateral Investment Guarantee Agency (MIGA) also sell insurance that provides protection for foreign receivables against commercial and political risks that could result in nonpayment of invoices. Commercial risks can arise from buyer insolvencies, bankruptcy, defaults and slow or delayed payment. These problems can come about for a variety of reasons, such as natural disasters or poor economic conditions in other countries. Political risks include war, riots and revolution, as well as currency inconvertibility, expropriation and changes in import or export regulations. Foreign receivables can often be insured under a multiple-obligor policy, and coverage can also be purchased for single obligors depending on their credit quality and other risk characteristics.

It is important to note, however, that credit insurance can only provide benefits for accounts that have a lower credit rating than the insurer itself—which makes it vital to purchase the policy from a highly rated insurer.

Structuring the Credit Insurance Policy
Risk managers can work with their treasury colleagues to understand the composition of the receivables included in a securitization program to determine which portions can be best enhanced through credit insurance. This requires them to build models and conduct cost-benefit analyses to compare the incremental cost of buying insurance versus the benefits of raising additional lower-cost funding from the securitization.

This process begins with an identification of the top obligors that represent a large proportion—more than 20 percent—of eligible receivables. In addition, the risk manager should determine the volume of foreign receivables that may be currently ineligible for inclusion in the program. Likewise, the financial institution advising the company on the securitization may have put additional restrictions on volatile classes of obligors, such as those in price-sensitive industries or those rated below a specified threshold. Most securitization agreements also exclude receivables that represent a concentration risk or higher-than-normal risk of credit loss. Finally, the risk manager should examine the level of receivables generated by key clients of the company and identify any restrictions that are being placed on the sales to these clients.

The ultimate objective is to ensure that the firm achieves the best possible results, by optimizing the trade-off between the size of the retention, which is a function of the quality of the portfolio and the loss history, and the cost of buying credit insurance. 

Working with Treasury
In most companies, the responsibility for fundraising and credit risk management is assigned to treasury personnel while hazard risk management and the interface with insurance providers is the domain of the risk manager. The treasurer or assistant treasurer in charge of capital markets, who may be handling securitization and fundraising, is often unaware of the value of tapping credit insurance to maximize the benefits of securitization.

Given the importance of fundraising and funding costs for a company, this provides risk managers with an opportunity to partner with their treasury colleagues, showing them how to use credit insurance to enhance a securitization program. 

The relationships that risk managers have with their broker and the insurance markets are invaluable in this context. They should therefore highlight the benefits of tapping this nontraditional source of credit capacity, as well as the value of their relationships to the CFO and senior financial management.