A Service Provider's Dilemma:
Where's My Value Added?
As a service provider to the asset based lending and lease finance industry the main issue that confronts our company daily is where is our Value Added. One's value added is its ability to understand a client's needs and design products that add efficiency to the ever changing nature of tax based lease and loan products, the continuing refinement of accounting standards worldwide and the evolution of financial products such as securitized loan and lease financings. The traditional definition of and use for residual value insurance, is no longer all that the markets demand from the product. If a company is to grow and maintain market share, and even more importantly profitable market share, in today's fast paced global financial marketplace the mantra must be "Add Value".
As manufacturing concerns have moved to "just-in-time" inventory systems and labor's participation in the profitable outcome of the manufacturing process, the message that we all "hear" is the "partnering" concept. Manufacturers cannot enjoy the profits of "just-in-time" inventory without the cooperation of suppliers and employers cannot attain greater labor efficiency without the participation by the workers. So to do we need to understand these concepts as well as to find "partners" within our industries as well as within our client base so as to "assist in the solution" of our client's challenges.
Residual value insurance, in its traditional definition, 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 specified in the policy. The objective is to indemnify the insured for a financial loss due to an unexpected occurrence. This level of coverage has become associated with "FAS 13" insurance; whereby, an rvi policy assists a lessor in the conversion of an Operating Lease into a Direct Finance Lease. This has been our Value Added. A catastrophic event in the context of asset value/residual value insurance would be a value determination by the market which is considerably below the minimum expected value when the coverage was purchased. Therefore, the most basic use of residual value insurance occurs in the classic insurance context; indemnification for a catastrophic loss occurrence which the finance industry has utilized to convert an Operating Lease into a Direct Finance Lease.
      The Challenge
Potential insureds, however, believe that residual value insurance in its classical format does not answer their most pressing requirements. The challenges facing the financial community are to create tools for transaction yield enhancements, liquidity enhancements or asset monitization. The residual value insurance solution to these issues is insurance at higher levels of risk by the insurer. Since premiums are a fairly small proportion of the coverage provided, two (2%) to four (4%) percent of the insured amounts, a few losses would destroy the insurer as its margin of error is the premium charged. The dilemma posed the insurance provider is how does it provide value added to its client base while maintaining the integrity of its balance sheet so as to be able to provide continuing support to these clients.
An examination of many requests for insurance leads us to believe that the real requirements for these coverages may be met by creative insurance and transaction structuring. The Value Added the product can bring to asset based financing transactions is set in one of three structures:
    1. A Catastrophic Level of coverage utilized to arbitrage accounting standards such as FAS 13 whereby residual value insurance assists in converting Operating Leases into Direct Finance Leases. Unfortunately, these levels can not always be reached so we two below has been developed to address higher risk levels.

    2. Financial Statement Management at efficient cost levels for higher value added risk levels mainly utilized by Operating Lessors and Equipment Manufacturers. A higher level of coverage is required as these transactions are most likely to be short term in duration.

    3. Monitization of asset values within asset securitization and tax driven loan and lease financings.
The following outline sketches our results to date. The solutions are set in context of an actual transaction; an asset whose expected fair market value is $47 million and stressed value is $33 million, both at an insured point three (3) years from the asset purchase date.
The Value Added Answers
The first challenge that faces the lender or lessor is to obtain basic catastrophic risk coverage at $20 million, or sixty percent (60%) of the asset's stressed value. The insurer answers this challenge with coverage at this level of risk for a 3% of $20 million or $600,000 due, as are all rvi premiums in a one time payment occurring at the closing date of the transaction. As this transaction is long term in duration (i.e. a full-payout leveraged, single investor or synthetic lease) this level of coverage is sufficient to secure the conversion of an Operating Lease into a Direct Finance Lease for the lessor, while permitting the lessee Operating Lease treatment.
The second challenge a lessor may face involves the conversion of an Operating Lease into a Direct Finance Lease for a risk level above the insurer's normal comfort level. The insurer's answer is to provide a two step product combining traditional indemnity insurance with a "non-funded finite risk" layer of coverage. Transactions of this nature are executed in two steps. The total insurance coverage required is $40 million. The first step is similar to the above example, whereby, the coverage/risk layer between $0 and $20 million would be insured for a cash premium component of $600,000. Step two is the creation of a layer of coverage for the risk layer between $20 and $40 million. The second risk layer would incur a premium of $20.2 million with $.2 million payable in cash and $20 million payable in the form of a note from the insured to the insurer. At the transaction's termination, the insured point, if the asset is "worth" (i.e., sells) for more than the $40 million, the insurer presents the note to the insured for payment and subsequently the insurer pays the insured a "no claims" policy dividend of $20 million. The net cost of the coverage to the insured is the $800,000 cash premium made at closing. If, however, the asset were to be "worth" $30 million, the policy dividend would be reduced to $10 million. This offsetting process would be the same unless the asset were to be "worth" less than $20 million. At that point, there would be no policy dividend payable and the insurer would make a payment to the insured.
The third challenge that faces the lessor or lender is the creation of synthetic equity in an asset securitization or tax based loan or lease financing. The need is coverage sufficient to provide "equity", or more appropriately to unlock the inherent equity, in a transaction by monitizing a significant portion of the asset's residual value. The insurer's answer is to provide coverage of $40 million obtained for a two part premium. The first stage of the premium, paid at closing, is five percent (5%) of the insured amount or $2 million. The second stage of the premium is a contingent premium which would consist of a twenty percent (20%) share in either the asset's liquidation proceeds or release or renewal rentals, all according to a negotiated formula. The coverage is in the amount of the full $40 million; in the event the asset were to be "worth" $25 million, the insured would claim $15 million from the insurer with no offsetting self funded premium. If the asset is "worth" $50 million the insurer gains an additional $2 million in the form of a contingent premium.
The difference between the coverage types is a product of their uses.
    1. The first, Catastrophic or FAS 13 Coverage, provides the classic insurance function.
    2. The second, provides an insurance policy in an amount sufficient for transaction structuring purposes at a moderate cost to the insured.
    3. The third, provides the capability of monitizing residual value while providing the insurer with a sufficient margin for reserves against the inevitable losses.
Who Is My Partner?
In challenge one, the partner should be the leasing company whereby the insurance company can rely upon the leasing company for a continuing flow of business. This predictable business flow will have two major benefits for the insurance company:
    1. The insurance company will be able to price its product with the expectation that the cost of product manufacturing will be spread over an approximate business volume.

    2. The insurance company will understand the underwriting risk inherent with the client's/insured's portfolio so it can take risk where risk is required to assist the leasing company in winning new business.
The benefit to the client, the insured, will also be twofold:
    1. An insurer that will be able to predictably underwrite the insured's portfolio asset risk.

    2. An insurer that will be able to competitively price the insured's portfolio asset risk.
The end result should be a net gain in business and profitable market share for both the insurer and the insured.
In challenge two, the partner would most likely be the insured's internal and external accounting personnel. It will be only with this constituency in agreement that a transaction of this nature can be properly structured so as to meet GAAP, SEC and corporate accounting standards.
The benefits for the insured are:
    1. An insurance program that will assist the insured in achieving the desired accounting and tax treatment for the transaction at an acceptable cost level and risk level.

    2. The ability to record a product sale, ready a portfolio for a securitization financing etc.



      The benefits for the internal and external accounting staff will be:

    3. The ability to be proactive in properly assisting the corporation in achieving the desired accounting and tax treatment with minimal bureaucratic friction.

    4. The ability for the accounting staffs to have early access to transaction structuring process so an acceptable partnering relationship can be forged to meet the overall objectives of the corporation.
In challenge three the manufacturer or operating lessor might be the most probable partner.
The benefits for the insured should be:
    1. The ability to create present value liquidity and working capital for the operating lessor or manufacturer.

    2. The ability for the manufacturer or lessor to attain more efficient use of the asset's inherent value

      The benefits for the insurer should be:
    3. The manufacturer or lessor as a partner in managing the risk as it will be able to remarket the asset, in the event of a claim, in partnership with the insurance company and not in competition with the insurer.

    4. The ability for the insurance company to gain a needed revenue source, the contingent premium, so as to properly reserve for a possible claim situation.
The net result of this structuring is to create "win win" situations. The ability to "partner" with one's clients and constituents will be the key to successfully providing service to one's clients.
* * *
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.