If your company has financial obligations, such as payments to an insurance company, you can obtain a letter of credit, which essentially states your intention to pay the debt.
But while the lure of using LOCs can be tempting, the advantages they bring do not come without risk.
Daniel R. Slezak, vice president with ECBM Insurance Brokers and Consultants, says using LOCs will reduce a company’s borrowing capacity with its bank, which can leave business owners with their hands tied if an opportunity for growth comes along.
“If your business has shown a need to borrow money as a catalyst for growth, a large LOC amount may be limiting your capacity to do just that,” Slezak says.
Smart Business spoke with Slezak about how LOCs can strangle your growth and what alternatives businesses should consider.
What is a letter of credit, and why would a company need or want to use one?
A letter of credit is a legal commitment issued by a bank that states the bank will pay monies on behalf of its customer to the holder in this case an insurance company upon demand. You would use an LOC to secure your obligations to the insurance company, which has required you to post collateral to insure future payment obligations.
LOCs are also sometimes used as a protection tool when doing business internationally. Companies can receive a letter of credit to ensure they will get paid for what they are selling before they release it to the buyer. Or they can issue a letter of credit to ensure that they get what they are expecting to get before they pay for it.
What are the pros and cons of using letters of credit?
The first advantage is that the rate to post the LOC is lower than the rate the company would have to pay to borrow money to fulfill its obligation.
The second advantage is that the LOC is an ‘off balance sheet’ form of financing. That makes it different than a direct loan, which would have to be shown as debt on the company’s balance sheet.
There are also disadvantages that need to be considered. Using LOCs does reduce a company’s borrowing capacity with its bank. Also, the cost of LOCs has skyrocketed for even the best, most creditworthy customers. Banks now have to expend capital to support LOCs because of risk-based requirements that have been imposed on them. The bank will meet those requirements and support your LOC, but for a fee.
How can LOCs in your insurance program strangle your growth?
An LOC is designed to cover obligations that extend for many years. That means that as you continually stack consecutive years of those obligations, the LOC amount increases, as well. Normally, the amount of credit needed levels off in about five years.
If you are the owner or executive of a business for which the conditions show a need to borrow money as a catalyst for growth, the LOC amount may be limiting your capacity to do so.
If the LOC needs approximately five years to level off, what happens each year to determine the need?
Each year of obligation stacks another year of an LOC need. During the year, a business is paying losses that reduce the need of the previous year(s).
While a new year starts with a full year’s exposure, the older years(s) have diminished by the payments made contractually. An insured business needs to have its broker do an analysis of the claim paid and incurred to determine the future need. A loss triangle would reflect the specific financial exposure of that business.
Finding the results is a very complex process.
How can companies determine whether they should be using LOCs, and what alternatives are available?
Every business needs to measure its own specific needs. To secure your obligations to the insurance company, you generally have the option (if the insurance carrier allows for it) of using an LOC, cash held by the carrier, or a bond or a third-party collateral trust.
Trust programs are becoming more relevant to businesses as an option. The trust account can allow you to deposit cash/securities to a third party, and you would retain the investment control and the growth of the funds held to your benefit. It is generally accepted that monies held in this fashion to secure your obligations need to be stated as ‘restricted cash’ in your financials.
You may also be able to get your auditors to agree that it is not restricted if certain documentation is afforded.
What advice would you give to companies considering using LOCs?
When you consider the rising costs of LOCs and the possible impediment on your balance sheet for borrowing purposes, consider looking at a properly drafted trust as an alternative.
One last note to considered is that your documents with the insurance company should be written in such a fashion that would allow a business the options to choose the above collateral methods and allow the specific measurement of losses be accounted for to minimize future financial exposure to the business.
Daniel R. Slezak is a vice president with ECBM Insurance Brokers and Consultants. Reach him at firstname.lastname@example.org or (610) 668-7100.