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A Real Wizard's Lesson on Long-Term Contracts

long-term-contracts-6Steve is in his 60’s and stands more than 6’5”. He has white, wild hair, but is bald on top. His voice is deep and booming as he leans back in his chair and gestures with huge hands high above his head. His white mustache dances as he laughs. His wink lets you know he is glad to share his knowledge.

I often described him as a wizard. 

Many consider him a pure genius for his ability to create unique financially structured, offshore reinsurance programs. I was a benefactor of this intelligent man with the things he taught me while I worked with him for three years.

Among his many lessons was one about contracts, most specifically the lack of value in using long-term contracts.

The lesson came in the late 1990’s as the life insurance industry was running short of capital to post as reserves for trillions of risk that had been written in the advance of Guideline XXX. The new guideline required insurers to post more reserves for term life insurance, which had become very inexpensive due to the belief that we were all going to live longer. Solutions to this need for capital were hard to find. Reinsurers often set up operations offshore, where laws are different regarding the need to post massive reserves.

One solution offered offshore was to secure a letter of credit for the amount of the needed reserve. A letter of credit is a document issued by a financial institution assuring payment to a seller of life insurance. Should the need arise (claims), the financial institution would provide capital that would have been posted as reserves. Because the actual money didn’t sit in one single account as reserves, it could be leveraged for multiple carriers with the belief that not all the insurers would need the money at the same time. The direct writing insurer pays for the letter of credit, and the cost is a mere fraction of the amount that would have been posted as reserves. Offshore companies were competing for the business with increasingly longer contracts. Finally, one company offered a 20-year contract!

Upon hearing this, I asked Steve if it was a good idea for us to sign this low-cost, long-term contract. His immediate answer was no! “But,” I replied, “it’s the lowest rate, and we can lock it in for 20 years.”

“Dave,” he said, “how often does the industry come up with a new way of meeting the need for capital?” He answered his own question with, “Almost immediately. It’s pretty-much continuous.”

The lesson was that if we had signed the 20-year contract and a better, more efficient, and less expensive way of meeting the demand for capital came out next year, we would regret signing the contract and get “stuck” with an inferior product for another 19 years. History proved Steve right, and it would have been a bad deal for us.

He went on to add that long-term contracts rarely have value for the person or entity that buys the contract. New government regulations can cause a long-term contract that initially seemed advantageous to the buyer to sour overnight. Personnel changes, new market strategies, the development of new technology, a competitor’s new product, and a host of other reasons can negatively impact long-term contracts. While a lot of work goes into writing them, very little thought or work is given to how to unwind or terminate the contract due to these many unforeseen reasons.

Once a long-term contract is in place, what might happen to the quality of service from the provider? What happens if the salesperson retires, and the next salesperson is incompetent? Mergers and acquisitions can be stopped in their tracks when long-term contracts with ambiguous language are found during due diligence. In case of the provider becoming involved in a merger or acquisition, what happens to the long-term promise made to you?

Yes, the long-term contract may offer more incentives today, it may promise more to you because there’s a guarantee you won’t leave within the next year, which keeps acquisition costs lower for the provider. There are those who flip from vendor to vendor like grandma flipping pancakes on a cold January morning. But, after some time, those “flippers” get exposed, and they don’t get competitive offers to ensure the provider is recovering its expenses over a shorter period of time.

How to Not Get Suckered

The financial services industry continues to see new innovations, next-generation products and services. A truly good provider—a good partner—is one who stands behind their product and service and gives you the opportunity to fire them at any moment if they don’t deliver their promise. That’s true incentive to perform! And, that’s best for those who depend on you for the latest, most innovative, thought-out, and best-priced products and services. Ultimately, that need to perform ensures the provider delivers on its promises so you keep them longer. Those providers are most often the ones who are on the forefront of development because they understand the business better than their competition.

We don’t control the world around us, and it continuously presents risk to all of us. Writing shorter contracts ensures you are better prepared for whatever might happen. Steve called it “strategic agility.” 20 years after learning the lesson, I call it common sense.

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