Improving liquidity during and after the pandemic
Beyond its impact on people, the continuing COVID-19 pandemic has had severe effects on the Australian and global economies. As Australia moves into the “recovery phase” of the pandemic lifecycle, whilst it will take some time before “business as usual” is achieved, maintaining liquidity can act as a bridge until economic activity improves. A number of insurance and risk management strategies can enable that process.
Cash flow challenges
Since the pandemic began, businesses have had to contend with volatile financial markets and uncertainty about their current and future revenues and cash flow. With worries about a potential recession growing, many businesses have taken steps to preserve cash — including laying off or furloughing employees and shutting down production — while exploring potential lines of credit and other ways to maintain liquidity. The Australian government has gone to unprecedented lengths to encourage businesses to retain staff, including the creation of the JobKeeper Payment.
But adverse effects and uncertainty for businesses will likely persist for some time — with the worst possibly still to come — which underscores how important it is for businesses to preserve cash. In addition to any actions they may have taken so far, businesses will likely need to explore other solutions, such as claims and collateral cost reduction strategies, credit insurance products, premium financing, and the use of captive insurers — all of which can help them stay liquid.
Closing and settling outstanding insurance claims
Closing out and settling legacy claims proactively can help businesses improve their balance sheets and access cash flow. Companies should move quickly to identify the outstanding claims and then formulate a strategy on how to negotiate with insurers and expedite the settlement. Companies should utilise forensic accountants and claims advocates to quantify losses, prepare claims documentation and negotiate with insurers to maximise recovery amounts without further delay.
Replacing bank guarantees with surety bonds
As businesses face higher financing costs, limited access to credit facilities, and falling counterparty value, surety bonds represent a viable means for posting collateral, and an attractive alternative to bank guarantees (BG).
Unlike a BG, a surety bond does not count against a company’s overall borrowing capacity. Surety bonds can be more cost-effective than BGs and can enable principals to free up capital and credit for other, more productive uses. They can also allow principals to avoid being overly reliant on their banks.
Businesses are increasingly using surety bonds to meet a range of collateral commitments. These include posting security for performance/maintenance obligations, meeting financial assurance requirements for mining rehabilitation, credit support for Australian Energy Market Operator requirements, large leases, and satisfying requirements for self-insured workers’ compensation programs.
Financing premium payments
Preserving and strategically deploying capital is vital to a business’s success at any time, regardless of market conditions, but it is critically important now as businesses try to restabilise their operations and cash flow after months of disruption. Premium finance can help businesses to preserve working capital that would otherwise be used to pay commercial insurance premiums.
Insurance payments are due upfront. A large upfront payment can prevent a business from meeting other critical and cash-intensive obligations, including payroll and supply chain expenditures, at the time a policy incepts or in the future.
Premium finance allows the insured to spread the cost of payments over equal monthly instalments. The premium funding company pays insurance premium on behalf of the policyholder, with the underlying policy serving as collateral for the loan. This allows the insurer to collect premium upfront and extend coverage to the policyholder without the need to tie up valuable assets or encumber any credit facilities. For insurance buyers of virtually any line of coverage, premium finance can serve as an effective cash management tool whereby the policyholder can both secure necessary coverage and preserve capital that can be used to meet immediate or long-term needs.
Using trade credit insurance to protect accounts receivable
Typically, accounts receivable represents approximately 35% to 40% of a company’s assets. Trade credit insurance can help a company protect these assets from losses caused by insolvency and default, among other potential risks, and help them improve their liquidity.
A trade credit insurance policy, meanwhile, can be used as security for additional liquidity. Assigning a policy to a bank or financial institution enables receivables to be used as a secured asset against which a bank can offer funds.
Funding can also be provided through a factoring agreement supported by trade credit insurance; a bank would have its own trade credit policy, purchasing invoices from its customer with support from insurers on exposures. In the event of a claim, trade credit insurance can indemnify a policyholder for up to 90% of the loss.
Lending and returning profits to captive parents
Among other benefits, captives can extend loans to parent organisations or invest in other parent company assets, including real estate and trade receivables. A captive can also return profits to a parent via dividends and fund a parent’s risk management expenses, including large risk consulting projects.
Whether a parent organisation can pursue these strategies, however, depends on the financial health of a captive — namely, whether it can generate surplus and/or reduce the amount of surplus required by its regulator. Captive owners may be able to achieve this via:
- Reserve reviews: A systematic process, such as a claim inventory workout, can lower a captive’s loss reserves and generate more surplus.
- Purchasing reinsurance: This can lower overall surplus requirements, since a captive would retain less exposure.
- Discounting loss reserves: This would result in a lower book value and corresponding increase in surplus.
- Adjusting premium-to-surplus ratios: Increasing this ratio can result in both a lower surplus requirement and enable captives to increase loans and issue dividends.
Pursuing these strategies can help parent organisations generate liquidity immediately and in the long run. Since the pandemic began, parent organisations of Marsh-managed captives have freed $US 2.6 billion from their captives to aid their cash flow. These strategies, however, may require regulatory approval, detailed financial calculations, and input from tax advisors and other professionals.
Retaining more risk to reduce insurance premiums
With competing cash flow pressures, it is timely for organisations to re-evaluate whether they can potentially retain more risk to help reduce their insurance premium spend. This is becoming increasingly relevant in an environment where policyholders are faced with increases in premium and reductions in capacity from insurers. To help companies make an informed decision, they need to have a clear understanding of the following:
- What is their risk bearing capacity, i.e how much financial impact can a company withstand without significantly impacting its operations?
- What is the company’s strategic appetite to take on more risk?
- What is the company’s cost of capital to fund risk?
- What are the trade-offs between taking on more risk and potential premium savings?
To assist with answering these questions, a Risk Tolerance exercise is valuable to model the losses an organisation is exposed to, followed by a Risk Finance Optimisation exercise to identify the ideal risk retention (deductible) and insurance limits to optimise premium spend for a particular organisation.
As the financial and economic effects of the pandemic continue to put a strain on businesses, financial and risk professionals should explore their options for addressing cash flow challenges. They should work with their advisors to consider these and other insurance and risk management strategies that can help ensure their liquidity as the crisis continues.
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