Letters of Credit (LOCs): The Basics

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September 26, 2023 |

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Letters of credit (LOCs) are utilized in a variety of risk management transactions and are the most frequently used type of collateral. An LOC is a legal commitment issued by a bank stating that, upon receipt of certain documents, the bank will pay against drafts meeting the terms of the LOC. The bank issuing an LOC assumes responsibility for paying drafts drawn under the LOC when accompanied by a document stating that an event has occurred, such as nonpayment of a premium due under a retrospectively rated insurance program. Thus, the bank, for a fee, extends its financial backing to the insured, for which it normally provides other banking services, guaranteeing that a potential debt (i.e., premium or loss reimbursement to an insurer) will be paid.

Under an LOC for risk financing purposes, the bank agrees to pay the insurer (in the event that the insured cannot meet its obligations) and in turn would become a creditor of the insured and look to the insured for reimbursement.

Uses of LOCs for Risk Financing

Some of the types of risk financing programs collateralized with LOCs are noted as follows.

Collateralization Uses of LOCs

  • Incurred-but-not-paid losses in paid loss retrospective rating programs
  • Satisfaction of captive insurance capitalization requirements
  • Securing obligations under self-insured workers compensation programs
  • Satisfaction of the collateral requirements under large deductible programs
  • As a fronting company asset for statutory accounting purposes

Operation of LOCs

An LOC transaction involves three parties—the issuer (a bank), the issuer's customer (the insured), and the beneficiary (the insurer)—and three separate contracts. These contracts are illustrated below.

Contracts Related to LOCs

LOCs require contracts between the following.

  1. The insured and the insurer, under which the insured agrees to pay premiums and losses as required by the loss sensitive program
  2. The insured and a bank, under which the insured requests the bank to issue an LOC in favor of the insurer and agrees to reimburse the bank for payments made to the insurer
  3. The bank and the insurer (the actual LOC) in which the bank agrees to honor drafts drawn by the insurer (upon compliance with certain conditions)

Operation of an LOC

It should be recognized that an LOC is a demand instrument. Therefore, if the beneficiary (i.e., the insurer) makes the demand, the bank must pay, without investigating whether the claim is justified or not. Consequently, insurers generally prefer LOCs rather than other forms of collateral to secure loss sensitive programs.

Key Features of LOCs

Some important features of LOCs are as follows.

  • Revocability. An LOC may be revocable or irrevocable. Unless otherwise agreed, once an irrevocable LOC is established by the customer (e.g., the insured), it can be modified or revoked only with the consent of the beneficiary (i.e., the insurer).

    In contrast, once a revocable LOC is established, it may be modified or revoked by the issuer (bank) without notice to, or consent from, the customer (insured) or beneficiary (insurer).

    The National Association of Insurance Commissioners established standards in 1980 that require LOCs to be irrevocable. (Such LOCs are sometimes referred to as having "evergreen clauses.") This requirement makes funds immediately available to the insurer simply upon presentation of a sight draft on the issuing bank.

  • Regulatory agency involvement. The increased use of domestic LOCs has generated a response from regulatory agencies. For example, the Federal Deposit Insurance Corporation, the Federal Reserve Bank, and the Comptroller of the Currency regulate issuances of credit by national banks. Each agency has responded to concerns about the dangers of unregulated bank issuances of LOCs by issuing regulations establishing guidelines and requirements. Also, Article V of the Uniform Commercial Code contains the legal rules expressing the fundamental theories underlying LOCs.

Advantages of LOCs to Insureds and Banks

It could be argued that a customer can simply borrow needed money from a bank rather than use LOCs. However, LOCs do have definite advantages. They are as follows.

  • Lower cost than a loan. If the LOC is not drawn upon, an LOC will be less expensive than a loan. The bank's fee for an LOC varies from .25 percent to 4 percent of the amount of the LOC, according to the financial strength of the firm seeking the LOC. More importantly, if the customer borrowed the same amount of money, the amount of the debt would have to be shown on its balance sheet. Thus, an LOC is an effective form of "off balance sheet" financing. (If the amount of the LOC is "material," however, it must be referenced in a footnote in the organization's financial statements.)
  • Working capital efficiency. Some banks that are experienced and knowledgeable about LOCs might prefer to issue one rather than make a loan. Also, if the bank is willing to write LOCs with less than 100 percent collateralization, the customer can obtain more leverage from a given amount of working capital. For a growing and developing company, working capital efficiency may be among the most important goals of the firm.
  • Advantages to banks. LOCs offer advantages to banks as well as to customers. Banks like LOCs because they allow them to earn a fee without giving up cash.

Pitfalls Associated with LOCs

Despite their benefits, LOCs are not without certain drawbacks. They are as follows.

  • Stacked LOCs. Outstanding collateral for multiple loss years can involve sizable dollar amounts and "stacked" LOCs. If LOCs are allowed to stack on top of one another year after year, an insured faces the possibility of a reduction in credit lines.
  • The "Pyramiding LOCs Example" illustrates the growth in collateral requirements for a large-deductible workers compensation program with $3.5 million in annual losses. Subscribers to Risk Financing in Vertafore ReferenceConnect and IRMI Online can find the example at the links below.Using average loss payout factors, the chart shows the cumulative effect of multiple years of outstanding losses on collateral requirements. In this example, after 9 years, a total of over $13 million is required. As a program matures, the incremental change in amounts from year to year decreases, and the overall amount required should stabilize. One exception is when an insured's loss experience is volatile. In that case, an insurer's collateral demands may be disproportionate due to the volatility. Deterioration in an insured's financial condition can also result in disproportionate increases in collateral demands. In addition, switching insurers can result in higher collateral requirements due to the higher demands during the first few years of a program. Subscribers to Risk Financing in Vertafore ReferenceConnect and IRMI Online can find payout factors at the links below.

    Generally, an insurer will require a renewable LOC for each annual period so that adjustments in the outstanding amount become easier to monitor. If the issuing bank were to call the outstanding LOCs, an insured could be pressed with financial difficulties. When LOCs are stacked, greater liquid assets are required, since the total cash outflows under the program increase as a result of multiple loss years under the plan.

  • Another difficulty associated with stacked LOCs is that as their total amount increases, the insurer gains increasing leverage over the insured regarding the amount of collateral required to support the program. This difficulty is compounded if the insured changes insurers because the previous insurer, now lacking a relationship with its previous insured, will be more stringent in setting the required amount of collateral. Accordingly, the amount of collateral (backed by an LOC) and the terms for adjustments should be negotiated prior to initiating a program.

    Subscribers to Risk Financing in Vertafore ReferenceConnect and IRMI Online can find a section on establishing collateral requirements at the links below.

    An insured can employ an actuary to help estimate and negotiate a reasonable level of funding.

  • Reduced borrowing capacity. Another disadvantage of having an outstanding LOC is that it reduces an insured's capacity to assume additional debt. This could create a problem for an organization if business conditions necessitate additional borrowing.
  • Problems for banks. Recent years have witnessed a reduction of the advantages for banks that LOCs once provided. The imposition of risk-based capital requirements now makes banks recognize LOCs on their balance sheets as a liability, thus requiring them to expend capital to support LOCs. Previously, LOCs were not accounted for as liabilities.

This article is based on information in the section on "Collateralization of Risk Financing Plans" of Risk Financing by Steven T. Bird, published by International Risk Management Institute, Inc.

September 26, 2023