Residual Value Insurance: What is it?

Residual Value Insurance is one of the many new financial guarantee insurance products that have been brought to the market in an effort to bring insurance company capital to work in the arena of asset based finance. The main role that residual insurance plays in a transaction is to assist in one or more of the following transaction enhancements:

Create Increased Portfolio and Single Transaction Liquidity. Favorable Accounting Treatment for Lessors, Lenders and Manufacturers. Favorable Accounting Treatment for Lessees and Borrowers. Removal of a Contingent Liability from Lessors, Lenders and Manufacturers Balance Sheets. Support Regulatory Capital Requirements. · Hedge the Accumulation of Asset Risk on a Lessors, Lenders or Manufacturers Insurance.

Product Definition

A RESIDUAL INSURANCE POLICY INDEMNIFIES THE INSURED AGAINST A LOSS WHICH MIGHT OCCUR IF THE SALE PROCEEDS OF A PROPERLY MAINTAINED ASSET ARE LESS THAN THE ASSET'S INSURED RESIDUAL VALUE AT THE POINT IN TIME SPECIFIED IN THE POLICY.

A few key points from this definition deserve further explanation;

The policy is a contract of indemnity; its purpose is to reimburse the insured for a covered loss, thereby, returning the insured's financial position to its level prior to the loss. To qualify as an insured, a party must have an insurable interest; that is, the loss of asset value being insured against must cause a financial loss to the insured. A sale or valuation must be obtainable by the insurer prior to establish the basis for a claim. Generally, a physical asset to which the insurer can obtain title must be present in the transaction. A claim may be established through an actual sale (our "proceeds policy" format) or through an appraisal procedure (our "fair value policy"), the mechanism for which is spelled out in the body of the policy. The asset must be properly maintained, according to the lease or loan documentation and in the insurance policy.

What Residual Value Insurance Does

The following four sections describe the types of uses to which residual insurance is currently being put. We would like to emphasize that these are only descriptions of current and recent utilizations. Our best ideas have always come from our clients. Our favorite telephone call begins "I don't know if you can do this, but..."

I. Financial Statement Management

The use of residual insurance for earnings and balance sheet management had its inception in the pronouncement of FAS 13 by the US Financial Accounting Standards Board as well as similar accounting standards in the international arena. The crucial section was the permitted differentiation between Operating Lease treatment for a lessee and Capital Lease treatment for a lessor. Four tests qualify a transaction for this treatment. The most limiting test in most transactions is the test calling for the present valuing of the lessor's minimum guaranteed payments. The lessee's objective is to minimize the balance sheet treatment of its obligations. So long as the present value of the lessee's obligations (chiefly the rent) are less than 90% of the fair market value of the asset subject to lease at the transaction's inception, the lessee's obligations are restricted to a footnote to the balance sheet. In the event of Operating Lease characterization, the lessor's book asset is described full disclosure ownership of an asset subject to the lease agreement. The lessor will record the entire asset on its balance sheet, thereby, distorting his asset/liability mix and its Return on Equity (ROE) on its balance sheet and income statement. This situation can cause the lessor to suffer an accounting income loss during the first 20% to 30% of a lease transaction. Please note that these are accounting issues, occur independent of any tax consequences of the transaction. However, if the lessor were to have contractual receivables totaling 90% or more of the asset's fair market value at lease inception, the transaction would be accounted for as any other loan or financial asset, with the lessor receiving book interest income over the life of the transaction, and showing a balance sheet asset as a lease receivable.

The conflict existing between the lessee's objectives, an off-balance sheet Operating Lease (minimal lease payments for financial statement purposes) and the lessor's objectives, a direct finance lease leads to the development of residual insurance as the means of providing sufficient additional contractual receivables for the lessor.

A product developed from the FAS 13 reporting dichotomy described above is the Off-Balance-Sheet Loan ("OBL") or Synthetic Lease. The residual insurance product described above secured favorable accounting treatment for a traditional lease transaction. The lessor owns the asset for tax purposes and enjoys the tax benefits, such as depreciation. The OBL financing structure is designed to provide operating lease accounting treatment for a borrower, who also enjoys the tax benefits of ownership. Residual Insurance provides the lender with sufficient guaranteed minimum payments to "book" a loan (direct finance lease) for accounting purposes.

A recent development has been the Finite Risk coverage. The objective here is to issue a policy for large unusual risks. In this case a level of traditional insurance is provided, in return for a regular, non-refundable premium. The difference in coverage between this level and the desired level is provided by charging the insured an additional premium in an amount equal to the additional coverage. In the event no claim is made, the additional premium is refunded in full to the insured, as a premium dividend. (The exact formulation depends on the tax consequences in the jurisdiction concerned.) The additional premium, if paid in present value terms, might be deductible for tax purposes in certain jurisdictions.

Finite Risk is used by manufacturers and financiers in the creation of off balance sheet financing vehicles, especially in cases where the amounts and levels of coverage desired are beyond the market's current capacity.

Underwriter's Perspective

All of these policy types require a level of coverage generally considered to be well within the guidelines of prudence, although the traditional component of finite risk is generally higher than that under the first two. These coverages generally are simply uses of insurance capacity, and are priced accordingly. The traditional component of Finite Risk is generally the highest that would normally be insurable, with an appropriate premium level.

II. Catastrophic Value Decline

This use is closest to the traditional notion of property and casualty insurance. The basic mechanism for Residual Insurance value setting is an analysis of the forecast stressed value of the asset at the insured point in time. This value will be below the range that is forecast to encompass the cyclical variations in value normal to any asset over a business cycle. These variations are the risks of equity ownership, and bring appropriate returns, including the possibility of realizing gains in value. The insurance is provided for a premium, which does not include any reward in the event of value appreciation. Coverage levels are set accordingly.

III. Residual Value Monetization

Residual Insurance is used here as a guarantee of recovery for a non-recourse financier in either a debt or equity transaction. The policy is issued to the financier as insured. The transaction generally is structured so that the final payment is optional to the primary term obligor, the lessee or borrower. The financier's collateral for the transaction is the Residual Insurance policy, which is collateralized by the actual asset. The policy is used to monetize asset value at the end of transactions, where the availability of debt finance is limited by loan to value restrictions in the capital markets or by the major rating agencies. A typical use would be a guarantee of a balloon note, possibly in zero coupon form, to provide additional proceeds for financing the asset's acquisition.

Underwriter's Perspective

The underwriting decision here is for the provision of the maximum coverage consistent with prudent underwriting standards. Premiums are set at the appropriate level.

IV. Structured Equity

These coverages are crafted so as to provide support for financial transactions similar to that described in the asset monetization use above, but at higher levels. Generally, the higher level of coverage is compensated for by charging a higher overall premium in two components. The first is the regular residual insurance premium charge, but reflective of the higher level of coverage. The second component is a contingent component, depending on which of several possible outcomes may occur. The total charges are designed to reflect the equity nature of the insurance being provided,

Underwriter's Perspective

The key underwriting issue here is the complete delineation of the transaction's possible outcomes, and the setting of the insurer's returns at an appropriate level to compensate for the risk level. The view here should be to the building of insurance company reserves sufficient to withstand, on a portfolio basis, the possible adverse outcome of several such policies either simultaneously or in sequence given the higher insured to value ratio.

The Developing Residual Insurance Market

The market for financial statement management was the reason for the product's invention. This area continues to be a major consumer. However, as can be seen from the above outline, emphasis has moved toward adding insurance to the economic structuring tool kit. This is the area we feel to be most open to innovation. This area creates liquidity, yield enhancement and synthetic transaction equity.

The most striking current development in the financial markets is the move toward asset securitization. This development can de defined for our purposes as the creation of pools of income producing assets in which fund managers can invest on the basis of their appetites for specifically configured types of risk; term, interest rate, credit, etc. The impact on marketing financial risk mitigation products lies in the audience to whom the marketing effort must be addressed. The buyers, the commercial bank and investment conduits, the managed funds pools operating as mutual funds, insurance company fixed income buyers, etc., are passive acquirers of assets. The decisions as to what elements are combined into these pools lie with the bankers who originate them. These may be investment banks, commercial bank capital markets groups, corporate finance boutiques, or others. These markets are intensely price competitive, very conscious of the credit standing of the provider, and absolutely intolerant of any lapse of professionalism in product delivery. The attraction of this market place is the enormous and growing flows of funds involved.

The Underwriter's Perspective in Assessing Residual Risks

The level of insurance provided and the premium charged are a function of the following factors as they apply in each transaction. To the extent each factor may not be present, structural changes might be used to mitigate the underwriter's concerns.

An identifiable, liquid secondary market for the asset must exist. The more standard, and therefore broadly useable the asset, the better; Exposure to technological obsolescence should be minimal, The asset's useful life must be in excess of the policy's terms.

The Underwriting Process

All of the traditional insurance (i.e. insured risk) written for the products described below is written to a minimal loss ratio, net of recoveries. This means that the expectation at any policy's inception is that, even if a claim is made and paid, recoveries from liquidation of the asset insured will leave the insurer without loss. The levels insured need not necessarily be low relative to value at inception. However, the underwriting process must insure that asset coverage (projected asset value divided by total residual value insured) is as strong as possible.

The process used to meet these objectives involves the use of extensive asset specific databases as well as valuation services. The databases must cover value history over several cycles. Preferably multiple sources will be consulted. At least two valuation firms should be consulted on each asset type. Attention should be paid to the reputation for disinterestedness of each valuation firm. Internal valuations are the start of any underwriting; however, external valuation services are utilized so as to add further market input to the internal underwriting process.

The valuation process is designed to yield a view of fair market value at transaction inception, and of fair market and stressed value at the requested insured point. A view on the current fair market value will indicate whether the financial transaction of which the insurance is a part is supporting a realistic asset value. Overvaluation could indicate trouble at the insured point. The fair market and stressed values at the insured point will be determined in constant dollars, or without regard for inflation. The spread between expected fair market and stressed values will indicate the asset's expected liquidity.

The underwriter will consider the above data in the following context:

What is the effect on this particular asset type or model of the current position of the market cycle? What are the specific return conditions offered for the asset in this transaction? What is the nature of the secondary market for the asset? What is the outlook for technological developments in the asset's marketplace? What effect are the overall economic and asset cycles having on this asset? How consistent is the requested coverage level with the values projected above?

All this analysis will be designed to focus on one variable; the expected stressed value of the asset at the insured point. The level of coverage as a percentage of that value that can be comfortably underwritten will then be determined. Premium will be set by a pricing model relating coverage underwritten to return on assets and other financial target criteria.

The goal of residual value insurance is to create a value added product that can:

Create Increased Transaction Liquidity Arbitrage Accounting Conventions Enhancement Transaction Yields Arbitrage Tax Conventions Assist in Regulatory Capital Relief

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Thomas A. Orofino is a Managing Partner of Collateral Guaranty LLC Westport Ct (203.227.7080). He is responsible for the marketing and product design of residual value insurance products and services worldwide. Mr. Orofino is a graduate of Villanova University where he earned his BA in Economics.