Industry the July/August 2023 issue

Are Your Clients Thirsty for Liquidity?

There’s a way to keep letters of credit for high-deductible and self-insured accounts off clients’ balance sheets.
By Chris Larson Posted on July 18, 2023

The company had a high-deductible workers compensation policy, backed by $20 million worth of collateral via a letter of credit provided by two banks it had credit facilities with. The policy was up for renewal on Jan. 1.

The letter of credit was treated as drawn capital, as is typical. That meant the company was unable to use $20 million of its credit. But at this moment, it had a bigger issue to deal with: one of the banks behind the letter of credit was Credit Suisse.

The Swiss bank had been struggling through financial losses, scandals and regulatory challenges. In the middle of December, the hospitality company’s insurer informed its broker, Hub International, that because of Credit Suisse’s problems the insurer would no longer accept that letter of credit. It would need to be replaced within 30 days of renewal.

Brokers in Hub’s complex risk practice suggested the client turn to a company called 1970 Group. The company, launched in 2020 by a group of insurance and financial services veterans, had pioneered a way to provide letters of credit that are backed by investors and kept off of companies’ balance sheets, freeing up their liquidity.

1970 Group, launched in 2020, provides letters of credit that are backed by investors and don’t affect a company’s balance sheet.

Insurance Collateral Funding has gotten interest from clients looking to release liquidity tied up by existing letters of credit.

The liquidity problem is especially acute for companies that move into higher-deductible insurance programs.

The company agreed and got its insurer an acceptable letter of credit after a quick process. “1970 Group commenced the underwriting process in late December,” says Hub’s complex risk practice leader, Mary-Beth Hahn. “The replacement security was posted in early February.”

The client, she adds, “was very happy with the result.” The insurer, of course, had good reason to question Credit Suisse’s financial stability: the faltering bank finally collapsed in March.

1970 Group is finding traction for its product, which it calls Insurance Collateral Funding (ICF), from companies worried about their bank’s solvency and, even more so, from those that want to free the liquidity that is tied up by their existing letters of credit. As brokers learn about the product, they’re increasingly offering it as a possible solution to their clients—or using it to get in front of a prospect.

“It’s a tremendously helpful solution,” says Lee Newmark, senior director for healthcare at Gallagher.

What’s the Problem?

Some companies choose to move away from guaranteed cost insurance programs and instead enter high-deductible, loss-sensitive programs for their workers comp, general liability or commercial auto policies. Doing so lowers their premium costs, but most insurers will require collateral for the policy. And there aren’t a lot of ways to put up that collateral.

“Really, every company that’s in a loss-sensitive program is faced with two choices,” says Stephen Roseman, chairman and CEO of 1970 Group. In some cases, they can put cash in trust for the carrier’s benefit, although doing so is “a horrible use of the balance sheet,” Roseman says, and not all insurers will accept that. “Or they can do what most companies do: they ask their bank for a letter of credit.”

Getting that letter isn’t usually an issue. It’s typically backed by the existing credit facility that a company has with its bank, which it uses for its everyday operations. But the problem—and it’s a big one—is that, because that credit facility sits on the company’s balance sheet, the letter of credit is treated as drawn capital. In other words, it reduces the amount of credit the company has available to it by the value of the letter of credit.

While the exact amount will differ based on specific circumstances, it can mean a huge amount of a company’s overall credit, its liquidity, is tied up by the letter of credit. When that happens, the company loses access to potentially millions of dollars—or more—that it can no longer use to grow and run its business.

“We’ve seen companies where as much as 70% of their liquidity has been encumbered by letters of credit,” Roseman says. “That’s a death blow. That can be like having a boot on your neck. It’s not good.”

Brokers say they are increasingly hearing from their clients about this kind of situation.

“We definitely see that having liquidity tied up through a letter of credit is something that, for lack of a better term, has irked our clients,” Hahn says. “They want to use their letters of credit for business improvements, for real estate, for buying a new fleet. When that line of credit is instead used up by insurance, that’s highly annoying to them.”

The liquidity problem is becoming especially acute in sectors like healthcare, as companies grow through acquisition or are acquired by private equity firms and move into higher-deductible insurance programs in part to save costs.

“About seven years ago, we didn’t have more than 10% of our book that had any sort of reason for collateral,” says Newmark, who focuses on healthcare. Since then, he says, that need has grown substantially among both clients and prospects.

James Noteman, senior vice president at Thompson Flanagan, an NFP subsidiary, says he and his team have been “getting more and more requests” to talk about liquidity needs over the past six to 12 months. “And then they ask, ‘Are there alternative methods in lieu of a letter of credit that ties up our liquidity?’”

Some brokers and sponsors have tried to develop alternative methods in recent years, but none have taken hold.

“It’s a problem that companies have struggled with for decades,” Roseman says. “We’re not new to identifying this problem. We’re new to creating a solution that works and that is scalable and could be commercially adopted.”

How It Works

1970 Group acts as a coordinator among the various parties in the transaction—the company that needs the letter of credit, its broker, the insurer that is asking for the letter, the bank that will issue it, and the investors who provide the capital to back the letter.

When a company signs up for ICF, 1970 Group will identify a bank to issue the letter; it can work with any of the 200-plus banks on the NAIC-approved list. “We have pretty robust processes internally, and our relationships with the banks are such that we actually even handle KYC [know-your-client] and AML [anti-money-laundering] for most of our bank partners,” Roseman says. “So we make it very easy for the banks to want to do business with us. And the banks also like it because, for them, it’s incremental business.”

1970 Group oversees the due diligence on the company’s finances, a process that typically takes two to three weeks. It’s thorough but not unusually so. “I wouldn’t call it a heavy lift, but there’s a bit of work involved,” Noteman says. “They want financials and loss runs and revenues. … It’s almost like a secondary program evaluation.”

Once the due diligence is finished and the bank is on board, 1970 Group takes money from institutional investors—pension funds, endowments, sovereign wealth funds, private equity and private debt funds—and, on behalf of its client, deposits that money at the bank. The bank issues the letter of credit, which, unlike the previous one, is never on the client’s balance sheet. The client can then cancel the old letter, getting back its liquidity. The whole process usually takes 30 to 45 days.

1970 Group charges an annual financing fee based on the company’s credit profile. Roseman says the fee is competitive with the cost of senior debt.

The company targets clients in the United States and Canada with $100 million or more in annual revenue that take out insurance policies in workers comp, general liability or commercial auto. The energy, healthcare, transportation and logistics sectors have used this solution, which could work across all sectors.

The bulk of 1970 Group’s business, about 85%, comes from private-equity owned companies, according to Roseman. Such companies can be particularly interested in 1970 Group’s product.

“Most of these companies employ leverage because that’s how the sponsor bought the company—with debt,” he says. “So they are already starting with a levered balance sheet, which means liquidity is especially dear to them.”

We’ve seen companies where as much as 70% of their liquidity has been encumbered by letters of credit. That’s a death blow. That can be like having a boot on your neck.
Stephen Roseman, chairman and CEO, 1970 Group

What It Means for Brokers

When it comes to introducing the solution to the companies that need it, brokers are “an important channel partner for us,” Roseman says. The company works with all of the top-20 brokerages in the United States and the majority of the top-50 brokerages, he says.

Brokers that have used the product praise it. “It’s a really good solution,” Newmark says. “For a client that needs the liquidity, it makes a lot of sense to be able to relieve that off of their balance sheet. It solves a big problem.”

It’s also a good prospecting tool. “You do not have to be the broker to bring this to a client,” Hub’s Hahn says. “So we have used this in trying to gain new business. It’s good to get creative ideas and solutions in front of our prospects.”

For Gallagher, the product has been “a really good talking point and a good wedge,” Newmark says. “I’m using it in conversations I’m having with large healthcare organizations that I know have programs where they have to put up collateral.” He has also discussed it with a range of private equity firms.

The product’s relatively young age in the market is a benefit to brokers who know about it. “Nine times out of 10, if I bring it up to a prospect, they haven’t heard of it yet. Which is great for me,” Newmark says. “That will change; it’s definitely gaining traction. But for now, we’re absolutely using it as a wedge.”

Noteman says he likes to talk about the product to existing clients as well, using it as a “differentiator.” That’s crucial, he says, because, “as a broker, you’re always fighting to retain your business.”

“Part of our job is not only to understand the marketplace and where rates are going and the like—we also have to make sure we know what’s going on in the industry that can help our clients,” Noteman says. “So we have used this to say to a client, ‘Hey, we’re out there finding new solutions that we think can benefit you and your business. Here’s one of them.’”

He’s also talked about the product with private equity firms. “We’ve gone with this to firms to say, ‘We know that collateral is a real pain point for you and that it affects the way that you manage your portfolio companies,’” Noteman says. Being able to have
such conversations, he adds, “helps us with private equity firms to show them that we’re learning about new solutions and learning about ways to help their businesses.”

1970 Group knows that brokers are crucial for expanding the reach of its product and generating more sales, and the company spends a lot of time with brokers, educating them about the product and the concepts behind it. “With a lot of brokers,” Roseman notes, “they’re experts at speaking about risk, but they’re not necessarily experts at speaking about finance.”

Those efforts, he says, are paying dividends as the ICF becomes better known.

“Three years ago,” Roseman says, “a broker was taking a risk in introducing us to their client, because we were new.” Brokers would understandably be cautious about introducing a new company with a brand-new solution, he points out. “Fast-forward to today, and a broker is taking a risk if they don’t introduce us, because if they don’t introduce us to their client, their competition will.”

Companies have few options for meeting their insurer’s demands for collateral. And as far as getting a letter of credit that’s off the balance sheet, Hahn says, “I’m not aware of any other full solutions that are out there.”

If a company has to provide security to its insurance company, “They could revert back to some type of first-dollar program,” Newmark says. “But then they don’t get the trade-off and benefits of taking on that risk. There are other things you can do, like put a trust together. But that still requires money and still requires some type of security.”

Rising Interest as Rates Rise

The growing interest in liquidity solutions can be traced, at least in part, to rising interest rates. Banks teetering or even failing could also drive companies to seek a solution like 1970 Group’s, especially if they have a letter of credit through one of those banks, as happened to the Hub client with a Credit Suisse letter of credit.

“Our solution serves companies in all interest rate environments and becomes particularly attractive in this higher-rate backdrop,” Roseman says. “Certainly we don’t root for distress or recession. That’s not good for anybody. But that environment does keep us busier.”

Higher interest rates mean the cost of capital goes up: it costs more to borrow, and service on existing debt could rise too. Higher rates might also lead to lower revenue for some companies, forcing them to look to free up some cash that’s now constrained by a letter of credit.

Rising rates can be especially painful for private-equity owned companies that are highly leveraged. Cash is crucial for such companies, and they need to keep a close watch on their debt ratio.

While all this is bringing more attention to 1970 Group, brokers say it’s not for everyone. If a company doesn’t have liquidity needs—if it doesn’t have major expansion plans, for instance, or if its cash on hand is simply more than adequate—it will probably find it more economical to stick with its bank letter of credit and avoid the annual financing fees the product carries.

“For a client that doesn’t need the liquidity, this isn’t really a solution for them,” Newmark says. “If you’re just looking to relieve that balance sheet pressure and do nothing else with it, then it’s not a good product.”

The fee has to be considered as an alternative to having millions of dollars tied up in a letter of credit. “That annual fee is a lot more attractive to some CFOs than putting $2 million or $4 million or whatever into a letter of credit,” Noteman says.

In short, brokers say, if a company needs liquidity, the product is likely worth it. “As a way to get those millions of dollars back on the balance sheet, to be able to reinvest that money, it’s been good,” Newmark says.

“As we’re coming up for discussions about what’s happening for renewals for collateral alternatives, we’re able to say, ‘Rates are going up. Banks had some issues,’” Hahn says. “So you want to make sure you’re investigating all of your options.”

Chris Larson contributing writer, Leader's Edge Read More

More in Industry

Another Battle in the War on Non-compete Clauses
Industry Another Battle in the War on Non-compete Clauses
The Federal Trade Commission overstepped its authority with a new rule.
Industry Unifying Voices: Empowering Diversity in Insurance
Five organizations united in April for an extraordinary event to move DEI forwar...
Happy 20th, Leader’s Edge!
Industry Happy 20th, Leader’s Edge!
Here are a few thoughts from the founder on this platinum anniversary.
Louisiana Prioritizes Insurance Reform
Industry Louisiana Prioritizes Insurance Reform
We are taking insurance reform very seriously to address deep-rooted, fundamenta...
Strengthening Crop Insurance
Industry Strengthening Crop Insurance
Eight Republican senators have introduced legislation to hel...
The Leaders We Need, Today and Tomorrow
Industry The Leaders We Need, Today and Tomorrow
The Council is joining with She Should Run to help empower w...