Credit insurance, Basel III and COVID-19

May 2020 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

May 2020 Issue

The use of credit insurance has exploded in recent years.

Credit insurance is used by suppliers and manufacturers for cashflow management purposes in the same way that factoring is used. Whereas factoring is typically limited to domestic transactions, credit insurance evolved through government backed export import credit agencies to support international trade. As supply chain lending and invoice financing have expanded with the rapid increase in international trade, financial institutions now comprise a significant proportion of the buyers of credit insurance, and mainstream insurance companies and the Lloyd’s market have joined the export credit agencies in providing capacity.

There are two main drivers for the uptake of credit insurance by financial institutions: balance sheet protection and regulatory capital relief. Regulatory capital relief, which has the result that they need to allocate less capital against the risk of counterparty default, enables financial institutions to offer lower rates which keeps them competitive. It can also increase the amount that they can lend as their counterparty exposures are diversified. Financial institutions are starting to use the product in secured lending situations for the same reasons.

Regulatory framework

Basel III is the source of prudential regulation for banks in all major jurisdictions. Basel III permits banks to claim capital relief by probability of default (PD) substitution, meaning that the protected portion of an exposure is assigned the risk weight of the protection provider. The uncovered portion of the exposure is assigned the risk weight of the underlying counterparty. However, a bank can only do this where the protection providers, and the credit risk mitigation instrument, meet certain prescriptive criteria.

The following are the requirements for the ‘standardised approach’. First, the protection provider must be an ‘eligible protection provider’, which means banks and corporate entities that are externally rated. Second, the credit risk mitigation (CRM) technique must be an eligible CRM technique. This includes guarantees. Credit insurance performs legally and economically as if it were a traditional guarantee and is generally accepted as being a guarantee for this purpose. Third, all documentation must be binding on all parties and legally enforceable in all relevant jurisdictions. Banks must have conducted sufficient legal review to verify this and have a well-founded legal basis to reach this conclusion and undertake such further reviews as necessary to ensure continuing enforceability.

A guarantee must satisfy the following requirements. First, the guarantee must be direct, explicit, irrevocable and unconditional. Second, it must represent a direct claim on the protection provider and explicitly reference a specific exposure or a pool of exposures, so that the extent of cover is clearly defined and incontrovertible. Third, the guarantee must be irrevocable, except for non-payment by a protection purchaser of money due. It is important to note that the irrevocability condition does not require that the credit protection and the exposure be maturity matched, rather that the maturity agreed ex ante may not be reduced ex post by the protection provider. Fourth, the guarantee must not contain any clause that would allow the protection provider to unilaterally cancel the credit cover or that would increase the effective cost of cover as a result of deteriorating credit quality in the protected exposure. Fifth, the guarantee must be unconditional – there should be no clause outside the direct control of the bank that could prevent the protection provider from being obliged to pay out in a timely manner in the event that the original counterparty fails to make the payment due. Sixth, on the qualifying non-payment by the counterparty, in a timely manner, the bank may pursue the guarantor for any monies outstanding under the documentation governing the transaction. Seventh, the bank must have the right to receive any such payments without first having to take legal actions in order to pursue the counterparty for payment. Eighth, the guarantee must be an explicitly documented obligation assumed by the guarantor. Ninth, the guarantee covers all types of payments the underlying obligor is expected to make. Where a guarantee covers payment of principal only, interests and other uncovered payments should be treated as an unprotected amount. Finally, supervisors must be satisfied that banks fulfil certain minimum operational conditions relating to risk management processes.

The advanced internal ratings-based (IRB) approach allows banks to use any entity as a guarantor, provided the bank has clearly specified criteria for the types of guarantors it will recognise.

All these criteria must be strictly complied with for a bank to claim the desired capital relief. Banks should have robust internal processes and procedures to ensure compliance. Insurance contracts having a body of law that is discrete from ordinary commercial contracts, insurance contracts are governed by the duty of utmost good faith (in the UK this is codified as the duty of fair presentation). Legal review by experienced counsel is recommended to ensure that a policy meets these regulatory criteria. The additional benefit that experienced counsel can add is that they can advise whether a policy is market standard. As insurers become more familiar with needing to meet these regulatory criteria, the wordings are becoming more user friendly. Wordings that seemed good even two or three years ago may be able to be improved for the benefit of the bank.

Size of the market

Various reports put the size of the global credit insurance market at US$9bn to $11bn in 2018. Prior to the outbreak of COVID-19 it was expected to reach $10bn to $13bn by 2025. In contrast, the value of ‘outstandings’ in the supply chain finance market is estimated to be $46bn on 60-day payment terms and estimated to be more than $1.2 trillion for Organisation for Economic Co-operation and Development (OECD) countries.

COVID-19

All reports suggest that the world is heading toward recession, if it is not there already. One does not need to be a qualified economist to have some comprehension of the magnitude of the financial impact COVID-19 has already had and will continue to have for many months to come. In all probability, there will be significant volumes of financially distressed companies in all countries, and in all sizes and sectors. Tourism and travel-related industries will be the hardest hit, along with all businesses affected by social distancing requirements, such as leisure, hospitality, retail, personal services and so on.

This level of distress will have a ripple effect into almost every other sector. There will be a significant reduction in spending while individuals and businesses focus on their very survival. What is left of any economy will depend significantly on how long COVID-19 is a real threat to society and the ability of governments to provide financial support.

What we can say with certainty is that this will result in financial distress. Buyers and obligors will default on their invoice and debt obligations.

What about insurance?

Business interruption will not cover most businesses for the interruption caused by COVID-19 as this typically requires physical damage as a triggering event. Marine cargo insurance rarely covers delays in shipments. Major events usually have event cancellation insurance (Swiss Re has reported that it will incur a loss of $250m if the Tokyo Olympics are cancelled; it is unclear what the cost of postponement will be), but most smaller events are not covered by insurance. So, insurance is not going to provide a solution for these losses.

However, although perhaps not anticipated on the scale that is likely, this is exactly the sort of situation for which credit insurance is designed. Credit insurance covers non-payment and does not consider the underlying cause of such non-payment unless the cause is excluded. The exclusion of non-payment caused by business interruption is not a standard exclusion.

While the use of credit insurance has allowed banks to diversify the risk of their trade finance portfolios, banks also need to remember that credit insurance is not a liquidity facility. All policies, except in the case of insolvency, apply a waiting period which results in a delay of five to six months and sometimes more, from non-payment by the original obligor to pay-out by the insurer.

Credit insurance is also not a back-up for poor business decisions. Non-payment of invoices for goods shipped after the manufacturer, supplier or bank was aware of the financial distress of the buyer or other circumstances that mean non-payment is foreseeable, is typically excluded. Claims need to be supported by evidence of non-payment, and, in light of market conditions, banks should expect to be able to demonstrate that they positively satisfied themselves prior to each shipment that the obligor was not under financial distress at the time of the shipment and that non-payment was not reasonably foreseeable.

Manufacturers, suppliers and banks need to pay very close attention to the financial condition of their buyers and the conditions in the shipment destination and not ship goods if non-payment is foreseeable. There will be a fine line to tread between doing what is morally necessary to keep the supply chain functioning and running the risk of default and non-payment. Banks and insurers need to work together to ensure that they are aligned – both will need each other when the world gets back on its feet.

Anna Tipping is a partner at Norton Rose Fulbright. She can be contacted on +65 6309 5417 or by email: anna.tipping@nortonrosefulbright.com.

Anna Tipping

Norton Rose Fulbright