A new era is upon us next year when Basel II comes into force worldwide, says Robert Piller, Director of Aupres Consult, in Geneva. He explains the issues that insurers should be aware of.

After years of delay, Basel II is finally coming on in full in 2008 when the advanced internal ratings-based approach kicks in. So what is in store for trade credit and political risk insurance (and by TC/PRI I would include all sectors that underwrite it – the private sector, ECAs and multilateral agencies). My answer would be: “still a lot”.

The reason for this is that in the scheme of things, not that much has actually been done in respect of TC/PRI. Hence, a number of issues remain to be uncovered. The reason is not wholly surprising – for most banks, TC/PRI is a drop of an issue in a lake of Basel II compliance issues. And the Basel Committee was realistic enough to say that not all areas within a bank would be ready at the same time and that Basel II would in practice roll out over time.

The premise of Basel II is that banks are encouraged to develop their risk management policies, procedures, models and methodologies and that national supervisors will vet these against the Basel II criteria. I do not believe that many banks will have done an adequate job of this vis-í -vis TC/PRI by January 2008.

In respect of TC/PRI as credit risk mitigation (CRM), there are two broad areas of concern: (1) the Pillar I operational criteria for guarantees and (2) the Pillar II requirements that bank must rigorously assess the effectiveness of the CRM techniques they are using.
Pillar 1 approach

These criteria are most relevant to those banks that must substitute the probability of default of the guarantor for that of the obligor (ie, those banks using the standardised and foundation internal ratings-based approaches) and those banks that opt to do so (ie, banks adopting the advanced IRB approach).

The criteria in general are concerned about clauses in the guarantee that would make the cover revocable or unacceptably conditional. The Basel II framework is rather absolute on the issue – eg, in respect of ‘unconditional’ there should be ‘no clause outside the direct control of the bank” that would allow the protection provider not to be obliged to pay in a timely manner upon the obligor’s default. Thus, if any one clause contravenes the criteria, the entire guarantee is rendered ineligible in respect of Basel II capital relief.

In a nutshell, the framework requires a rather painstaking clause-by-clause review of the guarantee. Listening to the market, there has been significant discussion, and in terms of private sector cover, in particular the Lloyd’s market, some good effort to make policies ‘Basel II-compliant’.

Any such steps are certainly steps in the right direction. It should be noted, however, that ECA and multilateral agency cover are also not exempt from these criteria. I have the distinct impression that many people have been mesmerised by the ‘zero-risk weighting’s that an ECA can offer if it represents a claim on its national government.

Certain multilateral agencies can also qualify for a zero risk weighting. I however believe that there is a significant and as yet unrecognised issue: in my view there is a significant risk that while the ECA cover is zero risk weighted, the guarantee itself may be ineligible.

I say this because virtually every ECA or multilateral agency guarantee that I have worked on has at least one clause, and often several, that potentially contravene one of the operational criteria.

As these clauses still exist at this late date (and in writing this I looked up the guarantee wording posted on the website of a particular ECA and indeed there are problematic clauses), I believe that most banks have not at all focused on this. Hence there may be some surprises to come.
Pillar II requirements

The key phrase here is ‘residual risk’. Pillar II requires that banks must assess the residual risks (legal, documentary, operational, liquidity, market risks) of the CRM they use. TC/PRI certainly present their users with legal, documentary and operational risks. If a TC/PRI provider has ever denied a claim for one of these reasons (eg, breach of warranty or non-disclosure of material information), then the TC/PRI cannot be 100% effective.

I would say that this is also true for ECA and multilateral agency cover as well as the private sector market. In fact, no TC/PRI can be 100% effective. The reason is that all policies and guarantees, even those considered most like guarantees such as the guarantees of US Ex-Im Bank, still have conditions that impose a degree of operational, legal or documentary risk on the bank.

The question is: how effective is it

  • Basel II likes to see data, but given that in general there is a lack of relevant data available that would help a protection buyer to make this assessment, banks must do so qualitatively. I believe few banks actually do this. 

    The Pillar II requirements pose a risk to the banks, the risk being that if the bank has not developed a documented, rigorous approach to assessing these instruments, its national supervisor may require the bank to put up additional capital against the insured exposures.

    So stay tuned, it’s not all over yet and there almost certainly more to come.