Determining the Safe Load of Debt
Underwriters in Chapter 5 have to assess the risk of a loan going into default before it can be admitted into the captive insurance company. This assessment of loss has to be made while the ink is still drying on the loan documents. While the lending officer and the financial officer of the borrowing company are clinking glasses at some swank restaurant celebrating the closing of the loan, underwriters are attempting to gauge how much may be lost in insuring the loan. The banker and the financial officer are celebrating the birth of a loan; the underwriters are contemplating its demise. Undertakers deal with the certainty of death, underwriters deal with the probability of death, and neither gets invited to the birthday party.
The decision to underwrite the risk of default in guaranteeing the principal of a loan should follow the same general process of making the loan to a borrower. The underwriter is in the same boat as the lender. Both lose if a loan gets into trouble. The underwriter must put up funds to guarantee the remaining principal of the loan. The lender may seem on the surface to be made whole because the insurance company has covered the loss. However, the lender will eventually pay for the folly of being involved in the default through the risk premium. The risk premium is determined by the loss record and increases as losses escalate. Insurance shares the losses among those seeking the solace of not having to face a catastrophic loss by shifting the cost of the loss from one individual to many. The loss does not disappear; it is merely redistributed. Neither the lender, the guarantor, nor the originator of the loan can escape the consequences of a loan in default.
Therefore, it does not really matter whose perspective is taken in determining the safe level of debt in the capital structure of a company. Neither the lender, borrower, nor the guarantor is interested in becoming involved with a loan that may destroy a company. No one benefits. The only difference in perspective
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Publication information: Book title: Computer Simulation in Financial Risk Management:A Guide for Business Planners and Strategists. Contributors: Roy L. Nersesian - Author. Publisher: Quorum Books. Place of publication: New York. Publication year: 1991. Page number: 155.