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Getting cash to flow is key to disaster survival.

Getting Cash to Flow Is Key to Disaster Survival

A major property loss poses a threat to any firm's income and to the financing of day-to-day operations. The destruction of a branch plant, for example, may not paralyze the entire corporation, but the company will need time to adjust. Even if the company has a fine-tuned emergency plan, beefing up production in other plants, retooling an outdated plant or speeding up construction of a new one will not happen overnight. If plants are interdependent, the problem is compounded. Finding an alternate supply source for the remaining sites probably will increase production costs. Furthermore, heavy expenditures will be required at the moment income has plummeted. The firm must continue to pay bills, service its debt and meet its payroll obligations.

One way to ease the short-term financing problems associated with such an occurrence is to have a standby line of credit. Indeed, there are benefits to including lines of credit in disaster management programs, not only for very large firms but also for smaller organizations.

An adequate insurance program, which may or may not include business interruption coverage, will not necessarily eliminate cash flow problems. The claims settlement process can be long, as a business interruption claim can only be finalized after the interruption is over. Generally speaking, the settlement process takes as long as the time of actual business interruption. A claim for a six month stoppage will, therefore, only be put to rest a year after the loss.

It is possible that advances under a business interruption policy, or even a property insurance program, are available. However, reasonable evidence of a valid claim needs to be provided to the insurer. This can be time consuming, especially if the cause of the loss is not clear. Discussions as to whether, or to what extent, the loss is covered under a policy could seriously delay advances, thereby cutting off this source of short-term funding.

Since insurance and other financial markets tend to move countercyclically, lines of credit can complement traditional insurance programs. In the early 1980s, interest rates ballooned into the 17 to 19 percent range, while insurance premiums were relatively low and coverage could be obtained easily. Insurers were relying on their investment portfolios to generate healthy profits. The easing recession and decline in interest rates made borrowing cheaper, but it also caused insurers' investment incomes to decrease. This, coupled with increased claims from the previous underwriting excesses, led insurers to withdraw from the market. The supply of insurance coverage dried up as prices soared. Companies, especially those in need of specialty coverages such as earthquake, were obliged to take on greater amounts of self-insurance and hope that a major loss would not occur. Thus, since the cost of borrowing had dropped substantially, a line of credit could have served as a backup for lost insurance.

Assume a firm has a $500 million revolving line of credit as a guarantee for its commercial paper program or other general corporate purposes. The firm has never needed more than $350 million for financing or credit enhancement. In that instance, up to $150 million could be readily allocated for insurance purposes. Therefore, when insurance markets harden, the insurance allocation could be increased by either reducing the amount that would otherwise be drawn or increasing the principal amount of the credit facility. On the flipside, when insurance markets soften, the insurance allocation could once again be reduced, freeing up the facility for other uses. This requires coordination between the company's risk management and treasury departments, to ensure that the insurance allocation is not used for other purposes.

To decide the amount of insurance allocation required under a line of credit and negotiate the right to draw on the line in the event of a disaster, an evaluation of the company's probable maximum loss (PML) should be performed. This analysis should include scenarios for reducing the loss and an action plan for restoring operations in an orderly and expedient manner. It can also be an opportunity to remind senior management and others of the numerous benefits of loss prevention programs and emergency plans.

The right to tap a line of credit in the wake of a disaster involves amendments to the material adverse change clause normally found in credit agreements. This clause usually requires the borrower to make a representation that no event has occurred since a specified date which could adversely affect its financial situation. The date specified is usually that of the latest audited financial statements available at the time of signing the credit agreement. At the date of a drawdown, the borrower must be able to repeat the representation or will not be able to access the credit facility.

The broadest amendment involves dropping the need to repeat the representation at each drawdown. At first glance, it may seem impossible that lenders would agree to this amendment. For a corporation with an excellent financial track record and loss experience, it is not that difficult. Lenders may be impressed with the firm's prudence in seeking prefunding of catastrophic losses. It would be wise for the borrower to emphasize that the line of credit would enhance its insurance program. Lenders should be made aware of the limitations of insurance for providing cash flow immediately following a disaster. In addition, studies of PML and prevention programs can demonstrate that the corporation has taken all possible steps to reduce the probability of a catastrophe. This will provide comfort to the lenders that their risk will be minimal.

However, if a broad amendment to the material adverse change clause is unpalatable, more restrictive modifications are possible. Referring to a particular cause of a disaster, such as an earthquake, or to a specific installation being severely damaged, may be feasible.

Additionally, credit agreements generally require the borrower to warrant that at the time of drawdowns there is no litigation pending which may have a materially adverse effect on the borrower. An exception is made only for litigation disclosed at the time of entering into the credit agreement. A major property loss may, however, harm third parties and lead to liability suits. It is therefore important to amend the litigation clause to make it correspond to the modified material adverse change clause.

Standby fees and utilization costs associated with lines of credit should also be examined. As the current costs for existing lines of credit are already known, only costs associated with amending the credit facility to permit disaster funding need to be explored. The firm's credit standing and competitiveness in the marketplace will likely influence the cost. Some of the markets for syndicated revolving credit facilities have been extremely aggressive in recent years. Renegotiation of the material adverse change and litigation clauses might involve paying an upfront fee with no change in interest rates. Similarly, it may be possible to obtain attractive rates for a new credit facility containing no material adverse change clause.

If lenders insist upon higher utilization costs, the firm should seek a tiered system. This can take the form of paying a higher rate for "disaster" drawdowns. Another possibility is to increase rates after the draw is outstanding for more than a given period following the catastrophe, thereby converting to bridge financing.

Another financial argument which should be addressed is the availability of post-disaster funding. An advantage of postfunding is that the firm will not incur the standby fees of the other costs of prefunding an unlikely disaster. On the other hand, if and when a major catastrophe does occur, the financial markets are likely to be jittery, and they may not be receptive to new borrowing until the firm is on the road to recovery. Thus, short-term postfunding may simply not be available. Moreover, to attract lenders, the company will probably have to offer higher yields, which could wipe out the savings from not paying prefunding standby fees.

Another argument against disaster loans, which insurance brokers point out, is that capital and interest on loans must be repaid while insurance does not have to be reimbursed. However, it should be realized that the credit facility is not intended to be a substitute for insurance, although it could serve as a backup for a self-insurance program. Yet, it is meant to cushion the firm against the volatility of insurance markets and guarantee that money is available before insurance programs step up to provide disaster funding. Furthermore, a line of credit is also useful when an insurer is unable to meet its claims due to financial woes such as insolvency.

Obviously, lines of credit are not attractive to all firms. Other forms of risk financing can meet cash flow requirements and provide ready cash when a disaster strikes. For example, American public entities have been able to use tax-exempt municipal bonds to create self-insurance funds. Also, some corporations may decide to create reserves.

Indeed, lines of credit guarantee timely funding and insulate against future volatility of insurance markets. But regardless of the financing alternative selected, the cash flow problems associated with a catastrophic loss must be addressed. It is not enough to know how much money will be needed to support the loss; it is essential to know when the funds will be needed. The best insurance program is rendered ineffective if the funds are not available the moment they are needed.

Isabel M. Pappe is the manager of risk and insurance for Hydro-Quebec and is also a member of the Quebec Bar.
COPYRIGHT 1989 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1989 Gale, Cengage Learning. All rights reserved.

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Author:Pappe, Isabel M.
Publication:Risk Management
Date:Mar 1, 1989
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