The goal of the presentation will be to demonstrate the link between
individual credit assessments, the cost of credit and the cost of capital; and
how each of these has an affect on capital structure. We will then examine
the effect of market volatility on a company’s risk management program
and finally look at the market in Canada for laying off credit risk.
Market Volatility and Risk Mitigation
Why do we need to mitigate risk? (cont’d)
• The more appropriate answer is we are challenged more and more to
find ways to support increased sales levels with the same number of
buyers, and without increasing enterprise risk.
• This raises three fundamental questions:
• How to determine the maximum acceptable amount of credit on any one
counterparty;
• Is there a cost to credit and if so, how does one determine it; and,
• What are the cost of capital issues related to trade credit?
Market Volatility and Risk Mitigation
Some theoretical background
• How trade credit replaces working capital loans.
• Current exposure versus potential exposure.
• Black Swans.
• M&M Proposition II and Capital Structure Optimization.
Market Volatility and Risk Mitigation
How much is too much?
• If we accept that trade credit is a necessary part of business, what goes
into establishing the proper amount for any one counterparty.
• This has become even more important as firms increasingly need to
consider potential exposure as opposed to current exposure.
• Companies that are targeting increased output, coupled with increasing
commodity prices must now actively challenge assumptions with
regard to acceptable risk levels – particularly since there is a finite (and
small) numbers of buyers for energy supply.
Market Volatility and Risk Mitigation
How much is too much? (cont’d)
• This should not be a mechanical exercise.
• While modeling can be helpful, the real value of any model is in the
testing of assumptions and prevailing thinking.
• So rather than provide a model, we will focus on the factors that should
be considered in establishing the “number”.
Market Volatility and Risk Mitigation
Factors to consider – financial analysis
• Technical Analysis
• Fundamental Analysis
• Macro / Micro Analysis
Market Volatility and Risk Mitigation
Factors to consider – portfolio considerations
• Investment portfolio theory.
• Timing – the absolute amount is time dependant; in other words the
view will change as events unfold. However, positions are usually
static for at least some time horizon.
• Overall portfolio characteristics. The amount of exposure you can take
on in total is limited by your own capital.
• Correlation of counterparty default. This will have an impact on the
overall level or maximum total exposure, and in turn the amount
allocated to any one buyer in the portfolio.
• Is there a difference between the credit maximum for physical
exposure as opposed to financial (MtM) exposure. Again this goes to
current versus potential exposure.
Market Volatility and Risk Mitigation
Factors to consider – corporate structure
• Ownership issues - do you want to have more invested in the company
than the owners.
• Capital structure considerations - what percentage of your working
capital is acceptable to invest in any one company.
Market Volatility and Risk Mitigation
Factors to consider – business relationship
• Look at it from the customer side as well. How much do they want to be
tied to any one supplier:
• Toyota’s philosophy is to ensure that they only represent 40 to 45% of total
production from any one supplier. In contrast, the GM - Ford model is to
have a much larger share of the suppliers capacity - an issue of control. If
that supplier then runs into difficulty, GM must take effective ownership of
the supplier (through a bailout or guarantee) to ensure continued supply.
Toyota’s philosophy is to have healthy suppliers rather than ones they
control.
• Rules of thumb.
Market Volatility and Risk Mitigation
Cost of credit
• Broadly speaking, the components of the cost of credit can be broken
down into:
• Administrative Costs:
• Human resources
• Information tools
• Surveillance costs
• Legal
• Costs of buyer default
• Capital Costs:
• The cost of allocating capital to the risky asset
• Opportunity costs
• Company’s own default cost
Market Volatility and Risk Mitigation
Cost of credit (cont’d)
• How much capital should be allocated to Accounts Receivable (AR)?
• It could be the probability of default associated with the AR base to
arrive at an expectation of loss. Then the company must allocate a
certain amount of capital to this figure, and the cost of credit is the cost
of that capital.
• However, this is the expected default cost, what about the unexpected
default cost?
• Market value approach - assessing the risk premium attached to
“owning” a piece of your buyer.
Market Volatility and Risk Mitigation
Cost of credit - other issues
• Wrong way risk - does the price fluctuation of the underlying
commodity affect the risk of the exposure?
• Floating versus fixed costs - do you have the ability to pass on the cost
of credit in the price. If not, a deteriorating risk with your buyer will
have a direct and negative impact on margins.
• Bottom line: without understanding your own cost of credit, how can
you determine the efficiency of laying off the risk.
Market Volatility and Risk Mitigation
Cost of capital considerations
• Basic capital structure dictates a mix of debt, equity and internal
funding to support the asset base.
• The optimal mix is determined by many factors including:
• Volatility of the asset base;
• Growth expectations;
• Tax regime;
• Timing and market expectations; and,
• Agency costs.
• Even with bankruptcy costs, debt is a cheaper form of capital than
equity.
Market Volatility and Risk Mitigation
Cost of capital considerations (cont’d)
• Volatility of the asset base is a key determinant. Even in the energy
sector, AR is a risky asset.
• The larger the proportion of AR to the total balance sheet, all things
being equal, the greater reliance the firm will place on equity funding.
• By mitigating the credit risk associated with AR, the firm lowers
volatility and can reduce its dependence on equity.
• Furthermore, stability in cash flows and lower enterprise risk reduces
the equity premium demanded by investors.
Market Volatility and Risk Mitigation
Risk mitigation
• The goal of any mitigation strategy should be to transfer the amount of
risk which best improves the capital allocation decision while
maximizing stakeholder value.
• These products are specifically designed to achieve these goals while
providing an opportunity for management to protect one of the largest
corporate assets.
Credit Insurance protects the firm against that which it cannot see,
not that which is inevitable.
Market Volatility and Risk Mitigation
The Canadian market
• North America is a mature market with respect to Risk Transfer options.
• Primary options are Credit Insurance, Credit Default Swaps (CDS) and
Receivable Put Agreements.
• The primary mechanism for risk transfer in Canada remains Credit
Insurance with all the major global participants having a significant
presence in Canada.
• In the US, CDS outpaces all risk transfer options with a current nominal
value in the range of USD62 trillion at YE 2007.
Market Volatility and Risk Mitigation
Risk transfer options
• Credit Insurance: • Generally the cheapest form of cover.
• Flexible in portfolio design and degree of risk transfer - both single
• buyer or multiple buyers acceptable.
• Aggressive risk appetite.
• Non-cancelable limits possible with Atradius, AIG, ERIS and some
• secondary markets.
• Strong service offering.
• Ability to syndicate a structure to enhance limit capacity.
• CDS Market: • Very large market - despite its size, significant liquidity issues of late.
• Offers long term structures allowing buyers to reduce basis risk of contract tenor.
• Complex agreements to structure.
• Not designed for multiple counterparties.
• Possibility to attain 100% indemnity.
Market Volatility and Risk Mitigation
Risk transfer options (cont’d)
• Receivable Put Market: • More closely related to Credit Insurance than CDS market.
• Not designed for multiple counterparties, strictly one-off transactions.
• Aggressive risk appetite and pricing from key players such as Credit Suisse and Deutsche Bank. This is tied to their
presence in the distressed debt market.
• Long term structures possible (up to 5 years with most common tenors in the 1 to 3 year range).
• 100% indemnity, however, insolvency the only risk covered.
• Much simpler agreements to structure as compared to CDS.
Market Volatility and Risk Mitigation
Structural Issues
• Because CDS and Receivable Puts are overlays on one buyer, portfolio
structures are not possible. As such, these products are usually
considered when Credit Insurance is not viable (for example
transferring GM risk in 2005 / 2006) or when term structures are longer
than one year.
• CDS and Receivable Puts are designed to hedge an existing or potential
position. Credit Insurance is used as a mechanism to leverage existing
positions and increase exposures on counterparties to levels the
company is not comfortable with on their own.
• Credit insurance allows a company to structure a portfolio to meet the
specific needs based on buyer risk, exposure size, concentration,
financing requirements, etc. Basically any portfolio can be designed as
long as the risk presented is not adverse selection.
Market Volatility and Risk Mitigation
Comments on pricing
• Credit Insurance is usually the cheapest form of protection. In
comparison to LCʼs, insurance is generally 30 to 40% their cost.
• While single buyer transactions are becoming much more common in
Credit Insurance, portfolio pricing is generally more competitive. It also
allows the Insurer to be more aggressive in their risk appetite.
• Receivable Puts are more cost effective than a comparable CDS
instrument since most CDS products are laid off in another market.
• CDS pricing is capital market driven and therefore can be subject to
severe volatility (as well as liquidity concerns).
Market Volatility and Risk Mitigation
The Canadian insurance marketInsurer Rating Premium Base
(YE 2006)Comments
AIG AAUSD52.7 billion (total premium for all lines)
• Credit Insurance a small part of their overall
Offers non-cancelable limits
Atradius A €1.8 billion
• With the recent merger with CYC in Spain, they are
the largest in the world
• Flexible in tailoring solutions
• True non-cancelable policy structure
Coface AA- €975 million
• Newest participant to CDN market
• Lacking service presence in Canada
Aggressive pricing
EDCAAA(backed by the sovereign)
CDN90 million
• Sovereign rating provides policyholders preferred
lending margins
• Strong risk appetite
Euler AA- €1.7 billion• Largest number of “in country” risk experts
• Strong service presence in Canada
Market Volatility and Risk Mitigation
The product - overview
• Credit Insurance is designed to protect the seller from non-payment of its buyer.
• Can be triggered by either the Insolvency of your buyer or Protracted Default due
to cash flow problems.
• Other risks covered include repudiation or the buyers non-acceptance of goods,
and political risks.
• The premise of cover is that the Insurer can step into your shoes once a claim is
paid. As such, the underlying contract must be enforceable.
• Premiums are based on the policyholders usage, either through assessing a rate
per dollar of sales, or basis points for credit exposure allocated.
• Most policies today are losses attaching – meaning the coverage is based on a
policy being in force when goods are shipped, not when the loss actually occurs.
Market Volatility and Risk Mitigation
The product - pricing structure
• Portfolio / single buyer approach:
• In most instances the Insurer requires a spread of risk through a portfolio of buyers. The premise is they
require is a reasonable spread of risk – taking the “good” with the “bad”.
• They will consider a single buyer portfolio as long as the risk is reasonable. This is most often used when the
exposure on a buyer exceeds defined levels of acceptance within the capital structure.
• Aggressive pricing today:
• Pricing reflects the risk premium required to hold exposures on the basket of buyers – similar to pricing debt
instruments.
• Can tailor risk sharing proportions (through co-insurance and/or deductibles) to maximize the value of
premium dollars spent.
• Despite the recent turmoil in capital markets, Insurers remain aggressive in pricing. This is largely due to the
fact they are very familiar with this kind of volatility and do not over-react to a “crisis” environment. They are
not totally reliant upon the capital markets for pricing structures, rather they use them as a guide since the
time line is much longer than with other credit instruments.
Market Volatility and Risk Mitigation
Comments on non-cancelable limits
• Whenever a non-cancelable policy is issued, the basic premise is that the credit is of sufficient
quality that the Insurer can take a longer term outlook on the capacity provided. It offers the
Insured greater protection that the Insurer will not withdraw cover due to a risk deterioration.
In other words, the Insurer cannot change the conditions of cover to rebalance their own risk
profile.
• It does not relieve the Insured from all obligations related to credit risk management. The
Insured must continue to act in a prudent manner as it relates to risk assessment, most
importantly in the event of a loss.
• This is not to say that the limit will be continued irrespective of the credit risk. If there is
specific knowledge of imminent failure, cover is halted going forward (it has no effect
retroactively on shipments already made).
• Insolvency and protracted default are covered risks. However, in the energy sector, protracted
default is akin to insolvency due to the realities of a delay in payment.