What CFOs Can Do To Improve Balance Sheet Liquidity

by Stephen Roseman

Given the recent challenges in the traditional credit and direct-lending markets, a company’s ability to tap into existing liquidity sources instead of having to obtain additional debt through new loan facilities is valued by shareholders, and especially by PE-owned companies.

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Given the diversity of risks that businesses face, it's essential for companies and their CFOs to implement effective risk and insurance programs to protect their assets and to mitigate potential losses, all while minimizing the potential liquidity-limiting nature of these programs. The typical commercial insurance program has implications to a company’s balance sheet and can impact its ability to finance day-to-day business operations. Suboptimal insurance program design can be particularly consequential for private equity owned businesses, whose higher leverage ratios can make it more difficult and potentially expensive to procure financing in the lending marketplace.

In all economic backdrops, businesses rely on strategies that generate liquidity to capitalize on growth opportunities and enable a company to navigate economic headwinds. Given the recent challenges in the traditional credit and direct-lending markets, a company’s ability to tap into existing liquidity sources instead of having to obtain additional debt through new loan facilities is valued by shareholders, and especially by PE-owned companies. The recent disruption in banking has only drawn a brighter spotlight to the issue. One highly important, yet commonly overlooked, opportunity is to tap into the latent liquidity that can be found within a company’s risk and insurance program.

Observing the current commercial insurance program landscape, many businesses are confronting challenges that arise when a meaningful percentage of their balance sheet liquidity becomes blocked by the designs of their risk and insurance programs. The situation has become more acute as increasingly popular, high deductible and other loss-sensitive programs have been adopted to help companies manage overall insurance costs. These programs also come with a mandate of collateral requirements to cover the deductibles that accompany these policies, with these requirements usually satisfied through the use of letters of credit issued by the company’s bank. The liquidity challenge comes from these same letters of credit being treated as drawn capital against the issuing bank’s credit line, thereby reducing available funding that would otherwise be utilized by the company for growth and day-to-day operations. Therefore, it remains paramount that companies with such policies conduct regular reviews of their risk and insurance programs to ensure they are designed with corporate liquidity needs in mind.

To address these challenges, there are several important steps CFOs can take to optimize their risk and insurance program:

Determine risk appetite when choosing insurance policies: The first step in optimizing a risk and insurance program is to review the company’s current coverage. This review should include an analysis of the company’s assets, liabilities, and potential risks. Once the company has a clear understanding of its current coverage, it needs to determine its risk appetite. This involves evaluating the company’s tolerance for risk and determining what it is willing to accept through the insurance policies it chooses. In the case of loss-sensitive programs, a company assumes insurance claim responsibility up to the amount of a deductible negotiated with the insurance carrier, and by doing so can lower the annual premium costs of their policies.  

Improve understanding of company and industry specific vulnerabilities: Whether the company ultimately selects a loss sensitive or a fully guaranteed insurance program, CFOs and their teams should invest in recurring actuarial analyses to better understand what has caused claims, premiums, and collateral requirements to change over time and how vulnerable the company is to those trends. Including this analysis as a matter of practice will support efforts to maintain and reduce collateral levels over time, with insurers reacting positively to improvements in cash flow from operations or liquidity and coverage ratios.

Additionally, CFOs should ensure their risk managers are evaluating their insurance programs through the lens of multiple economic environments. The impact of an economic slowdown, for example, will affect businesses unequally. Companies with risk profiles that are more vulnerable to reductions and fluctuations in revenue, cash flow, and liquidity ratios are more likely to see increasing collateral demands from their carriers. In such a scenario, the resulting decrease in a company’s ability to draw on its borrowing capacity can have adverse business impacts. To protect against the effects of insurance program collateral on corporate balance sheets, companies can adopt alternative financing strategies that release credit lines trapped by insurance policy requirements. 

Implement risk management strategies through off-balance sheet financing solutions: An increasing percentage of companies utilizing loss-sensitive insurance programs have turned to an off-balance sheet financing solution to minimize the collateral-caused blocked credit line problem. The solution, more commonly referred to as Insurance Collateral Funding (ICF), enables companies to transfer their collateral requirements off their balance sheets through a substitute collateral arrangement that fully satisfies insurance carrier collateral requirements. A third-party provider arranges and backs a replacement letter of credit in exchange for a financing fee. As an off-balance sheet transaction, the financing fee considered an insurance expense. This financing solution is made further appealing to company CFOs due to its unsecured nature, and its usual exclusion from financial covenants.

Many companies also turn to surety bonds to further open balance sheets. Surety bonds provide insurance carriers guarantees on the deductible component within loss-sensitive programs, and their implementation does not result in the loss of credit access that occurs with traditional letters of credit. Unfortunately, the total amount of guarantees provided by surety is limited. However, surety can work as an effective complement to Insurance Collateral Funding and other off-balance sheet financing solutions. Such combinations provide finance teams with a robust solution that serves to manage overall insurance program costs and increase access to liquidity.

Optimizing a risk and insurance program requires a comprehensive review of the company's appetite for risk, an understanding of its vulnerabilities, and the exploration of alternative financing solutions that mitigate the collateral requirements that can tie up balance sheet capital. By taking these steps, companies can extract additional liquidity to maximize company growth and value. 

Stephen Roseman is CEO of 1970 Group