Credit Enhancement

Credit enhancement is a process of reducing the risk of default by requiring additional collateral in a structured transaction. Instruments such as insurance, financial guarantees, derivatives and surety products can be structured and used as collateral for credit enhancement. Credit enhancement enables debt issuers to raise capital and liquidity in a cost-effective and market-efficient manner.

Debts that corporations, municipalities, financial institutions and special purpose entities issue are structured into securities. The securities contain rights to underlying assets that produce measurable cash flow streams. Asset classes and cash flow streams that are securitized range across a broad spectrum, from mainstream to esoteric, including:
 

Montgomery Moore RE has extensive experience working across this broad spectrum of asset classes. The types of credit enhancement instruments that Montgomery structures to help clients manage or transfer default risk are comparatively broad. Examples of credit enhancement instruments include:

• Financial Guarantee
  A financial guarantee provides assurance that if the issuer of a debt instrument cannot fulfill its obligations to make scheduled principal or interest payments, the financial guarantor will step in and make full and timely payments on its behalf. The financial strength of the guarantor enhances the credit quality of the debt instrument by virtue of its obligations to assume the default risk as defined in the financial guarantee.
  
  In the U.S., a number of state insurance regulators restrict multi-line property/casualty insurance companies from writing financial guarantees and only permit monoline bond insurers to write this coverage. Monoline insurance companies have a restrictive and limited risk appetite due to their finite amount of capital and surplus and their need to maintain long-term, strong, investment-grade ratings.  Monoline insurers provide financial guarantees to such debt instruments as:
  
   

  • Municipal bonds and loans

  • Asset-backed securities collateralized by consumer and corporate receivables

  • Collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs)

  • Commercial mortgage-backed securities (CMBS)

  • International public-sector project financing

  • Credit default swaps

Montgomery Moore RE  packages credit default risks through tranching and transfers these risks synthetically to financial guarantee insurers for efficient execution.

• Insurance & Reinsurance
  In the U.S., insurance regulators in a number of states restrict multi-line property/casualty insurance companies from writing financial guarantees. These regulations were implemented in the 1980s to limit the potential for insurance company insolvencies posed by the combination of large losses in both fidelity and financial guarantee underwriting lines. As a result, multi-line insurance companies in the U.S. that underwrite default risk must use alternative instruments to financial guarantees in order to comply with certain state insurance regulators.
  
  A number of large, international, multi-line insurance and reinsurance companies have underwriting units that are staffed with the necessary underwriting, actuarial, finance, investment and legal resources to properly underwrite default risk. These multi-line insurance companies have made the necessary long-term commitment to be in the structured finance and credit enhancement business. Many of these multi-line insurance and reinsurance companies have greater levels of capital and surplus than the monoline bond insurers. This large capital and surplus base allows them to entertain a broader risk appetite for underwriting default risks than the monoline bond insurers. 
  
  Montgomery Moore RE  structures customized credit enhancement products using multi-line insurance and reinsurance companies that underwrite default risk. When undertaking this process, Montgomery Moore RE works with the client, the multi-line insurer, rating agencies and investors to ensure that the insurance instrument meets the needs of all parties to the transaction as well as state insurance regulators.
  
   

• Derivatives & Swaps
  A derivative is a financial instrument that transfers credit and default risks between counter-parties for a fee or premium, similar to insurance. Derivative products can be structured in various forms, such as credit default swaps and total return swaps. Derivatives and swaps are contracts routinely executed by and between financial institutions and insurance companies for purposes of transferring credit and default risks.
  
  Montgomery Moore RE  utilizes derivatives and swaps as credit enhancement alternatives to financial guarantees. In many cases an insurance company can more efficiently execute a transaction by using a derivative or swap because those instruments are not subject to the sort of insurance regulations that interfere with writing financial guarantees.
  
   

• Credit Insurance
  Credit insurance is an insurance product that provides protection against the risk of non-payment of goods and services supplied on credit terms (trade receivables). Companies typically use credit insurance to minimize the impact of bad debt on their balance sheet.
  
  Credit insurance can also be used as a form of credit enhancement in an asset-backed security when the underlying assets are trade receivables. The default risk of the trade receivable is transferred from the issuer to the credit insurer according to the terms of the credit insurance policy. By transferring the default risk to an investment grade insurance company, the underlying credit quality of the asset is enhanced. The tenure of a credit insurance policy typically does not exceed one year; therefore, credit insurance is best used in short-term financing vehicles such as commercial-paper conduits.
  
  Montgomery Moore RE  works with owners and financiers of trade receivables on structuring credit insurance as a form of credit enhancement in a structured finance transaction