Emerging Form Of Insurance Collateral Improves Capital Flexibility
By Stephen Roseman
The past few years have highlighted how important liquidity can be to oil and gas companies’ viability and long-term prosperity. When geopolitical events or economic growth spur increased demand, firms with access to capital will be in the best position to capitalize on higher prices. If unexpected events bring prices down, those same firms will have the financial cushion to weather the tough times and take advantage of the lull in activity to test new ideas.
Liquidity’s importance will likely increase with time. Recent history suggests prices will remain volatile, requiring producers and service firms to bring greater flexibility to their balance sheets in readiness for multiple market scenarios. With the cost of debt rising rapidly, corporate liquidity strategies can help firms position themselves to capture near- and long-term opportunities, while managing the anticipated volatility in shorter-term pricing and production volumes resulting from the geopolitical and economic forces in play.
One important and often overlooked means of raising corporate liquidity is unlocking capital trapped in a company’s commercial insurance program, including workers compensation, general liability and commercial vehicle coverages. Many mid-to-large-size companies in the oil and gas production industry have benefitted from the move away from guaranteed cost insurance programs to high deductible loss-sensitive programs in order to lower insurance premium costs and increase company cash flow. With these loss-sensitive programs come requirements from insurance carriers that collateral be set aside to cover program deductibles.
The leading solution used by finance and risk teams to collateralize their insurance requirements is letters of credit, a common vehicle offered by a firm’s banking providers. However, letters of credit (LOCs) suffer from a major drawback: They are treated as drawn capital with respect to a company’s credit facility, effectively reducing the amount available to a company to operate and grow its business.
The following example illustrates the loss of liquidity being widely experienced across the industry. A natural gas producer that has a $40 million credit facility with its banking provider approaches the bank for a $10 million LOC to satisfy its insurance carrier’s collateral requirements. With the LOC treated as drawn capital, the firm immediately would lose 25% of its liquidity that otherwise would be used for a variety of business investments.
To make the problem worse, premiums are rising in response to more stringent underwriting and higher claims costs, which have forced carriers to push for higher collateral requirements in high deductible programs. Inflationary trends have compounded the problem even further.
A New Solution
The loss of deployable capital has stymied finance teams for decades, with various proposed solutions—including cash escrow, surety bonds and the aforementioned LOCs—only partially addressing the problem. However, after years of development, a new risk financing solution has been brought to market that fully releases capital trapped in collateral obligations. Insurance collateral funding (ICF) accomplishes this goal by transferring a company’s collateral obligation off its balance sheet.
Because it can be treated as off-balance sheet financing, it typically is excluded from financial covenants. Unlike a traditionally sourced LOC, it does not reduce the amount available under a firm’s credit facility. As a result, the company regains access to its capital without impacting its leverage ratios, an improvement over the alternative of accessing private or public markets for additional credit.
Freeing capital is powerful enough that ICF has grown rapidly. Since 2021, the solution has been deployed in numerous business sectors, including energy, transportation and pharmaceutical manufacturing. Service industries such as healthcare, hospitality and food service also love it, as do a variety of retail and wholesale distributors.
How ICF Works
Developing ICF required a deep understanding of carrier requirements and credit structures, as well as robust banking relationships. But for an oil and gas company, the solution is easy to implement. The company only needs to share information about its insurance program with an ICF specialist, which works with its partner banks to issue a replacement LOC for the client’s existing LOC or other forms of collateral supporting its policies.
This substitute LOC is delivered to the company’s existing insurance carrier. Then the insured company cancels its previous LOC or other forms of collateral, freeing its balance sheet and gaining access to additional liquidity.
To satisfy insurance carrier requirements, an extensive array of banks approved by the National Association of Insurance Commissioners participates, including banks found on all carriers’ approved bank lists. The process is seamless and easy to implement with the insurance carrier, which receives a clean, irrevocable and evergreen LOC coterminous with the company’s annual policy renewals. The letter of credit remains identical to the carrier’s desired form of LOC.
The entire funding process typically takes four-six weeks, and the solution can be implemented at any time, independent of a company’s insurance policy renewal dates. ICF is flexible enough that it can raise or lower collateral amounts as a company’s requirements evolve. It’s capable of accommodating any company’s collateral needs, from hundreds of thousands to hundreds of millions of dollars.
ICF is available to firms across the United States and Canada. The cost is comparable to a company’s cost for capital, an attractive price point for a solution that can be treated as off-balance sheet financing and is typically excluded from financial covenants.
Throughout the oil and gas value chain, significant amounts of insurance collateral previously have been posted with insurance carriers. Today, well-run companies can devote these resources to buying new equipment, exploring acquisitions, refining technologies and sustaining business operations.
Not long ago, the liquidity provided to upstream companies through ICF was being earmarked for managing ongoing business operations in the face of still-depressed energy prices. By the second quarter of 2022, in the wake of climbing oil prices, industry participants sought to rapidly release capital to invest in growth. The solution offers an easy and affordable way to accelerate organic growth and enable acquisitions.
After a relatively sluggish decade in upstream merger and acquisition activity, deal flow began to accelerate in late 2021, and U.S. M&A volumes reached their 2022 high in the third quarter. The incremental liquidity generated through ICF can support acquisition activity, reducing the extent to which firms need to tap into credit markets at a time when the cost of debt financing has risen to 15-year highs.
As they evaluate acquisitions, executives are faced with the sobering realization that acquired firms come with their own set of insurance coverages and collateral obligations, placing pressure on finance teams to come up with even more insurance collateral. Whether through organic growth or M&A, expanding operations creates a need for more collateral. Companies looking to be acquired can leverage ICF to strengthen their financial profiles and balance sheets, alleviating some trepidation of potential buyers.
Although oil and gas pricing trends continue to provide tailwinds for the industry, recent geopolitical instability portends ongoing unpredictability in global oil and natural gas markets. Access to additional capital can act as a buffer against the operating impacts of price hyper-volatility. When prices soar, the extra capital can help companies scale up and compete for limited supplies. When prices drop and activity mellows, it can give companies the freedom to retain skilled employees and invest in research and development to prepare for the next upswing.
A Growing Need
The need to address insurance-related collateral lockup is heightened by macroeconomic forces that indicate commercial property and casualty insurance rates will continue to rise for the next few years. Driven by employee wage inflation, both premiums and collateral requirements are predicted to increase significantly in loss-sensitive workers compensation, general liability and commercial vehicle insurance programs in 2023.
During this period of inflation, labor instability and an anticipated economic downturn, executives have become increasingly concerned about the rapidly growing opportunity cost of tying up capital in insurance collateral obligations. The bottom line is that capital has become more precious, with debt financing costs running higher and liquidity clearly becoming a greater priority.
When oil and gas companies post collateral to satisfy insurance requirements, access to balance sheets can be severely restricted, reducing the capital otherwise available for operations and investment. By combining shrewd insurance programs with collateral strategies that employ ICF, the insured company satisfies its collateral obligation in a manner that restores its balance sheet to its fullest potential. The emerging solution’s ability to create incremental liquidity, improve leverage ratios and free existing debt capacity is helping smart leaders get the resources their companies need to grow and prosper.
STEPHEN ROSEMAN is chairman, chief executive officer and co-founder of 1970 Group, which pioneered insurance collateral funding. Before forming 1970 Group, Roseman was president of Spencer Capital Holdings, chairman of the board at Southwest Dealer Services and founder of Thesis Capital Group. He has worked in other leadership positions across a range of financial services companies. Roseman earned an M.B.A. in finance from Fordham University’s Gabelli School of Business, and he holds a CFA® charter.