Are There Insurance Alternatives to Standby LC facilities?

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Lets face it, getting a Standby Letter of Credit facility these days is not cheap. Standbys are used for numerous things, and are used as a credit backstop for both commercial and non financial transactions. Standbys represent an irrevocable obligation to the beneficiary on the part of the issuer to make payment when drawn. They can be drawn upon certification by the beneficiary that the account party has failed to fulfill its obligation to the beneficiary.

They typically underlie some commercial activity, which could be a tender for a project (bid guarantee), an advance payment (advance payment guarantee), an installation (retention guarantee), a warranty period (warranty guarantee).

Standbys can be used in so many ways. For example, if you issue Commercial Paper, you usually get a standby as a backstop to support cash flow. Or you can issue a Standby for an advance payment to a supplier for partial payment upfront to cover materials to be used under the contract. The buyer asks for this type of Standby as assurance that if the supplier defaults on the contract the advance payment will be returned.

So I was interested to speak to Alastair Malcolm, CEO XS Reserve Limited, who for 30 years has been working around risk mitigation and insurance. Alastair is old school, and comes from an era when insurance managed risk and banks managed liquidity.

Take the case of bad debt reserves. Large corporations must set aside reserves in case of defaults.  Under Excess of Loss credit insurance policies, companies fund the retained risk they hold (ie, typically a policy could have them cover aggregate first loss of £250,000 to £3 million).

What Alastair and XS Reserve have devised, together with AIG London, is an excess loss credit product that acts like a term life insurance product (for those that remember those).  For example, instead of reserving for a bad debt or getting a standby facility to reserve $1M, a company would make equal payments over a term, say 36 months ($30,000 month), to an escrow account.

If the contingent liability event occurs, the client can draw down $1m, even if the event occurs in the first month. This policy is also a wholly assignable contract, which enables the policy owner to hand over to a financier for cash collateral.   In essence, the client has leveraged the credit rating of AIG (single A) to access a more cost effective Excess Loss trade credit solution rather than ground up cover, while still benefiting from immediate credit risk mitigation. If there is no loss in three years, the lien is released and the client has their money back.

XS Reserve provides the servicing platform. The risk AIG faces is if the client fails to make payments.

Today, this product is only offered out of AIG’s London office.

Why do we need a product like this? Alistair believes that Standby facilities have become increasing expensive because of Basel III. Standbys (or their sister product guarantees) are used instead of cash collateral and when additional security is required. They require credit on the part of the applicant.

XS Reserves provides a treasury alternative to the standby or guarantee for risk management.   It gets back to the point Alastair made on our call, let the insurance guys handle risk, and the bankers handle liquidity.

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