Proxy for Capital

Capital for Proxy

How publicly-traded companies can use insurance as a means to beat a coming recession

Your company has a problem. The United States is facing a credit crunch, which means debt may become very costly or virtually unavailable. Or it could be worse: a recession might be unfolding, potentially inflicting collateral damage globally, in which case you can be fairly sure your company and its customers will also be affected. Dealing with a recession of uncertain depth and breadth can be a risk management exercise par excellence. To help buffer its effects, your CFO is thinking of ways to cut costs without imperiling productivity or losing customers or market share.

There are many ways to address these issues. However, in a moment of inspired thinking, you suggest your CFO consider a risk management strategy designed to save money through the purchase of insurance. Assuming the CFO doesn’t scoff outright, there might be an opportunity to explain how insurance can be a much more fungible instrument than many realize — it can take on a different form. In this instance, you’ll get to explain how it can be a proxy for capital.

Typically, business leaders only regard insurance as a line-item expense — and perhaps an expensive one at that. Moreover, many would avoid purchasing insurance if lending institutions didn’t require it. In this regard, insurance has traditionally been used as a means to help access capital. Bankers and other lenders will generally only provide capital if what’s

being purchased is insured, such as machinery or property against typical hazard risks. Insurance in such cases is just considered part of the cost of doing business.

However insurance can also become a form of capital itself. Progressive thinkers have come to see how insurance has a value that goes beyond covering a loss or for meeting a bank’s requirements for a loan. But how does that work? It starts with looking at your company’s debt, equity and risk capital.

DAS CAPITAL 101

All organizations need capital to operate. They need operational capital to meet day-to-day expenses, and risk capital as a buffer to protect against unusual losses or expenses. Publicly-traded companies also need signalling capital to “signal” to investors and analysts that the company is a well-positioned going concern, and that it can capitalize things like investments in new operations, new products, or possibly the acquisition of other companies.

Most public companies are capitalized on the basis of both debt and equity. In some cases, the debt to equity ratio may be 50/50 — capital that is 50% debt and 50% shareholders’ equity. In other cases, the ratio may be 80/20, with only 20% of capital coming from equity.

Both debt and equity cost companies money. Debt usually carries a fixed interest rate that today could be between 4-6%. Equity, however, comes at a higher cost than debt because shareholders require some risk premium above the “limited” risk rate. So, equity may carry a cost of between 8% and12%. When the interest rates are combined, depending on the debt-to-equity split, the cost of capital for the firm may be between 5% and10%. For example, if a company has a total of $100 million in combined debt and equity capital at a cost of 5%, it would cost that company $5 million — minimum — per year for the cost of that capital.

ROLE OF INSURANCE

So how does insurance play into this? Many publicly-traded companies do not buy insurance for every eventuality. For instance, if insurance is not purchased for hazard-type risks such as fire, lawsuits, auto accidents, etc., then a certain amount of capital would need to be set aside for these events should they occur. That capital has a cost. Now, if an insurance policy can reduce the amount of capital required to be set aside, then it may be possible to reduce the overall cost of capital.

For instance, take the example above, in which a company has a $100-million capital requirement and a capital cost of 5% (or $5 million). The risk and signalling capital requirement could be reduced by the purchase of insurance if the premium for the insurance is lower than the cost of the capital it replaces. If a $50-million liability insurance policy, at a cost of $200,000, reduces the company’s capital requirement from $100 million to $80 million (5% of $80 million = $4 million), the company would save $1 million in capital costs by spending $200,000 on insurance. [See Figure 1.] A wise CFO would thereby reduce the company’s annual capital costs by $800,000 simply by accessing insurance capital rather than debt or equity capital. All of a sudden, insurance has become something more than it is traditionally believed to be, and in such a scenario makes excellent sense.

In effect, the company saves money while it receives non-recourse financing, which is the insurance to cover against whatever losses the policy is intended to cover.

Although the exact amount of capital offset by an insurance policy is not known, one can determine the minimum amount of capital reduction and calculate the savings on that basis. If it is a positive number, then insurance, regardless of whether a loss ever occurs, has been a good investment.

The capital and insurance needs of companies can differ enormously. Based on what your company’s capital and insurance needs are, it’s worthwhile looking at what can be done to maximize savings on capital costs. Understanding how insurance can become something else — a proxy for capital — can make a significant difference to buffering the effects of a credit crunch or a recession.

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Without insurance: Capital required: $100 million Capital cost: $5 million (at 5 % interest)

With insurance: Cost of insurance: $200,000 ($50-million liability policy) Capital required: $80 million Capital cost: $4 million (at 5% interest) Savings: $800,000 (Derived from subtracting the capital

cost with insurance from the

capital cost without insurance, subtracted by the cost of the insurance premium)