Credit Risk T ransfer Solutions
RISK MANAGEMENT 4 STRATEGIES TO MANAGE CREDIT RISK TRANSFER Avoidance Acceptance Limitation *Most use one of several strategies on a single counterparty
CREDIT RISK TRANSFER TOOLS TRADITIONAL Letter of Credit Credit Insurance On-Demand Payment Bond Receivable Put Option Credit Default Sw aps PROGRESSIVE
CREDIT INSURANCE WHAT IS IT? An insurance coverage that protects the business against unexpected bad debt losses (A/R + Mark to Market) due to counterparty: Insolvency Non Payment Political Risk (Exports) Credit Insurance can cover : - A single counterparty - International only - All receivables - Key counterparties - Separate business units - Domestic only
CREDIT INSURANCE THE DETAILS Optional Features KEY CATEGORY CREDIT INSURANCE CREDIT CAPACITY Unsecured , does not tie up credit capacity. ‘Discretionary’ Credit Limits COVERED LOSSES A/R, Price Risk (Mark to Market), Non-Delivery (Pre-Payment) Bank Assignment / Loss Subrogate debt to Insurer . Insurer works with counterparty to collect on RECOVERY debt or through bankruptcy court and any “salvage” Payee Insolvency, non-payment (typically 90 days past due) of debt owed. TRIGGER TO CLAIM Political Risk for exports. Preference Claw Back Cover The policy holder (beneficiary) must file a claim and prove debt is valid , SETTLEMENT which is reviewed and evaluated by the insurer. Payment schedule can be Cancellable vs Non- negotiated to 30 days upon completed claim filing. Typically 90% Insured. Cancellable Based on a combination of counterparty credit quality, recovery potential, UNDERWRITING FOCUS and credit procedures. Typically on a ‘silent’ basis. Can be sourced and paid for by either PROCUREMENT counterparty. Typically renew on an annual basis , Structured Credit Ins may be CONTRACT DURATION available for up to 3 years or longer, depending on credit quality.
CREDIT INSURANCE EXAMPLE STRUCTURE OTHER STRUCTURES SAMPLE SIMPLIFIED “CATOSTROPHIC” APPROACH No Deductible Programs 1 - Maximum Limit of Liability = $100M Key Counterparty Basket 2 - Insured % = 90% 3 - Discretionary Credit Limit = $1M per counterparty 4 - Annual Aggregate Deductible = $500k Single Counterparty 5 - Customer Specific Credit Limits (Counterparty A = $55M, Counterparty B = $20M, Counterparty Counterparty C = 15M…D,E,F…..) “Hybrid” Brief Definitions: 1. Maximum Limit of Liability : The cap an insurer will pay during the policy period. 2. Insured % : The amount of A/R insured in the event of a loss. Typically 10% of risk is retained with the insured. 3. Discretionary Credit Limit : The amount per customer the insured can approve based on compliance with credit procedures. Typically covers everything except the largest 10 – 15 customers. 4. Annual Aggregate Deductible : The total credit losses that the insured must take before a claim is paid – a 1 time deductible . Typically 50% of the Discretionary Credit Limit and based on loss history. 5. Maximum Payment Terms : The longest credit terms you can sell on and be insured. Typically equal to your longest payment terms. 6. Customer Specific Credit Limits : The cap an insurer will pay for a loss to a customer. Typically the peak seasonal exposure.
CREDIT INSURANCE MOST ACTIVE SCENARIOS: Streamline risk management / transfer for large number of smaller counterparties Partial credit approval or exposure breaching credit approval Credit approved for commercial reasons Enterprise Risk Management - shift catastrophic losses off balance sheet
ON DEMAND PAYMENT BOND WHAT IS IT? On-Demand Payment bonds are accepted assurance methods that can be called on if the counterparty (principal) defaults. They are designed to be an alternative to Letter of Credit, while minimizing working capital constraints. • 100% risk cover • Unsecured, maximizes working capital • Callable at any time during the coverage period • Pays out in short time frame • Priced competitively with other collateral instrument rates
ON DEMAND PAYMENT BOND THE DETAILS Optional Features KEY CATEGORY ON-DEMAND PAYMENT BOND Generally unsecured , does not tie up credit capacity unless required by CREDIT CAPACITY Cost paid by the counterparty Surety based on credit risk. (principle) COVERED LOSS Amount of bond, can include A/R and Price Risk (Mark to Market). Streamline payment flow, Surety will require an indemnity agreement which outlines rights in the RECOVERY similar to LC event of a loss. TRIGGER TO CLAIM On Demand - non-performance with the underlying contract Transaction specific , based on a combination of credit quality, capital, UNDERWRITING FOCUS capacity, recovery potential (indemnity agreement), and details of the company “character”. A 3 party agreement requiring involvement from both counterparties and PROCUREMENT surety. CONTRACT DURATION Typically renew on an annual basis , similar to evergreen letter of credit.
ON-DEMAND PAYMENT BOND MOST ACTIVE SCENARIOS: Replacement of Letter of Credit Transactions / counterparties looking to free up working capital or reduce costs Strong Credits Partial credit approval or exposure breaching credit approval
RECEIVABLE PUT OPTIONS A Receivable Put Option is a tool to protect Receivables from a counterparty’s insolvency. They are typically offered by banks or hedge funds, willing to take the risk. • 100% risk cover • Pay out on insolvency only, must occur during contract period • Limited conditionality • Hedging tools taken by banks or hedge funds (CDS, Short Bonds, etc.) • Benefits over a Credit Default Swap • Substantially more expensive than other risk transfer tools
RECEIVABLE PUT OPTIONS THE DETAILS Optional Features KEY CATEGORY Receivable Put Option CREDIT CAPACITY Unsecured , does not tie up credit capacity. Post – Petition coverage, COVERED LOSS A/R Only conversion from Chapter 11 to Subrogate debt to Bank/Investment fund, they will work with RECOVERY Chapter 7 counterparty to collect on debt through bankruptcy court and any “salvage” TRIGGER TO CLAIM Insolvency only The contract (beneficiary) must file a claim and prove debt is SETTLEMENT valid , which is reviewed and evaluated by the Put writer. Payment is immediate generally upon satisfactory evidence. Transaction agnostic . Typically used for highly distressed names UNDERWRITING FOCUS with publicly traded debt. Banks or Investment companies may hedge through CDS, 3 rd party investors, or shorting bonds. PROCUREMENT Can be sourced and paid for by either counterparty. CONTRACT DURATION Highly flexible from 2 months up to 3 years .
RECEIVABLE PUT OPTIONS MOST ACTIVE SCENARIOS: Distressed counterparty - option to Risk Avoidance Seeking alternative to other Risk Transfer solutions Debtor in Possession
SAMPLE DECISION TREE Accept Credit Risk Credit Letter of Credit Insurance Transfer Credit Risk Counterparty On Demand 3 rd Party Risk LC Risk Review Surety Bond Limitation- Replacement Solutions Pre-Pay / Receivable Cash Posting Put Risk Transfer Avoid Credit *Letter of Credit and 3 rd Party Risk - Decline solutions can be combined Credit Default Swap
S&P CHART EXAMPLE Counterparty Credit On Demand Receivable Credit S&P Rating Insurance Payment Put Option Default Estimate Bond Swap X X X X AAA+ to AA X X X X A to BBB- X X X X BB+ to BB- X X X B+ to B- may require portfolio spread X X CCC+ X X <CCC+
SUMMARY OVERVIEW CREDIT RECEIVABLE PUT KEY CATEGORY LETTER OF CREDIT ON DEMAND BOND CREDIT INSURANCE DEFAULT OPTION SWAPS COLLATORAL Generally Secured Generally unsecured Unsecured Unsecured Unsecured REQUIRED Notional value of contract less and Subject to underlying A/R and Price Risk (Mark to A/R and Price Risk (Mark to COVERED LOSS A/R Only recoveries on agreement Market). Market). underlying bond. ‘basis risk’ On Demand - Non- On calling, depending on L/C Insolvency or non- payment Insolvency / subject to TRIGGER TO CLAIM performance with the Insolvency only Terms of debt owed. ISDA underlying contract ELIGIBLE Public or Private Public or Private Public or Private Public Public COUNTERPARTY Typically annual with Typically renew on an CONTRACT evergreen clause and ability Typically renew on an annual basis , Structured Highly flexible from 2 months Typically, from 1 to 5 to draw in the event of non- Credit Insurance can lock DURATION annual basis , similar to LC. up to 3 years . years . renewal. cover for 3-10 years.
One Source Risk Management David Kinzel 303-945-1486 dkinzel@onesourcerm.com
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