Insurance and its Role in Asset Based Finance ? World Leasing News

Insurance and its Role in Asset Based Finance

By Thomas A. Orofino, Managing Partner, Collateral Guaranty LLC

Over the last six (6) years the financial world has changed dramatically, and the financial meltdown has changed appetite for risk and everyone?s view of what exactly risk is.

The market has also changed as new investors have entered the market seeking greater yield than conventional investment alternatives offer.? Low interest rates have investors looking into the world of asset-based finance, lease financing and even more interestingly the arena of operating lease financing.

Non-traditional investors have entered the markets in record numbers bringing new ideas and new needs to the market place.

The days of the 20-year leveraged leases are over. Real estate has become a more mainstream investment, with shorter 10 ? 12 year terms. Due to the shorter terms, residual values are becoming more important. The market is more global. The Basel Accord is upon us and life insurance company lenders are participating in a wider area of asset based financing than they have in the past with a need to ?make? these financings ?fit? NAIC 1 or 2 criterion. Transactions must be more ?bondable?. Portfolios must be more portable and tradable.

The above has all served to reshape the market and the desire for investors to find new ways to mitigate their risks. As all this change is upon us, the role of insurance to mitigate these risks is evolving to meet the growing needs to assist in ?plugging? the holes.

The aim of the new insurance products is to convert an asset risk into a bondable/ratable/securitizable/financable cash flow, to make foreign investments more mainstream and to assist in deploying capital more efficiently.

How does a purchaser offer a greater purchase price and not over extend exposures in certain asset classes?? How does an asset exchange take place with complicated documentation and a newly minted exchange party?? How does an investment banker securitize a portfolio and finance the transaction at tighter spreads, yet maintain an aggressive advance ratio?? The role of a knowledgeable insurance advisor is to bring insurance capital to bear on the solutions of leasing, securitization and asset based lending challenges.

The huge amount of liquidity currently available in world financial markets ensures that some competitor will manage to find an acceptable manner in which to either take or mitigate these risks.? As always, the race is to the fittest.? These financiers continually request solutions often beyond the efficient reach of traditional banking products.? The financing sources are demanding products that:

• Increase Transaction Liquidity
• Enhance Transaction Yields
• Arbitrage Tax Conventions
• Arbitrage Accounting Conventions
• Create Structural Transaction Enhancements
• Create Transaction Credit Enhancements.

The good insurance consultant identifies risks in financial transactions, structures an appropriate insurance approach, markets the structure to the insurance community, and coordinates the provision of cover with the closing of the financing.

This article outlines a number of the products and approaches that have been adapted to serve particular client needs. Many other products are available. Most policies start from a boilerplate and are then customized to specific user needs.

This article will discuss the three forms of enhancement as detailed below.

I.???????? Project Guarantees

II. ????? Risk Protection

III.???? Financial Risk Insurance

IV.????? Structural Transaction Enhancement Insurance.

Project Guarantees

These project guarantees are most often used in Renewable Energy projects but have application in almost any Project Finance application.

Project Guarantees vary from conventional Equipment Warranty Insurance to Project Debt Guarantees.? Insurance products mitigate the technology and financial risk for Project Lenders, Equipment Manufacturers and Project Developers:

? ? ? ?To insure that a facility will generate sufficient output to produce sufficient cash flow on a periodic basis to pay a project?s on going operating expenses and required debt payments (?Breakeven Level?).

?????? To create bondable cash flows from project finance revenues.

? ? ?? To smooth the cash flow of project in order to alleviate the financial consequences of interrupted cash flow caused by a project?s inability to perform due to unanticipated outages or technological issues.

Asset Risk Protection?

Residual Value Guarantee Insurance

The residual value insurance product was the original asset based finance form of coverage.? Many of the issues which emerged in the development of this coverage reappear in the newer products.

Residual policies providing investment grade guarantees of asset values in both the equipment and real estate sectors are used to:

??????? Support asset acquisition

??????? Enhance securitization and refinance transactions

??????? Provide liquidity for existing portfolios of investments.

?General Features

Residual value insurance (?RVI?) is defined as follows:

A RVI policy indemnifies the insured against a loss which might occur if the disposition proceeds of a properly maintained asset are less than the asset?s insured residual value at the point specified in the policy.

Several key points should be noted.

• The insurance is generally not structured as an unconditional put; however.? Return of the asset, as specified in the lease documents is the insured?s responsibility to enforce. However, the insurer will require that he have the ability to assume the financier?s rights of enforcement of maintenance and return conditions under the documents;

• The maintenance and return conditions are as critical to the underwriting process as they are to the underlying financing.? The strength or weakness of these provisions influences the level of coverage and premium;

• The policy is a contract of indemnity. Its purpose is to reimburse the insured for a covered loss, thereby returning the insured?s financial position to its level prior to the loss.

?

RVI Value Added in an Asset Acquisition

The RVI policies issued by investment grade insurers can be used by the asset financier to increase the amount of debt financing used to acquire a portfolio of assets subject to leases.

Leverage can be increased by monetizing the back end value of the property through the use of RVI.

An owner?s capital can deployed in a more efficiently.

From a prudent lender?s perspective an insured residual loan will:

• Increase the primary loan to value ratio given there are two primary sources of repayment, and
• Create a highly rated loan asset for NAIC or Bank rating purposes leading to lower capital charges.

A situation is therefore created whereby there is an investment grade guaranteed third party source of repayment rather than only the asset itself. The same theory may also be used in the acquisition of a portfolio of assets providing the purchaser or lender with the ability to receive at least a guaranteed mount at the end of the holding period.

Financial Risk Insurance

?Trade Credit Insurance

Trade Credit Insurance may be used to cover a single transaction or trade with only one borrower/buyer. Trade credit insurance can also cover a portfolio of borrowers and pays an agreed percentage of a loan or receivable that remains unpaid as a result of a default, insolvency or bankruptcy.

Trade Credit Insurance is an insurance policy and a risk management product offered by private insurance companies to business entities wishing to protect, in the case of a lending institution, a loan, or in the case of a vendor their receivables from loss for the reasons stated above. The cost (premium) is usually paid periodically, and is calculated as a percentage of all outstanding receivables.

This points to the major role trade credit insurance plays in facilitating international trade. Trade credit is offered by lenders or vendors to their customers as an alternative to prepayment or cash on delivery terms, providing time for the customer to generate income from sales to pay for the product or service. This requires the vendor to assume non-payment risk.

In a local or domestic situation as well as in an export transaction, the risk increases when laws, customs, communications and customer?s reputation are not fully understood by the lender or vendor. In addition to increased risk of non-payment, international trade presents the problem of the time between product shipment and its availability for sale. The receivable is like a loan or in the case of a bank is a loan and represents capital invested, and often borrowed, by the vendor. This is not however a secured asset until it is paid. If the customer?s debt is credit insured the large, risky asset becomes more secure, like an insured building. This asset may then be viewed as collateral by lending institutions and a loan based upon it used to defray the expenses of the transaction and to produce more product. Trade Credit Insurance will generally lead to lower reserve requirements for the lending institution. Trade credit insurance is, therefore, a trade finance tool.

Political Risk Insurance

Political Risk Insurance is a type of insurance that can be taken out against political risk ? the risk that a political entity may default in a guarantee provided to lenders or vendors to induce them to execute business with a local corporation or governmental entity. It will also cover risks as extreme as country revolution or other political conditions will result in a loss.

Political Risk Insurance is available for several different types of political risk, including but not limited to:

• Political violence, such as revolution, insurrection, civil unrest, terrorism or war;
• Governmental expropriation or confiscation of assets;
• Governmental frustration or repudiation of contracts or guarantees issued;
• Wrongful calling of letters of credit or similar on-demand guarantees;
• Business Interruption; and
• Inconvertibility of foreign currency or the inability to repatriate funds.

As with any insurance, the precise scope of coverage is governed by the terms of the insurance policy.

The underwriting of Political Risk Insurance is a dynamic, growing business. As globalization increases, there are more corporations doing business in more places around the world with each passing year. Some of the changes occurring in the business are high growth, new product offerings, with a greater role for private capital.

While Political Risk Insurance policies are sometimes written for specific situations, the major political risk insurers have standard forms for the coverages that they issue. For ?complex? or larger investments specific policies are the norm.

Structural Transaction Enhancement Insurance

The following represent three examples of specific insurance products designed for specific needs.

1.? Policies Directed Toward Real Estate Financings

Certain risks apply specifically to real estate based transactions as well as portfolios. The objective is to apply as many insurance mitigants as possible to upgrade a less than triple-net lease to a bondable status for securitization and for NAIC rating purposes. These coverages are used in both the specific property, private market mortgage financings and in the new mortgage securitization markets.

2.? Condemnation and Casualty Coverage

This coverage protects holders of lease-backed loans against a tenant?s exercise of early termination rights in the event of a condemnation or substantial casualty to the property. In the event a tenant exercises this right, the policy will pay the unamortized balance of the lease-backed loan. If the lender prefers yield maintenance, the policy can be designed so that the regularly scheduled debt payments are maintained for the remainder of the loan.

3.? Pollution Insurance

Determination of the presence of pollution in a property has become a major concern in the financing of real estate in the USA.? The current approach is to secure a ?Phase I? report.? This engineering analysis determines whether standard tests have established that levels of pollution are or are not present.? If pollution is present the Phase I Report will outline what measures are needed to remediate the pollution.

When an insured applies for Environmental Protection Coverage (EPC) the underwriting will determine if pollution is present.? If pollution is not present the insurer will insure against pollution over the term of the financing.

If pollution is present the underwriter will determine the costs of remediation and insure that the remediation cost will not exceed a contracted amount.? Once a site is remediated the insurer will insure against pollution over the term of the financing.

Conclusion

To properly effectuate any of the above coverages there should be a close working relationship between the insured, their representative and insurers as each party has to understand the other?s needs.? Insurers do not yet understand the asset based leasing and lending business in the same way financiers understand the business.? Consequently, all parties must ask questions of one another to see how a transaction may be of mutual benefit.

The best ideas regarding insurance programs are generated by client demand to find a means of mitigating asset risk which is straightforward in approach, cost efficient, and offered by creditworthy entities.

Source: http://www.worldleasingnews.com/articles/insurance-and-its-role-in-asset-based-finance/

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